Policy Debate: Should U.S. Financial Markets Be Deregulated?

...[T]he name Eugene Ludwig won't light up your typical cocktail party conversation-- unless the drinkers are insurance agents. As Comptroller of the Currency, Ludwig...has made himself infamous among that crowd for almost single-handedly dismantling the Glass-Steagall Act by allowing national banks to expand into insurance and securities underwriting. Senate Banking Chairman Alfonse D'Amato grouses that the change exposes taxpayers to risks that Glass-Steagall was designed to foreclose.
~ Birmbaum, Jeffrey H., "Washington's Most Dangerous Bureaucrats," Fortune Magazine, September 29, 1997

I believe there are five principles that should underlie any efforts to modernize our financial services system. First, we must ensure that banks remain safe and sound. Second, financial reform must help promote fair access to financial services for all, including low- and moderate-income individuals and others that the current system may under-serve. Third, a newly remodeled system should encourage healthy competition that will benefit all users of financial services. Fourth, financial modernization should not proceed in a way that unfairly burdens smaller banks, which provide critical services to important sectors of the economy. Fifth, we must not place unneeded restrictions on the form in which banks conduct their business.... I believe these principles can provide the foundation for true reform.
~ Testimony Of Eugene A. Ludwig, Comptroller of the Currency, before the Subcommittee on Financial Institutions and Consumer Credit, U. S. House Of Representatives, February 13, 1997

Historically, financial markets, which include banks, insurance companies, investment companies, and brokerage firms, have been subject to heavy governmental regulation. For the most part, this regulation, is a result of the fear caused by widespread financial failures immediately before and during the Great Depression. Congress responded to these failures by adopting the Banking Act of 1933. Provisions of the Banking Act of 1933, collectively known as the Glass-Steagall Act, separated commercial banking from investment banking, thus distinguishing each as separate lines of commerce. The Glass-Steagall Act also prompted Washington to establish the Federal Deposit Insurance Corporation (FDIC) as a permanent government agency.

Created as an independent government corporation under authority of the Federal Reserve Act of 1933, the FDIC serves to insure bank deposits in eligible banks against loss in the event of a bank failure. It also serves to regulate certain banking practices.

The corporation is authorized to insure bank deposits in eligible banks up to $100,000 for each deposit and is entitled to borrow up to $3,000,000,000 from the U.S. Treasury, a privilege it has never used.

The FDIC's income is derived from assessments on insured banks and from investments. Insured banks are assessed on the basis of their average deposits. They are currently allowed pro-rata credits totaling two-thirds of the annual assessments after deductions for losses and corporation expenses.

One of the criticisms of the current system of deposit insurance is that it results in a moral hazard problem that encourages banks to issue risky loans. Banks may compete for deposits by offering higher interest rates. These higher interest payments, however, encourage banks to make riskier loans that pay higher interest rates. Depositors who know that their deposits are insured have an incentive to place their funds in those banks that offer the highest interest payments, regardless of the riskiness of the banks' portfolios. This moral hazard problem did not exist prior to the 1980s since interest rates were regulated by the Federal Reserve Board. Banking deregulation in the 1980s, however, increased competition among banks and created an incentive system that favored the issuance of relatively risky loans. This moral hazard problem is one of the causes of the crisis in the savings and loan industry during the 1980s. More stringent regulation and stricter bank supervision has reduced the extent of the moral hazard problem during the 1990s.

Formerly cooperative institutions in which savers were shareholders in the association and received dividends in proportion to the organization's profits, savings and loan associations are mutual organizations that now offer a variety of savings plans. Many offer the same services as do other savings institutions, such as tax-deferred annuities, direct deposits of Social Security checks, automatic deductions from accounts for mortgage payments and insurance premiums, and passbook loans.

The Glass-Steagall Act has been the subject of controversy between advocates of laissez-faire and those who prefer more government regulation. Critics of the Act contend that the separation of commercial banking from investment banking is unnecessary and harmful to the competitiveness of the U.S. financial services industry in the global marketplace. Conversely, the advocates of regulation fear a new financial crisis that could replicate the Great Depression. Such critics of deregulation often cite the S & L crisis of the 1980s as evidence of the need for this separation.

