VideoAs usual, the headlines heralding yet another attempt to repeal the Glass- Steagall Act miss the mark. While lawmakers dither, federal regulators already have lowered barriers between commercial and investment banking. Indeed, the businesses of lending money and underwriting securities have successfully coexisted under the act's Section 20 subsidiary rule 1987. So legislative action to kill the weak prohibitions left in the 1933 law seems almost redundant.
What has not been tested, however, is the mixture of banking and commerce--if anything, a more controversial proposition because it expands the number of areas in which banks can get into trouble. The test case, of course, is the Citicorp/Travelers Group merger, which will combine commercial banking, securities, and insurance underwriting within a single entity to be known as Citigroup. The deal challenges not only Glass-Steagall, but also the Bank Holding Company Act of 1956 (BHCA), which limits bank affiliates to activities that are "closely related to banking"-- activities that do not include insurance.
True, the legislation recently passed by the House of Representatives--the Financial Services Competition Act of 1998, commonly known as H.R. 10-- would "permit affiliations between commercial banks, securities firms, insurance companies, and, subject to certain limitations, other commercial enterprises." But even H.R. 10 does not allow nationally chartered banks to underwrite insurance, a prohibition that would seem to prevent Citigroup from keeping Travelers's property and casualty lines. Citigroup does have other options, such as switching to a thrift charter to take advantage of regulations that permit unitary thrift holding companies to engage in insurance and real estate activities. However, this plan is only viable if H.R. 10 doesn't become law, because the bill as it stands now would eliminate the unitary thrift structure. So pressure is on the Federal Reserve Board to decide whether and how to approve the formation of Citigroup and whatever like- minded deals follow in its wake as the financial services industry continues to consolidate.
Clearly, the banks do not want to wait for Congress, and, so far, regulators have been willing to help them push against existing boundaries. The entire situation raises questions of risk and conflict of interest, provoking memories of why banks were regulated in the first place, after the so-called New Era of unfettered capitalism in the 1920s, when scores of banks failed as the result of unsound practices.
Back when the likes of J.P. Morgan and his West Coast counterpart, Bank of America's A.P. Giannini, dominated the financial landscape, commercial banks made loans to their investment affiliates to finance stock purchases and accepted the stock as collateral, for example. They also tied up demand-deposit funds in illiquid or long-term investments, such as real-estate loans. And some enticed wealthy corporations to contribute surplus capital for lending by promising higher interest rates and sometimes even guaranteeing the loans. This recklessness helped produce the 1929 stock market crash.
It Must Be Different This Time
Will the repeal of Glass-Steagall and the BHCA bring back the bad old days? Perhaps a cautionary case is the $6.75 million in fines recently paid by NationsBank Corp. for allegedly misrepresenting risky bond funds as insured deposits to a number of investors. These were individual consumers, but couldn't corporate clients be at equivalent risk of unfair behavior by unfettered banks? Economist Henry Kaufman recently went on record with fears that current trends make it easier for banks to implicitly guarantee a market for the commercial paper of clients that issue securities through them. What, after all, is to prevent a bank from promising that its money managers will buy those securities even if that doesn't suit other customers?
The answer, to be sure, is the Fed's Section- 20 firewalls, now known by the gentler term "operating standards." But these grant banks greater discretion than ever. While the Fed requires banks to adopt internal controls, including "exposure limits," governing their participation in Section-20 affiliate transactions, the limits themselves and other control mechanisms are apparently left up to the individual banks. While the Fed isn't likely to allow banks to get really reckless, might there be reason to worry that weaker walls will not hold in the event of a recession?
"Probably not," says Jim Hanbury, an analyst at Schroder & Co., an investment bank in New York. "The people underwriting both equities and fixed income are pretty substantial entities." However, he adds, "you're not really going to know [how well they work] until after a recession hits."
In short, the question is, What kind of regulatory environment is needed in the new New Era of corporate financial services to head off what experts call "systemic risk"-- that is, the chance that the nation's entire payment system will be endangered by even a single large-bank failure because of the interlocking nature of deposits and transactions among our financial institutions?
"Evolution leads us to assume that mergers such as Citicorp and Travelers will take place," says Dimitri Papadimitriou, executive director of the Jerome Levy Economics Institute of Bard College. "But to make sure we don't have systemic risk, we must have regulations that are uniform and transactions that are transparent, so that regulators can evaluate the risks that all the subsidiaries have and what that might entail vis-à-vis moving assets from one corporation to the other to cover losses." He believes such regulations will come, but perhaps not soon enough. "My only concern is that we are pushing fast on repealing Glass-Steagall and allowing commercial industrial firms to own banks without also bringing together a system of regulation."
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