Liquidity Bust Bypasses the Banking System

Henry C.K. Liu

Part I: The Rise of the Non-bank Financial system

Part II: Bank Deregulation Fuels Credit Abuse

This article appeared in AToL on September 6, 2007


Federal Reserve data show that the outstanding stock of US commercial paper has fallen by $255 billion or 11% over the last three weeks, a sign that many borrowers have been unable to roll over huge amounts of short-term debt at maturity. Asset-backed commercial paper (ABCP), which accounted for half the commercial paper market, tumbled $59.4 billion to $998 billion in the last week of August, the lowest since December. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest rated asset-backed paper due by August 30 rose 0.11 percentage point to a six-year high of 6.15%.

Some analysts are comparing the current collapse of the CP market to the sudden drain on liquidity that occurred at the onset of the 2001 dotcom bust. Others are comparing the current crisis to the 1907 crash when large trusts did not have access to a lender of last resort as the Fed had not yet been established. Still others are comparing the current crisis to the 1929 crash when the Fed delayed needed intervention.

Today, key market participants who dominate the credit market with unprecedented high level of securitized debt operate beyond the purview of the Fed in the non-bank fiancial system and these market participants do not have direct access to a lender of last resort when a liquidity crisis develops except through the narrow window of the banking system.

Banks Get No Respect from Non-Bank Debt Markets

Banks are now unhappy about capital and debt markets where they are no longer getting respect. Market analysts have been crediting capital and debt markets for the long liquidity boom, rather than bank lending. Banks’ share of net credit markets, according Fed data on flow of funds, dropped from a peak of over 62% in 1975 to 26% in 1995 and still falling rapidly, while securitization’s share rose from negligible in 1975 to over 20% in 1995 to over 60% in 2006 and still rising rapidly, with insurers and pension funds taking the rest.

Debt securitization in the first half of 2007 stood at over $3 trillion up from $2.15 trillion in 2006, $375 billion in 1985 and 156 billion in 1972.  About $1.2 trillion are asset-backed securities. The biggest issuers are: Countrywide, $55 billion; Washington Mutual, $43 billion; General Motors Acceptance Corporation (GMAC), $40 billion.  Big bank issuers are: JPMorgan/Chase, $38 billion; Citibank, $29 billion; Barclays Bank, $29 billion. Big brokerage issuers are: Lehman Brothers, $37 billion; Merrill Lynch, $31 billion, Bear Sterns, $31 billion; Morgan Stanley, $26 billion.  Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 Asian financial crisis primarily because of an underdeveloped debt securitization market.

The DOW and Interest Rates

In February 2000, the Dow closed below 10,000 - a psychological bench mark from a peak of 11,723 just 4 weeks earlier, and 10,000 was only a transitional barrier.  Some bears predicted lack of support until 8,000. It was the first retreat from the 10,000 mark in 10 months, off 14.22% for the year, while the broader S&P 500 lost 9.25%. On September 17, the DJIA fell 684.81 points to close at 8,920.70, largest dollar loss in history, down 7.13%. On October 9, the DJIA fell 215.22 points to close at 7,286.27.  The market had declined 4,436.71 points, or 38%, from January 14, 2000 when it rose 140.55 to close at all time high of 11,722.98, first close above both 11,600.00 and 11,700.00.

On May 16, 2000, the Fed Funds rate was raised to 6.5%. After that, the Fed began lowering it on January 3, 2001 thirteen times to 1% on June 25, 2003 and held it there below inflation rate for a full year, unleashing the debt bubble. On July 19, 2007, the DJIA closed at 14,000.41, reaching a new all time high. The DJIA rose 6,714 points, or 92%, since the low point of 7,286.27 on October 9, 2002, in 4 years and10 months. The GDP rose from $10.5 trillion in 2002 to $13.2 trillion in 2006, a rise of 30%. Asset prices outpaced economic growth by a multiple of 3 during that period.

This extraordinary divergence shows more than the different economic fundamentals of the old and new economy.  It shows the financial effect of a shift of importance from banks as funding intermediaries to the exploding capital and debt markets, in which with the advent of structured finance, the line between equity and debt has been effectively blurred.

Greenspan’s Forked-Tongue Policy Pronouncements

NASDAG companies rely less on banks for funds and were thus less affected by Greenspan’s threats of interest rate hikes.  Greenspan had been vocal in explaining that his monetary policy moves of rising Fed Funds rate targets were not specifically targeted towards “irrational exuberance” in the stock markets, but toward the unsustainable expansion of the economy as a whole.  But data show that the economy did not expand at the same rate as the rise of equity prices.  Economic growth would be more sustainable without irrational exuberance in the stock market.

With the same breath, Greenspan decried the dangers of the wealth effect if it ever ends up heavier on the consumption side than on the investment side. It was a curious position, as most Greenspans positions seem to be. The Greenspan gospel says asset inflation is good unless it is spent rather than used to fuel more asset inflation.  He continued to restrain demand in favor of supply in an already overcapacity economy.

The need for demand management was argued by post-Keynesian economists who had been pushed out of the mainstream in recent decades by supply-siders. In housing, Greenspan was trapped in a classic dilemma of not knowing if housing is consumption or investment. Homeowners have been living in an asset (thus consuming it) that rises in market value faster than the rise of their earned income. Home equity loans enabled homeowners to monetize their housing investment gains to support their non-housing consumption. It is hard to see how home prices rising higher than homebuyers can afford to pay for them can be good for any economy. Yet the Fed celebrates asset price appreciation for shares and real estate, but treats wage rise like a dreaded plague.

