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Table of Contents

Financial stability: Shadow banking and securitization - Part 7


2.3 The Glass Steagall Act

The Glass-Steagall Act has for years have stayed as one of the many numerous pillars of banking law since the time it has been passed in the year 1933 by framing a wall between commercial banking and investment banking. In consequence, it keeps banks from doing business on Wall Street, and vice versa. In reality, there are actually two Glass Steagall measures. “The first was the Glass-Steagall Act of 1932, a bookkeeping provision that allowed the Treasury to balance its account. And what is commonly known today as the Glass-Steagall law is actually the Bank Act of 1933, containing the provision erecting a wall between the banking and securities businesses.” The act also laid the foundation for legislation which allows the Federal Reserve to permit banks into the securities business with a few limitations.

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2.3.1 The need for the Glass Steagall Act

The Glass Steagall Act is actually the entire Banking Act of 1953 and is named after Senators Carter Glass and Henry B. Steagall. This Act primarily restricts affiliation between banks and securities firms. Right from the 1960s, the regulators in the United States interpreted the Glass Steagall Act in a manner allowing banks to have an increasing list and volumes of securities activities and probably the 1998 Citi Bank’s affiliation with Salomon Smith Barney. Gramm – Leach – Bliley Act (GLBA) repealed the affiliation restrictions of the 1933 Glass Steagall Act and this became the route for the 2008-09 financial crises.

2.3.2 Effects of the Act

The Glass Steagall Act necessitates the need of the banks to restrict them to conservative commercial lending. The person behind the evolution of this Act - Mr. Glass, a former Treasury Secretary in the U.S. Senate, “strongly believed that bank involvement with securities was detrimental to the Federal Reserve System, contrary to the rules of good banking, and responsible for stock market speculation, the Crash of 1929, bank failures, and the Great Depression.”

2.3.3 Different Provisions of the Glass Steagall Act

“The Glass-Steagall Act has come to mean only those sections of the Banking Act of 1933 that refer to banks' securities operations -- sections 16, 20, 21, and 32. Sections 16 and 21 refer to the direct operations of commercial banks. Section 16, as amended by the Banking Act of 1935, generally prohibits Federal Reserve member banks from purchasing securities for their own account. But a national bank (chartered by the Comptroller of the Currency) may purchase and hold investment securities (defined as bonds, notes, or debentures regarded by the Comptroller as investment securities) up to 10 per cent of its capital and surplus.”

“Sections 20 and 32 refer to affiliations related to the commercial bank. Section 20 forbids member banks from affiliating with a company 'engaged principally' in the 'issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stocks, bonds, debentures, notes, or other securities'.”

2.3.4 Repeal of Glass Steagall Act

The repeal of the Glass Steagall Act was considered as the one that paved way for non-transparent manipulation of financial information of the organizations. It also helped in the use of leverage to transfigure the actions of investment, to accumulate enormous fortunes for all the investment bankers who planned, marketed and supervised the use of leveraged investments, and also to spawn devastatingly speculative deeds at hedge funds, which went unregulated by the oversight of the government.

2.4 The recent Financial Crisis – Role of Investment Banks and Deregulation

There is certainly a role of hedge funds in the subprime lending. This is evident from the fact that some companies, despite the prevailing credit crunch are stepping into the subprime mortgage market. A recent example is that of Newcastle Investment Corporation - a real estate investment trust that is managed by hedge fund giant Fortress Investment group, steps into the subprime mortgage market despite the credit crunch. Another similar happening, according to the reports Reuters was that Accredited Home Lenders Holding Co.

Even in the past, hedge funds had a very important role in many financial crunches that took place. This fact is evident from the financial crunch that took place in 1997-98. During that period, the hedge funds of the United States, by manipulating their domestic currencies became responsible for the destruction of various global economies.

Though it has been stated that there is a key role played by the hedge fund managers, most of the top hedge fund managers defend them when they faced the law makers of the United States. As an aftermath of the financial crisis, the lawmakers of the United States have started to investigate the reasons which caused the crisis. As part of these investigations, top hedge fund managers of the country were hauled before a committee that has been formed for this purpose.

