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Douglas Landy |
In 1986, the Federal Reserve, led by Chairman Paul Volcker, began a series of actions that ultimately led to the demise of Section 20 of the Banking Act of 1933 - the Glass-Steagall Act. Allen & Overy’s partner, Douglas Landy, assesses why Volcker has now changed his mind
With the Glass-Steagall Act, Congress had for more than 50 years required a separation of commercial banks from securities firms in the US. Many commentators challenged the rationale for this separation, and US banks argued that these restrictions were hurting their ability compete globally.
Consequently, the Fed decided in 1987 to permit some affiliation of these entities, so long as the securities affiliate was not 'engaged principally' in underwriting or dealing in non-government issued securities (so called ineligible securities). All of a sudden, US banks moved into new areas of financial activity and were able to act as global banks. These new securities affiliates were called 'Section 20' subsidiaries, and they were the beginning of the end of Glass-Steagall.
Over the following decade, the Federal Reserve continued to relax the restrictions on Section 20 subsidiaries until the adoption of the Gramm-Leach-Bliley Act of 1999 (Gramm-Leach Act), which repealed Section 20 and moved the structure of US banks, and foreign banks engaged in banking and securities in the US, significantly closer to the universal banking model predominate throughout the rest of the world.
However, US banks were never permitted to combine banking and securities activities within the same entity – they could only affiliate within the same corporate holding company structure. This restriction was intended to protect depositors in US banks - as well as US taxpayers, who subsidise these banks by way of their access to the financial 'safety net' of deposit insurance, the discount window, and the payment system - from the perceived greater risk of the non-banking activities of their securities affiliates.
Notwithstanding their differing structures, US and European banks performed similarly through the credit crisis that began in 2007. But as national governments and supervisors began to review weaknesses in the regulation of global banks, Paul Volcker had a significant change of heart and proposed the so-called 'Volcker Rule,' which was adopted in revised form as Section 619 of the Dodd-Frank Act of 2010.
The Volcker Rule requires a partial reimposition of Section 20 in that it bans US banks from engaging in, or affiliating with entities engaged in, certain proprietary trading and principal investment activity. Unlike Section 20, however, it does not draw a line between securities underwriting and banking. Instead, it draws a line between activities that presumably generate 'principal' risk above that considered appropriate for an entity also engaged in banking activities.
Why did Paul Volcker change his mind? He appears to have looked at the complexity of the modern financial network and found that it is lacking in public utility: as he put it "the only useful thing banks have created in 20 years was the ATM."
And with proposals in the UK and Europe to 'ring-fence' similar financial activities in universal banks, it seems the rest of the world is ready to follow the US back in time to before 1986.
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