In 1933, the US was in the worst depression in its history, with a 25 per cent unemployment rate, a 46 per cent decline in industrial production, a 70 per cent decrease in foreign trade and a banking industry that had shrunk by 43 per cent as 11,000 of the nation’s 25,000 banks either failed or were forced to merge.
Although the stockmarket crash of 1929 is widely blamed as the culprit, the structural weakness of the banking system was also at fault.
As a result, a pivotal banking reform law, the Banking Act of 1933, better known as the Glass-Steagall Act, was enacted.
In order to avoid further runs on banks, the act created a government corporation that guaranteed deposits up to US$2,500 at member banks in the form of insurance.
Additionally, the act capped interest rates, broadened the powers of the Federal Reserve and erected a wall separating commercial banking from investment banking.
Commercial banks earn profits by accepting deposits and then lending them at higher rates, the key driver of profitability being the interest spread.
Prior to Glass-Steagall, banks engaged in underwriting could use their assets to purchase and trade corporate securities, taking on significant exposure, with potential risk of loss to depositors.
Conflicts of interest were inherent in the system.
A bank underwriting, and investing in, the security of its corporate customers had an interest in seeing the underwriting transaction and market price perform well and could very well be tempted to aggressively distribute the more speculative stock investments to their customers, as an alternative to the more conservative savings deposits.
Unsound loans could also be made to customers where the bank was the underwriter, in order to shore up the financial position of the company.
Besides separating commercial and investment banking activities, Glass-Steagall prevented both the unfair competitive advantage of banks getting cheap access to government-guaranteed deposits and playing the market with those deposits.
The act was further extended in 1956, barring commercial banks from engaging in non-banking activities, principally insurance.
In the 50 year period following Glass-Steagall, bank failures were very few and overall economic growth was strong and stable.
But banks attempted to chip away at Glass-Steagall.
In 1987, the Federal Reserve re-interpreted the act and allowed a holding company of a commercial bank to earn as much as five per cent of gross revenues from dealing in certain types of debt securities.
In 1989, the Fed expanded the type of securities, permitting equities, and raised the cap to 10 per cent.
Two years later, the limit was lifted to 25 per cent.
It was the merger between Citicorp, a commercial bank, and Travelers, who owned an investment bank, in 1998 that effectively dismantled Glass-Steagall.
The merger was illegal at the time.
A $300 million lobbying effort, political support from then-secretary of the Treasury Robert Rubin (who later joined Citigroup and, through his tenure, received $126 million in cash and options) and sponsorship from Republican senator Phil Gramm, who co-authored the act that repealed much of Glass-Steagall and later joined investment bank UBS in 2001, led to the ultimate demise of the separation of commercial and investment banking.
What followed was a wave of commercial banks absorbing investment banks, riskier lending practices, the creation of sophisticated financial instruments that investors did not understand, unparalleled leverage, and a financial crisis in 2008 with a $1 trillion-plus taxpayer bailout of the banking system.
There is momentum to reinstate parts of the Glass-Steagall act from both the public, epitomised by the Occupy movement, and the government, with the tabling of the Dodd-Frank reform bill and Volcker Rule.
Former Citicorp chief executive John Reed recently regretted his role in lifting the provisions of Glass-Steagall, and said it was a mistake.
Hopefully, the government will learn from its mistakes.
Anthony Galliano is the chief executive of Cambodian Investment Management.