Most of the managers who were summoned for the investigations defended their role by stating that it was the high amount of leverage by banks and other financial institutions like Lehman were the causes for the crisis rather than the hedge funds. They also said that regulation is lacking and hence requested the authorities to increase the role of regulation in banks and financial institutions. Apart from this the managers also blamed investment banks, credit sellers of default swaps, mortgage dealers as the people who must be held responsible for the crisis. The hedge fund managers also feel that they need not tighter regulations for the industry.

The financial crisis of the United States is undoubtedly hampering the entire economy on a whole along with the financial system. Hedge funds are believed to destabilize the global economy. Actually, there is no prescribed rule of thumb that can be followed while dealing with hedge funds. Bu off-late, the trades of hedge funds have used diverse styles of trading. The long-short strategy that has been recently adopted resulted in the capturing of almost 30 – 40 percent of the businesses in the United States (See Table II).

Table 2 US mortgage debt outstanding, by type of property and holder

According to Henry Waxman, chairman of the US House Oversight and Government Reform Committee, lack of regulation is also one reason for the recent bubble in the financial market. Hedge funds in the U.S. market are virtually not regulated properly. None of the hedge funds in the U.S. financial market, according to the existing rules, are required to report any information with respect to their amount of holdings, or their leverages or strategies.

Though unbelievable, it is a prudent fact that most of the regulator are neither aware of the number of hedge funds that are existing in the market nor the amount of money that is controlled by those funds. As already stated earlier, hedge funds were the ones responsible for the downfall of two of the major investment banks namely the Lehman Brothers and the American International Group and also for the poor performance of the U.S. Stock market.

Subprime mortgage crises have become an ongoing economic problem in various parts of the globe. The basic reasons behind these crises may be described as contracted liquidity in the banking systems across the globe and also in the credit markets. Risky lending, excess of corporate and individual debt levels, risky practices of borrowing also can be added to the list of reasons for subprime crisis to occur.

According to the so called Big Bank theory, no government across the globe will allow any big financial institution or a bank to collapse so easily. This is because the after effect or the consequences of such collapses would definitely be great and at time will be out of control to handle despite how big the economy in which the collapse occurred. This exactly is the basic reason as to why AIG was bailed out by the U.S. Federal Reserve. If the scenario or the case of Lehman Brothers’ is observed, the company was having problems with its financial situation for almost more than a year now i.e. since the year 2007, one year even before the company bankrupted. In the month of August 2007, the company closed one its subprime lenders. As a result of this the company recorded a onetime post-tax charge of approximately $25 million. This scenario did not end there. The basic reasons behind these crises may be described as contracted liquidity in the banking systems across the globe and also in the credit markets. Risky lending, excess of corporate and individual debt levels, risky practices of borrowing also can be added to the list of reasons for subprime crisis to occur.

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Volatility can represent opportunity rather than risk, as this type of security tends to provide higher returns than more placid ones. In dealing with volatility, such an approach would definitely help. In the long run, it can be your friend, not your enemy. Even after joining the ERM, the economic condition and the situations did not seem to be improving. The United Kingdom was rapidly going into a recessionary phase. “High inflation and deteriorating economic activity was making the Pound less attractive. Therefore, the Pound kept falling to its lower limit in the ERM.” Another reason as felt by market analysts was illiquidity. During the Crash, trading mechanisms in financial markets were not able to deal with such a large flow of sell orders. Due to the economic conditions and various other relevant reasons, the UK became desperate and hiked its interest rates to a booming price. According to theoretical beliefs, hike in interest rates would attract hot money inflow into the economy. However, this theory did not work in favour of the UK as it was believed that the hike in interest rates was a mere desperate action made by the government. “The market knew these were fantasy interest rates which couldn't be maintained, the selloff continued and eventually, the government caved into the inevitable and left the ERM. The Pound fell 15%, interest rates were cut, and the economy was able to recover.”

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