Pecora in Perspective: Investment Banking, Commercial Banking, and Glass-Steagall
The Pecora Commission report devotes a substantial number of pages to a discussion of the evils of allowing the commingling of investment services and commercial banking services all in one house.
The investment banker is the intermediary between the borrowing corporation or government [in the case of foreign debt] and the investing public.
(Pecora commission report at p. 83)
Funds raised through investment banking are meant to be long term investment or "capital funds," and are raised through the issuance of stock.
Commercial banks, on the other hand, are supposed to give shorter term loans to business. These loans allow the business to buy inventory, meet payroll and the like.
Pecora found that a "prolific source of evil has been the affiliated investment companies of large commercial banks." (p. 113) He also found:
These banks, violated their fiduciary duties to depositors seeking disinterested investment counsel from their bankers, referred these depositors to the affiliates for advice. These depositors were then sold securities in which the affiliates had a pecuniary interest.
(Report at p. 163)
And Pecora also showed that the interrelationship between commercial banks and their investment affiliates created a situation where there was an
utter disregard by officers and directors of commercial banks and investment affiliates for the basic obligations and standards arising out of the fiduciary relationship extending not only to stockholders and depositors, but to persons seeking financial accommodations or advice.
Personages upon whom the public relied for the guardianship of finds did not regard their position as impregnated with trust, but rather as a means for personal gain.
(Report at p. 186)
As a consequence of the information unearthed during the Senate Committee on Banking and Currency, the Banking Act of 1933 was passed and signed in to law. You may know it as Glass-Steagall.
Pecora described it thusly:
The banking Act of 1933 is an expression of the legislative policy of complete divorcement of commercial banking from investment banking. Further legislation may be required to completely effectuate this policy.
(Report at p. 185, emphasis added)
At the behest of the banking lobby, the Act was substantially loosened during the mid-1980’s and finally repealed outright through the efforts of Senator Phil Grahm. See a great timeline here.
In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote comes after the Fed Board hears proposals from Citicorp, J.P. Morgan and Bankers Trust advocating the loosening of Glass-Steagall restrictions to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, then vice chairman of Citicorp, argues that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC; knowledgeable investors, and "very sophisticated" rating agencies. Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures – a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking.
OK, who besides me got a belly laugh out of the part I put in bold? (Oh, and was Volker correct in his fears, or was he correct in his fears?)
Or, as eloquently explained by the gentlemen at the Motley Fool:
You can’t have a chicken without first having an egg. The relaxing of Glass-Steagall back in the 1980s — which permitted the predecessors of JPMorgan Chase (NYSE: JPM), Citigroup, and others to deal in instruments like mortgage-backed securities and commercial paper — was the rotten egg which eventually hatched into the present derivatives debacle. The failure to heed the lessons of history permitted history to repeat itself.
Derivatives became the scourge of the Earth only after flourishing in a sea of deregulation. Indeed, the unchecked expansion of derivatives in recent years formed a key foundation for my reluctant bearishness toward the U.S. dollar. Since 2002, when Warren Buffett called derivatives "financial weapons of mass destruction" in a letter to Berkshire Hathaway (NYSE: BRK-B) shareholders, the global derivatives market has ballooned from $100 trillion to at least $684 trillion. Jim Sinclair, chairman and CEO of Tanzanian Royalty Exploration, estimates a notional value of well over $1 quadrillion (that’s 1,000 of these!).
The unwinding of these instruments may indeed yield shock and awe, but the mess could never have been made with those Depression-era regulations intact
The Fool said that, but I concur.
This is the seventh part of a continuing series on the original Pecora Commission and its relevance today. Previous posts can be found here: part one, part two, part three, part four, part five, part six)