Banking Deregulation Research Paper

Deregulation

The Glass-Steagall Act of 1933 was the first major attempt at regulating the financial industry. The Act was passed by President Roosevelt with the objective of restoring public confidence in the banking system. Glass-Steagall sought to, among other things "prevent the undue diversion of funds into speculative operations," in response to the market crashes that had sparked the Great Depression (Maues, 2013). The reason for this was simple -- speculation was always a temptation for the banking industry, and if left unchecked the industry was likely to indulge in more speculation than the financial industry could sustain while performing at a high level of health and public confidence.

It has been argued that Glass-Steagall, for decades, had been able to prevent the type of accumulation in speculative assets within the banking system that occurred in the 2000s. Commercial and investment banking had been separated for this time, which meant that if investment banks wanted to engage in speculation, their failure would not affect the commercial banking system. In 1999, this separation was ended with legislation that essentially set the tone for the Great Recession a few years later. The basic principle is that now commercial banks were now able to take on investments and risk that they previously would not have bene able to take on. The normal relationship between risk and return works two ways -- you can assume that with more risk you will get a better return, but risk is just volatility.The reality is that these banks were unprepared for the volatility associated with their positions -- that is to say they had very quickly become overleveraged (Rickards, 2012).

The changes in 1999 came about with the Financial Services Modernization Act, which sought to remove many of the restrictions that Glass-Steagall placed on the banking industry. The initial reactions to this act were positive from the industry. The FSMA were an increase in stock prices for investment banks, and predictions of potential gains from economies of scope, market power and the implicit extension of government guarantees ("too big to fail") to banking affiliates (Carow, 2002). It was somewhat surprising that commercial banks did not respond much to the new laws, whereas investment banks and insurance companies did. The market expected, perhaps, the acquisition of these companies by the major commercial banks. But in the years after 1999, the larger institutions in all categories earned abnormal….....