By 1929, the NYSE capital requirement had developed into a requirement that firms hold capital equal to:
5% of customer debits;
a minimum 10% on proprietary holdings in Treasury or municipal bonds;
30% on proprietary holdings in other liquid securities; and
100% on proprietary holdings in all other securities.
During October 1929, the US stock market crashed, losing 20% of its value. The carnage spilled into the US banking industry where banks lost heavily on proprietary stock investments. Fearing that banks would be unable to repay money in their accounts, depositors staged a “run” on banks. Thousands of US banks failed.
The Roaring ‘20s were over, and the Great Depression had begun. During this period, the US Congress passed legislation designed to prevent abuses of the securities markets and to restore investors’ confidence.The 1933 Banking Act combined a bill sponsored by Representative Steagall to establishing federal deposit insurance with a bill sponsored by Senator Glass to segregate the banking and securities industries.
> commercial banking, which is the business of taking deposits and making loans,
All banks were required to select one of the two roles and divest businesses relating to the other. Chase National Bank and the National City Bank both dissolved their securities businesses. Lehman Brothers dissolved its depository business. The First Bank of Boston split off its securities business to form First Boston. JP Morgan elected to be a commercial bank, but a number of managers departed to form the investment bank Morgan Stanley.
Glass-Steagall also formed the Federal Deposit Insurance Corporation (FDIC) to provide deposit insurance for commercial banks. All member banks of the Federal Reserve were required to participate. Other banks were welcome to participate upon certification of their solvency. The FDIC was funded with insurance premiums paid by participating banks. Deposits were insured up to USD 2,500—if a bank failed, the FDIC would make whole depositors for losses on deposits up to USD 2,500. That insurance level has since been increased to USD 100,000.
Two other acts addressed the securities markets. The 1933 Securities Act focused on primary markets, ensuring disclosure of pertinent information relating to publicly offered securities. The 1934 Securities Exchange Act focused on secondary markets, ensuring that parties who trade securities—exchanges, brokers and dealers—act in the best interests of investors. Certain securities—including US Treasury and municipal debt—were exempted from most of these acts' provisions.
The Securities Exchange Act established the Securities and Exchange Commission (SEC) as the primary regulator of US securities markets. In this role, the SEC gained regulatory authority over securities firms. Called broker-dealers in US legislation, these include investment banks as well as non-banks that broker and/or deal non-exempt securities. The 1938 Maloney Act clarified this role, providing for self regulating organizations (SRO’s) to provide direct oversight of securities firms under the supervision of the SEC. SRO’s came to include the National Association of Securities Dealers (NASD) as well as national and regional exchanges. Commercial banks continued to be regulated by the OCC or state regulators depending upon whether they had federal or state charters.
In 1938, the Securities Exchange Act was modified to allow the SEC to impose its own capital requirements on securities firms, so the SEC started to develop a Net Capital Rule. Its primary purpose was to protect investors who left funds or securities on deposit with a securities firm. In 1944, the SEC exempted from this capital rule any firm whose SRO imposed more comprehensive capital requirements. Capital requirements the NYSE imposed on member firms were deemed to meet this criteria.
An investment company is a mechanism for investors to pool money to be invested by professional managers. The company sells shares to the investors and a manager invests the proceeds on their behalf. The notion includes both open-end and closed end-mutual funds. Investment companies became popular in the 1920s. A number of incidents of abuse prompted Congress to pass the Investment Company Act in 1940. With a few exceptions—which encompass most of today's hedge funds—this granted the SEC regulatory authority over investment companies.
Between 1967 and 1970, the NYSE experienced a dramatic increase in trading volumes. Securities firms were caught unprepared, lacking the technology and staff to handle the increased workload. Back offices were thrown into confusion trying to process trades and maintain client records. Errors multiplied, causing losses. For a while, this “paperwork crisis” was so severe that the NYSE reduced its trading hours and even closed one day a week. In 1969, the stock market fell just as firms were investing heavily in back office technology and staff. Trading volumes dropped, and the combined effects of high expenses, decreasing revenues and losses on securities inventories proved too much for many firms. Twelve firms failed, and another 70 were forced to merge with other firms. The NYSE trust fund, which had been established in 1964 to compensate clients of failed member firms, was exhausted.
