Professional Documents
Culture Documents
Should commercial
and investment
banking be separated?
Dominic Casserley
Philipp Hrle
James Macdonald
Contents
Summary
Introduction
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2 Moral hazard
Does underwriting the banking system encourage undue risk taking?
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Under what conditions do banks become too big to fail, and threaten to become too big to bail?
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4 Regulation or separation
Should banks be split up, or simply better regulated?
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Notes
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Further reading
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Summary
One of the key questions that the UK government has
mandated the Independent Commission on Banking to
answer is whether universal banks should be split into
commercial and investment banks, have their scope of
operations narrowed, or have their scale reduced.
This question is not new. It has been discussed on
many different occasions in many countries, whether
in response to a banking crisis or not. Although
todays banks and financial markets have developed
tremendously and become far more complex since
the question was last aired, the current debate cannot
easily be understood without a knowledge of the
history that lies behind it.
The rise of universal banking in all major Western
markets is the first strand in this history, and can best
be illustrated by the contrasting experiences of the
United States, Germany, and the United Kingdom.
Whereas the large German banks have been universal
banks for a long time, the separation of commercial
and investment banking by law was a reality in the US
for much of the twentieth century. In the UK, universal
banking developed relatively recently, in the 1980s,
although it was not prohibited by law prior to that.
Introduction
The severity of the 2008 financial crisis has inevitably
prompted calls for strong measures to prevent any
recurrence. Blame for the crisis has been laid at many
doors: that of bankers, for their greed and hubris;
regulators, for their complacency; economists, for their
mistaken theories; politicians, for their encouragement
of subprime mortgage lending and a general increase in
leverage; and even Asian consumers, for their allegedly
excessive savings.
Part I
The rise of universal banking
The United States: Freedom and checks
In no other country has the debate over whether
commercial and investment banks should be separated
raged more fiercely or for so long.
The history of banking in America can be understood
only in the context of a continuing tension between
two opposing forces. One was the need for a powerful
financial sector that could fund the requirements of
a rapidly growing economy; the other was a deeprooted popular opposition to big banks, and to large
concentrations of financial power in general. This tension
goes back to the earliest years of the republic. It fed
into the National Bank Acts of 1863 and 1864, which
established the principle of the separation of commercial
and investment banking; it was an essential feature of
the GlassSteagall Act of 1933, which set this principle in
stone; and it is still in evidence in current political debates
on banking reform.
Early days
The First Bank of the United States was founded in 1791
by Alexander Hamilton, the first US Secretary of the
Treasury. It was modelled on the Bank of England, the
thinking being that if the new republic wanted to emulate
the economic success of Great Britain, it also needed to
emulate its financial system. However, popular opposition
to concentrations of financial power extended to the very
idea of a central bank, and in 1811 the disproportionate
representation of the smaller frontier states in the Senate
led to its abolition. The Second Bank of the United
States was founded in 1816, but it too fell foul of western
opposition, and its charter was not renewed when it
expired in 1836.
Thereafter the United States operated without a central
bank, and the only form of paper money to augment the
supply of coins was a motley assortment of notes issued by
approximately 7,000 state-chartered banks. Some of these
banks were sound, but many were insubstantial singlebranch unit banks whose notes circulated at a discount.
When the Civil War broke out in 1861, it was immediately
apparent that it could not be financed without a national
currency of some kind. The alternative, as Senator John
Sherman put it, would have been to depend on the
inflated currency of all the local banks in the United States;
banks over which you have no control, and which you
cannot regulate or govern in the slightest degree.3
The Lincoln administrations initial solution was to issue
paper money itself greenbacks, as they became
known. However, this was considered a stop-gap
emergency measure, and in 186364 the government
passed acts authorizing the creation of nationally
chartered banks. These banks would be permitted to
Separation
In the period immediately after the depression, the
question of what had caused it was central to enacting
reforms intended to prevent future crises.
In 1932, Carter Glass, the most influential member of
the Senate banking committee, introduced a bill to
separate commercial and investment banking. He and
his supporters reasoned that allowing the banks to enter
the securities business had created an overproduction
of securities5 that had inexorably led to the crash.
At the same time, the holding of volatile securities on
banks books had weakened their balance sheets and
contributed to a loss in confidence in the banking system.
Moreover, selling securities to their customers had given
rise to serious conflicts of interest.
The bill was opposed by the Hoover administration and
by the Federal Reserve of New York, on the grounds that
regulation was a sufficient solution to any problems that
had occurred and that separation would cause further
disruption to an already fragile financial system. Support
in Congress was mixed, and the bill might have died had it
not been for the confluence of three factors.
