It’s been almost 80 years since the U.S. government has reached as deeply into the financial markets as it will do when the regulatory overhaul being crafted in Congress becomes law.
Few historians, market participants or former regulators say they expect the current bill to put an end to financial crises any more than the post-Depression rules did. In one major area the new legislation is weaker because it departs from a central goal of 1930s lawmakers -- to control the size and scope of the largest financial institutions.
The Glass-Steagall Act, which separated commercial and investment banking in 1933, “was the most effective antitrust law we’ve ever had,” said Charles Geisst, a finance professor at Manhattan College in New York, who has written about Wall Street’s history.
Glass-Steagall was as much about breaking up companies as ensuring customer deposits wouldn’t be used for risky practices, Geisst said. Today’s Congress may live to regret that they’ve done almost nothing to shrink firms such as JPMorgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc., he said.
In the current debate, people are buying the lobbyists’ argument that “you just can’t live without a series of powerful banks that are all too big to fail,” Geisst said.
Government regulation of Wall Street began in earnest after the 1929 stock market crash, when Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the SEC, required investment banks to disclose material information about securities they peddled and prohibited brokers from deceiving clients. The laws responded to abuses that were rampant in the 1920s, such as banks selling stocks and bonds in companies that were already bankrupt.
Congress repealed Glass-Steagall in 1999, contributing to mergers and the growth one-stop-shopping financial services companies.
The repeal helped pave the way for the formation of Citigroup by the $46 billion merger of Citicorp and Travelers Group Inc. It also made it possible for Goldman Sachs and Morgan Stanley, the two biggest U.S. securities firms, to convert into bank holding companies, enabling them to get cheap funding from the Federal Reserve during the financial crisis. If the law hadn’t been repealed, Bank of America Corp. wouldn’t have been allowed to acquire Merrill Lynch & Co.
Under Glass-Steagall, the financial system didn’t approach a meltdown. The law also didn’t prevent government rescues when banks failed. The biggest collapse before the 2008 crisis occurred in 1984, when Continental Illinois National Bank and Trust became insolvent, prompting the Federal Deposit Insurance Corp. to buy $4.5 billion of its bad loans. The savings-and-loan crisis of the 1980s and 1990s cost the taxpayers about $124 billion.
The legislation approved by the Senate last week and the measure adopted by the House in December arose amid public outrage over the $700 billion federal bailout of the financial markets in 2008. The bills emphasize the role of regulators and rules in constraining abusive practices.
Among other things the bills would create a new agency to oversee consumer financial products, establish a council to monitor systemic risk and increase regulation of derivatives, mortgage brokers, credit-rating companies and hedge funds.
Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather.
Although it is unlikely to prevent future crises, the congressional bill, with all its weaknesses and loopholes, probably will mitigate the impact of the next blow-up, said Harvey Goldschmid, a former SEC commissioner who is a professor at Columbia Law School.
“Undoubtedly there will be further problems, it’s just the nature of business and the financial business in particular,” Goldschmid said. “But this will avoid some significant problems and limit the impact of others.”
Goldschmid, who sat on the SEC as it implemented an overhaul of corporate accounting in 2002 and 2003, the Sarbanes- Oxley Act, said the new bill will have a large impact on the way Wall Street works, increasing scrutiny of the biggest banks.
“You’re going to create oversight in areas where we just haven’t had it and in areas that have been part of the problem,” he said. “Will it make it perfect? Of course not. Will it make it better? Definitely.”
Others, particularly banks and their lobbyists, see a historical over-reaching by Congress that has the potential to stifle the economy for years to come.
“We’re beginning to see people price in the impact on this on the entire financial system, on the availability of credit,” said David Hirschmann, president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness. “There are estimates that range up to $2 trillion of credit that would be sucked out of the economy.”
William Sweet, a former attorney at the Federal Reserve Board, disagrees. Assuming that some of the measure’s more contentious aspects get changed in a House-Senate conference, including a requirement that banks wall off their swaps-trading desks and another that directs higher capital requirements, the legislation isn’t likely to be as disruptive as the 1930s changes, said Sweet, a partner at Skadden, Arps, Slate, Meagher & Flom in Washington.
“This gives the regulators more authority to be more vigilant, it gives them new tools and powers, but doesn’t do anything like Glass-Steagall,” said Sweet. “While this is a political response to a similar situation, it avoids doing too much damage.”
Another issue of concern in the current legislation is that it may lead to unintended consequences, which has happened before when lawmakers have tried to rein in U.S. corporations. The risk is higher, opponents argue, in complex areas such as financial regulation.
For example, Congress in 1993 tried to curb excessive pay by prohibiting tax deductions on annual salaries that exceeded $1 million. Companies could continue deducting pay that they didn’t dole out as salary, such as stock options.
As a result, businesses issued a flood of options to their employees. Some companies then began abusing options by backdating grants to periods when stock prices were lower to ensure big payouts to executives -- prompting more than two dozen enforcement actions by the SEC.
During the legislative debate over the past year, firms have argued that the overhaul would unintentionally push derivatives trading overseas, for example. Mutual funds have fought another provision that would allow the FDIC to pay some creditors more than others after a big bank fails, saying it could disrupt the bond market.
“There is nobody who knows everything that is in” the Senate’s financial overhaul bill, said former SEC Chairman Harvey Pitt, who was appointed by President George W. Bush. “We run a big risk of feeling the love of unintended consequences and feeling it in all its unleashed fury.”
Pitt, who headed the SEC during the Sarbanes-Oxley era, said the broader problem with the new legislation is that it leads investors to believe the political rhetoric that a law can solve all the problems that created the mess. The 2002 law he helped implement was born out of the massive accounting frauds at Enron Corp. and WorldCom Inc. It required corporate executives to attest to the accuracy of their books and put new strictures on the accounting industry.
“We needed a bill that demonstrated that this country wouldn’t tolerate financial shenanigans, but it got sold to the American public as the solution for everything that went wrong,” he said. “If Sarbanes-Oxley had really been all that good, would we have had what we’ve seen in the financial meltdown? I think the answer to that is no.”
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