What The Glass Steagall Act Was Finance Essay

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The Roaring Twenties was a decade of prosperity and financial boom. The Wall Street Crash of 1929 brought an end to this era and marked the beginning of the Great Depression. Prior to the Crash, a speculative bubble in the stock market kept increasing the price of stocks. Several Americans thought that investing in stock was the quickest and and surest path to prosperity. A significant number of investors had taken loans in order to purchase stock and defaulted on them when the stock market crashed. Banks themselves had heavily invested in the stock market. Unable to recover the money they had invested, several banks were forced to shut down. As news of banks shutting down spread, people panicked and began withdrawing money from the banks that were still functioning which further led to a series of bank runs throughout the United States. This caused even more banks to close and led to a nationwide banking failure. As Gailbraith (1954, P.196-7) notes, "When one bank failed, the assets of others were frozen while depositors elsewhere had a pregnant warning to go and ask for their money. Thus one failure led to other failures, and these spread with a domino effect". Several economists, such as Krugman (2009) and Milton Friedman (1963) argue that it was the banking crisis that turned a recession into a depression. The Glass-Steagall Act (GSA) was an emergency response to the Wall Street Crash, the nationwide banking failure and the Great Depression. The GSA was sponsored by Senator Carter Glass and Representative Henry Steagall and passed by the US National Congress in 1933. It was a depression era regulation with two major provisions; the insurance of bank deposits and the separation of commercial and investment banking . Between 1929 and 1933, the United States witnessed a series of bank runs which eventually led to a a nationwide banking failure. The Federal Deposit Insurance Corporation (FDIC) was established by the GSA to provide deposit insurance in the event of such bank failures. By insuring deposits, the FDIC regained depositors' trust in the banking system and virtually put an end to bank runs. In 1943, the FDIC insured deposits up to $2,500 per depositor. This amount increased over the years and is currently $250,000 per deposit. The GSA also created a regulatory firewall separating commercial and investment banking. This was done to protect deposits form risky investments. Any bank that accepted deposits could not trade in securities (with the exception of government bonds) and any bank that underwrote securities or engaged in speculating could not accept deposits.  As Krugman (2012, p. 59) explains, "any bank accepting deposits was restricted to the business of making loans; you couldn't use depositors' funds to speculate in stock markets or commodities, and in fact you couldn't house such speculative activities under the same institutional roof". The financial crisis of 2008 began with the bursting of the real estate bubble in the the United States and transformed into the worst recession the world has experienced since the Great Depression. The housing bubble in the United States peaked around 2006. Several people took out mortgages they couldn't afford and subsequently defaulted on them. However, these mortgages were resold as securities to various financial institutions around the world. As soon as the bubble burst and people defaulted on their loans, the value of these securities fell and led to the destabilization of the global financial system. But the housing bubble alone did not cause the global financial crisis. Various policies and regulations of the financial sector contributed to the establishment of the crisis. The sudden boom is housing prices was caused by the expansive monetary policy of the US Federal Reserve (Fed) between 2003 and 2005. As Anna J. Swartz (2009 p. 19) explains, "An asset boom is propagated by an expansive monetary policy that lowers interest rates and induces borrowing beyond prudent bounds to acquire the asset". The Fed kept interest rates at a historical low between 2003 and 2005. These low interest rates increased the appeal of adjustable rate mortgages [1] (ARM) to borrowers. Borrowers found it easily affordable to meet monthly payments due to the initial low interest rates on ARMs. After 2005, the Fed increased interest rates. Interest rates on ARMs were reset in response to the Fed's decision. This made monthly payments unaffordable and consequently many borrowers defaulted on their loans. Deregulation of the financial sector was a major factor that was responsible for the financial crisis of 2008. Financial deregulation in the United States began in 1980s under Carter with the passing of Control Act of 1980, which ended regulations preventing banks from paying interest rates on different kinds of deposits. This change increased competition between banks based on interest rates offered on deposits. While this was good for depositors, it meant that only those banks willing to make risky