Until 1863, US banks were regulated by the states. The Federal
Government had twice established a national bank, but abandoned both
efforts. In 1863, the Civil War had been raging for two years, and the
Federal Government was desperately short of cash. Secretary of the
Treasury Salmon P. Chase came up with an innovative source of financing.
The Federal Government would charter national banks that would have
authority to issue their own currency so long as it was backed by holdings
in US Treasury bonds. The idea was implemented as the National Currency
Act, which was completely rewritten two years later as the National
Banking Act. The act formed the
Office of the
Comptroller of the Currency (OCC) with authority to charter and
examine national banks. In this way, a dual system of banking was
launched, with some banks chartered and regulated by the states and others
chartered and regulated by the OCC.
The 1913 Federal Reserve Act formed the
Federal Reserve System (the Fed)
as a central bank and lender of last resort. The system included several
regional Federal Reserve Banks and a seven-member governing board.
National banks were required to join the system, and state banks were
welcome to. Federal Reserve notes were introduced as a national currency
whose supply could be managed by the Fed. The notes were issued to reserve
banks for subsequent transmittal to banking institutions as needed. The
new notes supplanted the OCC's purpose related to currency, but that
organization continued to be the primary regulator of national banks.
Prior to 1933, US securities markets were largely self-regulated. As
early as 1922, the New York Stock Exchange (NYSE) imposed its own
requirements on member firms. Firms were required to hold capital equal to
10% of assets comprising proprietary positions and customer receivables.
By 1929, the NYSE capital requirement had developed into a requirement
that firms hold capital equal to:
5% of customer debits;
10% on proprietary holdings in
30% on proprietary holdings in other liquid
100% on proprietary holdings in all other securities.
During October 1929, the US stock
market crashed, losing 20% of its value. The carnage spilled into the US
banking industry where banks lost heavily on proprietary
investments. Fearing that banks would be unable to repay money in their
accounts, depositors staged a “run” on banks. Thousands of US banks
During October 1929, the US stock market
The Roaring ‘20s were over, and the Great Depression had begun. During
this period, the US Congress passed legislation designed to prevent abuses
of the securities markets and to restore investors’ confidence.
The 1933 Banking Act combined a bill sponsored by Representative Steagall to establishing federal deposit insurance with a bill sponsored
by Senator Glass to segregate the banking and securities industries. More
commonly known as the Glass-Steagal Act,
which is the business of taking deposits and making loans, and
which is the business of underwriting and dealing in securities.
All banks were required to select one of the two roles and divest
businesses relating to the other. Chase National Bank and the National
City Bank both dissolved their securities businesses. Lehman Brothers
dissolved its depository business. The First Bank of Boston split off its
securities business to form First Boston. JP Morgan elected to be a
commercial bank, but a number of managers departed to form the investment
bank Morgan Stanley.
Glass-Steagall also formed the
Federal Deposit Insurance
Corporation (FDIC) to provide deposit insurance for commercial
banks. All member banks of the Federal Reserve were required to
participate. Other banks were welcome to participate upon certification of
their solvency. The FDIC was funded with insurance premiums paid by
participating banks. Deposits were insured up to
USD 2,500—if a bank
failed, the FDIC would make whole depositors for losses on deposits up to
USD 2,500. That insurance level has since been increased to USD 100,000.
Two other acts addressed the securities markets. The 1933 Securities Act
focused on primary markets, ensuring disclosure of pertinent information
relating to publicly offered securities. The
1934 Securities Exchange Act
focused on secondary markets, ensuring that parties who trade
securities—exchanges, brokers and dealers—act in the best interests of
investors. Certain securities—including US
debt—were exempted from most of these acts' provisions.
