Banking Industry Structure essay
Two regulations that had a particularly strong impact on the banking industry in the United States were the Glass-Steagall Act (GSA) passed in 1933 that prohibited banking organizations to get involved into both investment banking and commercial banking industry, and the Gramm-Leach-Bliley Act (GLBA) passed in 1999 that repealed the prohibition of GSA to combine investment and commercial banking. The critics of the GLBA state that it was the cause of the banking industry crisis and financial recession in 2007-2009, and that repealing the GSA was a mistake. However, analysis shows that the key factors that caused the crisis were unaffected by the GLBA and that the passage of the GLBA in fact reduced the impact of crisis on the banking industry due to greater diversification of banking services and portfolios. So, repealing the Glass-Steagall act was not a mistake, but rather a correct and timely measure that made the banking industry more competitive and helped alleviate the impact of the crisis to a small extent.
In order to evaluate the consequences of repealing the Glass-Steagall Act in 1999, it is necessary to consider the prerequisites of this legislation and the economic context that led to the creation of this Act. The considered time period is between 1927 and 1933 (Heakall, 2003). Initially, the Glass-Steagall Act was created to prevent banks from committing fraud and misusing public trust. The major events that shaped the economic context for the GSA were the economic boom in the 1920s followed by the Great Depression that started in 1929 (Heakall, 2003). One of key causes of the Great Depression was commercial speculation performed by banks – banks took huge risks to get rewards and used shady schemes to encourage their clients to invest into risky assets (Cftech.com, 1998).
In 1933, commercial speculation was considered the major cause of the crisis. However, in several decades economists came to the conclusion that the key factor of the recession was economic depression itself, while security speculation was only a minor catalyst of the financial decline (Cftech.com, 1998). Another supposed key cause of the Great Depression was the lack of nationwide banking system – banking operations in the 1920s were performed by unit banks within states (Cftech.com, 1998). Moreover, Senator Glass who was the main ideologist of the GSA 2 years later came to the conclusion that the GSA was an overregulation and attempted to have it repealed (Cftech.com, 1998). So, GSA regulations were excess and too strict from the very beginning. However, in 1956 Congress extended the GSA and created one more barrier – between insurance and banking (Heakall, 2003). So, the banking industry was strongly regulated until 1999.
It is also important to analyze the economic context in 1999 when the GLBA was enacted and the barriers created by the GSA were repealed. First of all, banking segment became more globalized as well as investment capital, so the barriers between national and foreign investments were blurred (Tatom, 2011). Furthermore, banking institutions used many ways of diversifying its trading portfolios outside the GSA regulations – for example, investment banks were allowed to trade and hold such risky assets as derivatives, debt obligations, mortgage-backed securities, etc. (Calabria, 2009).
Large banking organizations emerged and gained power despite the presence of GSA regulations because of consolidation and integration processes going in the banking industry (Wallace, 2014). Therefore, the context in which the banking industry operated changed, and the GSA provisions made American banking system less diversified and less flexible compared to international players. Furthermore, the GLBA repealed only one section of the GSA – the prohibition to combine investment and commercial banking, so its impact on the whole development of the banking industry was not so “deregulatory” as the supporters of Occupy Wall Street movement claimed (Tatom, 2011).
Finally, it is necessary to consider key causes of the financial recession that took place in 2007-2009 and the interrelationship of the GLBA with these factors. According to Brook & Watkins (2012), the institutions that resorted to risky borrowing and investment practices were Bear Sterns, Lehman Brothers, Fannie Mae and Freddie Mac, AIG and Merrill Lynch; however, none of these organizations was influenced by the GSA repeal. Furthermore, those commercial banks the activities of which were expanded by the GLBA went into trouble due to investing into mortgage-backed securities and residential mortgages (Wallace, 2014). However, the GSA did not prohibit commercial banks to use the above-mentioned securities, so the repeal of the GSA did not contribute to the failure of commercial banking either. In addition, the number of financing holding companies that actually used the GLBA benefits and combined commercial and investment banking was quite low in the pre-crisis years (Calabria, 2009).
The research conducted by Collins, Kwag and Yildirim (2003) shows that the actual impact of the GSA repeal on the banking industry was the following. Banking organizations received more opportunities to diversify their portfolios, which allowed them to shift and diversify risks (Collins, Kwag & Yildirim, 2003). As a result, banking industry became less risky both for stockhodlers and for regulators (Collins, Kwag & Yildirim, 2003). At the same time, no significant wealth redistribution was noted, which means that the attractiveness of the considered financial sector did not increase compared to other sectors of financial industry. Collins, Kwag and Yildirim (2003) suggest that this fact can be explained by the long-term evolution of competition in the financial industry. In other words, the GLBA did not lead to excess wealth creation or commercial speculation, but instead it allowed to reduce systemic risks and therefore benefit both the customers and the organizations in the banking sphere.
These conclusions are in line with the findings of Calabria (2009) who states that few financial holding organizations took advantage of the GLBA and combined investment and commercial banking. According to Calabria (2009), the repeal of the GSA might even have mitigated the consequences of the crisis for the banking system. In any case, repealing the GSA division between commercial and investment banking in 1999 was a timely and appropriate measure that corresponded to the demands of the economic environment.
Despite the fact that there are numerous advantages of GLBA, it is important to note that there still might emerge conflicts of interest in banking involving commercial and investment banking, and it might be necessary to have proper regulation in place in order to identify such cases and to prevent speculation and fraud. However, the need for regulating potential conflicts of interest does not mean that banks should be prohibited to engage in commercial and investment banking as it was in the GSA times. Rather, it is necessary to pass more specified and more flexible regulations that would target conflicts of interest without affecting the ability of the banking sector to diversify portfolios.
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