Home / Uncategorized / The credit crisis was NOT a Black Swan event (Part Two)

The credit crisis was NOT a Black Swan event (Part Two)

Could we have forecast the credit crisis?  Yes.  Lots of thoughts on this, including last week's comment, but here's some more new stuff.

Ten years ago in the US of A, Sandy Weill put great pressure on Bill Clinton's office to repeal the Glass-Steagall Act with some success.  This was because Sandy had a vision for Citigroup, which had grown from a retail bank to an integrated bank and insurer thanks to the merger with Travellers. 

Sandy now wanted to create a global universal bank, integrating insurance, securities and retail banking, with Citibank, Travellers and Salamon Smith Barney at the forefront. 

Trouble was that his plans were being thwarted by regulations, as Glass-Steagall prohibited any one institution from acting as
a combination of investment bank, commercial bank and insurance company.  This ruling was made after the 1929 Great Depression and stock market crash.

After years of lobbying, Weill was successful, and the Glass-Steagall Act was repealed and Gramm-Leach-Bliley (GLB) came into force.  The Gramm-Leach-Bliley Act allowed commercial banks, investment
banks, securities firms and insurance companies to consolidate, and therefore created the legal platform for Citigroup to emerge.

At the time, we thought the revolutionary model the act would allow was bancassurance, where more banks would offer full service in-house insurance.  Instead, it allowed the riskier activities of the investment markets to infect the rest of the financial ops.

These risky activities would infect the rest of the financial ops regardless – just look at Long Term Capital Management – as the markets are like a house of cards.  However, it did create a significant step towards the crash situation we are dealing with today.

Did no-one object?

Sure, a few did and, today, the US Senator Byron Dorgan is being accredited as the visionary.  Here's what he had to say back in 1999:

Senator Byron Dorgan from Chris Skinner on Vimeo.

His full senate floor speech included a few other harbingers of doom:

I spoke earlier today about this legislation, which is called the Financial Services Modernization Act of 1999, and said then that I am probably part of a very small minority in this Chamber, but I feel very strongly that this is exactly the wrong bill at exactly the wrong time. It misses all the lessons of the past and, in my judgment, it creates definitions and moves in directions that will be counterproductive to our financial future.

What does this bill do? It would permit common ownership of banks, insurance, and securities companies, and to a significant degree commercial firms as well. It will permit bank holding companies, affiliates, and bank subsidiaries to engage in a smorgasbord of expanded financial activities, including insurance and securities underwriting, and merchant banking all under the same roof.

This bill will also, in my judgment, raise the likelihood of future massive taxpayer bailouts. It will fuel the consolidation and mergers in the banking and financial services industry at the expense of customers, farm businesses, family farmers, and others, and in some instances I think it inappropriately limits the ability of the banking and thrift institution regulators from monitoring activities between such institutions and their insurance or securities affiliates and subsidiaries raising significant safety and soundness consumer protection concerns.

And further proof from the New York Times at that time:

CONGRESS PASSES WIDE-RANGING BILL EASING BANK LAWS
By STEPHEN LABATON
November 5, 1999

WASHINGTON, Nov. 4— Congress approved landmark legislation today that opens the door for a new era on Wall Street in which commercial banks, securities houses and insurers will find it easier and cheaper to enter one another's businesses.

The measure, considered by many the most important banking legislation in 66 years, was approved in the Senate by a vote of 90 to 8 and in the House tonight by 362 to 57. The bill will now be sent to the president, who is expected to sign it, aides said. It would become one of the most significant achievements this year by the White House and the Republicans leading the 106th Congress.

''Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century,'' Treasury Secretary Lawrence H. Summers said. ''This historic legislation will better enable American companies to compete in the new economy.''

The decision to repeal the Glass-Steagall Act of 1933 provoked dire warnings from a handful of dissenters that the deregulation of Wall Street would someday wreak havoc on the nation's financial system. The original idea behind Glass-Steagall was that separation between bankers and brokers would reduce the potential conflicts of interest that were thought to have contributed to the speculative stock frenzy before the Depression.

Today's action followed a rich Congressional debate about the history of finance in America in this century, the causes of the banking crisis of the 1930's, the globalization of banking and the future of the nation's economy.

Administration officials and many Republicans and Democrats said the measure would save consumers billions of dollars and was necessary to keep up with trends in both domestic and international banking. Some institutions, like Citigroup, already have banking, insurance and securities arms but could have been forced to divest their insurance underwriting under existing law. Many foreign banks already enjoy the ability to enter the securities and insurance industries.

''The world changes, and we have to change with it,'' said Senator Phil Gramm of Texas, who wrote the law that will bear his name along with the two other main Republican sponsors, Representative Jim Leach of Iowa and Representative Thomas J. Bliley Jr. of Virginia. ''We have a new century coming, and we have an opportunity to dominate that century the same way we dominated this century. Glass-Steagall, in the midst of the Great Depression, came at a time when the thinking was that the government was the answer. In this era of economic prosperity, we have decided that freedom is the answer.''

In the House debate, Mr. Leach said, ''This is a historic day. The landscape for delivery of financial services will now surely shift.''

But consumer groups and civil rights advocates criticized the legislation for being a sop to the nation's biggest financial institutions. They say that it fails to protect the privacy interests of consumers and community lending standards for the disadvantaged and that it will create more problems than it solves.