The Securities Exchange Act established the
Securities and Exchange
Commission (SEC) as the primary regulator of US securities
markets. In this role, the SEC gained regulatory authority over
firms. Called broker-dealers
in US legislation, these include investment banks as well as non-banks that broker
and/or deal non-exempt securities. The 1938
Maloney Act clarified this role, providing for
organizations (SRO’s) to provide direct oversight of securities firms
under the supervision of the SEC. SRO’s came to include the
of Securities Dealers (NASD) as well as national and regional
exchanges. Commercial banks continued to be regulated by the OCC or state
regulators depending upon whether they had federal or state charters.
In 1938, the Securities Exchange Act was modified to allow the SEC to
impose its own capital requirements on securities firms, so the SEC
started to develop a Net Capital Rule. Its primary purpose was to protect
investors who left funds or securities on deposit with a securities firm. In 1944, the SEC exempted from this
capital rule any firm whose SRO imposed more comprehensive capital
requirements. Capital requirements the NYSE imposed on member firms were
deemed to meet this criteria.
An investment company
is a mechanism for investors to pool money to be invested by professional
managers. The company sells shares to the investors and a manager invests
the proceeds on their behalf. The notion includes both open-end and closed
end-mutual funds. Investment companies became popular in the 1920s. A
number of incidents of abuse prompted Congress to pass the
Investment Company Act in 1940.
With a few exceptions—which encompass most of today's
granted the SEC regulatory authority over investment companies.
Between 1967 and 1970, the NYSE experienced a dramatic increase in
trading volumes. Securities firms were caught unprepared, lacking the
technology and staff to handle the increased workload. Back offices were
thrown into confusion trying to process trades and maintain client
records. Errors multiplied, causing losses. For a while, this “paperwork
crisis” was so severe that the NYSE reduced its trading hours and even
closed one day a week. In 1969, the stock market fell just as firms were
investing heavily in back office technology and staff. Trading volumes
dropped, and the combined effects of high expenses, decreasing revenues
and losses on securities inventories proved too much for many firms.
Twelve firms failed, and another 70 were forced to merge with other firms.
The NYSE trust fund, which had been established in 1964 to compensate
clients of failed member firms, was exhausted.
The US stock market declined through 1969.
In the aftermath of the paperwork crisis, Congress founded the
Securities Investor Protection Corporation (SIPC) to insure client
accounts at securities firms. It also amended the Securities Exchange Act
to require the SEC to implement regulations to safeguard client accounts
and establish minimum financial responsibility requirements for securities
As a backdrop to these actions, it came to light that the NYSE had
failed to enforce its own capital requirements against certain member
firms at the height of the paperwork crisis. With its trust fund failing,
it is understandable that the NYSE didn’t want to push more firms into
liquidation. This inaction marked the end of SROs setting capital
requirements for US securities firms.
In 1975, the SEC updated its capital requirements, implementing a
Uniform Net Capital Rule (UNCR) that would apply to all securities firms
trading non-exempt securities. As with earlier capital requirements, the
capital rule’s primary purpose was to ensure that firms had sufficient
liquid assets to meet client obligations. Firms were required to detail
their capital calculations in a quarterly Financial and Operational
Combined Uniform Single (FOCUS) report.
During the Great Depression, the Fed had implemented
Regulation Q that, among other things, capped the interest rates
commercial banks could offer on savings account deposits. The intent was
to prevent bidding wars between banks trying to grow their depositor
bases. Rising interest rates during the 1970s contributed to a
migration of larger institutional deposits to Europe, where interest rates were not limited by
Regulation Q. The emergence of money market funds, which pooled cash to
invest in money market instruments, caused further erosion of bank
In 1980, Congress passed the
Depository Institutions Deregulation and Monetary Control Act.
Among other things, this terminated the Regulating Q ceiling on savings
account interest rates, effective in 1986. In response to this and an
ongoing decline in bank
bank regulators implemented minimum capital requirements for banks. There
was some debate about what should be included in a bank's capital. This
was resolved by defining two classes of capital. A
bank's primary capital would be a
bank's more permanent capital. It was defined as
owners' equity, retained earnings, surplus, various reserves and perpetual
preferred stock and
Secondary capital, which was more
transient, included limited-life
preferred stock and subordinated notes and debentures. In 1981, the Fed and OCC implemented
one capital requirement, and the FDIC implemented another. Generally,
these specified minimum primary capital ratios of between 5% and 6%,
depending on a bank's size.
