In late 1999, the bulwark bank regulation of 1933, the Glass-Steagall Act - the wall between investment banks and commercial banks - was torn down. This was a great victory for creative bankers, who had found the wall irksome and restrictive.
The teardown opened the way for the Bankers Panic of 2008. Senator Carter Glass, who was a leader in the creation of the Federal Reserve System in 1913, saw how the deposits of correspondent banks flowed to New York City where the big banks were tempted to speculate with the funds and he was determined to keep the investment-banking foxes out of the commercial-banking chicken coop. A wall was created around the banking system to prevent bank deposits being used for speculation by investment banks.
When the wall came down in 1999 with the Financial Modernization (Gramm-Leach-Bliley) Act, what was outside the wall should have been brought under expanded regulatory responsibilities of the Federal Reserve or the SEC, or both. Banks and investment banks were allowed by the 1999 Act to join up through the bank holding company mechanism that had been created in 1956.
When bank holding companies were first allowed, the law cautiously required Federal Reserve approval to create a bank holding company and it prohibited bank holding companies headquartered in one state from acquiring a bank in another state. It generally prohibited a bank holding company from engaging in most non-banking activities or acquiring voting securities of certain companies that are not banks. I was an economist at the Federal Reserve Board and the FDIC during the William McChesney Martin era at the Fed, and I vividly remember a long-time staff member of the FDIC, a southerner with an amazingly large-brimmed floppy hat, telling me more than once that if you hadn't lived through the Depression you couldn't know how much damage is caused when bank credit dries up and how important it was to keep commercial bank assets from being used for speculation.
Back then, in 1999, the Economist Magazine wondered why the wall between banks and investment banks was taken down without regulatory reform. Two years before, the Brits consolidated their regulatory system. The reason for the persistence of the multiple financial regulatory authorities in Washington (and the states) was given as follows by John D. Hawke, Jr., Comptroller of the Currency, in a speech to the NY State Bankers Association in 2000: "Regulatory competition has stimulated innovation and efficiency. Competition keeps all of us on our toes, and provides incentives to add real value to our supervision. While the system unquestionably provides opportunities for regulatory arbitrage, there is little evidence that it has stimulated the competition in laxity that former Federal Reserve Chairman Arthur Burns discussed 30 years ago."
Today, in fact, competition in laxity and regulatory arbitrage seem good descriptions of what has occurred in financial markets since 1999, at an accelerating pace. The worst possible situation for an institution seeking to avoid regulation is a single regulator. A large number of regulators creates the impression for the consumer that the system is tightly controlled, while creating ample opportunity for innovators to do what they want. Could mortgage bankers have succeeded in processing so many subprime mortgages if borrowers weren't fooled by the paperwork into thinking that the process was under some kind of regulation? Could so many CDOs have been sold if investors in the United States and overseas weren't reassured by the many bank regulators and the SEC and the monoline insurers and the rating agencies that the securities they were buying were as advertised?
If we really want to modernize the American financial system, we need a single government entity in Washington to oversee it. This entity - perhaps a Treasury-Fed-SEC Regulatory Commission - might seek to impose and enforce capital adequacy requirements proportional to risk on all financial institutions and address issues such as moral hazard and disclosure across the entire range of players.
The Economist was right in 1999 to recommend that modernization of the American financial system be accompanied by regulatory reform. On March 19 ("What Went Wrong") the Economist now argues that the financial industry "is unlikely to grow as it did in the 1980s and 1990s. If finance is foolishly reregulated, it will fare even worse." This wobbly sentence needs to be parsed:
- Reregulation is not a good way of describing what is under consideration in Washington because reinstating Glass-Steagall is not an option.
- If the sentence means that any new regulations would be foolish, the Economist is pre-judging what the Congress might come up with. New regulations are going to happen.
- If the Economist means that new regulations should not be adopted if they are foolish, then who could argue with that?