A Short History of Banking Regulation
Strap in. It’s a long one.
Last week’s failure of the Silicon Valley Bank and the news that followed reminded many of us of late 2008. For others, last week re-awakened generational memories of the devastating bank failures of the early 1930s that led to the Great Depression. A sense of unease is in the air. Listening to the radio and reading the news, one thing seems clear: Even the most highly educated economists in responsible positions are not entirely certain which of the adjustments available to them will produce a good outcome. Only the events of the coming weeks and months will tell us whether last week was the beginning of a period of economic instability with real dangers for the average citizen or if the system will settle down.
Most of us see the economy through the lens of our personal finances. Unless you were one of those wiped out in the housing market crash of 2008 the idea of a bank failing somewhere in Silicon Valley seems very far away.
My parents lived through the Great Depression of the 1930s, an event that left them with more than a rudimentary understanding of bank failures and monetary instability. They understood that the Stock Market Crash of 1929, the event that triggered the bank failures of the Great Depression, was the result of irrationally optimistic buying of stocks with money borrowed from others. Prices of stocks were bid up by investors who leveraged their money using loans based on dubious collateral (like the inflated value of stock they already owned). When some investors realized this was a wobbly house of cards, they began selling their stock positions. As others looked around and realized how financially exposed they were, the contagion spread, they too wanted out, and prices fell as supply (stocks offered for sale) increased. Investors who had been buying stocks with, for example, 90% borrowed money, found themselves “under water” when just a 10% drop in the market wiped out the part of their investment they had made with their own money. They wound up owing more money than they still possessed. Some, realizing their plight, committed spectacular and much-noted suicides. Banks who had loaned the investors the 90% (using other common men’s deposited money), had no prospect of being paid back. Banks found themselves with little or no reserves to pay out to the nervous “little guy” depositors worried if their money was safe. All the “little guys” like my parents (and like the townspeople in “It’s a Wonderful Life”), converged on the local banks to withdraw their money—and the whole house of cards (pyramid scheme?) collapsed.
The lessons my parents took away from their experience were twofold: 1) with rare exceptions (like a mortgage on a house), don’t buy things with borrowed money and 2) banks and the stock market regulation are necessary to keep this from happening again. (My parents subscribed to the mortgage exception because they shared the general wisdom of the time that houses and property would forever appreciate in value. People who lived in Detroit and in many smaller towns over the last few decades will now point out, if asked, that there is no guarantee of forever appreciation in the housing market.)
Without bank and stock market regulation imposed by government my parents might never have developed the confidence necessary for them to put their savings in a bank account again. However, they were also aware that the value of a dollar varied over time—almost invariably losing value on account of what was to me a mysterious process called inflation. To “keep up with inflation” required finding a secure investment that paid interest that would match or exceed the rate at which prices inflated.
In my parents’ minds there was a key to establishing confidence in the security of one’s bank deposits. In 1933 Franklin Delano Roosevelt and the newly elected Democratic majority in Congress passed the Banking Act of 1933 (often referred to as Glass-Steagall). The Act established the Federal Deposit Insurance Corporation (FDIC)—an entity that assures depositors that, up to a certain limit (which has grown over time), deposits in checking and savings accounts were not going to be lost to a bank failure—such deposits are insured. The Banking Act of 1933 (click to learn more) also put numerous curbs on speculation the like of which caused the Crash of the stock market in 1929. The Act established rules by which banks had to operate to shore up their stability. Among the rules was a requirement that banks either as commercial or investment institutions, not both.
As I was learning these principles from my parents in the 1950s and 60s, banks still paid significant rates of interest even on small deposits. They welcomed small deposit amounts by young people learning something about personal finance. “The bank” was a vintage 1930s building downtown, built with a lot of marble, that my parents and I visited during our weekly shopping visit to the town center.
Based on dad’s experience with the Depression, he considered purchases made “on time” or on “layaway” as courting financial disaster—a sort of speculation. Dad died in 1974 when most monetary transactions were still done with cash or checks. Had he lived he would be appalled by instant credit at high rates of interest offered as credit cards, the skimming off of a small fee from each credit card transaction. He would shake his head at the scant (far less than inflation) rates of interest and exorbitant transaction fees banks now impose on savings accounts.
