The Multinational Monitor

October 1988 - VOLUME 9 - NUMBER 10


E C O N O M I C S

AN INVITATION TO SECURITIES ABUSE

Repealing the Glass-Steagall Act

By Jon Brown
THE GLASS-STEAGALL ACT, enacted by Congress in 1933, came under fire from the banking lobby and some members of Congress this year. Each sought to repeal the restraints on underwriting and dealing in securities that the Act imposes on commercial banks. The legislation, sponsored by retiring Sen. William Proxmire, D- Wisc., failed to pass, but is expected to resurface next year.

The effort ignores the historical circumstances that precipitated Glass-Steagall as well as the ramifications--for both individual investors and the national economy--of letting commercial banks engage in corporate securities activities.

Glass-Steagall was a response to several specific abuses by financial institutes that contributed to the general economic collapse of 1929. Banks played a key role in fuelling the speculative frenzy in the stock market during the 1920s, extending large amounts of credit for securities investment. In addition, the securities affiliates of many banks were underwriting and peddling to their customers a massive volume of securities of questionable worth. Glass-Steagall imposed a structural solution by separating commercial banking from underwriting and dealing in securities.

The move to repeal Glass-Steagall's structural distinction between commercial and investment banking was sparked in part by changes that have occurred in financial markets since the 1930s. First, there are many more links between banking and securities markets than existed even 10 years ago. Under the Reagan administration, federal regulators have aggressively exploited loopholes in Glass-Steagall to allow banks to engage in some limited securities activities. In addition, the decline in bank profitability in recent years, due primarily to losses on Latin debt and loans in energy and real estate sectors, led banking interests to advocate for new powers that would generate fee income, securities underwriting among them, in order to offset the falling profits in traditional banking activities. But, as one observer noted, "Arguing that you need new powers to compensate for the fact that you have mismanaged your existing powers requires either an Alice in Wonderland suspension of logic or a lot of political clout." Proxmire made much of the fact that bank entry into securities markets would increase competition and lower underwriting fees. Underwriting of investment grade corporate securities, however, is already reasonably competitive, and bank entry is likely to have only a minor impact on the price of issuing such securities.

On the other hand, underwriting fees on junk bonds and other speculative securities are often three to four times greater. Consequently, repeal of Glass-Steagall is likely to draw the largest banks, which have resources far beyond those of the largest securities firms, into aggressive promotion of junk bonds and speculative securities. Boosting the junk bond market will further fuel leveraged buy-outs and hostile takeovers, a trend that is undermining the capital base of U.S. corporations.

Banks would be in an excellent position to facilitate and profit from such freewheeling corporate restructuring, since they are already able to extend large "bridge" loans to finance the tender offers that start the process. The Proxmire bill would have required banks to conduct most securities activities in separate subsidiaries under a bank holding company structure. This approach, it was claimed, would ameliorate concerns about bank safety and soundness, and prevent raids on bank capital to promote speculative securities activities. The bill--and the hearings the Senate Banking Committee held on it--did not, however, address the potential for conflicts of interest and insider trading that is inherent in allowing banks to engage in securities activities.

A serious conflict of interest exists when, for example, a bank underwrites securities issued by a corporation that has loans outstanding from the bank. As an underwriter, the bank has a "due diligence" obligation to provide accurate information on new securities issues to investors. But as a creditor, the bank may want a troubled corporate borrower to issue securities so that the proceeds can be used to repay the bank's loan. In effect, control of the underwriting process may enable the bank to shift potential loan losses to public investors.

(balance of this article omitted here; unscannable)


Jon Brown is Executive Director of Bank Watch, a Washington- based public interest organization.