Exploring the Real Roots of our Financial Meltdown

A lot of accusations are flying over who is to blame for the our financial mess, but I think you can make a good case that the root of the problem lies in the long struggle to deregulate the financial markets.  A White House official said the other day that the problem is that we have a “21^st Century financial system” laboring under regulations put in place in the ‘30s.  In light of this completely disingenuous statement, I thought it would be interesting to look at the decades-long effort to remove the protections afforded by that scorned “1930s regulation,” the Glass-Steagall Act. 

The lynchpin of bank regulation, the Glass-Steagall Act, was passed in 1933, named for the two Democrats who introduced it.  Its aim was to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds.  The act also established the Federal Deposit Insurance Corporation (FDIC) and strengthened the Federal Reserve's control over credit.

In 1956, restrictions on banks, including their ability to engage in non-banking activity, were extended by the Bank Holding Company Act. 

By the ‘60s, banks were spending heavily for Congressional permission to get into muni bonds.  They failed, but in the 1970s some brokerage firms began to offer interest-bearing money-market accounts that allowed check-writing, and offered credit or debit cards – bankers’ territory!

In December 1986, the Fed reinterpreted Section 20 of the Glass-Steagall Act: banks could now have up to 5 percent of gross revenues from the investment banking business and could for the first time do some underwriting. The camel’s nose was in the tent.

In the spring of 1987, Citigroup, J.P. Morgan and Bankers Trust convinced the Fed to further ease regulations despite the opposition of Chairman Paul Volcker. Banks were allowed to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities.

The Fed argued that "a very effective" SEC, knowledgeable investors, and "very sophisticated" rating agencies would check corporate misbehavior. (Insert irony here) Volcker feared that lenders would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.  

In August 1987, Alan Greenspan -- formerly a director of J.P. Morgan and a fan of banking deregulation -- became chairman of the Federal Reserve Board, and In January 1989, the Fed Board expanded the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. Later it raised the revenue limit for underwriting to 10 % of revenues.

In 1990, the Fed allowed J.P. Morgan to underwrite securities, so long as its underwriting business did not exceed the 10 percent limit.

In 1984 and 1988, the House blocked Senate bills that would lift major restrictions under Glass-Steagall.  In 1991, the Bush administration proposed its repeal, but this, too, was defeated in the House.   More attempts to kill Glass-Steagall also fail.

In December 1996, Greenspan’s Fed issues a “precedent-shattering” decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting (up from 10 percent).  Glass-Steagall is now effectively obsolete, since any bank could easily meet this requirement.

In August 1997, the Fed decided that the risks of underwriting had proven to be "manageable," and allowed banks to acquire securities firms outright.  This despite the fact that Glass-Steagall remained law!  Never mind: money is the trump card.

Banks weren’t slow to move, and by 1998 the envelope was pushed further. Travelers, which owned Salomon Smith Barney, merged with Citicorp and formed Citigroup, the world's largest financial services company.  Insurance, banking, brokerage: the kind of mix that the law meant to prevent.

So the question was, what to do about Glass-Steagall? Well, Congress would just have to change the law, which it had been trying to do for 20 years.  PR and lobbying firms went right to work, urging Congress to replace Glass-Steagall with “the Financial Services Modernization Act of 1999.”

The House Republican leadership wanted to ram it through, worried that the mid-term elections would bring in unsympathetic Democrats, but the session ended before it could be passed.  Lobbyists joked – predicted is a better word – that this issue would spark another round of political fund-raising.  About $150 million worth, as it turned out.

Finally, after 25 years and more than $300 million in lobby money, Glass-Steagall is repealed and the new law is signed by President Clinton.

And the stage was set for the crisis we are trying to manage today.