The House of Representatives passed legislation (H.R. 10) in the fall of 1998 that effectively repeals the Glass-Steagall Act. A similar resolution (S. 900) was passed by the Senate on May 6, 1999. These two versions were consolidated into the Gramm-Leach-Bliley Act. This act was passed and was signed by President Clinton on November 12, 1999 and became effective in 2001.

The huge growth of the derivatives (assets whose value is a function of the value of underlying assets) markets, has also caused concern to those who advocate a more "hands-on" regulatory approach.

• U.S. Department of the Treasury, Office of the Comptroller of the Currency
  http://www.occ.treas.gov/
  The Office of the Comptroller of the Currency (OCC) is an independent bureau of the Treasury Department. This office, however, does not directly deal with the nation's currency; rather, it is the oldest federal financial regulatory body and oversees the nation's federally chartered banks.

• The Federal Financial Institutions Examination Council
  http://www.ffiec.gov/
  The Federal Financial Institutions Examination Council is a formal interagency body empowered to prescribe uniform principles, standards, and report forms for the federal examination of financial institutions and to make recommendations to promote uniformity in the supervision of financial institutions.

• Federal Reserve Bank of Kansas City, "Laws, Regulations and Guidance"
  http://www.kc.frb.org/BS&S/Regs&Guide/ExistingLawsEtc.htm
  On this page, the Kansas City Federal Reserve Bank provides links to information about banking laws and regulations.

• Senate Banking Committee, "Effective Dates of Key Provisions in Gramm-Leach-Bliley Act
  http://www.senate.gov/~banking/prel99/1117glb.htm
  This November 17, 1999 summarizes the effective dates of the Gramm-Leach-Bliley Act that effectively repealed the Glass-Steagall Act.

• Senate Banking Committee, "Gramm-Leach-Bliley: Summary of Provisions"
  http://www.senate.gov/~banking/conf/grmleach.htm
  This document provides a brief summary of the Gramm-Leach-Bliley Financial Services Modernization Act.

• Senate Banking Committee, "Conference Report and Text of Gramm-Leach-Bliley Bill"
  http://www.senate.gov/~banking/conf/confrpt.htm
  Those who want to see the entire text of the Gramm-Leach-Bliley Financial Services Modernization Act may find it here, along with the Conference Report.

• Federal Reserve Bank of Minneapolis, "The Financial Services Modernization Act of 1999: A brief summary of Gramm-Leach-Bliley"
  http://minneapolisfed.org/pubs/region/00-03/glb-summary.cfm
  This article, contained in a special 2000 issue of The Region, summarizes the provisions of the Gramm-Leach-Bliley Act of 1999.

• Loretta J. Mester, "Repealing Glass-Steagall: The Past Points the Way to the Future"
  http://www.phil.frb.org/files/br/brja96lm.html, (printed in Business Review, July/August 1996)
  Loretta Mester, assistant vice president and head of the Banking and Financial Markets section in the Research Department of the Philadelphia Federal Reserve Bank, argues that empirical evidence supports the argument that banks should be able to act as investment companies. "Congress has been debating whether to repeal the Glass-Steagall Act, which was passed in 1933 in the aftermath of the large number of bank failures that occurred during the Great Depression. One of the problems the act sought to address was the potential conflict of interest when a commercial bank that lends to a firm also underwrites that firm's securities," Mester writes. "Empirical evidence based on the pre-Glass- Steagall days and on commercial banks' recent experience in debt underwriting suggests that, on balance, conflicts of interest have not been a problem: the data support the repeal of Glass-Steagall."

• David C. John, "Gramm-Leach-Bliley Act (S. 900): A Major Step Toward Financial Deregulation"
  http://www.heritage.org/Research/Regulation/BG1338.cfm
  David C. John discusses the Gramm-Leach-Bliley Act and presents arguments in support of it in this October 28, 1999 Heritage Foundation Backgrounder. He argues that this Act will eliminate obsolete restrictions on banking and will result in more efficient U.S. financial markets.

