Financial History 143 Fall 2022 - Page 35

The Great Depression inflicted crippling losses on universal banks in both the United States and Europe . Leading American universal banks failed or were bailed out during a series of banking crises in the United States between 1930 and 1933 . European governments rescued a large number of troubled universal banks during the 1930s . In contrast , Britain and Canada did not experience systemic banking crises during the Great Depression . The separation of commercial banks from securities markets in Britain and Canada was an important factor that contributed to the greater resilience of banks in both countries during the 1930s .
Congress responded to the Great Depression by adopting the Glass-Steagall Act of 1933 . The Glass-Steagall Act broke up universal banks to prevent a recurrence of the boom-and-bust cycle that led to the Great Depression . The Act forced banks to spin off or shut down their securities operations , and it prohibited non-banks from accepting deposits . Congress also established a new federal deposit insurance program , which greatly reduced the threat of bank failures due to depositor runs .
The Glass-Steagall Act created a stable financial system by establishing independent sectors with clearly defined legal boundaries . The Act also eliminated the toxic conflicts of interest and perverse incentives for excessive risk-taking that universal banks exhibited during the 1920s . The statute ’ s sponsors — Carter Glass and Henry Steagall — insisted that banks could never act as prudent lenders or as disinterested , trustworthy investment advisers unless they were barred from underwriting and trading in securities ( except for government bonds ).
Glass-Steagall ’ s decentralized system of independent financial sectors prospered from the end of World War II through the 1970s . The United States did not experience any systemic financial crises during that period , even though financial institutions faced significant challenges from rising inflation and volatile currency exchange rates . An important reason for that era ’ s financial stability was that problems arising in one sector of the financial system were much less likely to spill over into other sectors . Regulators could address financial disruptions with targeted responses that did not require massive bailouts of the entire financial system . Regulators could also encourage financial
Bettmann institutions in one sector to help troubled institutions in another sector . For example , the Federal Reserve mobilized leading banks to provide much-needed credit to troubled securities broker-dealers when the stock market crashed in October 1987 .
The Demise of Glass-Steagall , Second-Generation Universal Banks and the Great Recession
During the 1980s and 1990s , large US banks waged a determined campaign to undermine and repeal the Glass-Steagall Act . Federal agencies and courts opened loopholes that allowed banks to conduct a widening array of securities and insurance activities . Regulators also permitted US securities broker-dealers and other non-bank financial institutions to become shadow banks by issuing short-term financial instruments that served as functional substitutes for deposits . Those short-term instruments — including money market funds , commercial paper and securities repurchase agreements ( repos )— offered deposit-like treatment to investors by providing repayment at par ( 100 % of the amount invested ) on demand or within a short period of time .
Congress repealed Glass-Steagall ’ s core provisions in 1999 . That repeal allowed banks to recreate universal banking organizations by establishing financial holding companies that owned securities and insurance subsidiaries . The United Kingdom and the European Union also deregulated their financial sectors during the 1980s and 1990s . By the early 2000s , large universal banks dominated financial markets on both sides of the Atlantic .
President Franklin D . Roosevelt signs the Glass-Steagall Act , June 16 , 1933 .
Universal banks played major roles in the subprime lending boom that led to the global financial crisis of 2007 – 09 . Universal banks packaged trillions of dollars of high-risk loans into asset-backed securities , which were sold as “ safe ” investments to purchasers around the world . The five largest US securities firms also participated in the subprime lending and securitization wave , and they used short-term deposit substitutes to fund a significant share of their operations . Universal banks and securities firms compounded the risks of subprime lending and securitization by creating collateralized debt obligations and credit default swaps . Those toxic devices enabled financial institutions and investors to make highly leveraged bets on the performance of subprime loans .
The subprime lending and securitization boom of the 2000s resembled the credit bubble of the 1920s in many ways , including the presence of widespread conflicts of interest and perverse incentives for excessive risk-taking . The subprime “ assembly line ” that packaged unsound mortgages into mortgage-backed securities generated lucrative up-front fees for loan brokers , lenders , loan servicers , securities underwriters , credit ratings agencies and issuers of financial guarantees . Those fees encouraged participants in the “ assembly line ” to ignore the risks created by subprime mortgages and mortgage-backed securities . Universal banks had the most pervasive conflicts of interest and the strongest incentives to disregard risks because they performed multiple roles and received multiple fees .
In 2007 , the subprime lending surge ended when US housing prices began to fall . The collapse of the subprime
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