From the late 1990s through 2008, the United States experienced the largest boom-and- bust cycle in its securities and housing markets since the “Roaring Twenties” and the Great Depression. Scholars have studied the events that led to the recent financial crisis and have compared those events to the causes of the Great Depression. In particular, analysts have considered whether ‘universal banks’ – financial conglomerates that control deposit-taking banks as well as securities broker-dealers – played central roles in both crises.
Congress responded to the Great Depression by adopting the Glass-Steagall Act of 1933, which outlawed first-generation universal banks and established a wall of separation between commercial banks and securities firms. During the 1980s and 1990s, regulators and courts steadily undermined Glass-Steagall, and Congress finally repealed the statute in 1999. Is it more than a coincidence that the demise of Glass-Steagall was followed by the most spectacular economic boom since the 1920s and the most serious financial and economic crisis since the 1930s? This article is part of a larger project in which I plan to examine the rise and fall of first-generation universal banks during the 1920s and 1930s and to compare their experience with the performance of second-generation universal banks during the 1990s and 2000s.
As described in my article ‘Prelude to Glass-Steagall: Abusive Securities Practices by National City Bank and Chase National Bank During the 'Roaring Twenties', first-generation universal banks became leading underwriters and distributors of securities in the United States during the 1920s. The preeminent universal banks of the 1920s were the two largest U.S. commercial banks – National City Bank (National City) and Chase National Bank (Chase). National City and Chase and their securities affiliates earned huge profits during the economic boom of the 1920s but suffered massive losses during the Great Depression. Both banks received bailouts from the Reconstruction Finance Corporation in December 1933.
The Pecora Committee’s investigation in 1933 revealed that National City and Chase used deceptive and manipulative techniques to sell massive volumes of foreign bonds and other high-risk securities to ordinary investors and smaller financial institutions. Both banks made unsound loans to support the activities of their securities affiliates. Both banks organized trading pools to pump up the prices of their own stocks as well as the stocks of favored clients. Insiders took advantage of both banks’ securities operations to reap extraordinary financial gains. Revelations of both banks’ securities abuses and their top executives’ self-dealing triggered widespread public outrage and generated public support for enactment of the Glass-Steagall Act as well as the Securities Act of 1933 and the Securities Exchange Act of 1934.
The abuses and conflicts of interest that occurred at National City and Chase illustrated the potential dangers of allowing commercial banks to affiliate with securities broker-dealers. The evidence produced by the Pecora Committee supported Glass-Steagall’s fundamental premise that universal banks created intolerable hazards that could not be resolved without dismantling the universal banking model. National City and Chase mobilized their deposits, lending resources, and retail branches to underwrite and sell high-risk securities to unsophisticated investors who trusted in both banks’ presumed soundness and investment expertise. National City and Chase exhibited pervasive conflicts of interest that caused both banks to make unsound loans to their securities affiliates, to investors who purchased securities from their affiliates, and to companies that issued securities underwritten by their affiliates.
The disastrous experiences of National City and Chase demonstrated the clear dangers of allowing commercial banks to use their deposits and lending resources to promote speculative underwriting and trading operations. The near-collapse and bailouts of both banks also highlighted the systemic risks that arise when major banks establish close links with the securities markets.
The hazards of universal banking became manifest again in the 1990s and 2000s. Second-generation universal banks played leading roles in securitizing and marketing high-risk, asset-backed securities (and related derivatives) that helped to precipitate the greatest worldwide boom and crash since the Great Depression. To prevent a collapse of global financial markets, government officials in the United States, United Kingdom, and Europe rescued troubled universal banks and supported not only their banking units but also their securities and other nonbanking subsidiaries. U.S. regulators arranged emergency deals that (1) converted two leading securities firms (Goldman Sachs and Morgan Stanley) into universal banks and (2) enabled existing universal banks (JPMorgan Chase and Bank of America) to become even larger by acquiring troubled securities firms. The foregoing government measures confirmed the existence of a 'too-big-to-fail' (TBTF) policy that embraced the banking system as well as major segments of the securities and insurance markets.
The Dodd-Frank Act of 2010 promised to end TBTF. However, many analysts believe that goal is a long way from being accomplished. As policymakers evaluate the desirability of further reforms to end TBTF, they should reconsider the lessons of the Great Depression as well as the wisdom of Glass-Steagall’s regime of structural separation between the banking industry and the securities markets.
Arthur E. Wilmarth Jr. is a Professor of Law at the George Washington University Law School