• Edward G. Boehne, "Financial Modernization: Vastly Different or Fundamentally the Same?"
  http://www.phil.frb.org/files/br/brja00eb.pdf
  Edward G. Boehne, the former President of the Philadelphia Fed, examines the possible consequences of the Gramm-Leach-Bliley Act in this article appearing in the July/August 2000 issue of Business Review. He argues that this Act will change the structure and delivery systems of the financial services industry, but will not necessarily make it less stable. Boehne indicates that the stability of the financial services industry relies upon public confidence. He suggests that either the banking industry or state or federal legislators should take steps to restore public confidence if any of the trends in banking undermine confidence in the banking system.

• Laurence H. Meyer, "Implementing the Gramm-Leach-Bliley Act"
  http://www.federalreserve.gov/boarddocs/speeches/2000/20000203.htm
  Federal Reserve Board Governor Laurence H. Meyer discusses several issues associated with the implementation of the Gramm-Leach-Bliley Act in this February 3, 2000 speech before the American Law Institute and American Bar Association. Meyer notes that this 385-page Act is a complex piece of legislation. He notes that this Act only allows well capitalized bank holding companies to become financial holding companies that may own subsidiaries that underwrite and sell securities and insurance policies.

• Malcolm Bush, "The Road Not Taken: The interests of lower-income families ignored in financial modernization"
  http://minneapolisfed.org/pubs/region/00-03/bush.cfm
  Malcolm Bush argues, in this 2000 online article, that the Gramm-Leach-Bliley Act will result in greater concentration in financial markets. This will, he suggests, further harm low-income households who are already facing predatory lending practices.

• Catherine England, "Banking on Free Markets"
  http://www.cato.org/pubs/regulation/reg18n2b.html
  In this Cato Institute article, Catherine England argues that there was no sound economic or empirical argument for the original passage of the Glass-Steagall Act. She suggests that the repeal of the Glass-Steagall Act would be successful as long as it is done in a manner in which the owners of banks are putting their own money at risk. England argues that government regulation is the cause of many of the problems in the banking industry and suggests that more competition should be encouraged in this industry.

• João Cabral dos Santos, "Glass-Steagall and the Regulatory Dialectic"
  http://www.clevelandfed.org/Research/com96/021596.htm
  João Cabral dos Santos, an economist at the Federal Reserve Bank of Cleveland, first reviews the interactions among banks and regulators as banks attempted to expand their activities across state lines. Next, he discusses whether any lessons from those interactions can be applied to the ongoing debate over reforming the Glass-Steagall Act.

• Alan Greenspan,, "Financial Reform and the Importance of a Decentralized Banking Structure," http://www.federalreserve.gov/BOARDDOCS/SPEECHES/19970322.htm
  Alan Greenspan, the Chairman of the Board of Governors of the Federal Reserve System, issued this speech at the 1997 Annual Convention of the Independent Bankers Association of America. Just as we have learned that the optimal level of crime and pollution is not zero, Greenspan argues, "...regulators and legislators should not act as if the optimal degree of bank failure were zero." Greenspan is famous for his elliptical style, so do not be deterred if you encounter trouble attempting to parse his meaning. One of his concerns is the "moral hazard" that occurs when you keep the gains and someone insures your losses. To meet this challenge he recommends removing the safety net from banks that get involved in some of the newer financial activities.

• Alan Greenspan, Testimony before the Senate Committee on Banking, Housing, and Urban Affairs (June 17, 1998)
  http://www.federalreserve.gov/BOARDDOCS/TESTIMONY/19980617.htm
  Alan Greenspan indicates the Federal Reserve Board's support for the repeal of the Glass-Steagall Act in this testimony before the Senate Committee on Banking, Housing, and Urban Affairs. He argues that this repeal is needed for U.S. banks to compete effectively in a global economy. Greenspan also notes that the moral hazard problem that results from deposit insurance requires the government to maintain a supervisory role in the banking industry.

