In the late Nineties, Congress repealed the Glass-Steagall Act (aka the Banking Act of 1933). Glass-Steagall mandated that commercial banking and investment banking activities could not both be conducted in or by the same legal entity. The Act was a reaction to abuses that led to the collapse of the stock market in the US during 1929 and beyond.
The bill that repealed Glass-Steagall was the Gramm-Leach-Bliley Act of 1999. Although formulated by Republicans and passed along party lines in the Senate, the bill received bipartisan support in the House and was signed by Bill Clinton, a Democratic president. The ostensible purpose of Gramm-Leach-Bliley was to allow American banks to expand activities to compete better with the big foreign “universal” banks, primarily in Europe. But by once again permitting commercial banks to also do investment banking activities inside one entity, GLB opened the floodgates to the unfettered proprietary trading that has yielded such disastrous results over the past several years.
The ensuing problem
Part of the problem with the American commercial bank/investment bank conglomerates that were spawned by GLB was that the investment bankers and traders working at these entities turned out to be, by and large, either incompetent or dishonest. In addition they were supervised by commercial bank executives cut from the same cloth, who seem to have had no clue about what the investment bankers they supervised were doing.
In the simplest terms, GLB allowed the investment banks in the combined entities to use the stronger credit rating of the commercial bank parent to lower their borrowing costs. This financing advantage would in theory lead to “extra” profits in the investment bank and increased financial strength in the parent.
What happened instead was that the investment bankers in these conglomerates “bought” business by accepting lower anticipated returns on the high-risk deals they took part in. The could do this only because their own cost of funds was so low. When these marginal deals started to turn sour (it turned out the returns were overestimated in the first place), they ended up not only hurting the investment banks but also destroying the credit ratings of the commercial bank parents.
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