The first was the bills adoption by Franklin Roosevelt
in his presidential campaign. He declared, Investment
banking is a legitimate business. Commercial banking is
another, wholly separate business. Their consolidation
and mingling is contrary to public opinion.6 The second
factor was the Senate investigation into banking practice
led by Ferdinand Pecora in early 1933, which uncovered
a series of unsavoury insider deals, conflicts of interest,
and tax-avoidance tactics. The revelations outraged
Full circle
From 1933 to the late 1970s, the GlassSteagall Act
remained largely unchallenged. However, it is not hard
to see why the commercial banks started to push for its
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Funding industry
When Friedrich Krupp wanted to build his first factory
in 1811, he had to turn to his mother and siblings for a
loan. However, by the 1840s German private banks were
helping to finance business start-ups in exchange for
board representation. In the 1850s they were joined by
the first joint-stock banks, which were able to deploy the
greater amounts of capital needed for railway investment.
After unification in 1871, the pace of industrialization
accelerated dramatically. The boom of the early 1870s led
to the formation of 183 joint-stock banks, while the crash
of 1873 prompted successive waves of consolidation
that led to the rise of the big Berlin banks. Without any
restrictions on branching, the largest banks were able to
assume a dominant role in the national economy. By 1913
the three largest German companies were banks.
While the biggest German banks were larger in relation to
the size of the national economy than anything found in
America, they played no central banking function. In 1876
Germanys central bank, the Reichsbank, had been set
up with a monopoly on issuing notes. Unlike the Bank of
England, it had an extensive branch network that enabled
it to provide not just payments facilities but also shortterm business loans. As a result, the big banks tended to
concentrate on providing capital for industrial expansion.
In common with the United States, there was a tendency
for German companies to form monopolies or cartels so
as to avoid what was perceived as fruitless competition.
By the early twentieth century the German economy was
characterized by networks of dominant corporations
financed by a small group of large banks that exercised
influence through shareholdings and directorships.
For the most part these banks focused on their large
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Consolidation
The advent of limited-liability banking was followed by
a wave of consolidation, so that by the early twentieth
century Britain was dominated by a small number
of nationwide banks. However, unlike their German
counterparts, the large British banks confined themselves
to commercial banking even though there was no law
requiring them to do so.
The likely explanation for this division of labour is that Britain
had had plenty of time to develop efficient capital markets
with specialist investment banks, so there was no need for
commercial banks to get involved in securities activities. At
the same time, because of the relatively late development
of limited-liability banking, an increasingly wealthy society
was able to provide more than enough profitable business
for retail banking. By comparison, Germany came much
later to the Industrial Revolution and found it needed a lot
of capital to catch up with Britain. Since its capital markets
were undeveloped, it needed universal banks.
By the First World War, some qualms were emerging at
the excessive concentration of banking in Britain, which
now had the worlds biggest banks. In 1918 the Colwyn
Committee recommended that any further consolidation
be avoided. However, the issue did not excite the passion
aroused in America or Germany, most likely because the
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its own benefit. . . .This is not the first time that a powerful
economic elite has risen to political prominence. In the late
nineteenth century, the giant industrial trusts many of
them financed by banker and industrialist J. P. Morgan
dominated the US economy with the support of their allies
in Washington, until President Theodore Roosevelt first
used the antitrust laws to break them up.22
The counter-argument is that claims regarding the
accumulation of power by banks are exaggerated, at least
nowadays, when banks seldom exercise influence through
shareholdings or directorships in a systematic way.
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2 Moral hazard
Does underwriting the banking system encourage
undue risk taking?
One argument for separation is that it is not appropriate
for universal banks to make risky bets that are funded at
least partly by insured deposits and implicit government
guarantees. This is the central moral hazard argument. If
you believe that someone will bail you out, you can take
high risks because you are protected from failure.
The moral hazard argument consists of two strands: the
underwriting of the banking system through a lender of
last resort, deposit insurance schemes, or both; and the
undue risk taking that may result from it.
The history of the lender of last resort goes back to the
banking panic in England in 1825, when the Bank of
England had to provide liquidity, as its governor said, by
every possible means and in modes that we had never
adopted before.28 However, the thrusting of the bank
into this new role did not prevent further crises, which
recurred with monotonous regularity every decade until
1866, when the bank had to use all available means to
offset the dash for liquidity. In the wake of this event,
Walter Bagehot, editor of The Economist, set out the
principles underlying the role of lender of last resort in his
book Lombard Street: A description of the money market.