In the aftermath of the paperwork crisis, Congress founded the Securities Investor Protection Corporation (SIPC) to insure client accounts at securities firms. It also amended the Securities Exchange Act to require the SEC to implement regulations to safeguard client accounts and establish minimum financial responsibility requirements for securities firms.
As a backdrop to these actions, it came to light that the NYSE had failed to enforce its own capital requirements against certain member firms at the height of the paperwork crisis. With its trust fund failing, it is understandable that the NYSE didn’t want to push more firms into liquidation. This inaction marked the end of SROs setting capital requirements for US securities firms.
In 1975, the SEC updated its capital requirements, implementing a Uniform Net Capital Rule (UNCR) that would apply to all securities firms trading non-exempt securities. As with earlier capital requirements, the capital rule’s primary purpose was to ensure that firms had sufficient liquid assets to meet client obligations. Firms were required to detail their capital calculations in a quarterly Financial and Operational Combined Uniform Single (FOCUS) report.
During the Great Depression, the Fed had implemented Regulation Q that, among other things, capped the interest rates commercial banks could offer on savings account deposits. The intent was to prevent bidding wars between banks trying to grow their depositor bases. Rising interest rates during the 1970s contributed to a migration of larger institutional deposits to Europe, where interest rates were not limited by Regulation Q. The emergence of money market funds, which pooled cash to invest in money market instruments, caused further erosion of bank deposits.
In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act. Among other things, this terminated the Regulating Q ceiling on savings account interest rates, effective in 1986. In response to this and an ongoing decline in bank capital ratios, bank regulators implemented minimum capital requirements for banks. There was some debate about what should be included in a bank's capital. This was resolved by defining two classes of capital. A bank's primary capital would be a bank's more permanent capital. It was defined as owners' equity, retained earnings, surplus, various reserves and perpetual preferred stock and mandatory convertible securities. Secondary capital, which was more transient, included limited-life preferred stock and subordinated notes and debentures. In 1981, the Fed and OCC implemented one capital requirement, and the FDIC implemented another. Generally, these specified minimum primary capital ratios of between 5% and 6%, depending on a bank's size.
Because these requirements were based on a bank's assets, they were particularly susceptible to regulatory arbitrage. Various modifications were made to the primary capital requirements, but it was soon clear that basing capital requirements on a capital ratio was unworkable. In 1986, the Fed approached the Bank of England and proposed the development of international risk-based capital requirements. This led to the 1988 Basel Accord, which replaced the asset-based primary capital requirements for US commercial banks. The concepts of primary and secondary capital were incorporated into the new accord as tier 1 and tier 2 capital.
As time went on, the Glass-Steagal separation of investment and commercial banking was gradually eroded. Some of this stemmed from regulatory actions. Much of it stemmed from market developments not anticipated by the act.
Glass-Steagall did not prevent commercial banks from engaging in securities activities overseas. By the mid 1980s, US commercial banks such as Chase Manhatten, Citicorp and JP Morgan had thriving overseas securities operations. Currencies were not securities under the Glass-Steagall Act, but since exchange rates were allowed to float in the early 1970s, they have entailed similar market risk. In 1933, futures markets were small and transacted primarily in agricultural products, so they were not included in the legal definition of securities. Also, depression era legislators did not anticipate the emergence of active OTC derivatives markets, so most derivatives did not fall under any definition of securities. By the early 1990s, commercial banks were taking significant market risks, actively trading foreign exchange, financial futures and OTC derivatives. They did so while enjoying FDIC insurance and membership in the Federal Reserve system. Neither of these benefits was available to the investment banks with whom they were increasingly competing.
Commercial banks focused on the prospect of repealing Glass-Steagal and related legislation. This would open the door to the creation of financial supermarkets that combined commercial banking, investment banking and insurance. Due to the nature of their business, commercial banks generally had more robust balance sheets than investment banks, and they could expect to dominate such a new world. There would be profits from cross-selling deposit taking, lending, investment banking, brokerage, investment management and insurance products to a combined client base. There would also be troublesome conflicts of interest.