Bifurcated Markets

The so-called “bifurcated” market indexes of the tech boom of the early 2000s indicated clearly that the Fed, whose sole monetary weapon being the Fed Funds rate, lost control of the new economy which appears impervious to short-tem interest rate moves.  Under such conditions, the only way the Fed could restrain unsustainable economic expansion in one sector was to overshoot the interest rate target to rein in an impervious Nasdaq at the peril of the whole economy.  Interest sensitive stocks were battered badly in 2000, including banks and non-bank lenders, such as GE, GMAC and Amex. This forced to Fed to aggressively ease subsequently to keep Fed Funds rate at 1% for a whole year from June 2003 to June 2004 to create the housing bubble. With inflation rate at 2%, the Fed was in effect giving borrowers a net payment of $1,000 for every $100,000 borrowed between 2002 and 2003.

The Peril of Uneven Profit Sharing

Financial services companies, including commercial banks, brokerage firms and mortgage lenders, investment bank and non-bank financial companies such as GE and GMCC, had since produced some of the biggest profits in the recent bull market fueled by a liquidity boom. The trouble with the financial sector making the bulk of the profit in the debt economy is that when newly created wealth is unevenly distributed to favor return on capital rather than through rising wages, it exacerbates the supply-demand imbalance which can only be sustained by a consumer debt bubble. The public have insufficient income to consume all that the debt economy can produce from over investment except by taking on consumer debt and home equity debt.

Liquidity Crunch Only Early Symptom

In recent weeks, the combination of sudden rise in interest rates due to a liquidity crunch and the hefty leverage employed by businesses in the financial sector has proved to be fatally hazardous to company cash flow and stock prices. Money center banks and broker dealers, along with their hedge fund customers are most vulnerable because they are most exposed to interest-rate-related risks through products such as interest rate swaps, default swaps and securitized mortgages. But this was just an early symptom, like an initial wave of high fever.

Lipper TASS reports that institutional and wealthy private investors poured $41.1 billion into hedge funds in the second quarter of 2007, which through performance gains swelled industry assets to an estimated $1.67 trillion by the end of June. The aggregate hedge fund performance of 5.19% by June 30 did not surpass market indices rise for the period. The S&P 500 returned 6.28%, while the MSCI World TR returned 6.71%. The biggest inflows were for market-neutral long-short equity strategies, which gained $14.9 billion, followed by event-driven funds, which gained $12.2 billion. Multi-strategy funds gained $6.1 billion during the period. Strategies that posted net outflows included global macro funds, which bet on world currencies and sovereign debt and were down by $848 million, and managed futures, which were down by 686.7 million.  Losses of this scale are bound to have structural effects.

The Credit Derivatives Overhang

The most popular of all derivative products is the interest rate swap, which essentially allows participants to make bets on the direction interest rates will take. According to the Office of the Comptroller of the Currency, interest rate swaps accounted for three out of four derivative contracts held by commercial banks at the end of 1999. The notional value of these swaps totaled almost $25 trillion; 2-3% of that reflected the banks’ true credit risk in these products, or between $500 billion to $700 billion. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. A 1% move in interest rate would alter interest payment in the amount of $4 trillion, albeit much the payments would be mutually canceling, unless in the case of counterparty default.

Comptroller of the Currency Quarterly Report on Bank Derivatives Activities shows that US commercial banks generated a record $7 billion in revenues trading cash and derivative instruments in first quarter of 2007, up 24% from the first quarter of 2006, which at $5.7 billion had been the previous record. Revenues in the first quarter were 82% higher than in the fourth quarter. Net current credit exposure, the net amount owed to banks if all contracts were immediately liquidated, decreased $5.3 billion from the fourth quarter to $179.2 billion. The data for the third quarter of 2007 are expected to be very negative to reflect market turmoil since July.

The notional amount of derivatives held by US commercial banks increased $13.3 trillion to $144.8 trillion in the first quarter of 2007, 10% higher than in the fourth quarter and 31% higher than a year ago. Bank derivative contracts remain concentrated in interest rate products, which represent 82% of total notional value. The notional amount of credit derivatives, the fastest growing product of the global derivatives market, increased 13% from the fourth quarter 2006 to $10.2 trillion in first quarter in 2007. Credit default swaps represent 98% of the total amount of credit derivatives. Credit derivatives contracts are 86% higher than at the end of the first quarter of 2006. The largest derivatives dealers continue to strengthen the operational infrastructure for over-the-counter derivatives through a collaborative effort with financial supervisors, the OCC reports calims. Still, counterparty risk remains problematic.

Derivatives of all kinds weigh heavily on banks' capital structures. But interest rate swaps can be especially toxic when interest rates rise. And since only a few business economists predicted a jump in rates for the first half of the year when 1999 began -- in fact, yields have risen 25% -- these institutions now find themselves on the wrong side of an interest rate gamble. Moreover, as interest rates rise, bank income diminishes from interest-rate-related businesses like mortgage lending. Interest-sensitive sources of income will be the revenue disappointments in 2008, as in 2000, and as trading was in 1999.

