What was Glass-Steagall?

The Glass-Steagall Act, the official name of which was “The Banking Act of 1933,” forced banks to separate Commercial Banking from Investment Banking. The intent was to “limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds. In the early part of the century, individual investors were seriously hurt by banks whose overriding interest was promoting stocks of interest and benefit to the banks, rather than to individual investors. The [law banned] commercial banks from underwriting securities, forcing banks to choose between being a simple lender or an underwriter (brokerage).”

Glass-Steagall was also responsible for adding deposit insurance, creating the FDIC: Federal Deposit Insurance Corporation. In 1934, deposits of up to $2,500 would be guaranteed by the Federal Government, should the bank that was holding deposits fail. These limits were raised over time, and now you are now insured by the FDIC for up to $250,000 invested in a single bank.

Broadening of Glass-Steagall: Separating Banking from Insurance Underwriting

In 1956, Glass-Steagall was broadened by a regulation called The Bank Holding Company Act. This act “further separated financial activities by creating a wall between insurance and banking. Even though banks could, and can still can, sell insurance and insurance products, underwriting insurance was forbidden.”

The Beginning of the End for Glass-Steagall

Even before Glass-Steagall was officially repealed, its rules enforcing the separation of insurance companies, commercial banks and investment banks began to crumble.

Merger: Citigroup, The Largest Corporate Combo Ever

In 1998, Travelers Insurance and Citicorp merged to form the behemoth Citigroup, with $700 billion in assets. The merging of an insurance company and a bank violated the 1956 Bank Holding Company Act. So why was it allowed to proceed?

From the NYTimes in 1998:

Sanford Weill, the Travelers chairman, said he expected the Fed to quickly approve his company’s application to become a bank holding company and added: “I don’t think we have to spin anything off to make this happen.”

Current law, he said, allows at least two and as many as five years for prohibited assets to be divested. “We are hopeful that over that time the legislation will change,” he added.

Deregulation: “The Financial Services Modernization Act of 1999” (The Death of Glass-Steagall)

Glass-Steagall was repealed by the “Financial Services Modernization Act” in 1999, also known as the Gramm-Leach-Bliley Act. This Act allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate. And consolidate they did.

Further Deregulation: “Commodity Futures Modernization Act”

In 2000, the Commodity Futures Modernization Act deregulated Over-the-Counter derivatives. These are the products that would be core to the 2008 crash.

It clarified the law so that most over-the-counter (OTC) derivatives transactions between “sophisticated parties” would not be regulated as “futures” under the Commodity Exchange Act of 1936 (CEA) or as “securities” under the federal securities laws. Instead, the major dealers of those products (banks and securities firms) would continue to have their dealings in OTC derivatives supervised by their federal regulators under general “safety and soundness” standards. (see:  http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000)

The Commodity Futures Trading Commission requested that there be “functional regulation” of this Over-the-Counter derivatives market. Their request was denied by lawmakers.

After this Act, “neither the Securities and Exchange Commission (SEC) nor the Federal Reserve, nor any state insurance regulators had the ability to supervise or regulate the writing of credit default swaps by hedge funds, investment banks or insurance companies.” (Barry Ritholtz, Bailout Nation p. 131)

Even More Deregulation: Five Investment Banks are allowed Unlimited Leverage… by the SEC

In April 2004, five members of the SEC met to discuss a change that was being asked for by the five largest investment banks (Goldman Sachs, Merrill Lynch, Morgan Stanley, Bear Stearns and Lehman Brothers). The requested change was to allow them to take on far more debt than was originally allowed under the net capital rule. Hank Paulson, who at the time was the CEO of Goldman Sachs, “led the charge.” The SEC’s members unanimously voted to grant this except to the five largest investment banks.

The old net capital rule had “limited investment bank leverage (defined as the ratio of debt to equity) to 12 to 1.” However, under this new exception, the big investment banks quickly increased their leverage by borrowing more money, leveraging up to 20-1, 30-1 and even as high as 40-1 leverage. This means that they had 40 times more (borrowed) money invested in various financial products than they actually had as equity (easy to sell assets).

These deregulatory forces paved the way for the global financial meltdown of 2008.

What is the Volcker Rule?

What is popularly referred to as “The Volcker Rule” is actually Section 619 of the Dodd-Frank Act, which was passed in 2010 and aims to regulate Wall Street. Its official title is “Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds.”The Volcker Rule bans proprietary trading (i.e. speculation) and investments in hedge funds at government backstopped banks.

The concern behind the Volcker Rule is that banks have used depositors’ funds from FDIC-insured checking and savings accounts, as well as access to virtually free money from the Federal Reserve, in order to take extremely risky bets in the financial markets.  When these bets fail, they leave bank depositors and the American taxpayer holding the bag.

Similar concerns arose during the Great Depression of the 1930’s, leading to the passage of the Glass-Steagall Act, which required retail banks to be separate from investment banks.  Unfortunately, in the 1990’s, federal regulators and Congress buckled under pressure from the banking lobby and gradually repealed Glass-Steagall.  The final death-knell of Glass-Steagall came in the form of the Gramm-Leach-Bliley Act.  The proposed Volcker Rule attempts to approximate the restrictions of Glass-Steagall. However, there are a large number of exceptions to the rule in the current draft, which we believe has the potential to be abused by the banks.

Why is it called “The Volcker Rule”?

The Volcker Rule is named after Paul Volcker, who served as the Chairman of the Federal Reserve from 1979-1987. Following the financial crisis of 2008, Volcker wrote a three-page memo to President Obama where he argued that to avoid a similar crisis in the future, one approach would be to eliminate proprietary trading at and ownership of hedge funds by the big banks.

Is the Volcker Rule in effect now?

The Volcker Rule is not currently in effect. That is because Section 619 passed the task of writing the actual implementation of this new rule on to the regulators (the SEC, the Federal Reserve, and others). The regulators released their draft in October 2011, and the public has until January 13th, 2012 to submit comments on this draft. All comments become a part of the public record, and can be viewed online. After the comment period, the regulators will create the final rule, taking into account the comments received. The final rule is scheduled to go into effect on July 21st, 2012.

What does the Draft Volcker Rule Say?

The Draft of the Volcker Rule that the SEC and the banking regulators have prepared does ban proprietary trading at banks, and prevents them from owning hedge funds, but it makes many exceptions to these broad bans. Here are just a few:

  • Banks are still allowed to perform underwriting and market-making.
  • They are allowed to have up to a 3% ownership interest in a hedge fund.
  • In the first year of a hedge fund, that 3% limit does not apply.
  • The trading of repurchase agreements (called repos for short) is given a blanket exemption.

These exceptions, in their current form, are so broad that they have the capacity to essentially nullify the Volcker Rule’s main restrictions.