Saturday, October 15, 2005

The 1933 Glass-Steagall Act 9 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
Excessive power always creates problems: the temptation to profit personally from the power one wields, and the conflicts of interest between the various overlapping fields that one has influence in. It is the role of government to rein in such power as and when it exists in the business world.

At the turn of the 20th century it was clear to many that bankers wielded such an inordinate measure of power. Since there was no central bank in the US then, they controlled both the supply of money as well as how it was allocated. In particular, the house of Morgan (JP) was where Wall Street revolved round. The bankers controlled business financing, being both lenders of capital to business owners as well as helping to underwrite bond and equity issues. It led to a consolidation of many industries, such as steel, railroad and utilities, as bigger players with good ties with the bankers obtained favourable terms to buy over smaller peers; not a few felt that such consolidation often led to monopolistic industries and stifling of innovation. Also, bankers often sat on many company boards as a result of their upstream financing, putting them in a position to further their own interests. The Pujo governmental committee in 1912 found that the officers of three major banks (including Morgan's) held 341 directorships in 112 corporations with resources of $22B. Ultimately it led to the formation of the Federal Reserve, the de facto central bank, in 1913.

But this was only one facet of the power that bankers wielded; other important areas had not been addressed. The commercial arm of a bank had easy access to what Brandeis, one of the leading socio-economic thinkers of the times, termed "other people's money". Deposit taking was a source of easy money, that banks could channel to their investment banking arm where they could make loans to brokers, and underwrite equity or bond deals for clients who inevitably had to give them a big cut of the deal. Furthermore, banks could tie commercial loan deals with clients to other deals on the investment banking side, such as future share underwritings etc; such power was very tempting. In fact, before a central bank was established, the banks had complete control over stock market prices, since they could ratchet liquidity up and down at will through margin loan availability.

Brandeis also had also other more radical views about banks, such as banks being a "public utility", since they performed a public service and operated in the public trust; the implication was that they should be heavily regulated like ordinary utilities, such as cost-plus pricing policies. He became a Supreme Court justice in 1916, and remained an enemy of bankers with his views through the booming 1920s when times were good and nobody made efforts to change the status quo. The impetus for change was triggered by the Great Depression and the ensuing witchhunts which implicated bankers as the biggest culprits for the crash. The Pecora investigations of 1933 (a witchhunt in itself) revealed the interrelationships between the various financial institutions and the existence of "preferred lists" of clients to whom bankers extended financial privileges and sought to influence; if rich clients received favourable rates while poorer clients effectively subsidised them, it was surely contrary to the principles on which the US was built on. In 1933, President took the reins of power and the Glass-Steagal Act was passed; it was the most revolutionary banking bill ever passed (and probably to this day as well). The most significant point in the bill was that commercial banking and investment banking were to be separated; a bank could not do both. This effectively destroyed the ability of banks to both take deposits and issue securities. New firms were born: Morgan Stanley from the investment banking arm of JP Morgan (which chose commercial banking); the investment bank of First Boston from First National Bank of Boston.

Despite the initial uproar and protests from bankers that without the right to receive deposits their investment banking services would be largely compromised, and running contrary to their expectations that the Act would prove short-lived, the Glass-Steagall Act actually survived several generations and defined the path of American finance until it was repealed in 1999 by President Clinton. It had the effect of limiting bankers' influence on that most critical resource to companies: financing. Furthermore, by delinking the two, it ensured that any crisis of margin loan default by money-losing speculators on the investment banking side would not spread to the the commercial banking side and cause a run on the bank by frantic depositors; no cross-subsidising of capital across inter-linked arms would be possible now.

A mature banking industry develops with governmental regulation, and that was the primary contribution of the Glass-Steagall Act in correcting the previous no-holds-barred approach. Applying the developments described above to the Singapore context, one should be able to see the rationale for opening up the Singapore banking sector to foreign competition, and also the MAS requirement for local banks to divest of their non-banking assets by 2006. Many would have heard unpleasant anecdotes of how local banks in the past have made use of their banking and financing business to exert financial pressure on companies whose assets they have then seized to augment their non-banking divisions. Such possibilities are endless and that is why they must be nipped in the bud.

(1) Wall Street A History (by Charles R. Geisst)
(2) Wikipedia entry: Glass-Steagall Act




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