Hedging Feeds Risk Appetite

The impact of the demised of the Nasdaq index on the wealth effect was not total.  Investment banks pitched to high tech/internet founders and early shareholders to hedge capital gains by signing away future upsides.  For those high tech swimmers who took advantage of the offers, this amounted to second layer swimming trunks that allowed them to lose the top layer without risking being caught naked when the tide receded suddenly.  It was the financial version of a flat-proved tubeless tire that can get you to the next gas station or 30 miles (whichever is closer) in the event of a puncture.  It does not, however, guarantee the driver the existence of a gas station that has not been forced to close from operational losses within 30 miles.

Meanwhile, pension funds were forced to jettison their old fashioned balanced portfolios in favor of structured finance strategies to seek higher returns. What the Greenspan Fed did was to penalize the general public by devaluing their future pension cash flow for the sins of the aggressively investing rich who continue to add to their wealth with Greenspan’s blessing as long as the risks of high returns are passed on to the system as a whole. This is what American economic democracy has come to.

Investor Confidence Low

Investors worldwide are unconvinced that the US Federal Reserve could succeed in stabilizing the US commercial paper market, the latest and so far biggest shoe to drop in the spreading contagion from US sub-prime mortgages. Banks are suddenly exposed to unexpected risks as US asset-backed commercial paper shrank by its biggest weekly percentage since November 2000 as investors shunned debt linked to mortgages and opted for the safety of Treasuries.

This means that investors prefer to lend money to the US government despite historically high levels of fiscal deficit and national debt, than to financial institutions that seek profit from interest rate arbitrage.  Market preference for speculative investment has vanished. Banks are suddenly holding the bad end of a massive amount of speculative debt instruments. When new commercial paper is not sold to roll over the maturing debt, borrowers must draw on bank credit at higher interest cost to prevent default, leaving banks with riskier debts that the market has rejected.

Fed Accepts ABCP as Discount Window Collateral

In the week to August 22, after the Fed lower the discount rate by 50 basis points to 5.75% on August 17, banks borrowed a daily average of only $1.2 billion from the Fed discount window, suggesting that banks were still unsure how to use the facility to lend to distressed clients. Officials at the New York Fed, the central bank’s liaison with Wall Street, received inquiries from commercial banks in recent days on whether their clients' asset-backed commercial paper could be pledged as collateral at the discount window.

The New York Fed issued a statement “in response to specific inquiries” from money-center banks on Friday, August 24, that it “has affirmed its policy to consider accepting as collateral investment quality asset-backed commercial paper (ABCP)” for discount-window loans to ease the liquidity crisis faced by the banks to try to calm a essential part of the money market the orderly functioning of which is critically needed to lubricate financial markets. But the statement only trimmed slightly the abnormally high average ABCP yield to 6.04%, still roughly 80 basis points higher than normal even for those borrowers who could sell commercial paper at all, which normally would be at rates close to the Fed funds rate of 5.25%.

Fed Exempts Banks from Lending Limits to Broker Dealer Subsidiaries

On the same day, the Fed eased regulations governing the relationship between Citibank NA, the US bank subsidiary of Citigroup Inc, and its broker-dealer subsidiary, Citigroup Global Markets Inc. The regulatory exemption allows Citibank to lend up to $25 billion to customers of the broker-dealer. Bank of America Corp. received a similar ease.

Section 23A of the Federal Reserve Act and the Fed Board’s Regulation W limit the amount of “covered transactions” between a bank and any single affiliate to 10% of the bank’s capital stock and surplus and the amount between a bank and all its affiliates to 20%.

The two banks proposed to extend to market participants in need of short-term liquidity to finance their holdings of certain mortgage loans and highly rated mortgage-backed and other asset-backed securities (Assets).  The banks proposed to channel these transactions through their respective Affiliated Broker-Dealers in the form of either reverse repurchase agreements or securities borrowing transactions (collectively, “securities financing transactions or “SFTs”).  Because the banks proposed to engage in SFTs with their respective Affiliated Broker-Dealers in amounts that exceeded the banks’ quantitative limits under the statute and rule, the banks must receive exemptions from the Fed to engage in the proposed transactions. The banks have agreed to limit their lending under the exemption to $25 billion which will constitute less than 30% of each bank’s total regulatory capital.

The Fed has allowed Citibank and Bank of America exemption to exceed the level limited by banking regulations to 10% of the bank’s capital. Lending the full $25 billion represents close to 30% of Citibank’s total regulatory capital.  The Fed explained that it made the exemption in the public interest, because it allows Citibank to get liquidity to the brokerage in “the most rapid and cost-effective manner possible” which ironically contradicts the Fed’s earlier explanation on “restoring orderly markets” by changing discount window procedures.

The two banks, along with JPMorgan Chase & Co. and Wachovia Corp., borrowed a total of $2 billion two days earlier in a symbolic show of support for the Fed’s anemic actions, while noting they still had access to cheaper funding than the new discount rate of 5.75%.

