The High Art of Ineffective Reform

“The real truth of the matter is, as you and I know, that a financial element in the large centers has owned the government ever since the days of Andrew Jackson.” -Franklin Delano Roosevelt

The legislation signed by FDR, Glass-Steagall, delivered a stable banking system for some 50 years. One section primarily provided that financial stability. It said, simply, that commercial banks were prohibited from investing on their own account (proprietary trading). It’s worth looking at the short operative lines of the section itself:

S 16 …The business of dealing in investment securities by the association shall be limited to purchasing and selling such securities without recourse, solely upon the order, and for the account of, customers, and in no case for its own account, …

The banks of the day had functioned as both investment and commercial banks. They were given a year to decide to specialize in one or the other. After that, if they opted to be a commercial bank, Section 16 applied.

The stock market was completely unregulated. Thus, at the same time FDR created the Security Exchange Commission to oversee it.

FDR’s choice for its first chairman was controversial, Joseph P Kennedy. As journalist Michael Chevy Castranova writing in the Gazette commented: “When Franklin Delano Roosevelt called upon Joseph Kennedy in 1934 to head the newly created Securities and Exchange Commission, surely there were those for whom foxes and hen houses alarmingly came to mind”.

Whatever the basis for Kennedy’s skill, he established the SEC and brought stability to the American stock markets.

Establishment of the SEC becomes relevant to our discussion, because the derivative market—particularly the CDO and CDS—was not covered by the SEC as they were not created until much later.

Revoking the Proven Safeguards

There was once the belief that the three sectors of the financial system:

• investment banks

• commercial banks

• insurance companies

should be kept separate. Like three watertight compartments on an ocean liner. Because they had different business cycles.

If one was down, the other two might be up and counterbalance that effect on the economy. And that separation was in effect because of Glass-Steagall.

Sandy Weil, the CEO of Citibank, wanted a new financial mega supermarket, one stop financial shopping center. In 1998, in direct violation of Glass-Steagall, he arranged a merger of:

• Citibank, a commercial bank

• Salomon Smith Barney, an investment bank

• Travelers Insurance

Instead of sanctioning Citibank, the government changed the law to eliminate the walls that had separated the three financial areas by an act called The Financial Modernization Act, 1999, known popularly as Gramm Leach Bliley.

Both parties in both houses of Congress subscribed to the neoliberal idea that regulations were not needed as the markets could govern themselves. This concept ignored the painful lesson of history that was the banks’ role in the Great Depression. And so, America - now on a precipice - may be doomed to repeat it.

The deregulation bill was easily passed. When Clinton signed it, he said,

"With this bill, the American financial system takes a major step forward towards the 21st Century.”

The media were also effusive in praise of getting rid of that outdated Glass-Steagall. In a look back, Harper’s magazine quotes a New York Times editorial:

“In one stroke, Mr. Reed and Mr. Weill will have temporarily demolished the increasingly unnecessary walls built during the Depression to separate commercial banks from investment banks and insurance companies”.

The Times article concluded:

“A collapse in the company’s securities and insurance operations could drag down its commercial bank. But that will happen only if Federal regulators fall sound asleep”.

The repeal of Glass-Steagall is now accepted as laying the groundwork for the financial system collapse of 2008.

Even Sandy Weil admits that the financial supermarket concept was a serious mistake that led to the 2008 financial crisis. In his Forbes article, "Rethinking Capitalism: Sandy Weill Says Bring Back Glass-Steagall", Steve Denning, quoted an interview on CNBC's Squawk-Box:

On July 25, 2012, former Citigroup Chairman and CEO Sandy Weill, considered one of the driving forces behind the considerable financial deregulation and "mega-mergers" of the 1990s, surprised financial analysts in Europe and North America by "calling for splitting up the commercial banks from the investment banks. He called for the return of the Glass-Steagall Act of 1933, which he said had effectively led to half-a -century-free of financial crises.

Now the commercial banks had restored almost the same conditions as before the Great Depression.

• The shackles were off any restraints on their use of depositor money for thos outsized banker paychecks.

• There was an unregulated securities market in which no one could see what they were doing.

But a new danger threatened the bank executive pay cheques. A pesky small regulator, Brooksley Born, wanted to peek into that dark market. In squashing her attempt at regulating the dark CDO market, we will see the power of the banks. Not only was she completely prevented from looking into the CDO market, but every regulator was also prevented. Unbelievable? Next chapter.

Acknowledgment: Bank image: James Qube, pixabay

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