According to Bagehot, the bank should declare itself
ready to lend freely on all acceptable forms of security
during any future panic:
If it is known that the Bank of England is freely advancing
on what in ordinary times is reckoned a good security on
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4 Regulation or separation
Should banks be split up, or simply
better regulated?
One argument against separation is that better
supervision is preferable to drastic structural measures.
However, debate rages over whether it is possible to
achieve truly effective supervision.
The question of supervision versus separation was
discussed as frequently in the 1930s as it is today. The
Federal Reserve of New York stated that:
the broad question to be determined is the extent to
which the capital market should be divorced from the
banking system and removed from all supervision, or
whether its relations with the banking system should be
maintained and placed under appropriate supervision.39
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Radical alternatives
The economists Laurence Kotlikoff and Christophe Charnley
proposed in 2009 that the banking industry should be transformed
into limited-purpose banking.40 In a reversal of the GlassSteagall
Act, which forced banks to abandon investment banking and
revert to traditional commercial banking, Kotlikoffs proposal would
effectively turn all banks into investment banks. Their function would
be to create and administer mutual funds in order to provide finance
for the economy in a variety of ways from which the investor would be
at liberty to choose. This proposal is reminiscent of Lowell Bryans
suggestion in his 1988 book Breaking Up the Bank41 that structured
securitized credit was the future of banking, and would provide
cheaper and more efficient financing to the economy with less
systemic risk.
The common theme in Kotlikoff and Bryan is the transformation
of banks from deposit takers into unleveraged intermediaries. As
a result, private investors would assume all the inherent risks and
rewards in lending and the systemic threat to the financial system
posed by the fragility of highly leveraged banks would no longer exist.
This idea has a partial ancestor in Irving Fishers 1935 book 100%
Money. Like Bryan and Kotlikoff, Fisher was worried about the risk
inherent in the fractional deposit system, which increases deposits
as money is re-lent by the banks. He had two objections. First, the
system posed the risk of banking panics because of the inevitable
mismatch in maturity between banks demand deposits and their
loan portfolios. Second, it amplified booms and busts by expanding
the broad money supply (namely cash and demand deposits) in
good times as deposits were created, and reducing it in bad times as
deposits were withdrawn.
Fishers solution was to have all demand deposits backed 100
percent by money, a step that would be achieved through a form of
quantitative easing. The central bank would print money up to an
amount that represented the reasonable requirements of the broad
money supply, which he estimated at one-third of GDP. It would then
buy assets such as government securities from the banks until they
held sufficient money to back all their demand deposits with cash.
A useful by-product of Fishers system would be that governments
would be able to borrow up to 33 percent of GDP free of interest.
Deposit insurance, which Fisher blamed for increasing risk, would no
longer be necessary.
Because demand deposits would be backed by cash, only savings
deposits would be available for making loans. However, since the
governments borrowing needs would be reduced, the amount of
money available for private-sector lending would be proportionately
increased.
Needless to say, Fishers plan was never put into effect.
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Notes
1 Alan Greenspan addressing the Council of Foreign Relations, 15 October 2009.
2 Independent Commission on Banking Terms of Reference.
3 Addressing the US Senate in January 1861. Quoted in R. E. Sharkey, Money, Class, and Party, Johns Hopkins, 1959, p. 44.
4 Louis D. Brandeis, Other Peoples Money and How the Bankers Use It, F. A. Stokes, 1914, reprinted A. M. Kelley, 1971, p. 19.
5 Sen. Robert Bulkley, 10 May 1932, US Congressional Record, volume 75, part 9, p. 9911.
6 US Congressional Record, volume 77, part 4, p. 3956.
7 US Congressional Record, volume 77, part 4, p. 3956.
8 Rudolf Hilferding, Finance Capital, 1910, chapter 14 (from www.marxistsfr.org/archive/).
9 Andreas Busch, Banking Regulation and Globalization, Oxford University Press, 2008, p. 110.
10 Quoted in W. T. C. King, History of the London Discount Market, Cass, 1936, p. 37.
11 House of Commons Committee, British Parliamentary Papers, 1832, volume VI, p. 154.
12 The Economist, 25 October 1879, quoted in T. E. Gregory, British Banking Statutes and Reports, Oxford University Press,
1929, p. 299.
13 Sen. Robert Bulkley, 10 May 1932, US Congressional Record, volume 75, part 9, p. 9911.
14 W. Nelson Peach, The Security Affiliates of National Banks, Johns Hopkins, 1941, p. 175.
15 Robin Leigh Pemberton in October 1986, quoted in Richard Dale, International Banking Deregulation, Blackwell, 1992, p. 108.