Because these requirements were based on a bank's assets,
they were particularly susceptible to
Various modifications were made to
the primary capital requirements, but it was soon clear that basing capital
requirements on a capital ratio was unworkable. In 1986, the Fed
approached the Bank of England and proposed the development of
international risk-based capital requirements. This led to the
1988 Basel Accord, which replaced the
asset-based primary capital requirements for US commercial banks. The
concepts of primary and secondary capital were incorporated into the new
accord as tier 1 and
tier 2 capital.
As time went on, the Glass-Steagal separation of
investment and commercial banking was gradually eroded. Some of this
stemmed from regulatory actions. Much of it stemmed from market
developments not anticipated by the act.
Glass-Steagall did not prevent commercial banks from
engaging in securities activities overseas. By the mid 1980s, US
commercial banks such as Chase Manhatten, Citicorp and JP Morgan had
thriving overseas securities operations. Currencies were not securities under the Glass-Steagall
Act, but since exchange rates were allowed to float in the early 1970s,
they have entailed similar market risk. In 1933,
futures markets were small and
transacted primarily in agricultural products, so they were not included
in the legal definition of securities. Also, depression era legislators did not
anticipate the emergence of active
derivatives markets, so most
derivatives did not fall under any definition of securities. By the early
1990s, commercial banks were taking significant market risks, actively
trading foreign exchange, financial futures and OTC derivatives. They did
so while enjoying FDIC insurance and membership in the Federal Reserve
system. Neither of these benefits was available to the investment banks
with whom they were increasingly competing.
Commercial banks focused on the prospect of repealing
Glass-Steagal and related legislation. This would open the door to the
creation of financial supermarkets that combined commercial banking,
investment banking and insurance. Due to the nature of their business,
commercial banks generally had more robust balance sheets than investment
banks, and they could expect to dominate such a new world. There would be
profits from cross-selling deposit taking, lending, investment banking,
brokerage, investment management and insurance products to a combined
client base. There would also be troublesome conflicts of interest.
While he was chairman of the Federal Reserve, Paul Volker
fought efforts to ease the separation between commercial and investment
banking. Allen Greenspan replaced Volker in 1987, and he brought with him
a more accommodating attitude. Section 20 of the Glass-Steagall Act had
always granted modest exemptions allowing commercial banks to engage in
limited securities activities as a convenience to clients who used the
bank’s other services. Tentatively under Volker, but aggressively under
Greenspan, the Fed reinterpreted Section 20 to expand that authorization.
In various rulings during the late 1980s, the Fed granted certain
commercial banks authority under Section 20 to underwrite
paper, municipal revenue bonds,
mortgage-backed securities and even
corporate bonds. In October 1989,
JP Morgan became the first commercial bank to underwrite a corporate bond,
floating a USD 30MM
bond issue for the Savannah Electric Power Company. A flood of commercial
bank underwritings followed.
The Fed also allowed commercial banks to acquire
investment bank subsidiaries through which they might underwrite and deal
in all forms of securities, including equities. These became known as
Section 20 subsidiaries. There were limitations on the use of Section 20
subsidiaries. The most restrictive was a cap on the revenue a commercial
bank could derive from securities activities under Section 20. In 1986,
the Fed had set this cap at 5%. It was expanded to 10% in 1989 and again
in 1996 to 25%.
Congress attempted to repeal Glass-Steagall in 1991 and
again in 1995. Both attempts failed, but the stage was set. The Fed had
already gutted much of Glass-Steagall. Commercial banks were deriving
considerable revenues from investment banking activities. Their lobbyists
had arrayed considerable forces in Congress ready to make another attempt.
Glass-Steagall was teetering, and all that was needed was for someone to
step forward and topple her.
