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To Save Commercial Banking From Gamblers, Re-enact Glass-Steagall Act
Updated: February 2010
In December 1863, H. McCulloch, U.S.
Comptroller of the Currency and later Secretary of the Treasury, wrote to all
national banks. Here are some of the paragraphs.
“Let no loans be made that are not
secured beyond a reasonable contingency. Do nothing to encourage speculation.
Give facilities only to legitimate and prudent transactions.
“Distribute your loans rather than
concentrate them in a few hands. Large loans to a single individual or firm,
although sometimes proper and necessary, are generally injudicious, and
frequently unsafe. Large borrowers are apt to control the bank.
“If you doubt the propriety of
discounting an offering, give the bank the benefit of the doubt and decline it.
If you have reasons to distrust the integrity of a customer, close his account.
Never deal with a rascal under the impression that you can prevent him from
cheating you.
“Pay your officers such salaries as
will enable them to live comfortably and respectably without stealing; and
require of them their entire services. If an officer lives beyond his income,
dismiss him; even if his excess of expenditures can be explained consistently
with his integrity, still dismiss him. Extravagance, if not a crime, very
naturally leads to crime.
“The capital of a bank should be
reality, not a fiction; and it should be owned by those who have money to lend,
and not by borrowers.
“Pursue a straightforward, upright,
legitimate banking business. ‘Splendid financing’ is not legitimate banking,
and ‘splendid financiers’ in banking are generally either humbugs or rascals.”
The McCulloch teaching is as relevant today as it were in 1863. Accepting and managing society’s saving is a sacred responsibility bestowed by the legislator exclusively upon commercial banks. Investment, insurance, and brokerage firms
are not banks and their executives are not bankers. That investment
firms are called “banks” is a misnomer. Investment managers will not be called
bankers here.
The deposit-taking culture of commercial
banking contrasts with the culture of investment companies. As custodians of
society’s saving, commercial banks are highly regulated. Their funding is
sourced primarily from people's deposits. By contrast, investment firms are
prohibited from seeking customers’ deposits (they fund their operations from
the money markets); thus, they are less regulated. Different funding sources
and regulations evolved into two very different cultures, value systems, temperaments, and personality types; thus, attracting two different kinds of people. Commercial banking appeals to cautious individuals. Commercial bankers
are generally dedicated to steady, long-term banking relationships with
depositors and borrowers. Bankers are taught to observe prudence in risk
management and avoid speculation. Bankers grow to view risk control structures with respect. They earn
relatively modest but comfortable salaries. On the other hand, investment managers are genetically risk-takers. They are aggressive, short-term transaction-by-transaction oriented
salesmen. With performance-bonus schemes and
scant training in risk analysis, investment managers regard control
structures as an impediment to profitable deals. To such individuals, commercial
bankers are “boring” and “unimaginative”.
The root cause of the trouble
The
liberalization years of the Reagan administration (1981-1989) led to
the repeal in 1999 of the Glass-Steagall Act of 1933. The repeal
removed the wall between commercial banks and the other types of
financial organizations. The current banking meltdown is in a great
measure the product of deregulation and eight years of a Bush administration
contemptuous of regulation. Commercial banks were cobbled together with
investment, insurance, and brokerage companies despite their very different
cultures. Non-bankers, “rascals” and “splendid financiers” took charge of the
billions in people’s saving to gamble away in speculative trades. The merged businesses became wildly diversified in terms of risky products
and colossal in size--impossible to manage successfully; notwithstanding, the "geniuses" who sit in their executive suites. In pursuit of huge performance
bonuses, an era of go-go banking was ushered into the previously well controlled
commercial banking, with the result that many of the once highly
respectable deposit-taking institutions became irreparably damaged.
The practice that grew in recent years of compensating
senior executives with mainly performance bonuses has had disastrous repercussions. Performance
bonuses can be soul destroying.