Until the repeal of the Glass-Steagall Act, banking regulation prohibited banks with federally insured deposits from operating brokerage subsidiaries. In the early part of the last century, individual investors had been repeatedly damaged by banks whose overriding interest was to profit from promoting stocks held by banks, rather than to enhance the interest of individual investors or protect the security of its depositors. After the 1929 market crash, regulators sought to limit the conflicts of interest created when commercial banks underwrote stocks or bonds which contributed to abuses that caused market crashes. A new law, known as the Glass-Steagall Act, banned commercial banks from underwriting securities, forcing banks to choose between being a regulated lender of high prudence or an underwriter-broker with high risk appetite. The law also established the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthens the Federal Reserve’s control over credit.


The 1933 Glass-Steagall Act became a key pillar of banking law by erecting a regulatory wall between commercial banking and investment banking. The law kept banks from participating in the equity markets, and equity market participants from being banks. The relevant measure of the Glass Steagall act is actually the Bank Act of 1933, containing the provision erecting a wall separating the banking and securities businesses. It also left a small lope hole to allow the Federal Reserve to let banks get involved in the securities business in a limited way to relieve otherwise cumbersome operation.

The Glass-Steagall Act was born in the 1933 depression. Media reports as summarized in a Public Television Service Front Line chronology of the life of the Glass-Steagall Act showed  the banking system as being in shambles with over 11,000 banks having failed or had to merge, reducing the number of surviving banks by 40%, from 25,000 to 14,000. The governors of several states closed their state banks and in March, President Roosevelt closed briefly all the banks in the country. Congressional hearings conducted in early 1933 concluded that the trusted professional of the financial markets: the bankers and brokers, were guilty of disreputable and dishonest dealings and gross misuses of the public trust. Historians, while acknowledging the role of malfeasance, now understand that the chief culprit of bank failures was structural, with inadequate regulations that permitted market abuse to become regular practice. Unethical practices were legal and competition was conducted with the law of the financial jungle.

The Banking Act of 1933 was the newly-elected Roosevelt administration response to the perceived shambles of the nation’s financial and economic system. But the Act did not address the structural weakness of the US banking system: unit banking within states and the prohibition of nationwide banking. This structure is a key reason for the failure of many US Banks, some 90% of which were unit banks with under $2 million in assets. The Act instituted deposit insurance and the legal separation of most aspects of commercial and investment banking, the principal exception being allowing commercial banks to underwrite most government-issued bonds.

Carter Glass was then a 75-year-old senator who physically stood only 5 feet 4 inches but historically a towering figure. A former Treasury secretary, he was a founder of the Federal Reserve System and a vocal critic of banks that engaged the risky business of investing in stocks. He wanted banks to stick to conservative commercial lending, and he exploited traditional anti-bank sentiments to push through changes. Henry Steagall, a rural populist from Ozark, Alabama, was Democratic chairman of the House Banking and Currency Committee, signed on to the bill to attach an amendment which authorized bank deposit insurance.

Senator Glass was convinced that bank should not be involved with securities underwriting or investment as such activities violate basic rules of good banking. As intermediary custodian of money, bank involvement in equity markets will lead to destructive speculation, as evidenced by the Crash of 1929 with its bank failures and the subsequent Great Depression.

Curbing the natural monopolistic tendency of banks has been a common legislative theme throughout US history until the recent onslaught of economic neo-liberalism. During the 1930s and 1940s, banks stayed regulated to stay within the basics of taking deposits and making secured loans funded by deposits. Congress did not intervene until 1956, when it enacted the Bank Holding Company Act to keep financial-services conglomerates from amassing excessive financial power. That law created a barrier between banking and insurance in response to aggressive acquisitions and expansion by TransAmerica Corp., an insurance company that owned Bank of America and an array of other financial services businesses. Congress thought it improper for banks to risk possible losses from underwriting insurance. While many banks today can sell insurance products provided by insurers, banks are not permitted to take on the risk of underwriting.

TransAmerica and the 1956 Bank Holding Company Act

Transamerica began when a young entrepreneur named A. P. Giannini started a small bank known as the Bank of Italy, later to be known as Bank of America. Giannini acquired Occidental Life Insurance Company through TransAmerica Corporation in 1930. In 1956, Congress passed the Bank Holding Company Act, which prohibited a company from owning both banking and non-banking entities. The company decided to divest itself of its bank holdings and keep its core life insurance businesses and related services under the Transamerica name. As a financial conglomerate, it acquired motion picture studio and distributor United Artists, Trans International Airlines, and Budget Rent A Car.

The Rise and Fall of Conglomerate

As private equity is the rage today, conglomerates were the new trend in the 1960s exploiting a combination of low interest rates and recurring alternative cycles of bear/bull markets, which allowed the conglomerates to buy companies in leveraged buyouts at temporarily deflated values with loan at negative real interest rates. As long as the acquired companies had profits greater than the interest on the loans used to buy them, the overall leveraged return on investment (ROI) of the conglomerate grew spectacularly, causing the conglomerate’s stock price to rise sharply within short periods. High stock prices allowed the conglomerate to borrow more loans without altering its debt to equity ratio, with which to acquire even more companies. This led to a chain reaction that allowed conglomerates to grow very rapidly.

But when interest rates finally rose to catch up with inflation, conglomerate ROI fell when anticipated “synergies” from owning diversified businesses failed to live up to expectation and conglomerate shares fell in market value, forcing them sell off recently acquired companies to pay off loans to maintain required debt to equity ratio. By the mid-1970s, most conglomerates had been dismantled, as many private equity deals are expected to in coming months.