The opponents of the measure gloomily predicted that by unshackling banks and enabling them to move more freely into new kinds of financial activities, the new law could lead to an economic crisis down the road when the marketplace is no longer growing briskly.

''I think we will look back in 10 years' time and say we should not have done this but we did because we forgot the lessons of the past, and that that which is true in the 1930's is true in 2010,'' said Senator Byron L. Dorgan, Democrat of North Dakota. ''I wasn't around during the 1930's or the debate over Glass-Steagall. But I was here in the early 1980's when it was decided to allow the expansion of savings and loans. We have now decided in the name of modernization to forget the lessons of the past, of safety and of soundness.''

Senator Paul Wellstone, Democrat of Minnesota, said that Congress had ''seemed determined to unlearn the lessons from our past mistakes.''

''Scores of banks failed in the Great Depression as a result of unsound banking practices, and their failure only deepened the crisis,'' Mr. Wellstone said. ''Glass-Steagall was intended to protect our financial system by insulating commercial banking from other forms of risk. It was one of several stabilizers designed to keep a similar tragedy from recurring. Now Congress is about to repeal that economic stabilizer without putting any comparable safeguard in its place.''

Supporters of the legislation rejected those arguments. They responded that historians and economists have concluded that the Glass-Steagall Act was not the correct response to the banking crisis because it was the failure of the Federal Reserve in carrying out monetary policy, not speculation in the stock market, that caused the collapse of 11,000 banks. If anything, the supporters said, the new law will give financial companies the ability to diversify and therefore reduce their risks. The new law, they said, will also give regulators new tools to supervise shaky institutions.

''The concerns that we will have a meltdown like 1929 are dramatically overblown,'' said Senator Bob Kerrey, Democrat of Nebraska.

Others said the legislation was essential for the future leadership of the American banking system.

''If we don't pass this bill, we could find London or Frankfurt or years down the road Shanghai becoming the financial capital of the world,'' said Senator Charles E. Schumer, Democrat of New York. ''There are many reasons for this bill, but first and foremost is to ensure that U.S. financial firms remain competitive.''

But other lawmakers criticized the provisions of the legislation aimed at discouraging community groups from pressing banks to make more loans to the disadvantaged. Representative Maxine Waters, Democrat of California, said during the House debate that the legislation was ''mean-spirited in the way it had tried to undermine the Community Reinvestment Act.'' And Representative Barney Frank, Democrat of Massachusetts, said it was ironic that while the legislation was deregulating financial services, it had begun a new system of onerous regulation on community advocates.

Many experts predict that, even though the legislation has been trailing market trends that have begun to see the cross-ownership of banks, securities firms and insurers, the new law is certain to lead to a wave of large financial mergers.

The White House has estimated the legislation could save consumers as much as $18 billion a year as new financial conglomerates gain economies of scale and cut costs.

Other experts have disputed those estimates as overly optimistic, and said that the bulk of any profits seen from the deregulation of financial services would be returned not to customers but to shareholders.

These are some of the key provisions of the legislation:

  • Banks will be able to affiliate with insurance companies and securities concerns with far fewer restrictions than in the past.
  • The legislation preserves the regulatory structure in Washington and gives the Federal Reserve and the Office of Comptroller of the Currency roles in regulating new financial conglomerates. The Securities and Exchange Commission will oversee securities operations at any bank, and the states will continue to regulate insurance.
  • It will be more difficult for industrial companies to control a bank. The measure closes a loophole that had permitted a number of commercial enterprises to open savings associations known as unitary thrifts.

One Republican Senator, Richard C. Shelby of Alabama, voted against the legislation. He was joined by seven Democrats: Barbara Boxer of California, Richard H. Bryan of Nevada, Russell D. Feingold of Wisconsin, Tom Harkin of Iowa, Barbara A. Mikulski of Maryland, Mr. Dorgan and Mr. Wellstone.

In the House, 155 Democrats and 207 Republicans voted for the measure, while 51 Democrats, 5 Republicans and 1 independent opposed it. Fifteen members did not vote.

Tucked away in the legislation is a provision that some experts today warned could cost insurance policyholders as much as $50 billion. The provision would allow mutual insurance companies to move to other states to avoid payments they would otherwise owe policyholders as they reorganize their corporate structure. Many states, including New York and New Jersey, do not allow such relocations without the consent of the insurer's domicile state. But the legislation before Congress would pre-empt the states.

Both the Metropolitan Life Insurance Company and the Prudential Life Insurance Company are in the midst of reorganizing into stock-based corporations that are requiring them to pay billions of dollars to policyholders from years of accumulated surplus. In exchange, the policyholders give up their ownership in the mutual insurance company.

The legislation would permit any mutual insurance company to avoid making surplus payments to policyholders by simply moving to states with more permissive laws and setting up a hybrid corporate structure known as a mutual holding company.

The provision was inserted by Representative Bliley at the urging of a trade association. It attracted little opposition because it was attached to a provision that forbids insurers from discriminating against domestic-violence victims.

In a letter sent to Congress this week, Mr. Summers said that the provision ''could allow insurance companies to avoid state law protecting policyholders, enriching insiders at the expense of consumers.''

About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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2 comments

  1. This is an insightful comment because it steps beyond the academic analysis of data, to the causality between human/personal motivations and human drama….. except this time it was very large and in financial services.

  2. Sen. Dorgan’s concerns were impeccably prescient. Even the timing of the impending doom was prophetic! Those who choose to forget their history are condemned to repeat it.

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