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Separation of Investment and Commercial Banking

Amirsaleh Azadinamin

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SEPARATRION OF INVESTMENT & COMMERCIAL BANKING Abstract This paper looks upon the Glass-Steagall Act of 1933 and how it caused the separation of commercial and investment banking following the claims by many who blamed the stock market crash of 1929 and the great depression on mixing commercial and investment banking. The paper discusses the reasons on why these two entities must be separate and how undertaking of these two functions by the same entity could cause conflicts of interest. But the conflict of interests is not the sole reason the paper offers for the separation of commercial and investment banking. The paper also discusses how the repeal of the act may have contributed to the current crisis of credit by letting financial institutions assume the same role as brokers and investors. The paper also goes on to discusses how the repeal of the act might have contributed to the current financial crisis by allowing commercial banks enter into risky activities and starting a chain reaction after their bankruptcy. The chain reaction was due to their enormous size after mergers and their numerous other financial institutions which were dependents on them directly or indirectly through the same markets.

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SEPARATRION OF INVESTMENT & COMMERCIAL BANKING Separation of commercial and investment banking There has always existed a natural tendency for banks to assume risk and start investment banking activities. This means that institutions that sell financial assets drawn on them are naturally in a position to sell financial assets drawn on third parties. Commercial and investment banks that merge use services offered by one another, and if they are the same entity, they will use this opportunity to transfer funds from surplus to deficit units (Cargill, 1988). Cargill (1988) goes on to continue that as a result commercial banks have gradually assumed investment bank functions throughout the development of the U.S. financial system until the passage of Glass-Steagall in 1933 (p. 27) The separation of commercial and investment banking, as it is known legally by the Glass-Steagall Act, has been a product of the United States congress in 1933, as some congressmen realized the dangers of the unification of these entities with different financial structures and responded by passing the Glass-Steagall Act. Following the stock market crash and the great depression, which led to the failure of one out of every five banks, was blamed on the convergence of commercial and investment banking (Benston, 1989); however, as Mandle and Orenbuch (1997) mention, the convergence happened again at the top of the corporate world: [B]y the beginning of March 1997, the Act was effectively dead, and the only question is whether Congress will give it a decent burial. Banks now offer a full range of capitalraising products to their corporate customers, including short-term loans and commercial paper, investment-grade debt, high-yield loan and bond financing, venture-capitalrelated equity, equity underwriting and M&A advice (p. 19).

SEPARATRION OF INVESTMENT & COMMERCIAL BANKING After the act was repealed in 1999, the late Senator Paul Wellstone made an impassionate plea on the Senate floor stating that the repeal of the Glass-Steagall Act would enable the creation of financial conglomerates which would be too big to fail. He further believed that the regulatory structure would not be able to monitor the activities of these financial conglomerates (Crawford, 2011). There are critics on both sides of the argument stating whether the investment banking activities would put the commercial banks and their depositors at risk, or whether the investment banking activities add strength to commercial banks. The Reason for the Firewall As Mandle and Orenbuch (1997) mention, [c]ompared to commercial banking in the U.S., investment banking has lower returns and more volatile earnings streams (p. 19). But this may not be the only issue taken by critics from the convergence of the two entities. Exposing the clients deposits to risk may be the more important issue at hand. Benston (1989) reminds the reader of three reasons on why the activities on these two entities must be separated. Opponents of its repeal point primarily to three concerns: possible conflicts of interest; competition among financial institutions; and the safety and soundness of the banking system (p. 287). Also, many may argue that the federal government and the taxpayer support the banking system through the Federal Depository Insurance Corporation, FDIC, so the banks would perform their role of the objective lender to the rest of society, not to support dealing in capital markets or other investment banking activities (Benston, 1989). Many believe that the repeal of the Glass-Steagall Act, which let you deregulation and less scrutiny, is what led to the financial crisis of 2007-8 and the failure of too-big-to-fail financial institutions.

