ThoughtNGine

The Power of Ideas

Let’s Revisit Glass-Steagall

Prior to the stock market crash of 1929, financial institutions could offer both commercial and investment banking services to their customers.  This created conflicts of interest that, in part, were to blame for the crash.  To address this, Congress passed the Glass-Steagall Act in 1933.  Thereafter, either you were a commercial bank or you were an investment bank.

In the ensuing seven decades, financial institutions and their lobbyists worked hard to limit the scope and effect of Glass-Steagall.  Finally, in 1999 what remained of this Act was repealed in its entirety.  I find it very interesting that not even a decade has passed and we are already in the midst of a major financial crisis whose depth and extent can be traced to the fall of Glass-Steagall; and I am not talking about the sub-prime mess (although the lack of boundaries between investment and commercial banking may have made these problems worse).

Over the last eighteen months, leveraged buyout and takeover activity has exploded.  Competition between financial institutions for the advisory and underwriting fees is fierce.  With large balance sheets, commercial banks try and win these mandates by funding these transactions directly or by providing funding guarantees.  Until recently, these transactions went smoothly.  Banks had no difficulty distributing this risk.

This summer turned out to be a different story.  The funding for several large deals (in particular, the Chrysler buyout and the KKR acquisition of Boots/Alliance) could not be completed.  Having committed to backstop these deals, major commercial banks found themselves swimming in tens of billions of dollars of unwanted bridge loans.  The capital markets were brought to their proverbial knees.  Borrowers of all sorts found their access to capital drying up and the cost of funding exploding (measured by the spread to risk-free government debt securities).  Equity markets swooned.  Treasury officials and central bankers were forced to take emergency measures, offering various types of life-preservers to the beleagured banking system.

While these emergency measures have had some positive effect, markets are still skittish.  Concerns about the adverse impact on the global economy has grown.  This week the U.S. Federal Reserve is expected to provide more relief by cutting rates.

Maybe we should not have been in this mess in the first place.  Large fee income is too alluring to large financial institutions.  When the dollars are large enough, it is easy for management to rationalize the conflicts as necessary and view the risk as manageable.  We have learned the hard way before that this is not the case.  Let us pay heed to Santayana and learn before we make the same mistake again.

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September 15, 2007 - Posted by | Economics, Finance, General Interest, Politics

4 Comments »

  1. What do you ascribe the performance to the stock market to? Obviously US stocks have become more volatile of late and are off their highs, but indexes remain closer to 52 week highs than lows. Profitability seems to be slowing down, and the bond and futures markets are all but forecasting recession…Is money still too easy? weak dollar bringing in foreign cash? are the stocks looking beyond local turmoil (is this all just a bump in the road)? or is the takeover/LBO engine poised to make a comeback? something else?

    Comment by Andrew Schulman | September 15, 2007

  2. Thanks NG…nice to read a new voice…Any opinions as to why the US stock markets have faired so well during all of the upheaval? There’s certainly been a lot more volatility, but indexes remain closer to highs than 52 week lows. Corporate profitability seems to be sliding…bond/futures markets are all but forecasting recession…

    Still easy cash? foreigners buying on the back of cheap dollars? LBO engine going to heat up again (even without access to easy financing)? stock just think this is all a bump in the road? other theories?

    Thanks

    Comment by Andrew Schulman | September 17, 2007

  3. While it is true that the banks, both commericial and investment, have gotten themselves in a bind by providing financing to LBO transactions, I’m not sure what this has to do with the repeal of the Glass Steagall banking laws. While not a lawyer or legal historian, as I understand it, the original intent of that legislation was to prohibit commercial banks from selling securities to its retail clients to the benefit of its wholesale/commerical lending practice. It was, in essence, a prohibitation created to protect retail clients from a conflict of interest. To the best of my knowledge, there have been no accusations of commercial banks pushing leverage loan transactions to their depositors, so I’m not really sure that the current market jitters would have been prevented or altered if Glass Steagall was still on the books.

    Comment by Mrock | September 17, 2007

  4. While it is true that the banks, both commericial and investment, have gotten themselves in a bind by providing financing to LBO transactions, I’m not sure what this has to do with the repeal of the Glass Steagall banking laws. While not a lawyer or legal historian, as I understand it, the original intent of that legislation was to prohibit commercial banks from selling securities to its retail clients to the benefit of its wholesale/commerical lending practice. It was, in essence, a prohibitation created to protect retail clients from a conflict of interest. To the best of my knowledge, there have been no accusations of commercial banks pushing leverage loan transactions to their depositors, so I’m not really sure that the current market jitters would have been prevented or altered if Glass Steagall was still on the books.

    Comment by Mrock | September 18, 2007


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