The Case of GE

During the 1980s, GE, traditionally an engineering and manufacturing company, moved into finance and financial services to become today the largest conglomerate with $400 billion in market capitalization. Finance in 2007 accounted for about 45% of the company’s net earnings. But in the 1980s, the GE business model was the opposite of the “typical” 1960s conglomerate in that it employed interest rate hedges to sell commercial paper so that when interest rates went up, GE was able to offer leases on equipment that were less expensive than buying using bank loans. In 2003, GE Capital acquired TransAmerica Finance from Aegon, which retained the rest of TransAmerica. In 2004, GE subsidiary NBC acquired the entertainment assets of bankrupt Vivendi Universal, excluding Universal Music, to form NBC Universal, of which General Electric owns 80%.

General Electric Capital Corporation (GE Capital) is a global, diversified financial services company that engages in commercial finance, consumer finance, equipment management and insurance. One of only seven non-financial companies to be rated “triple A” for credit worthiness, GE Capital is one of the worlds largest issuers of commercial paper.

GE Commercial Finance offers an array of products and services aimed at enabling businesses worldwide to grow. Its services include loans, operating leases, fleet management and financial programs with 2006 revenue of $23.8 billion and 17% profit margin, with 22,000 employees worldwide.

GE Industrial provides a broad range of products and services throughout the world, including appliances, lighting and industrial products; factory automation systems; plastics, and sensors technology; non-destructive testing and equipment financing; and management and asset intelligence services. 2006 revenue was $33.5 billion with a profit margin of 5% with 85,000 employees worldwide.

GE Money provides home loans, insurance, credit cards, personal loans and other financial services for more than 130 million individual customers. 2006 revenue was $21.7 billion with a profit margin of 15% with 50,000 employees worldwide. Product offered include corporate travel and purchasing cards, credit cards, debt consolidation, home equity loans, mortgage and motor solutions and personal loans to individual consumers and retail clients such as auto dealers and department stores.

NBC Universal is one of the world's leading media and entertainment companies in the development, production, and marketing of entertainment, news and information to a global audience. Formed in May 2004 through the combining of NBC and Vivendi Universal Entertainment, NBC Universal owns and operates a valuable portfolio of news and entertainment networks, a premier motion picture company, significant television production operations, a leading television stations group and world-renowned theme parks. NBC Universal is 80-percent owned by General Electric and 20-percent owned by Vivendi.

GE share repurchase program increased to $14 billion for 2007, with $12 billion expected to be completed between now and year end.

The Repeal of Glass-Steagall

Repeated unsuccessful attempts were made since 1933 by commercial bankers and sympathetic regulators to repeal or draft exceptions to those sections of Glass-Steagall Act that mandate separation of commercial and investment banking. As a result, the US and Japan, which was forced to adopt laws similar to the US Banking statues after the Second World War, alone among the world’s major financial nations, legally require this separation. Japanese banks can engage in many securities activities, however, including underwriting and dealing in commercial paper and ownership of up to 5 percent of non-bank enterprises.

Glass-Steagall commonly referred to those sections of the Banking Act of 1933 that deal with bank securities operations: sections 16, 20, 21, and 32. These four sections of the Act, as amended and interpreted by the Comptroller of the Currency, the Federal Reserve Board and the courts, govern commercial bank domestic securities operations.

Sections 16 and 21 refer to the direct operations of commercial banks. Section 16 as amended generally prohibits Federal Reserve System member banks from purchasing securities for their own account. But a national bank (chartered by the Comptroller of the Currency) may purchase and hold investment securities (defined as bonds, notes, or debentures regarded by the Comptroller as investment securities) up to 10 per cent of its capital and surplus. Sections 16 and 21 also forbid deposit-taking institutions from both accepting deposits and engaging in the business of “issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stock, bonds, debentures, notes or other securities”, with some important exceptions. These exceptions include US Government obligations, obligations issued by government agencies, college and university dormitory bonds, and the general obligations of states and political subdivisions. Municipal revenue bonds (other than those used to finance higher education and teaching hospitals), which are now issued and traded in larger volume than general obligations, are not included in the exceptions, in spite of the attempts of commercial banks to have Congress amend the Act. In 1985, however, the Federal Reserve Board decided that commercial banks could act as advisers and agents in the private placement of commercial paper.

Section 16 permits commercial banks to purchase and sell securities directly, without recourse, solely on the order of and for the account of customers. In the early 1970, the Comptroller of the Currency approved Citibank’s plan to offer the public units in collective investment trusts that the bank organized. But in 1971, the US Supreme Court ruled that sections 16 and 21 prohibit banks from offering a product that is similar to mutual funds. In an often quoted decision, the Court found that the Act was intended to prevent banks from endangering themselves, the banking system, and the public from unsafe and unsound practices and conflicts of interest. Nevertheless, in 1985 and 1986 the Comptroller of the Currency decided that the Act allowed national banks to purchase and sell mutual shares for its customers as their agent and sell units in unit investment trusts.

In 1987, the Comptroller also concluded that a national bank may offer to the public, through a subsidiary, brokerage services and investment advice, while acting as an adviser to a mutual fund or unit investment trust. Since 1985 the regulators have allowed banks to offer discount brokerage services through subsidiaries, and these more permissive rules have been upheld by the courts. Thus, more recent court decisions and regulatory agency rulings have tended to soften the 1971 Supreme Court’s strict interpretation of the Act’s prohibitions.

