The long and deep recession has prompted many references and comparisons to the Great Depression – the causes, the impact, the blame, and the government’s reaction and solutions. The parallels certainly ring true for financial regulation, as many of the same issues being hotly debated today also resulted in new legislation and policies during the Depression.
1933 Banking Act – More commonly known as the Glass-Steagal Act, this legislation distinguished between commercial banking (taking deposits and making loans) and investment banking (underwriting and dealing in securities). To protect commercial banking customers from the risk of investment banking, all banks had to choose one role and divest businesses relating to the other. Glass-Steagal was eroded over the years by market developments that it did not anticipate, such as the growth of futures and derivatives, neither of which were securities under the act and were therefore available to commercial banks. Weakened by the loosening of various rules by the Federal Reserve through the 1990’s, Glass-Steagal was finally revoked in 1999.
There are plenty of proposals to again insulate traditional depositors and borrowers from investment banking and trading activities of banks. Consistent with his stance as chairman of the Federal Reserve, Paul Volcker has recommended that banks not be allowed to trade securities with their own capital and not be allowed to own hedge funds or private equity investment operations.
FDIC – In response to “runs” in which frantic depositors demanded their cash from banks, Pres. Roosevelt ordered a four-day bank holiday in March, 1933. As a longer term solution, the Federal Deposit Insurance Corporation (FDIC) was also created by the 1933 Banking Act. The FDIC offered deposit insurance (initially set at $2,500 per depositor) which was funded by insurance premiums paid by participating banks, which included all federally chartered banks and other banks whose solvency was verified.
The “temporary” increase in FDIC coverage from $100,000 to $250,000 has been extended through 2013. While the FDIC has become very adept at swooping into a failed bank on Friday and having the bank reopened by Monday, many banking institutions may have become “too big to fail” and their failure would be beyond the FDIC’s capabilities and could threaten the entire financial system.
Federal Reserve – The Federal Reserve was actually created as a central banker, lender of last resort and issuer of Federal Reserve notes as a national currency in 1913 after a 50% stock market decline caused a financial panic in 1907. An independent Fed did not bail out banks in the early years of the Depression, and in 1935 Fed power was centralized in an Open Market Committee responsible for managing monetary policy. The Fed’s primary tools include setting short term interest rate targets for lending among banks and influencing the supply of money by buying or selling Treasury securities.
Over the last two years, the Fed has purchased $1.25 trillion of mortgage securities as the mortgage market dried up and has kept target interest rates at record lows. The Fed’s independence could be strained as it may become responsible for much broader financial oversight.
SEC – The 1933 Securities Act focused on the disclosure of information in primary markets, or the initial public offering of securities. The Securities and Exchange Commission (SEC) was created by the 1934 Securities Exchange Act which focused on secondary markets and the exchanges, brokers and dealers who trade securities. The SEC was charged with seeing that investment banks and non-banks acted in the interests of investors and maintained sufficient capital. The 1938 Maloney Act allowed the industry to create self-regulating organizations to police and enforce conduct among securities firms.
The SEC has come under much criticism for what many see as lax oversight of investment banks and investment firms, not the least of which is the $60 billion Madoff scandal. The SEC has stepped up its enforcement as demonstrated by the filing of civil charges against Goldman Sachs.
Investment Companies – Mutual funds as we think of them today were only introduced in the US in 1928. However, closed-end funds inflicted considerable pain on investors in the 1929 stock market crash, and some were exposed as simple Ponzi schemes. The 1940 Investment Company Act gave the SEC regulatory authority over investment companies (mutual funds), which are pooled investment vehicles which allow many parties to collectively invest in a professionally managed portfolio of assets. There were some exceptions, most notably today’s hedge funds, for institutional and “sophisticated” investors. Also in 1940, the Investment Advisers Act regulated the relationship between mutual funds and their investment managers and eliminated most self-dealing abuses.
Mutual funds have not been a core target for new regulation, although specific funds were exposed as having more risky investments than advertised. The biggest proposed changes are to money market funds, which were designed and sold as relatively safe investments that maintained their $1 share price. The Reserve Fund, the pioneering money market fund, saw its share price drop below $1 due to a large investment in Lehman Brothers. Money market funds will likely have to either reduce the risk in their investments, which would reduce the dividends to their investors, or allow their share price to fluctuate.
The rules and institutions coming out of the Depression dramatically changed the landscape of investment and financial services for many years. Whether those same concepts and policies are what is needed today is greatly complicated by dramatic changes in the technology, techniques and tools of banking. Still, it is always worthwhile to examine history for examples of both success and failure.