16 Quoted in George Benston, The Separation of Commercial and Investment Banking: The GlassSteagall Act revisited and
reconsidered, City University, London, 1990, p. 37.
17 Thomas Lamont, Primary steps for banking reform, Proceedings of the Academy of Political Science, volume 15, number 2,
January 1933.
18 Quoted in Vincent Carosso, Investment Banking in America, Harvard University Press, 1970, p. 369.
19 Charles Calomiris, Universal Banking and the Financing of Industrial Development, World Bank working paper 1533, 1995.
20 Louis D. Brandeis, Other Peoples Money and How the Bankers Use It, F. A. Stokes, 1914, reprinted A. M. Kelley, 1971, p. 1.
21 Quoted in Ron Chernow, The House of Morgan, Simon & Schuster, 1990, p. 367.
22 Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Random House,
2010, p. 6.
23 US Senate, 10 May 1932, US Congressional Record, volume 75, part 9, p. 9915.
24 Quoted in George Benston, The Separation of Commercial and Investment Banking: The GlassSteagall Act revisited and
reconsidered, City University, London, 1990, p. 209.
25 Quoted in Richard Dale, International Banking Deregulation, Blackwell, 1992, p. 22.
26 Lauchlin Currie, The decline of the commercial loan, Quarterly Journal of Economics, 45, 1931, p. 709. Quoted in Richard
Dale, International Banking Deregulation, Blackwell, 1992, p. 22.
27 Alan Greenspan, Subsidies and power in commercial banking, p. 5, in Proceedings of the 24th Annual Conference on Bank
Structure and Competition, Federal Reserve Bank of Chicago, 1990.
28 House of Commons Committee, British Parliamentary Papers 1832, volume VI, p. 154.
29 Walter Bagehot, Lombard Street: A description of the money market, 1873, 14th edition, John Murray, 1915, p. 188.
30 Henry Pole, Comptroller of the Currency, testifying in the House of Representatives, 14 March 1932.
31 Thomson Hankey, The Principles of Banking, Its Utility and Economy; with remarks on the working and management of the
Bank of England, second edition, Effingham Wilson, London, 1873, p. 30.
32 Forrest H. Capie, ed., History of Banking, volume IV, William Pickering , London, 1993, p. 368.
33 Sen, Robert Bulkley, 10 May 1932, US Congressional Record, volume 75, part 9, p. 9911.
34 Sen, Robert Bulkley, 10 May 1932, US Congressional Record, volume 75, part 9, p. 9911.
35 Hearings before the Subcommittee of the Committee on Banking and Currency, US House of Representatives, 23 March
1932, p. 59.
36 Letter from Federal Reserve Bank of New York to the Committee on Banking and Currency on 7 April 1932. Hearings before
the Committee on Banking and Currency, United States Senate, 2830 March 1932, p. 501.
37 Article in Fort Worth Star-Telegram,1 May 1932; US Congressional Record, volume 75, part 9, p. 9916.
38 Sen. Robert Bulkley, 10 May 1932, US Congressional Record, volume 75, part 9, p. 9913.
39 Hearings before the Committee on Banking and Currency, United States Senate, 2830 March, p. 501.
40 Christophe Charnley and Lawrence Kotlikoff, Limited purpose banking, The American Interest Online, MayJune 2009.
41 Lowell L. Bryan, Breaking Up the Bank: Rethinking an industry under siege, Dow JonesIrwin, 1988.
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Further reading
Theo Balderston, German banking between the wars, Business History Review, 1991
George Benston, The Separation of Commercial and Investment Banking, City University, London, 1990
Andreas Busch, Banking Regulation and Globalization, Oxford University Press, 2008
Charles Calomiris, US Bank Deregulation in Historical Perspective, Cambridge University Press, 2000
Vincent Carosso, Investment Banking in America, Harvard University Press, 1970
Michael Collins, Money and Banking in the UK: A history, Routledge, 1990
Richard Dale, International Banking Deregulation, Blackwell, 1992
Irving Fisher, 100% Money, Adelphi, 1935
Richard Grossman, The shoe that didnt drop: Explaining banking stability during the Great Depression, Journal of
Economic History, volume 54, number 3, September 1994
Daniel Verdier, Universal Banking and Bank Failures Between the Wars, European University Institute, 1997
Ingo Walter, ed., Deregulating Wall Street, Wiley, 1985
Eugene White, Before the GlassSteagall Act, Explorations in Economic History, January 1986