Sections 20 and 32 refer to commercial bank affiliations. Section 20 forbids member banks from affiliating with a company “engaged principally” in the “issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stocks, bonds, debentures, notes, or other securities”. In June 1988, the US Supreme Court, by denying certiorari, upheld a lower court ruling accepting the Federal Reserve Board’s April 1987 approval for member banks to affiliate with companies underwriting commercial paper, municipal revenue bonds, and securities backed by mortgages and consumer debts, as long as the affiliate does not principally engage in those activities. “Principally engaged” was defined by the Federal Reserve as activities contributing more than from 5 to 10 per cent of the affiliate's total revenue. In 1987, the DC Court of Appeals affirmed the Federal Reserve Board’s 1985 ruling allowing a bank holding company to acquire a subsidiary that provided both brokerage services and investment advice to institutional customers. In 1984 and 1986 the Court held that affiliates of member banks can offer retail discount brokerage service (which excludes investment advice), on the grounds that these activities do not involve an underwriting of securities, and that “public sale” refers to an underwriting.

Section 32 prohibits a member bank from having interlocking directorships or close officer or employee relationships with a firm “principally engaged” in securities underwriting and distribution. Section 32 applies even if there is no common ownership or corporate affiliation between the commercial bank and the investment company.

Sections 20 and 32 do not apply to banks that are not members of the Federal Reserve System and savings or loan associations. They are legally free to affiliate with securities firms. Thus the law applies unevenly to essential similar institutions. Furthermore, securities brokers cash management accounts, which are functionally identical to check accounts, have been judged not to be deposits as specified in the Act.

Commercial banks are not forbidden from underwriting and dealing in securities outside of the United States. The larger money center banks, against whom the prohibitions of the Glass-Steagall Act were directed, have been particularly active in these markets after World War II. Five of the top 30 leading underwriters in the Eurobond market in 1985 were affiliates of US Banks, with 11% of the total market. These affiliates include 11 of the top 50 underwriters of Euronotes.

Citicorp, for example, held membership in some 17 major foreign stock exchanges, and it offers investment banking services in over 35 countries. In 1988, it arranged for its London securities subsidiary to cooperate with a US Securities firm to make markets in US securities. The Chase Manhattan Bank advertised that it had offices in almost twice as many countries as ten major listed investment banks combined. Furthermore, commercial bank trust departments could trade securities through their securities subsidiaries or affiliates for pension plans and other trust accounts.

Commercial banks off shore could offer some aspects of investment advisory services, brokerage activities, securities underwriting, mutual fund activities, investment and trading activities, asset securitization, joint ventures, and commodities dealing, and they could offer deposit instruments that are similar to securities.

The generally accepted rationale for the Glass-Steagall Act is well expressed in the 1970 brief filed by the First National City Bank (FNCB) in support of the Comptroller of the Currency’s decision to give the bank permission to offer commingled investment accounts. For this case Investment Company Institute v. Camp, (401 US 617, 1971), which the Supreme Court decided in favor of the Investment Company Institute, FNCB attorneys described the rationale for the Act: “The Glass-Steagall Act was enacted to remedy the speculative abuses that infected commercial banking prior to the collapse of the stock market and the financial panic of 1929-1933. Many banks, especially national banks, not only invested heavily in speculative securities but entered the business of investment banking in the traditional sense of the term by buying original issues for public resale. Apart from the special problems confined to affiliation three well-defined evils were found to flow from the combination of investment and commercial banking.
(1) Banks were investing their own assets in securities with consequent risk to commercial and savings deposits. The concern of Congress to block this evil is clearly stated in the report of the Senate Banking and Currency Committee on an immediate forerunner of the Glass-Steagall Act.
(2) Unsound loans were made in order to shore up the price of securities or the financial position of companies in which a bank had invested its own assets.
(3) A commercial bank’s financial interest in the ownership, price, or distribution of securities inevitably tempted bank officials to press their banking customers into investing in securities which the bank itself was under pressure to sell because of its own pecuniary stake in the transaction.

The original and continuing reasons and arguments for legally separating commercial and investment banking include:
a) Risk of loses
Banks that engaged in underwriting and holding corporate securities and municipal revenue bonds presented significant risk of loss to depositors and the federal government that had to come to their rescue; they also were more subject to failure with a resulting loss of public confidence in the banking system and greater risk of financial system collapse.
b) Conflicts of interest and other abuses
Banks that offer investment banking services and mutual funds were subject to conflicts of interest and other abuses, thereby resulting in harm to their customers, including borrowers, depositors, and correspondent banks.
c) Improper banking activity
Even if there were no actual abuses, securities-related activities are contrary to the way banking ought to be conducted.
d) Producer desired constraints on competition
Some securities brokers and underwriters and some bankers want to bar those banks that would offer securities and underwriting services from entering their markets.
e) The Federal “safety net” should not be extended more than necessary
Federally provided deposit insurance and access to discount window borrowings at the Federal Reserve permit and even encourage banks to take greater risks than are socially optimal. Securities activities are risky and should not be permitted to banks that are protected with the federal “safety net”.
f) Unfair competition
In any event, banks get subsidized federal deposit insurance which gives them access to ‘cheap’ deposit funds. Thus they have market power and can engage in cross-subsidization that gives them an unfair competitive advantage over non-bank competitors (e.g. Securities brokers and underwriters) were they permitted to offer investment banking services.
g) Concentration of power and less-than-competitive performance
Commercial banks' competitive advantages would result in their domination or takeover of securities brokerage and underwriting firms if they were permitted to offer investment banking services or hold corporate equities. The result would be an unacceptable concentration of power and less-than-competitive performance.

