Document Type
Article
Publication Date
2005
Status
Accepted
Abstract
Commercial banks were leading participants in the U.S. securities markets during the great bull markets of the 1920's and the 1990's. Those stock market booms and the crashes that followed were extraordinary events. Is it merely a coincidence that the two most dramatic stock market booms and crashes in U.S. history occurred during periods when commercial banks played major roles in our securities markets? Or did the exercise of universal banking powers contribute to the financial and economic conditions that produced both episodes? This essay is the first installment of a larger project that seeks to answer these questions.
This essay offers a preliminary assessment of the role played by universal banks in the economic boom-and-bust cycle of 1921-33. Part I reviews the reasons for Congress' decision to prohibit universal banking in 1933. Senator Carter Glass and other proponents of the Glass-Steagall Act (GSA) maintained that banks and their securities affiliates encouraged speculative behavior and helped to promote unsustainable booms in the securities markets and the broader economy. Glass and his colleagues also contended that universal banking powers created conflicts of interest that prevented commercial banks from acting as impartial lenders or objective investment advisors.
Part II examines the role of commercial banks during the economic boom of the 1920's. In response to a relaxation of legal rules governing bank powers, banks greatly expanded their financing of business firms and consumers through five channels - loans on securities, securities investments, public offerings of securities, real estate mortgages, and consumer credit. This surge of new financing enabled business firms and consumers to assume heavy debt burdens and to make risky investments that proved to be unviable when the U.S. economy entered a sharp recession in the summer of 1929. In addition, the entry of commercial banks into the securities markets created competitive pressures that caused commercial banks and traditional investment banks to abandon prudential standards and promote speculative domestic and foreign ventures.
Commercial banks re-entered the securities markets during the 1990's as a result of court decisions and administrative rulings that opened loopholes in the GSA. In 1999, Congress enacted the Gramm-Leach-Bliley Act (GLBA), which effectively repealed the GSA and authorized the creation of financial holding companies. GLBA reflected a widely-shared view among modern scholars that the 1933 legislation was misguided from the outset. However, due to the bursting of the stock market bubble in 2000 and the revelation of scandals involving universal banks (e.g., Enron and WorldCom), some commentators have begun to reconsider the benefits and risks of universal banking. Part III of the essay offers a preliminary response to the modern scholarly critique of the GSA. First, contrary to the claims of some scholars, Congress did not adopt the 1933 legislation for the purpose of protecting investment banks from competition with commercial banks. Instead, Congress separated commercial and investment banking in order to prevent speculative booms and to ensure that banks acted impartially in making loans and providing investment advice. Second, there was substantial evidence for Congress' belief that universal banks posed serious risks to the banking system. Universal banks undermined the soundness of smaller correspondent banks by encouraging them to purchase speculative securities during the 1920's. Losses on securities were a major cause of bank failures during the 1930's. In addition, several large universal banks failed between 1930 and 1933, due in part to risky investments and loans they made to support their own stock prices and to prop up affiliates. Those failures triggered regional banking panics and also contributed to the widespread loss of depositor confidence in the banking system. Third, modern scholars have attacked the conclusions reached by the Pecora investigation of 1933-34. However, earlier scholars concluded that the Pecora hearings produced credible evidence of conflicts of interest and other abuses involving universal banks during the 1920's. Given recent episodes of similar misconduct by universal banks during the 1990's, further research is needed to evaluate the risks created by universal banks during both periods.
GW Paper Series
GWU Legal Studies Research Paper No. 171
SSRN Link
http://ssrn.com/abstract=838267
Recommended Citation
Arthur E. Wilmarth Jr., Did Universal Banks Play a Significant Role in the U.S. Economy's Boom-and-Bust Cycle of 1921-33? A Preliminary Assessment, 4 Current Dev. in Monetary & Fin. L. 559 (2005).