This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, April 28, 2010

Reflections on Glass-Steagall

It’s been pretty difficult lately – not impossible, but certainly difficult – to miss the headlines and news stories surrounding what is being called the “Death of Goldman Sachs.” It seems that the powers-that-be in Washington, with ambitions of widespread financial reform, are touting revelations of “conflicts of interest” as the hangman’s-noose for Goldman.

The revolutionary new idea being thrown around now is the novel notion that investment banking (dealing in securities) might need to be separated from commercial banking (taking deposits).

What’s really funny about this startling revelation is that these exact conditions existed for nearly 70 years as a result of legislation passed directly following the Great Depression, in order to prevent such conflicts of interest. Under the Glass-Steagall Act, which was signed into law in 1933, speculation by banks was strictly controlled through the simple division of functions.

What also seems funny is that, in the nearly 70 years operating under Glass-Steagall, which was enacted to limit that kind of speculation that led to the market crash in 1929, the banking system in this country didn’t experience a single major crisis as a result of speculation. Note: There was the Savings & Loan Crisis of the 1980’s, which resulted from a mismatch in bank loans versus deposits, not speculation.

However, in 1999 a Republican-led Congress, spurned by then-Treasury Secretary Robert Rubin, decided to repeal the Glass-Steagall Act, thinking it was outdated. A new piece of legislation, which repealed Glass-Steagall, was signed by President Bill Clinton that same year.

The repeal of Glass-Steagall, with its deep impact in the American financial system, was a long time coming. Since the 1980s the banking industry had lobbied politicians for its repeal, during which time Robert Rubin actually worked in the banking sector. Among other capacities, Mr. Rubin is the former head of (drum-roll please) Goldman Sachs. Surprise, surprise!

Interestingly enough, in 1987, in response to cries from the banking industry to repeal such a repressive law as Glass-Steagall, the Congressional Research Service prepared a report in that concluded with a list of pros and cons of the Act. Given what has happened in the banking world since 1999, they’re definitely worth a read.

The Congressional Research Service, in its 1987 report, listed the following reasons for “preserving” the Glass-Steagall Act:

  1. Conflicts of interest characterize the granting of credit – lending – and the use of credit – investing – by the same entity, which led to abuses that originally produced the Act.
  2. Depository institutions possess enormous financial power, by virtue of their control of other people’s money; its extent must be limited to ensure soundness and competition in the market for funds, whether loans or investments.
  3. Securities activities can be risky, leading to enormous losses. Such losses could threaten the integrity of deposits. In turn, the Government insures deposits and could be required to pay large sums if depository institutions were to collapse as the result of securities losses.
  4. Depository institutions are supposed to be managed to limit risk. Their managers thus may not be conditioned to operate prudently in more speculative securities businesses…

The same report from the Congressional Research Service found the following reasons for repealing Glass-Steagall:

  1. Depository institutions will now operate in “deregulated” financial markets in which distinctions between loans, securities, and deposits are not well drawn. They are losing market shares to securities firms that are not so strictly regulated, and to foreign financial institutions operating without much restriction from the Act.
  2. Conflicts of interest can be prevented by enforcing legislation against them, and by separating the lending and credit functions through forming distinctly separate subsidiaries of financial firms.
  3. The securities activities that depository institutions are seeking are both low-risk by their very nature, and would reduce the total risk of organizations offering them – by diversification.
  4. In much of the rest of the world, depository institutions operate simultaneously and successfully in both banking and securities markets. Lessons learned from their experience can be applied to our national financial structure and regulation

Isn’t it funny that the Congressional Research Center cited, as a reason for repealing Glass-Steagall, that “conflicts of interest can be prevented by enforcing legislation?” As we seen in since 1999, this obviously this isn’t the case. After all, this isn’t the role of regulators; as we’ve discussed previously, the role of regulators is to show up after an incident occurs to clean-up the mess and decide who to prosecute.

It seems so ironic today to hear political pundits discuss the need for sweeping “financial reform,” and nearly every single talking point is straight out an Act that successfully protected the American financial system against excess speculation for nearly three-quarters of a century. Yet, instead of pushing for restrictive banking laws that make sense, like Glass-Steagall, folks on Capitol Hill insist on trying to create new committees and agencies to make sure others are doing their job.

Unfortunately, as we all know, growing government will only make things worse. It’s about time to skip the pleasantries and get down to business with big banks. For 70 years this country had a system that works; and we abandoned it because of some large, well-placed political connections and contributions. It’s just about time we put banks back in their place, and cut the strings they hold in Washington. No more teachers, no more books; no more bailouts, no more crooks.

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