Beginning in the 1960s, banks began lobbying Congress to allow them to enter the municipal bond market.  In the 1970s, deregulation allowed brokerage firms to encroach on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards. In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterprets Section 20 of the Glass-Steagall Act, which bars commercial banks from being “engaged principally” in securities business, deciding that banks can only have up to 5 percent of gross revenues from investment banking business. The Fed Board then permits Bankers Trust, a commercial bank, to engage in certain commercial paper transactions. In the Bankers Trust decision, the Board concluded that the phrase "engaged principally" in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue< style="font-family: times new roman,times,serif;">.

In the spring of 1987, the Federal Reserve Board voted 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote legalized as policy proposals from Citicorp, J.P. Morgan and Bankers Trust to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, vice chairman of Citicorp, argued that three “outside checks” on corporate misbehavior had emerged since 1933: a very effective SEC; knowledgeable investors, and very sophisticated rating agencies, to render the tight regulations unnecessary. Yet in the current liquidity crisis, it has become clear that all three of these “outside checks” failed in recent years to protect both the public interest and the orderly function of markets. The SEC has largely been ineffective in preventing corporate fraud and market abuse, investors have been unable to fully understand the risk of complex financial instruments pushed on them by confused if not unprincipled brokers and rating agencies fell far short in accurately rating the true risk imbedded in debt instruments they rate.

Volcker Opposed Repeal

Paul Volcker, the Chairman of the Fed, was out-voted over his fear that banks would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. It was the financial equivalent of letting the camel’s foot into the tent.  Since then, the history of finance capitalism has been the triumph of the security industry’s aggressive culture of risk over the banking industry’s prudent culture of security.

In March 1987, the Fed approved an application by Chase Manhattan to engage in underwriting commercial paper. While the Board remained sensitive to concerns about mixing commercial banking and underwriting, it reinterpreted the original Congressional intent by focusing on the words “principally engaged” to allow for some securities activities for banks. The Fed also indicated that it would raise the limit from 5% to 10% of gross revenues at some point in the future to increase competition and market efficiency.

Greenspan Supported Repeal

In August 1987, Alan Greenspan, a director of J.P. Morgan and a proponent of banking deregulation, was appointed chairman of the Federal Reserve Board. Greenspan put the full power of his new position to advocate bank deregulation by asserting its necessity to help US banks become global financial powers in the context of US push for financial globalization. In January 1989, the Fed Board approved a joint application by J.P. Morgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. This marked a large expansion of the activities considered permissible under Section 20, because the revenue limit for underwriting business was still at 5%. Later in 1989, the Board issued an order raising the limit to 10% of revenues, referring to the April 1987 order for its rationale.

JP Morgan Jumpstart

In 1990, J.P. Morgan became the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10% revenue limit. In 1984 and 1988, the Senate passed legislation that would ease major restrictions under Glass-Steagall, but in each case the more populist House blocked passage. In 1991, the Bush Sr. administration put forward a repeal of Glass-Steagall proposal, winning support of both the House and Senate Banking Committees, but the House again defeated the bill in a full vote. And in 1995, the House and Senate Banking Committees approved separate versions of legislation to repeal Glass-Steagall, but conference negotiations on a compromise fell apart.

Attempts to repeal Glass-Steagall typically pit insurance companies, securities firms, and large and small banks against one another, as factions of these industries engage in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.

In December 1996, with the vocal public support of Chairman Alan Greenspan, the Federal Reserve Board issued a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25% of their business in securities underwriting, up from 10%. This expansion of the loophole initially created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively rendered Glass-Steagall obsolete, in view of explosive growth of banking. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25% limit on revenue, since banks are much larger institutions as compared to security firms. However, the law remained on the books, and along with the Bank Holding Company Act, continued to impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.

In August 1997, the Fed further eliminated many restrictions imposed on “Section 20 subsidiaries” by the 1987 and 1989 orders. The Board stated that the risks of underwriting had proven to be “manageable,” and allowed banks the right to acquire securities firms outright. In 1997, Bankers Trust, now owned by Deutsche Bank, bought the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm.

Traveler Insurance Bought Citibank

In the summer of 1997, Sandy Weill, head of Travelers insurance company, sought and nearly succeeded in a merger with J.P. Morgan, before J.P. Morgan merged with Chemical Bank, but the deal collapsed at the last minute. In the fall of the same year, Travelers acquires the Salomon Brothers investment bank for $9 billion to merge it with the Travelers-owned Smith Barney brokerage firm to become Salomon Smith Barney.

In February 1998, Sandy Weill of Travelers approached Citicorp’s John Reed on a merger. On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world's largest financial services company, in what was the biggest corporate merger in history.

The transaction had to work around remaining regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent a merger of insurance underwriting, securities underwriting, and commercial banking. The pending merger effectively gave regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.