That is what John Reed and Sanford Weill did. Reed was CEO
of Citicorp, a large commercial bank holding company. Weill was CEO of Travelers Group, a
diverse financial services organization. It had origins in insurance but
had recently acquired the two investment banks Salomon and Smith Barney
and merged them into a single investment banking subsidiary. In 1998, Reed
and Weill merged their firms, forming Citigroup, a financial services
powerhouse spanning commercial banking, investment banking and insurance.
This was an aggressive move that could easily have been blocked by
regulators. A permissive Fed was supportive of the deal, which forced the hand of
Congress. In 1956, Congress had passed the
Bank Holding Company Act, which
had supplemented Glass-Steagall by limiting the services commercial banks
could offer clients. The Citicorp-Travelers merger violated the 1956 act,
but there was a loophole. The Holding Company Act allowed for a two-year
review period—with an optional extension to five years—before the Fed
would have to act. The newly formed Citigroup was the world's largest
financial services organization, but it was operating under a five-year
death sentence. If Congress didn't pass legislation during those five
years, Citigroup would have to divest some of its businesses.
Pressure on Congress was immense. In 1999, they passed the
Modernization Act, and President Clinton signed it into law. The
act is also known for the names of its sponsors—the
detractors have called it the Citigroup Authorization Act. This
sweeping legislation finally
revoked the Glass-Steagall separation of commercial and investment
banking. It also revoked the 1956 Bank Holding Company Act. It permitted the creation of
companies (FHCs) that may hold commercial banks, investment banks and insurance
companies as affiliated subsidiaries. Those subsidiaries may sell each others products.
Within a year of the new act's passage, five hundred bank holding
companies formed FHCs.
Although it was sweeping, the Financial Services
Modernization Act was, in some respects, a half measure. It dramatically
transformed the financial services industry, but it did little to
transform the regulatory framework. Prior to the act, commercial banks,
investment banks and insurance companies had been separate, and they had
oversight from separate regulators—the Fed and OCC for commercial banks,
the SEC for investment banks, and state regulators for insurance
companies. Who would now oversee the new FHCs that combined all three
industries? The answer is no one. The act adopted a "functional" approach
to regulation. The Fed and OCC now regulate the commercial banking
functions of FHCs. The SEC regulates their investment banking functions.
State insurance regulators regulates their insurance functions. The act
has opened the door to abuses across functions, but no regulator is
clearly positioned to identify and address these.
At the same time that Glass-Steagall was being torn down,
dramatic growth in the OTC derivatives market led to
concern that there was no regulator with clear authority to oversee that
market. A 1982 amendment to the Securities Exchange Act specified that
options on securities or baskets of securities were to be regulated by the
SEC. This left structures such as
swaps outside the SEC's
jurisdiction. It also excluded derivatives on interest rates or foreign
exchange. A regulator with authority most relevant to these derivatives
was one whose original purpose was unrelated to financial markets. This
was the Commodity
Futures Trading Commission (CFTC).
Congress formed the CFTC under the 1974
Commodity Exchange Act (CEA). It
had exclusive jurisdiction to regulate commodity futures and options.
Whether this authority encompassed OTC financial derivatives was not
legislatively clear and motivated several law suits.
As a debate raged over how OTC derivatives should be
regulated—or if they even should be regulated—there was pressure for the
the CFTC to act. Because its authority was not clear, the CFTC hesitated,
and market participants were generally opposed to the CFTC intervening.
Position papers were written by industry groups and government agencies.
Inevitably, there were some turf skirmishes as different regulatory
agencies tried to position themselves for a role in any new regulatory
regime. A strong argument against increased regulation of OTC derivatives
was that it would drive the market overseas—as had happened 20 years
earlier to the market for USD deposits.
Finally, Congress acted in 2000 by passing the
Modernization Act (CFMA). This amended the 1974 Commodity Exchange
Act, exempting all OTC derivatives. The CFTC was not to regulate OTC
derivatives. The market was to remain largely unregulated.