• Thomas M. Hoenig, "Rethinking Financial Regulation"
  http://www.kc.frb.org/spch&bio/bankreg.txt
  Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City, also discusses the "moral hazard" that occurs with financial regulation. Hoenig makes two points in his article. "First, instead of regulating to make institutions fail-safe, an alternative approach is to strengthen the stability of the financial system by designing procedures that prevent large interbank exposures in the payments system and interbank deposits," Hoenig states. "Second, although moral hazard problems can be contained through traditional regulatory approaches, an alternative is to require those institutions that engage in an expanding array of complex activities to give up direct access to government safety nets in return for reduced regulation and oversight. By further emphasizing these elements within the regulatory system over expanded micromanagement, individual institutions could be permitted to engage in new activities and sometimes to fail because financial stability would be less threatened by the failure of an individual bank--large or small, global or domestic. At the same time, the cost of protecting the safety nets would be better confined because traditional regulation would focus on traditional banks that choose to have access to the safety nets."

• Thomas M. Hoenig, "Financial Modernization: Implications for the Safety Net"
  http://www.kc.frb.org/spch&bio/fdic.htm
  In this January 29, 1998 speech, Hoenig examines the effect of the potential repeal of the Glass-Steagall Act on the "safety net" programs (the FDIC and the Fed's ability to serve as "lender of last resort"). He notes that these safety-net programs result in a moral hazard problem that encourages financial institutions to engage in risky financial investments. Hoenig discusses alternative methods of dealing with this increased moral hazard problem if the Glass-Steagall Act is repealed.

• Martin Mayer, "Financial Services Reform: Consolidation in the Brokerage Industry," (Testimony to the Subcommittee on Finance and Hazardous Materials of the House Commerce Committee)
  http://www.brook.edu/views/testimony/mayer/19970514.htm,
  and "Financial Modernization," (Testimony before the House Banking Committee)
  http://www.brook.edu/views/testimony/mayer/19970521.htm
  Mayer's arguments counter those Greenspan makes in Financial Reform and the Importance of a Decentralized Banking Structure. "I am opposed to affiliations between banks and non-financial entities," Mayer states, "and quite belligerently opposed as long as the banks continue to receive the support of a federal safety net administered by banking regulators."

• Michael Patterson, Testimony Before the Senate Banking Committee
  http://banking.senate.gov/99_02hrg/022599/pattersn.htm
  The February 25, 1999 testimony by Michael Patterson, J.P. Morgan's chief administrative officer, provides a history of the Glass-Steagall Act, a comparison of the risks of securities underwriting and bank lending, and an analysis of the evolving role of commercial banks in the securities business. Since J.P. Morgan is among the financial services companies that would benefit from the repeal of the Glass-Steagall Act, this is an admittedly biased report. It does provide, however, an example of the "corporate" perspective in this debate.

• Alan Greenspan, "Issues for Bank Regulators"
  http://www.federalreserve.gov/boarddocs/speeches/2001/20010518/default.htm
  In this May 18, 2001 speech, Federal Reserve Board Chair Alan Greenspan discusses the current role of bank regulators. He argues that deregulation of the financial sector ultimately resulted in a more competitive and innovative banking industry. Greenspan suggests that regulators should encourage competition, but should be vigilant to ensure that the excessive risk-taking of the late 1980s and early 1990s does not re-occur.

• Mark G. Guzman, "Slow but Steady Progress Toward Financial Deregulation"
  http://www.dallasfed.org/research/swe/2003/swe0301b.html
  Mark G. Guzman discusses the Gramm-Leach-Bliley Act in this January/February, 2003 article. He provides several arguments to explain why this Act did not generate the sweeping changes envisioned by its supporters. Guzman argues that this Act has resulted in slow and steady improvements in the operation of financial markets and believes that these improvements will continue in the future as mergers occur and the regulatory environment is clarified.