SEPARATRION OF INVESTMENT & COMMERCIAL BANKING As one of the opponents of the repeal, Crawford (2011) mentions, in 1987, the Congressional Research Service prepared a study outlining the positives for preserving the Glass-Steagall Act, and an excerpt here offers the positive aspects on keeping the Act: 1. Conflict of interest occurs when the same entity that grants credit to customers uses

credit to invest. This is what originally led to the Glass-Steagall Act of 1933; and this could be mentioned as one of the major areas of conflict of interest. Having used credit to invest by the same entity that grants credit is contradictory in its very own notion, not to mention that the failure in using credit to invest may jeopardize the money of the depositors, and this is what the commercial banks is positioned to do. 2. Depository institutions, or commercial banks, possess enormous financial power by

having the possession of peoples deposits, and thus, commercial banks must be looked upon as institutions or markets for funds, whether loans or investments. So, looking at commercial banks as markets for fund may undermine the very nature of commercial banks. 3. As it was mentioned earlier by Mandle and Orenbuch (1997), the income streams from

investment banking activities are more volatile, and hence more risky. This could threaten the integrity of deposits. On the other hand, Federal Depository Insurance Corporation, FDIC, may have to bear bigger losses in time of a collapse or a failure. FDIC is ultimately paid for by taxpayers, and it is unfair for the taxpayer to bear the cost of commercial banks failure if they are consciously engaged in risky activities. 4. Depository institutions or commercial banks are meant to be managed to limit risk, and

thus, may not be positioned to operate in a speculative market like the market of security trading. Depositors do not have to bear the risk since many may view the deposits as risk-free assets. Having the commercial banks involved in speculative activities will alter the idea of

SEPARATRION OF INVESTMENT & COMMERCIAL BANKING deposits as risk-free assets. Some may claim that there is no risk involved because the commercial bank plays with the house money, but the house money is depositors money. On top of all reasons mentioned above, it does not seem to be a fair practice if the commercial banks engage depositors money to gain volatile returns while they pay a fixed return to depositors, while depositors are the only people bearing the risk. Awareness by the commercial banks clients about the commercial banks involvement in risky trades may cause the loss of customer confidence and would bring bigger repercussions for the financial system. Awareness on the issue may lead depositors to withdraw their deposits, and hence, decrease the banks liquidity. The Reversal of Glass-Steagall Act and Its Role in the Current Financial Crisis Many have blamed the financial and credit crisis of 2007-8 on the deregulation that had been expanded since the reversal of the Glass-Steagall Act. As one of many critics, Crawford (2011) mentions a report by Demos, a nonpartisan public policy and research organization, entitled "A Brief History of Glass-Steagall" addressing the impact of the repeal on the current day crisis. Crawford (2011) continues: The report concedes that much of the current financial damage was done by pure investment banks which would not have been constrained by the Glass-Steagall Act. However, Demos believes that commercial banks' securities activities may have made financial collapse worse and necessitated federal intervention. The report states, "...commercial banks played a crucial role as buyers and sellers of mortgage-backed securities and credit default swaps, and other explosive financial derivatives. Without the watering down and ultimate repeal of Glass-Steagall, the banks would have been barred from most of these activities. The market's appetite for derivatives would then

SEPARATRION OF INVESTMENT & COMMERCIAL BANKING have been far smaller and Washington might not have felt the need to rescue the institutional victims." (p. 131). In his paper Deconstructing the argument for the return of Glass-Steagall, Lou Grumet (2009) also discusses the need for the return of Glass-Steagall, and blaming the current financial crisis on repealing the act. The repeal of the Glass-Steagall Act may be the proverbial lightning bolt that created the current state of our economy. In its absence, monstrous financial companies have arisen, offering banking, securities and insurance services, making regulation extremely difficult. These monstrosities have wreaked havoc the economy (p. 6). Grumet (2009) goes on to argue that with generations-old financial institutions vanishing, the credit crunch, and people losing the houses due to mortgage crisis, there is a stronger case for regulation. The Glass-Steagall Act erected a barrier preventing the mixing of the commercial and investment banking activities and ultimately separating bankers and brokers. The main purpose is to separate each function and prevent it from influencing the other, and vice versa. Preventing financial institutions from becoming too big to fail, in which their failure would hugely impact the financial system as a whole and would jeopardize the depositors assets may be one way to prevent yet another financial crisis. The repeal of the Glass-Steagall Act opened the way for deregulation and many blame the current crisis on it. The deregulation opened the way for many institutions to become one of the too-big-to-fails, and their demise caused tremendous amount of assets to be wiped out. Grumet (2009) also mentions that the modern push for deregulation that started with the repeal of Glass-Steagall Act, has turned the blind eye to reason and logic. The repeal was initiated and lobbied because banking giants wanted to become yet bigger and more expansive. By the late 1990s and the dot-com