While he was chairman of the Federal Reserve, Paul Volker fought efforts to ease the separation between commercial and investment banking. Allen Greenspan replaced Volker in 1987, and he brought with him a more accommodating attitude. Section 20 of the Glass-Steagall Act had always granted modest exemptions allowing commercial banks to engage in limited securities activities as a convenience to clients who used the bank’s other services. Tentatively under Volker, but aggressively under Greenspan, the Fed reinterpreted Section 20 to expand that authorization. In various rulings during the late 1980s, the Fed granted certain commercial banks authority under Section 20 to underwrite commercial paper, municipal revenue bonds, mortgage-backed securities and even corporate bonds. In October 1989, JP Morgan became the first commercial bank to underwrite a corporate bond, floating a USD 30MM bond issue for the Savannah Electric Power Company. A flood of commercial bank underwritings followed.
The Fed also allowed commercial banks to acquire investment bank subsidiaries through which they might underwrite and deal in all forms of securities, including equities. These became known as Section 20 subsidiaries. There were limitations on the use of Section 20 subsidiaries. The most restrictive was a cap on the revenue a commercial bank could derive from securities activities under Section 20. In 1986, the Fed had set this cap at 5%. It was expanded to 10% in 1989 and again in 1996 to 25%.
Congress attempted to repeal Glass-Steagall in 1991 and again in 1995. Both attempts failed, but the stage was set. The Fed had already gutted much of Glass-Steagall. Commercial banks were deriving considerable revenues from investment banking activities. Their lobbyists had arrayed considerable forces in Congress ready to make another attempt. Glass-Steagall was teetering, and all that was needed was for someone to step forward and topple her.
That is what John Reed and Sanford Weill did. Reed was CEO of Citicorp, a large commercial bank holding company. Weill was CEO of Travelers Group, a diverse financial services organization. It had origins in insurance but had recently acquired the two investment banks Salomon and Smith Barney and merged them into a single investment banking subsidiary. In 1998, Reed and Weill merged their firms, forming Citigroup, a financial services powerhouse spanning commercial banking, investment banking and insurance. This was an aggressive move that could easily have been blocked by regulators. A permissive Fed was supportive of the deal, which forced the hand of Congress. In 1956, Congress had passed the Bank Holding Company Act, which had supplemented Glass-Steagall by limiting the services commercial banks could offer clients. The Citicorp-Travelers merger violated the 1956 act, but there was a loophole. The Holding Company Act allowed for a two-year review period—with an optional extension to five years—before the Fed would have to act. The newly formed Citigroup was the world's largest financial services organization, but it was operating under a five-year death sentence. If Congress didn't pass legislation during those five years, Citigroup would have to divest some of its businesses.
Pressure on Congress was immense. In 1999, they passed the Financial Services Modernization Act, and President Clinton signed it into law. The act is also known for the names of its sponsors—the Gramm-Leach-Bliley Act—but detractors have called it the Citigroup Authorization Act. This sweeping legislation finally revoked the Glass-Steagall separation of commercial and investment banking. It also revoked the 1956 Bank Holding Company Act. It permitted the creation of financial holding companies (FHCs) that may hold commercial banks, investment banks and insurance companies as affiliated subsidiaries. Those subsidiaries may sell each others products. Within a year of the new act's passage, five hundred bank holding companies formed FHCs.
Although it was sweeping, the Financial Services Modernization Act was, in some respects, a half measure. It dramatically transformed the financial services industry, but it did little to transform the regulatory framework. Prior to the act, commercial banks, investment banks and insurance companies had been separate, and they had oversight from separate regulators—the Fed and OCC for commercial banks, the SEC for investment banks, and state regulators for insurance companies. Who would now oversee the new FHCs that combined all three industries? The answer is no one. The act adopted a "functional" approach to regulation. The Fed and OCC now regulate the commercial banking functions of FHCs. The SEC regulates their investment banking functions. State insurance regulators regulates their insurance functions. The act has opened the door to abuses across functions, but no regulator is clearly positioned to identify and address these.