Predictably, over the years Republicans and Libertarians, through papers pumped out by their “think tanks”, railed against the regulations of Glass-Steagall, complaining that the rules unjustifiably hampered investment and innovation. After all, they argued, if you gave the investor class free rein the economy would boom and the results would trickle down to the working class. By the l990s banking regulation was out of sight and out of mind for the average voter. In the 22 years between 1970 and 1992 there were just 25 scattered bank failures on which regulators so quickly closed the gaps that depositors were barely aware. The failures themselves hardly made news.
In 1999 the Republican majority Congress passed and President Clinton signed the Gramm–Leach–Bliley Act (three Republican Congressmen), aka the “Financial Services Modernization Act” in response to lobbying from the banking industry and aided by the opinion pieces pumped out of Republican “think tanks”. This Act repealed major parts of Glass-Steagall. It removed:
…barriers in the market among banking companies, securities companies, and insurance companies that prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company. With the passage of the Gramm–Leach–Bliley Act, commercial banks, investment banks, securities firms, and insurance companies were allowed to consolidate. Furthermore, it failed to give to the SEC or any other financial regulatory agency the authority to regulate large investment bank holding companies.
Presciently, another name for this repudiation of New Deal era banking regulation was the “Federal Home Loan Bank System Modernization Act of 1999”. Those mortgage chickens came home to roost in 2008. Rampant speculation in the home mortgage market aided and abetted by arcane financial instruments like “credit default swaps” unleashed by the “Modernization Act” precipitated 61 major bank failures in the period between late 2008 and 2011, two and half times as many as in the previous 38 years. Much worse, unlike the prior failures, these bank failures took down the housing market and rendered many thousands of home mortgage holders “under water” or bankrupt, with the loss of meagre savings invested in “the American dream” of home ownership.
We are still living the political fallout from 2008 as many live out smoldering anger against “the government’s” bailout of banks “too big to fail” while common people with under water mortgages were mostly left high and dry. How soon we forget that the seeds of the 2008 crash were planted by the Republican Congress’ repeal of the Glass-Steagall in 1999. Perhaps the 66 years reign of Glass-Steagall banking regulations limited the ability of financial manipulators to amass wealth with arcane financial games, but those regulations also protected the investments of the middle class from the reckless speculation and bank failures we saw in 1929.
In response to the Crash of 2008, two Democrats, Rep. Barney Frank (D-MA) and Senator Chris Dodd (D-CT), proposed the “Dodd–Frank Wall Street Reform and Consumer Protection Act” commonly referred to as simply “Dodd-Frank”. It passed and was signed by President Obama in late 2009 with nearly all Democrats and (predictably) only a few Republicans voting in favor. Dodd-Frank sought to re-regulate parts of the banking industry in the hoping of preventing another crash like 2008.
To no one’s surprise, in 2018, under Donald Trump, Dodd-Frank was partially repealed on a largely partisan vote with all but one Republican in favor of the repeal and some Democrats joining in. This 2018 Republican-driven repeal of Dodd-Frank set the stage for current events.
Once again bank failures are in the news and concerns are voiced that the failures will spread. Once again decisions are made to rescue wealthy Silicon Valley Bank depositors with bailouts, echoes of 2008’s “too big to fail”. Once again some are angry and, not illogically, question the fairness of bailing out wealthy investors on the theory that not to do so risks an economic domino effect.
Predictably, “our” vocally anti-regulation, pro-wealthy, committed “trickle-down economics” supporter, U.S. Representative Cathy McMorris Rodgers, voted against Dodd-Frank in 2009 and for its repeal in 2018.
As a party, Democrats consistently—since 1933—have backed regulation that, when it is still in place, stabilizes the banking system and protects the investments of those my dad would call “the little guy” (including my dad himself). In the last thirty years Republicans have consistently sought repeal of those regulations with the backing of droning rhetoric about “job creators” from Republican think tanks, talk radio, and Fox “News”. When rules and the enforcement of banking regulations are weakened—as Republicans consistently advocate—financial games transfer more wealth to the already wealthy at the expense of “the little guys”. My parents, were they still alive, would be appalled at the unraveling of the banking regulations of the New Deal.
Remember which party has your interests in mind. It time to re-regulate.
Keep to the high ground,
Jerry
P.S. The need for regulation is only apparent when things fall apart. Successful regulation doesn’t produce attention-grabbing headlines. Who would read an article entitled “New Deal regulation credited for more than a half century of stable banking!”?—and, yet, that’s what happened.