After the Glass-Steagall Act was passed, the U.S. financial system worked very well for many decades. Occasionally, banks failed, but this did not put the entire system at risk of collapse. The Glass-Steagall Act, also known in 1932 as the “Banking Act,” separated commercial and investment bank activities, gave birth to the Federal Deposit Insurance Corporation or FDIC, and introduced limits on interest rates paid on bank deposits. Under the act, a bank could not always expect to be rescued in case of difficulty. It was understood that some banks would not be viable, but lawmakers ensured that their problems would not trigger a financial
All institutions made the same mistake at the same time
The FDIC protected investors against the loss of all their money, but it did not protect banks from going under. In fact, individual depositors were completely protected. In those times, it was easier to prevent a credit crisis because it was clear where the credit was: in the banks. Investment banks were limited to underwriting securities issues and related activities. It was the institutions that took the biggest risks, and none were protected. However, they were required to be more transparent and they were not allowed to borrow 100% of their venture capital. There were margin requirements on ownership of stocks and derivatives. These measures ensured that investment portfolios were not largely financed by debt.
Stock market bubbles could burst without bringing down the entire economy, so a bank could be allowed to fail.
In 1999, Congress repealed Glass-Steagall, but at the time, the line between deposit banks and investment banks was already blurred. In 1980, deposit banks started to ask for and obtain all sorts of privileges to engage in underwriting activities. The first to obtain such authorization was Citigroup. In 1990, deposit banks and investment banks had, for all intents and purposes, merged. Commercial banks that invested in 30-year mortgages for which they had to maintain large capital ratios became commercial banks that invested in financial securities backed by baskets of mortgages, in other words, securities guaranteed by the government for which a much lower capital ratio was required. When banks invested in 30-year mortgages, the default risk was limited to the banks concerned. The shift to mortgage-backed and government-backed securities resulted in all institutions making the same mistake at the same time: they all tried to hold the most “AAA-rated securities” with the least amount of capital to support them. With more banks holding more securitized debt instruments, risk spread throughout the entire system. These institutions then became too big to fail.
The finance geniuses working in financial institutions may well think they have reinvented the wheel and created the perfect risk-free financial instrument, but the regulatory agencies must see to it that no institution becomes too big to fail. That is the only way to ensure that everyone remains reasonable with regard to risk-taking.