First, a little history. It was the depths of the Great Depression. The Banking Act of 1933, often called the Glass-Steagall Act after its co-sponsors, was passed in Congress. It was designed to separate commercial banking and investment banking activities, which had become overheated, with commercial banks heavily involved in stock-market investment. Some believe that activity strongly contributed to the 1929 stock market crash.
Now the timeline zips ahead to 1999, when, believing an update was needed, Congress repealed Glass-Steagall, toppling many firewalls between commercial banks and investment firms.
Some believed the repeal permitted so-called super-banks to enter into the kind of financial activity common before the crash of ’29. Whatever its effect, America’s banking culture was revolutionized.
“What changed was the guys who ran the trading desks went into executive suites and focused on making numbers and generating returns. The need to make certain quarterly numbers exploded,” said Michael Dawahare, hedge fund manager and owner of his own Lexington firm, SRI, LLC. “[Financial] products were invented for these guys to sell. Suddenly, they were making huge sums of money in proprietary trading.”
Some financial observers think the repeal of certain restrictions in Glass-Steagall was one cause for the 2007-2010 financial emergency that seriously crippled the U.S. economy. They argued the repeal allowed Wall Street investment banks to gamble with their depositors’ money held in allied commercial banks. However, critics of that theory claimed those activities weren’t banned in Glass-Steagall.
The Dodd–Frank Wall Street Reform and Consumer Protection Act signed into law by President Barack Obama on July 21, 2010, contains what is known as the “Volcker Rule,” after economist and former Federal Reserve Chairman Paul Volcker, who originally proposed it. The rule, set for implementation beginning in July, would stop banks from making speculative investments.
Dawahare believes tighter rules are necessary to curb the creativity of Wall Street capital movers.
“Their technology is so incredible. The exotic derivatives and crazy instruments the financial industry created in the last 15 years are way beyond the means of Glass-Steagall. The Volcker Rule would prevent investment banks and commercial banks from using these exotic tools to make their own bets.”
A leading central Kentucky financial expert doesn’t see Glass-Steagall being reconstructed. Don Mullineaux, DuPont Endowed Chair in Banking at the University of Kentucky’s Gatton College of Business and Economics, thinks the new reforms are enough.
“I’d be surprised if the government tried to put that separation back in place. They’ve taken enough action with Dodd-Frank. I don’t see another Glass-Steagall-like law coming,” said Mullineaux.
“We’ve re-regulated enough,” he continued. “Dodd-Frank is already a massive piece of legislation.”
JPMorgan Chase revealed in May that its London office had orchestrated a failed hedging strategy, producing an eye-popping $2 billion trading loss. The news raised eyebrows. Were banks still taking too many risks? Were no lessons learned from the recent national financial crisis?
Mullineaux said the Volcker Rule, had it been in effect, wouldn’t have stopped JPMorgan Chase from hedging risks already on its balance sheet. “The JPMorgan Chase loss means absolutely nothing,” he said. “Even though $2 billion is a lot of money, Chase is a $2 trillion bank. The amount lost is 1 percent of its capital position. Given its size, it wasn’t a considerable loss, although they’re certainly not happy about it.”
While not defending Chase, Mullineaux said the announcement produced no substantive reaction in the markets; the economy seemed unaffected.
Some say the Chase incident is reason for additional safeguards, but Mullineau disagreed.
“We already have a ton of regulations in the Dodd-Frank bill if we let it work its way along and not add more to the 800-900 pages,” the UK researcher asserted.
Meanwhile, depositors in much smaller Main Street-type community banks need not worry about their institutions employing the kind of risky activities Chase purportedly engaged in.
Larry Jones, central region president of Community Trust Bank in Lexington, said his bank limits itself to accepting deposits, making loans and managing trust funds.
“We get painted with the same brush the rest of the industry gets painted with,” said Jones. “When things like that [Chase] happen, it affects our stock price. We’re publicly traded. We prefer not to see bad things happen in the industry that affect our stock.”
Jones agrees his industry is already heavily regulated.
“From our side of the table, we think it’s onerous and affects how we serve our customers,” he said. “However, many regulators and elected officials have their side of the story.”
“Talk to our leadership,” Jones continued. “You’ll hear that we’re just a basic banking operation. That’s how we want it. We hope we’re good for our depositors, loan customers and shareholders.”
About the massive Chase loss, Jones said, “Everything is relative. Two billion dollars is huge to me and you in Kentucky.”
“Too big to fail” means five to 10 U.S. banks are so large that failure of any one of them could be catastrophic. Some believe the federal government wouldn’t let banks like Chase, Bank of America, Wells Fargo or CitiBank collapse.
“What politicians and regulators say is that with Dodd-Frank, no bank should ever be rescued by taxpayers,” said Mullineaux. “They’ve put into the law a mechanism allowing regulators, especially the FDIC, to manage any failure of a large institution.”