Banking Deregulation

Deregulation The Glass-Steagall Act of 1933 was the first major attempt at regulating the financial industry. The Act was passed by President Roosevelt with the objective of restoring public confidence in the banking system. Glass-Steagall sought to, among other things "prevent the undue diversion of funds into speculative operations," in response to the market crashes that had sparked the Great Depression (Maues, 2013).

The reason for this was simple -- speculation was always a temptation for the banking industry, and if left unchecked the industry was likely to indulge in more speculation than the financial industry could sustain while performing at a high level of health and public confidence. It has been argued that Glass-Steagall, for decades, had been able to prevent the type of accumulation in speculative assets within the banking system that occurred in the 2000s.

Commercial and investment banking had been separated for this time, which meant that if investment banks wanted to engage in speculation, their failure would not affect the commercial banking system. In 1999, this separation was ended with legislation that essentially set the tone for the Great Recession a few years later. The basic principle is that now commercial banks were now able to take on investments and risk that they previously would not have bene able to take on.

The normal relationship between risk and return works two ways -- you can assume that with more risk you will get a better return, but risk is just volatility. The reality is that these banks were unprepared for the volatility associated with their positions -- that is to say they had very quickly become overleveraged (Rickards, 2012). The changes in 1999 came about with the Financial Services Modernization Act, which sought to remove many of the restrictions that Glass-Steagall placed on the banking industry.

The initial reactions to this act were positive from the industry. The FSMA were an increase in stock prices for investment banks, and predictions of potential gains from economies of scope, market power and the implicit extension of government guarantees ("too big to fail") to banking affiliates (Carow, 2002). It was somewhat surprising that commercial banks did not respond much to the new laws, whereas investment banks and insurance companies did. The market expected, perhaps, the acquisition of these companies by the major commercial banks.

But in the years after 1999, the larger institutions in all categories earned abnormal returns (Hendersholt, Lee & Thompkins, 2002). This deregulation encouraged greater risk-taking behavior among banks, including among commercial banks. But investment banks, unfettered by regulation, created new securities that they could sell to commercial banks. The banking system as a whole increased its leverage in the search for yield. This trend was echoed in many other countries as well -- Iceland, the UK and Ireland most famously.

These nations allowed their banks to increase risk in part to compete with the American banking industry but in part to follow the same path of increasing risk. However, this increased risk also created networks of risk sharing throughout the banking system. In other words, banks had created such complicated interrelationships that if one bank failed due to overleverage, it was likely to take down much of the banking system with it. Ultimately, that is what happened, when it was revealed just how overleveraged many American banks were.

Only nations that maintained strict banking regulations were able to avoid the financial crisis -- in other countries banks often were exposed to the same toxic assets as American banks, or just had exposure to U.S. banks in general. Thus, the FSMA encouraged greater risk taking and closer links between banks, both of which made the crisis worse than it otherwise.