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THE GLASS-STEAGALL ACT, enacted by
Congress in 1933, came under fire from the banking lobby and some members
of Congress this year. Each sought to repeal the restraints on underwriting
and dealing in securities that the Act imposes on commercial banks. The
legislation, sponsored by retiring Sen. William Proxmire, D- Wisc., failed
to pass, but is expected to resurface next year.
The effort ignores the historical circumstances that precipitated Glass-Steagall as well as the
ramifications--for both individual investors and the national economy--of
letting commercial banks engage in corporate securities activities.
Glass-Steagall was a response to several specific abuses by financial institutes that
contributed to the general economic collapse of 1929. Banks played a key
role in fuelling the speculative frenzy in the stock market during the
1920s, extending large amounts of credit for securities investment. In
addition, the securities affiliates of many banks were underwriting and
peddling to their customers a massive volume of securities of questionable
worth. Glass-Steagall imposed a structural solution by separating commercial
banking from underwriting and dealing in securities.
The move to repeal Glass-Steagall's structural distinction between commercial and investment
banking was sparked in part by changes that have occurred in financial
markets since the 1930s. First, there are many more links between banking
and securities markets than existed even 10 years ago. Under the Reagan
administration, federal regulators have aggressively exploited loopholes
in Glass-Steagall to allow banks to engage in some limited securities activities.
In addition, the decline in bank profitability in recent years, due primarily
to losses on Latin debt and loans in energy and real estate sectors, led
banking interests to advocate for new powers that would generate fee income,
securities underwriting among them, in order to offset the falling profits
in traditional banking activities. But, as one observer noted, "Arguing
that you need new powers to compensate for the fact that you have mismanaged
your existing powers requires either an Alice in Wonderland suspension
of logic or a lot of political clout." Proxmire made much of the fact that
bank entry into securities markets would increase competition and lower
underwriting fees. Underwriting of investment grade corporate securities,
however, is already reasonably competitive, and bank entry is likely to
have only a minor impact on the price of issuing such securities.
On the other hand, underwriting fees on junk bonds and other speculative securities
are often three to four times greater. Consequently, repeal of Glass-Steagall
is likely to draw the largest banks, which have resources far beyond those
of the largest securities firms, into aggressive promotion of junk bonds
and speculative securities. Boosting the junk bond market will further
fuel leveraged buy-outs and hostile takeovers, a trend that is undermining
the capital base of U.S. corporations.
Banks would be in an excellent position
to facilitate and profit from such freewheeling corporate restructuring,
since they are already able to extend large "bridge" loans to finance the
tender offers that start the process. The Proxmire bill would have required
banks to conduct most securities activities in separate subsidiaries under
a bank holding company structure. This approach, it was claimed, would
ameliorate concerns about bank safety and soundness, and prevent raids
on bank capital to promote speculative securities activities. The bill--and
the hearings the Senate Banking Committee held on it--did not, however,
address the potential for conflicts of interest and insider trading that
is inherent in allowing banks to engage in securities activities.
A serious conflict of interest exists when, for example, a bank underwrites securities
issued by a corporation that has loans outstanding from the bank. As an
underwriter, the bank has a "due diligence" obligation to provide accurate
information on new securities issues to investors. But as a creditor, the
bank may want a troubled corporate borrower to issue securities so that
the proceeds can be used to repay the bank's loan. In effect, control of
the underwriting process may enable the bank to shift potential loan losses
to public investors.
(balance of this article omitted here; unscannable)
Jon Brown is Executive Director of Bank Watch, a Washington-
based public interest organization.
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