Article by Arthur E. Wilmarth, Jr.
From the mid-1990s through 2008, the United States experienced the biggest booms and busts in its securities and housing markets since the “Roaring Twenties” and the Great Depression. Scholars have studied the events that led to the recent financial crisis and have compared those events to the causes of the Great Depression. Analysts also have analyzed whether “universal banks”--financial conglomerates that control deposit-taking banks as well as securities underwriters and dealers--played pivotal roles in both crises.
John Reed, a former cochairman of Citigroup, recently argued that the United States Congress made a serious mistake when it enacted the Gramm-Leach-Bliley Act (GLBA) in 1999. GLBA repealed the Banking Act of 1933 (Glass-Steagall) and authorized the creation of universal banks that resembled the bank-centered “financial department stores” of the 1920s. In Reed's view, “the universal banking model is inherently unstable and unworkable” and cannot be made safe by any amount of regulatory reform. Proposals to reinstate Glass-Steagall's wall of separation between commercial banks and securities firms became major topics of debate among presidential candidates during the early stages of the nomination battles for the 2016 election.
It therefore seems appropriate to revisit the question of whether Congress had good reasons in 1933 to separate commercial banks from securities firms. This Article is part of a larger project in which I plan to examine the rise and fall of financial department stores in the 1920s and 1930s and to compare their experience with the central role that second-generation universal banks played during the booms and crashes of the 1990s and 2000s.
As I will describe in Part II of this Article, large universal banks became leading underwriters and distributors of securities in the United States during the 1920s. The preeminent universal banks of the 1920s were also the two largest U.S. commercial banks: National City Bank of New York (National City), the predecessor of today's Citigroup, and Chase National Bank (Chase), one of the predecessors of today's JPMorgan Chase & Co. National City and Chase established securities affiliates to evade legal restrictions on the securities activities that were permissible for national banks. Both banks and their affiliates created far-flung networks of offices to facilitate their underwriting and sales of securities in the United States and foreign countries.
National City and Chase earned huge profits from their securities operations during the economic boom of the 1920s, but they suffered massive losses during the Great Depression. Both banks announced in March 1933 that they would shut down their securities affiliates. Both banks also received bailouts from the Reconstruction Finance Corporation (RFC) in December 1933.
As I will discuss in Part III.A, the Great Crash of 1929 and the waves of bank failures between 1930 and 1933 prompted Congress to hold a series of investigative hearings. Those hearings revealed that universal banks used unsound and deceptive practices to sell large volumes of high-risk securities during the 1920s. Universal banks also made ill-advised loans to investors and issuers to promote their underwriting and trading of securities. The sale of speculative securities by universal banks inflicted enormous losses on investors during the Great Depression. Congress responded in June 1933 by passing Glass-Steagall, which mandated a strict separation between the banking industry and the securities markets.
Part III.B provides illustrative examples of the abusive securities practices and conflicts of interest that occurred at National City, Chase, and their securities affiliates during the 1920s and early 1930s. National City and Chase used misleading prospectuses and high-pressure sales techniques to promote the sale of hazardous foreign bonds and other high-risk securities to retail investors (including their depositors) and smaller financial institutions. Both banks made unsound loans to investors and issuers of securities to support the activities of their securities affiliates. Both banks organized trading pools to pump up the prices of their own stocks, as well as the stocks of favored clients. Insiders at both banks took advantage of their securities operations to reap extraordinary financial gains. Revelations of securities abuses and insider self-dealing at National City and Chase triggered widespread public outrage and helped to build public support for enactment of Glass-Steagall as well as the Securities Act of 1933 and the Securities Exchange Act of 1934.
The abuses and conflicts of interest that occurred at National City and Chase illustrate the potential dangers of allowing commercial banks to affiliate with securities underwriters and dealers. The “Pecora hearings” revealed pervasive conflicts of interest that existed across the deposit-taking, lending, underwriting, and trading activities of National City and Chase. The disastrous experiences of National City and Chase during the early 1930s demonstrated the dangers of allowing banks to use their deposits and lending facilities to promote speculative underwriting and trading operations. The near collapse and bailouts of both banks also highlighted the systemic risks that are likely to occur when major banks and the securities markets become tightly linked. Finally, it does not appear to be a coincidence that the emergence of universal banks in the 1920s was associated with an enormous boom in the issuance of unsound and high-risk securities to the public. The misconduct that took place at National City and Chase demonstrated the need for strong laws to protect unsophisticated investors and other consumers against exploitation by powerful financial institutions.
About the Author
Professor of Law, George Washington University Law School
90 Tul. L. Rev. 1285 (2016)