Weill met with Alan Greenspan and other Federal Reserve officials before the announcement to sound them out on the merger, and later told the Washington Post that Greenspan had indicated a “positive response.” Weill and Reed carefully structured the merger to technically conform to the precedents set by the Fed in its interpretations of Glass-Steagall and the Bank Holding Company Act.

Unless Congress changed the laws and relaxed the restrictions, Citigroup would have two years to divest itself of the Travelers insurance business with the possibility of three one-year extensions granted by the Fed and any other part of the business that did not conform to regulation. Citigroup promised to divest on the assumption that Congress would finally change the law before the company would have to do so. Citicorp and Travelers lobbied banking regulators and government officials for support.

In late March and early April, Weill makes three heads-up calls to Washington: to Fed Chairman Greenspan, Treasury Secretary Robert Rubin, and President Clinton. On April 5, the day before the announcement, Weill and Reed make a ceremonial call on Clinton to brief him on the upcoming announcement.

The Fed gave its approval to the Citicorp-Travelers merger on Sept. 23. The Fed’s press release indicated that “the Board's approval is subject to the conditions that Travelers and the combined organization, Citigroup, Inc., take all actions necessary to conform the activities and investments of Travelers and all its subsidiaries to the requirements of the Bank Holding Company Act in a manner acceptable to the Board, including divestiture as necessary, within two years of consummation of the proposal. ... The Board's approval also is subject to the condition that Travelers and Citigroup conform the activities of its companies to the requirements of the Glass-Steagall Act.”

Following the merger announcement on April 6, 1998, Weill immediately launched a lobbying and public relations campaign for the repeal of Glass-Steagall and passage of new financial services legislation known as the Financial Services Modernization Act of 1999. Modernization was an euphemism for total deregulation for the brave new world of financial globalization.

The House Republican leadership wanted to enact the measure in the current session of Congress. While the Clinton administration generally supported Glass-Steagall “modernization,” there are concerns that mid-term elections in November could bring in new Democrats less sympathetic to changing the populist laws. In May 1998, the House passed legislation by a narrow vote of 214 to 213 that allowed the merging of banks, securities firms, and insurance companies into huge financial conglomerates. And in September, the Senate Banking Committee votes 16-2 to approve a compromise bank overhaul bill. Despite this new momentum, Congress was still not certain to pass final legislation before the end of its session.

As the final push for new legislation heated up around election time, lobbyists raised the issue of financial modernization with a fresh round of political fund-raising. Indeed, in the 1998 mid-term election, the finance, insurance, and real estate industries, known as the FIRE sector, built a bonfire of more than $200 million on lobbying and more than $150 million in political donations. Campaign contributions were targeted to members of Congressional banking committees and other committees with direct jurisdiction over financial services legislation.

After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hailed the change as the long-overdue demise of a Depression-era relic. Opponents saw it as the root for a future depression.

On October 21, with the House-Senate conference committee was deadlocked after marathon negotiations. The main sticking point is partisan bickering over the bill’s effect on the Community Reinvestment Act, which sets rules for lending to poor communities when much of the current subprime mortgages had initially been written before the abuse spread to the general market through securitization. Weill called President Clinton in the evening to try to break the deadlock after Senator Phil Gramm, chairman of the Banking Committee, warned Citigroup lobbyist Roger Levy that Weill had to get the White House moving on the bill or he would shut down the House-Senate conference. Serious negotiations resume, and a deal is announced at 2:45 a.m. on October 22.

Clinton Signed the Repeal

A few hours later, Weill and Reed issue a statement congratulating Congress and President Clinton, including 19 administration officials and lawmakers by name. The House and Senate approved a final version of the bill on November 4, three business days before the election and Clinton whom some Democrats call the best president the Republicans ever had, signed it into law the Gramm-Leach-Bliley Act, the official name of the Financial Services Modernization Act of 1999 on November 12, two days after the election to replaced the repealed Glass-Steagall Act of 1933. 

Repeal of Glass-Steagall Led to the Current Credit Crisis

What nobody expected, not even the most fervent opponents to bank deregulation, was that the repeal of Glass-Steagall paved the road to the emergence of the non-bank financial system which took off like a fighter jet of the deck of an aircraft carrier with the advent of deregulated global financial markets, which eventually rendered both banks and their central bank lenders of last resort irrelevant in a brave new world of finance.

Just days after the Treasury Department signed on to support the repeal of Glass-Steagall, Treasury Secretary Robert Rubin, a former co-chairman of Goldman Sachs, accepted a top position at Citigroup as Vice Chairman. The previous year, Weill had called Secretary Rubin to give him advance notice of the upcoming merger announcement. When Weill told Rubin he had some important news, the secretary reportedly quipped, “You’re buying the government?” Rubin could have added: “With debt?” The answer, while never reported, could have been: “No, the whole world.”

The world that Weill bought with debt from the non-bank financial system is now in a severe credit crisis with an irrelevant banking system that needs to have $1.3 trillion put back into the banks’ balance sheets. Even if the Fed bails out the banks by easing bank reserve and capital requirements to absorb that massive amount, the raging forest fire in the non-bank financial system will still present finance capitalism with its greatest test in eight decades.

Cash may be king in a liquidity crisis, but in a credit crisis, a king may echo Shakespeare’s Richard the Third: “A horse, a horse, my kingdom for a horse.”