Regulating the Banks

Is the structure of our banking system, in and of itself, a risk to our financial markets generally and, more broadly, our economy as a whole?
The answer is a resounding: "Yes!"

Part I - History

Banking used to be a relatively staid, unexciting business. After the collapse of the financial markets in 1929 and the failure of hundreds of banks in the early 1930's, our government sought to place regulations on both the financial markets and banks. They created the Securities Acts of 1933 and 1934 which regulated how securities were sold to the public. They also created the Glass-Steagall Act, which required separation of banks, or lenders, from investment banks - or purveyors of securities.

This forced institutions such as JP Morgan to spin out their investment bank (which became Morgan Stanley) into separate institutions. The banks were large publicly traded entities in order to have the necessary access to capital to support lending; the investment banks were typically private partnerships with limited capital that relied on their wits.

Further, the government created the deposit insurance system (now called the FDIC) to insure depositors against bank failures, and created rules which set capital and operating requirements upon the banks.

This worked extremely well, until 1984, when excessive lending to the "oil patch" in 1984 brought down a number of banks. Continental Illinois was deemed "too big to fail" at that time, and so it was rescued through government intervention - ie financial support. The oil patch fiasco deflated the real estate markets of Texas and Colorado significantly, leading to flat values in those markets for almost ten years. But the rest of the country was largely left untouched as a result of the Continental bailout. It was generally considered a success.

When the financial markets failed in 1990-1991, the government took quite a different tact. Government action exacerbated the issue, shutting down the leveraged lending markets. Instead of bailing out large institutions they aggressively foreclosed on them, including Lincoln Savings and Bank of New England. The government's Resolution Trust Company (RTC) then aggressively sold large portfolios of loans and securities inherited from the failed banks and S&Ls at fire-sale prices, further depressing their prices and making overnight fortunes for the owners of Apollo Investments, the Bass family, as well as TCW and others.

The smart view after this fiasco was that aggressive government intervention (via foreclosing and liquidation of financial institutions) was the real problem. Markets were deemed to be efficient, and banks/investment banks were deemed to be more effectively regulated by market pressure and moral suasion than by government officials who were too unsophisticated to understand these complicated issues.

Glass-Steagall was deemed out-dated: let banks and investment banks compete against each other and eliminate the distinction. After all, that is the way it was done in Europe and Japan and they had created behemoth institutions. This will lead to great liquidity in the capital markets, greater availability of funds and lower cost financings = the argument went. Indeed this did come to pass, and in the mid 1990s the line between banks and investment banks disappeared.

Interest rates dropped due to aggressive inflation management by Alan Greenspan, causing the cost of borrowing to drop to previously unheard of levels. On the equity front lower interest rates led to higher stock prices (for explanation of the math google: CAPM). But what drove equity prices further was a phenomena little commented upon: the widespread adoption of the 401k.

In the 1990s retirement accounts moved from defined benefit programs (which generally had been funded through investment grade bonds to match the expected liabilities) to defined contribution programs (with individuals moving into equities). As a result record amounts of money flowed into the equity markets, leading to previously unforeseen price levels: On April 17th, 1991 the Dow Jones Industrial Average exceeded 3000! Four years later on February 23, 1995 the Dow crossed 4000. Only nine months later it hit, 5000, and so on until it peaked at over 14,000 in October 2007.

At the same time banks created new products and new markets. As big as the equity markets became, the bond markets became many times bigger fueled by low interest rates.

Next: Part II - Path to Destruction