SEPARATRION OF INVESTMENT & COMMERCIAL BANKING bubble of 2000, the congress was somehow deluded into believing that the protection that comes from regulation is not needed in the financial sector. Allowing conflicts of interests, and the interests of the banks, insurance companies, investors, and depositors to merge was an obvious sign that all regulatory requirements were stepped on. The resulting concentration of wealth fueled the greed that overcame the professional and ethics standards. With no regulatory restraint, financial companies went on a binge in the past few years until the housing bubble burst. As hundreds of billions in mortgage related investments went south, investment banks have repackaged themselves as commercial banks. With channels of credit constricted, the public has lost confidence in the markets, and has paid dearly in 2008 (Grumet, 2009). Some may argue that with enough scrutinizing and harsh regulation there would be no need for a law such as the Glass-Steagall Act. However, this may prove to be daunting task as some institutions may use legal loopholes to show less clarity, and assume the roles of both investment and commercial banks. The repeal caused the current crisis not just by ultimately letting some institutions become too big to fail, but also by letting commercial banks engage in risky activities that would jeopardize the depositors money through the investment banking activities, and this means taking risk on the behalf of depositors but without their consent. Concluding Remarks Even though whether the repeal of the Glass-Steagall Act dedicated to the current financial crisis cannot be answered definitively, but the arguments opposing the repeal were compelling. As it was discussed throughout the paper, the repeal of the Glass-Steagall Act has caused a fundamental problem in the U.S. financial system. Mixing two entities with separate functions and contradictory natures into one entity, in which one grants credit and the other

SEPARATRION OF INVESTMENT & COMMERCIAL BANKING invests by receiving credit, has presented strong incentives to take risk and involves commercial banks in risky activities. This has greatly jeopardizes the depositors money and creates a heavy burden on DFIC in time of failure. The depositors deposits are viewed by many as risk-free, but merging the two entities may reduce the clients confidence in the bank. In addition to all the reasons offered in paper for the separation of the two entities, it does not seem fair when the gamble done by commercial banks in risky activities are done by using the depositors money, while the depositors will only receive a fixed rate on their deposits. Cargill (1988) adds to the argument by stating that, like the gambler playing with someone elses money, there is huge incentives to go for the big win all in the while having no problem assuming huge risk. In case of the win the investment bank gains, and in case of a failure DFIC will have to pick up the pieces, only bearing more cost to the tax payers. Having too-big-to-fail institutions fail, will also bear cost on other financially safe and capital adequate institutions and increases the markets risk of doing business, or what is called as the systematic risk. These gigantic institutions failures will impose costs on all institutions because all companies and their market of interest are the same, and hence, the system as a whole will be vulnerable and it would most likely sustain a loss. The failure of these gigantic institutions with numerous other dependent institutions would open the way for a chain reaction in case of a failure. Involvement of all these institutions within the same markets would cause all them individually to be vulnerable to other institutions demise and failure. Federal deposit guarantees must either vanish to lessen the cost on taxpayers or must find a way redefine their area of protection on banks who are involved in investment banking activities. This is a case where social cost is higher than the social benefits.

SEPARATRION OF INVESTMENT & COMMERCIAL BANKING References Benston, G. J. (1989). The Federal Safety Net and the Repeal of the Glass-Steagall Act's Separation of Commercial and Investment Banking. Journal Of Financial Services Research, 2(4), 287-305. Cargill, T. F. (1988). Glass-Steagall is still needed. Challenge (05775132), 31(6), 26. Crawford, C. (2011). The Repeal Of The Glass- Steagall Act And The Current Financial Crisis. Journal Of Business & Economics Research, 9(1), 127-133. Grumet, L. (2009). A financial Frankenstein. Accounting Today. pp. 6-8. Grumet, L. (2009). Bring back Glass-Steagall. CPA Journal, 79(12), 7. Mandle, R. I., & Orenbuch, M. A. (1997). Commercial and Investment Banking Convergence: The Few, The Proud, The Foolish?. Black Book - Weekly Notes, 19-22.