loans could survive in the industry (Krugman 2012 p.61). The trend of deregulation continued under Regan with the passing of the Garn-St. Germain Act of 1982, which decreased restrictions on the types of loans banks could offer and also continued under Clinton, who in 1999 passed the Gramm-Leach-Bliley Act (GLB) which repealed provisions of the Glass-Steagall Act that separated commercial and investment banking. The removal of this barrier that separated banking allowed commercial banks to indulge in investment banking and hence take more risks (Krugman 2008, p.163). Therefore the deregulation of the financial lead t an increase the amount of risk financial institutions could take. Securitization of sub prime mortgages also played an important role in the crafting the financial crisis. The Government National Mortgage Association (Ginnie Mae) was the first organization to securitize mortgages in the form of Mortgage Backed Securities [2] (MBS). Securitization was limited to prime mortgages, that is until the housing bubble. The securitization of sub prime loans was made possible by collateralized debt obligation [3] (CDO). CDOs sliced credit risk into different tiers, the senior share had higher expectations of repayment compared to the junior shares (which receive higher interest rates) and hence received a AAA rating from the rating agencies despite being backed by sub prime loans. Several institutional investors, such as pension funds, were willing to buy CDOs because of their high ratings and hence opened up large scale financing of CDOs ( Krugman 2008, p.150). In 2007, an estimated US$503 billion worth of CDOs were issued (source: Securities Industry and Financial Markets Association). However when the housing bubble burst and homeowners began defaulting on their mortgages and the the value of these securities dropped. But by this time, CDOs had already spread throughout the market. Several financial institutions, such as commercial and investment banks, who owned CDOs had to face massive losses. Derivatives such CDOs are traded over the counter (OTC). This means that there is no regulation or supervision of trading of derivatives. The recent financial crisis demonstrates the need for regulation of derivatives. Shadow banks are financial institutions that offer services that are similar to those offered by commercial banks, but unlike commercial banks are not regulated. The shadow banking system includes financial institutions like hedge funds, money market funds, structured investment vehicles. These institutions do not take deposits and instead rely on capital from auction rate security, asset backed commercial paper or by repo market. Initially the shadow banking system was a small part of the financial sector, but by 2007, it had a become an integral part of the financial sector and was bigger than regular banking (Krugman 2012, p.63). A large source of income for the shadow banks emanated from the trading of CDOs. As mentioned earlier any financial institution that owned CDOs faced huge financial losses. These losses weakened confidence in the shadow banking system and led to 'non-bank' bank runs on the shadow banking system. This ultimately led to its collapse (Krugman 2008, p.169-170). The collapse of the shadow banking system led to the destabilization of the financial sector. Therefore it is essential for the shadow banking system to be regulated in order to prevent 'runs' on it from destabilizing the financial sector. As Krugman (2008, p.163) explains, " anything that does what a bank does, anything that has to be rescued in crisis the way banks are, should be regulated like a bank. The financial crisis of 2008 revealed how hazardous large and systemic financial institutions can be. The effect that the collapse of Lehman Brothers had on the economy demonstrates the dangers of such financial institutions. According to Rajan (2010, p.170) financial institutions should be prevented from becoming too systemically important in order to prevent such an institution's collapse from affecting the whole economy. Another problem created by such institutions is that of moral hazard. Such institutions take higher amounts of risks knowing that the government would prevent them from collapsing owing to their systemic importance. Hence regulation is needed in order to prevent institutions from becoming too large and systemic. In conclusion, the expansive monetary policy of the Fed helped propagate the US housing bubble. Deregulation of the financial sector increased the amount of risk in the economy. Securitization of mortgages resulted in large scale financing of subprime loans. The lack of regulation of the shadow banking system and financial instruments like derivatives and the collapsing of systemically important institutions destabilized the economy. Therefore the recent financial crisis clearly demonstrates the necessity for new banking and financial policies. It also points up the need for regulation of the financial sector in order to safeguard the economy from future recessions.
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