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Sunday, March 09, 2008 3:57 AM

Did Lack Of Regulation Cause This Mess?

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Numerous people have been writing me about how the repeal of the Glass-Steagall Act has brought about our economic demise.

Here is a refresher course on Glass-Steagall.

The Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC) and included banking reforms, some of which were designed to control speculation. Some provisions such as Regulation Q that allowed the Federal Reserve to regulate interest rates in savings accounts were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. Other provisions which prohibit a bank holding company from owning other financial companies were repealed in 1999 by the Gramm-Leach-Bliley Act.

Two separate United States laws are known as the Glass-Steagall Act. The Acts (Glass & Steagall) were both reactions of the U.S. government to cope with the economic problems which followed the Stock Market Crash of 1929.

Both bills were sponsored by Democratic Senator Carter Glass of Lynchburg, Virginia, a former Secretary of the Treasury, and Democratic Congressman Henry B. Steagall of Alabama, Chairman of the House Committee on Banking and Currency.
Demise of Glass-Steagall

The Wall Street Fix is writing about The Long Demise of Glass-Steagall.

The above article depicts a "chronology tracing the life of the Glass-Steagall Act, from its passage in 1933 to its death throes in the 1990s, and how Citigroup's Sandy Weill dealt the coup de grâce".

Is More Regulation The Answer?

Actually the answer is no. The reason is that no one traces problems back to their original origin. The problems in the 1920's and the problems now did not arise from insufficient regulation. The problems then and now stem from rampant and excessive extension of credit. The origin of credit problems lies in fractional reserve lending.

Fractional reserve lending allows banks and other institutions to lend more money out than they have on deposit. Credit expansion now dwarfs what we saw in the 1920's. You can thank President Nixon for that. When Nixon closed the gold window (Ron Paul discusses the gold window in The End of Dollar Hegemony) the last remaining control over credit expansion was removed. Credit has since exploded.

Glass-Steagall is nothing but a smokescreen. The problem is massive credit expansion that created artificial booms such as we saw in housing. The party ends when borrowers are no longer able to service debt. That happened in 1929 and it is happening now.

In the 1920s, had banks not lent more than was on deposit there would not have been so many bank failures and bank runs. Look at what the solution "accomplished". By guaranteeing deposits, money has flowed to banks offering the highest rates on savings accounts and CDs.

This in turn sponsored insane activity and lending for massively overbuilt condo towers in Florida, California, Las Vegas and other places. Money continues to flow into banks that are going to go under.

Thus, the FDIC which came into existence during the great depression as a "solution" has done nothing but make the problem worse. By preventing periodic local bank failures, FDIC interim stability guaranteed a bigger systemic failure down the road.

For more on this idea, please see Does Stability Breed Instability?

Bank Exposure To Commercial Real Estate

According to the Comptroller of the Currency and Administrator of National BanksOver a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital.

Do we need another layer of oversight and more regulation, or do we simply need to disallow fractional reserve lending that allowed the above nonsense to take place?

If you are still unsure, remember that it was fractional reserve lending that allowed rampant credit expansion such as: no money down on housing, liar loans, toggle bonds, hedge funds like Carlyle Capital borrow money and use it at 32:1 leverage, $500 trillion in derivatives, etc.

FDIC Moral Hazard

The repeal of Glass-Steagall did not create this mess. Glass-Steagall itself helped create this mess. Would people put money on deposit at Corus Bank (CORS), Bank United (BKUNA), or Countrwide (CFC) were it not for FDIC? People flock to those places for one reason only: FDIC.

Banks that deserve to get no funding are getting it in spades because of the moral hazard of FDIC, a creation of Glass-Steagall.


Glass-Steagall prevented banks from writing insurance. Why? Should banks be prohibited from selling peanut butter sandwiches too? If banks want to sell either peanut butter sandwiches or insurance it is fine with me. The point is government ought not dictate what businesses do or do not do as long as there is no conflict of interest. I see no more conflict of interest in banks selling insurance or peanut butter sandwiches than I do in Wal-Mart selling bicycles, dresses, and fishing poles out of the same store.

Speaking of which, Wal-Mart recently asked to open a bank. It was not allowed. Why? Bribery is why. Congress was bribed (via campaign contributions from banks) to not allow Wal-Mart to open a bank. Banks oppose Wal-Mart because Wal-Mart would increase competition. Existing banks do not want more competition from non-banks. In essence, banks want to sell peanut butter sandwiches (insurance) while not permitting Wal-Mart to do the same.

Another fear that banks have is that Wal-Mart would come in and do something radical like offer ATMs that charged 25 cents or a dime to do a transaction. Regulation and government sponsorship is keeping costs high.

Would the repeal of FDIC cause more frequent bank failures? Perhaps. However, in the internet age of instantaneous information, banks would be less willing to take stupid risks when customers went poking around. And any bank offering well above market rates would be waving a red flag as opposed to the green flag we see today. Thus, if bank failures were more frequent, they sure we be smaller than what we are about to face.

The only FDIC I would keep would be on checking accounts, and then only under the stipulation that banks agree not to lend that money out. Banks would be free to choose: Offer FDIC and not lend checking deposits out, or not offer FDIC. Customers no doubt would choose accordingly.

Clearly, the repeal of Glass-Steagall is not at the root of the problems we face today. The root of the problem is fractional reserve lending in conjunction with a Fed that micro-manages interest rates without having a clue as to what they are doing. So, if banks want to sell insurance, peanut butter sandwiches, and Girl Scout cookies while offering checking services I say go for it, provided we get to the real solution to this banking mess.

The solution to this mess is not more regulation but less regulation and less government interference. The best things to do would be to abolish the Fed and eliminate fractional reserve lending, the latter on a phased in approach.

Mike "Mish" Shedlock
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