At the same time that Glass-Steagall was being torn down, dramatic growth in the OTC derivatives market led to concern that there was no regulator with clear authority to oversee that market. A 1982 amendment to the Securities Exchange Act specified that options on securities or baskets of securities were to be regulated by the SEC. This left structures such as forwards and swaps outside the SEC's jurisdiction. It also excluded derivatives on interest rates or foreign exchange. A regulator with authority most relevant to these derivatives was one whose original purpose was unrelated to financial markets. This was the Commodity Futures Trading Commission (CFTC).
Congress formed the CFTC under the 1974 Commodity Exchange Act (CEA). It had exclusive jurisdiction to regulate commodity futures and options. Whether this authority encompassed OTC financial derivatives was not legislatively clear and motivated several law suits.
As a debate raged over how OTC derivatives should be regulated—or if they even should be regulated—there was pressure for the the CFTC to act. Because its authority was not clear, the CFTC hesitated, and market participants were generally opposed to the CFTC intervening. Position papers were written by industry groups and government agencies. Inevitably, there were some turf skirmishes as different regulatory agencies tried to position themselves for a role in any new regulatory regime. A strong argument against increased regulation of OTC derivatives was that it would drive the market overseas—as had happened 20 years earlier to the market for USD deposits.
Finally, Congress acted in 2000 by passing the Commodity Futures Modernization Act (CFMA). This amended the 1974 Commodity Exchange Act, exempting all OTC derivatives. The CFTC was not to regulate OTC derivatives. The market was to remain largely unregulated.
Overheated technology stocks formed a bubble that collapsed during 2000. In 2001, the broader market also fell sharply. On September 11 of that year, terrorists hijacked airliners, slamming two of them into New York's World Trade Center. Another hit the Pentagon in Washington, and a fourth fell in a Pennsylvania field. With the terrorist attacks, the bad news seemed to accelerate. Within weeks, the Wall Street Journal was reporting on a brewing scandal at energy trading powerhouse Enron. The firm had been using accounting gimmicks and outright deception to inflate profits and hide debt. In December, it filed for bankruptcy—the largest in US history. In 2002, that record was broken by the bankruptcy of telecommunications firm WoldCom, which had inflated its 2000-2001 income by a whopping USD 74.4 billion. Enron and WorldCom were just the two most prominent in a slew of bankruptcies and accounting scandals, which included Global Crossing, Tyco, Rite Aid, Xerox, and others. In 2002, Accounting firm Arthur Andersen was convicted of a single charge stemming from its lackluster auditing of Enron. That action forced Andersen, one of the largest and most respected auditors in the world, to go out of business. In 2005, the US Supreme Court overturned the decision, concluding that the presiding judge had given the jury faulty instructions. This decision came too late to save Arthur Andersen.
There was plenty of blame to go around. Corporate executives had cooked books while lining their pockets. Analysts at investment banks had recommended stocks they knew were dogs in a quid pro quo that ensured banking business from those same firms. Accounting firms had been cross-selling consulting services to audit clients. Increasingly, their auditors had shied away from challenging management of firms so as to not jeopardizing those lucrative consulting engagements.
Amidst the gloom and finger-pointing, Congress passed the 2002 Sarbanes-Oxley Act, fondly known as "sox." This is a sweeping law that increases management accountability, mandates a variety of internal controls at firms, and strengthens the role of auditors. Accounting firms are largely prohibited from simultaneously auditing and consulting to any given client. A new federal agency, called the Public Company Accounting Oversight Board, (PCAOB or Peek-a-Boo), is to oversee accounting firms. Corporations must test internal controls regularly. To avoid conflicts, those tests must be performed by an outside firm other than the external auditor. Sarbanes-Oxley has been variously described as ineffective, overly costly to corporations, or too demanding. Maybe some of the criticism is reasonable—or maybe not. Time will tell.
In 2004, the Basel Committee finalized its new Basel II accord on bank regulation. US regulators perceive this as primarily relevant for internationally active banks. They intend to apply it to just ten of the largest US banks. Another ten will have the choice to opt-in. Other US banks will remain subject to existing US regulations, including those adopted under the original Basel Accord.
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