In their pursuit of self-enrichment, executives are tempted to not only
cut
corners on professional and ethical standards but also ignore the
spirit of the
law, and even violate the law (in the hope that they’ll never be
caught). The
monumental losses that surfaced in 2008 render the billions of bonus
dollars
paid to executives a travesty. Performance bonuses have also created
obscene
disparities in employee compensation within even the same bank, between
the managers of the investment divisions, on one hand, and the managers
of the commercial banking divisions. Such disparities
of incomes replaced the old institutional culture of loyalty,
commitment, and
collegiality by a culture of disloyalty, exploitation, and
I-only-work-here
syndrome.
The banking debacle is a result of the collective failure of "rascals", "splendid financiers", greedy lenders,
negligent government
supervisors, obsequious internal auditors, submissive external auditors
obsessed in lucrative consulting contracts with the companies they
audit, as
well as those pontificating rating agencies’ “experts” who are always
steps behind the events and who get paid by the firms they rate.
Solution
To protect national saving, investment firms must be kept
away from commercial banks. The repeal of Glass-Steagall Act was the primary misstep in creating the
conditions, which resulted in the crisis we face today. Astonishingly, in
the midst of this unraveling crisis, Goldman Sachs and Morgan Stanley, the two
leading firms of an industry that contributed greatly to the current banking
disaster, were upgraded to full commercial banking status by the Federal
Reserve Bank. Notwithstanding
the short-term arguments in favor of the upgrade, I predict that the
long-term effects of this action will prove to be a grave mistake.
Politicians, bankers, and lobbyists who argue against the reinstatement of Glass-Steagall because no major bank had collapsed in 2008--only investment companies, like Bear Stearn and Lehman Brothers, ignore important facts. First, the major banks would have collapsed had it not been for decisive government rescue. US Secretary of the Treasury, Timothy Geithner revealed
in December 2009 that “the entire U.S. financial
system and all the major firms in the country, and even small banks
across the country, were at that moment at the middle of a classic run,
a classic bank run". Geithner said further that "without the government’s extraordinary rescue
measures, the entire financial system was on the verge of collapse", and that "none of them would have survived” had the government stood aside and
let the crisis run its course. Secondly, the collapse of investment companies usually happens because such companies do not have a lender of last resort nor do they have a customer deposit base to rely upon when their loans mature at times of tight liquidity and no lender would roll-over those maturing loans or extend new credit. On the other hand, yesterday's investment companies that had merged with banking institutions and became investment departments within those banks were protected by trillions of dollars in customers deposits plus central bank's protection as lender of last resort, notwithstanding the damage that these investment pockets had inflicted on the financial integrity and the net worth of their parent banks, which forced the government to come to the rescue in 2008.
The protective wall around commercial banking must be rebuilt. Reviving the provisions of Glass-Steagall Act is crucial. It is significant that five former US Treasury Secretaries, Republicans and Democrats, said in a letter to The Wall Street Journal in February 2010 that banks benefiting from public support by means of access to the Federal Reserve and FDIC insurance should not engage in speculative trading activities unrelated to essential bank services.
Strict
governmental control over commercial
banks must be restored. External auditors should perform one function
only: Auditing. Management consultancies should be separated from audit
firms. Shareholders should take banks that hand out excessive compensation packages to task. The distribution of profits between shareholders and employees has gone too far in recent years against the interest of shareholders. That investment people earn multiples of the earnings of physicians, engineers, and university professors is wrong and unsustainable. It is heartening that a lawsuit against Goldman Sachs was filed on January 5, 2010 by an individual shareholder and on January 7, 2010 by an Illinois pension fund, the Central Laborers' Pension Fund, in New York state supreme court in Manhattan seeking to recover billions of dollars of bonuses and other compensation being awarded for 2009.
Government
regulators should ensure that senior bank executives and board members are “fit”
to serve. To be fit, a banker must not only be qualified technically but also
psychologically suitable. The current approval process conducted by central
banks of senior bankers is cursory. This process should include behavioral psychological
testing and background checks to keep gamblers away. If drunks are not allowed to drive cars why should gamblers be allowed to play the markets with society's saving?!
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