Overheated technology stocks formed a bubble that
collapsed during 2000. In 2001, the broader market also fell sharply. On September 11
of that year, terrorists hijacked airliners,
slamming two of them into New York's World Trade Center. Another hit the
Pentagon in Washington, and a fourth fell in a Pennsylvania field. With the terrorist
attacks, the bad news seemed to accelerate. Within weeks, the Wall
Street Journal was reporting on a brewing scandal at energy trading
powerhouse Enron. The firm had been using
accounting gimmicks and outright deception to inflate profits and hide
debt. In December, it filed for bankruptcy—the largest in US history. In
2002, that record was broken by the bankruptcy of telecommunications firm
WoldCom, which had inflated its 2000-2001
income by a whopping USD 74.4 billion. Enron and WorldCom were just the
two most prominent in a slew of bankruptcies and accounting scandals,
which included Global Crossing, Tyco, Rite Aid, Xerox, and others. In
2002, Accounting firm Arthur Andersen
was convicted of a single charge stemming from its lackluster auditing of
Enron. That action forced Andersen, one of the largest and most respected
auditors in the world, to go out of business. In 2005, the US Supreme
Court overturned the decision, concluding that the presiding judge had
given the jury faulty instructions. This decision came too late to save
There was plenty of blame to go around. Corporate
executives had cooked books while lining their pockets. Analysts at
investment banks had recommended stocks they knew were dogs in a quid pro
quo that ensured banking business from those same firms. Accounting firms had
been cross-selling consulting services to audit clients. Increasingly,
their auditors had shied away from challenging management of firms so as
to not jeopardizing those lucrative consulting engagements.
Amidst the gloom and finger-pointing, Congress passed the
2002 Sarbanes-Oxley Act, fondly
known as "sox." This is a sweeping law that
increases management accountability, mandates a variety of internal
controls at firms, and strengthens the role of auditors. Accounting firms
are largely prohibited from simultaneously auditing and consulting to any given
client. A new federal agency, called the
Accounting Oversight Board, (PCAOB or Peek-a-Boo),
is to oversee accounting firms. Corporations must test internal controls
regularly. To avoid conflicts, those tests must be performed by an outside
firm other than the external auditor. Sarbanes-Oxley has been variously
described as ineffective, overly costly to corporations, or too demanding.
Maybe some of the criticism is reasonable—or maybe not. Time will tell.
In 2004, the Basel Committee finalized its new
Basel II accord on bank regulation. US
regulators perceive this as primarily relevant for internationally
active banks. They intend to apply it to just ten of the largest US banks.
Another ten will have the choice to opt-in. Other US banks will remain
subject to existing US regulations, including those adopted under the
original Basel Accord.
agency security A
security issued by a US federal agency or government sponsored enterprise.
A committee of representatives from central banks and regulatory
authorities that has played a leading role in standardizing bank
regulations across jurisdictions.
A firm's value—assets minus liabilities.
corporation 1) A group of people, such as a guild or city, with a legal
collective identity. 2) A joint-stock, limited liability corporation.
In December 2001, energy trading powerhouse Enron filed for bankruptcy in the
midst of an accounting scandal.
regulation An overview.
Fed funds Deposits
held by US banks in accounts at their regional Federal Reserve banks.
risk management Practices by which a firm optimizes the
manner in which it takes financial risk.
Group of 30 Report
An influential 1993 industry report on OTC derivatives.
Risk from uncertainty due to legal actions or uncertainty in the applicability
or interpretation of contracts, laws or regulations.
A non-public offering of securities.
Capital that is held in accordance with statutory or regulatory requirements.
financial instrument such as a stock or bond.
US Federal Government debt obligation issued by the Department of Treasury.
is a history of US financial regulation during the 20th century. Gup (2004) is
an edited collection. It's focus is the Basel II capital accord, but it goes well beyond
that topic, exploring regulatory capital generally. Lander (2003)
is a detailed introduction to the Sarbanes-Oxley Act.
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