One thing the federal government is not likely to change in its reaction to the current financial crisis from its response to the Great Depression is its instinct to clamp down on Wall Street through a wave of new regulation. The Glass-Steagall Act of 1933, which created the Federal Deposit Insurance Corp., and tightened the reins on the banking industry, was perhaps the most profound change for banks in the wake of the 1929 stock market crash and ensuing Depression. A key element of the law separated depository institutions from other financial firms, dismantling banking behemoths like J.P. Morgan. In the free market, deregulation mindset of the 1990s, however, many restrictions on banks, including Glass-Steagall, were stripped away. That move's impact on the current crisis has been fiercely debated, but both sides can agree that, one way or another, Wall Street can expect some kind of renewed effort to rein in financial companies. "One of the things that will undoubtedly happen is the pendulum will swing the other way -- toward more and more regulation," says Christie Sciacca, a director at banking consultancy LECG, and former associate director of policy at the FDIC. "It's already started to happen. Congress and others are talking about how deregulation was the cause of this, and it's interesting that Congress passed the legislation that led to deregulation." A strong regulatory hand grasped the financial sector for several decades following the Depression, making banks more stable -- if more boring -- institutions. But as time went on, aversion to risk diminished, the lines of distinction blurred and competition from universal banks in Europe threatened to turn leading American institutions into runners-up.
Within a few decades, the industry found loopholes around Glass-Steagall and authorities became more lenient, fearing that a European competitor would overcome the U.S. to become the top financial powerhouse. The situation culminated in 1998 when Citibank and Travelers Group combined to form the giant financial services firm Citigroup ( C). Congress overturned the universal banking restriction of Glass-Steagall the next year with the Gramm-Leach-Bliley Act. Fast-forward ten years: Panic has gripped the markets again, the economy is in the doldrums, and regulators are taking unprecedented steps to clean up the mess that banks helped make under their watch. James Leach, a former Republican congressman from Iowa who co-sponsored the bill, places blame on the bankers rather than regulators. Banks that caved under pressure from mortgages and their complex derivatives were able to make the same investments before Gramm-Leach-Bliley, he asserts. "
T he issue is principally bad judgment rather than the right to compete," Leach, now a visiting professor at Princeton University, says in an article to be published by the Northwest Financial Review. "Legislation did not dupe Wall Street." In an email message, Leach adds that the repeal of Glass-Steagall "has been helpful in resolving some of the problems that developed," since stronger, full-service firms like Bank of America ( BAC) and JPMorgan Chase ( JPM) have been able to weather the storm and stepped in to take over smaller, struggling competitors, like Countrywide Financial and Washington Mutual, respectively. Few pin all the blame for the current crisis on the repeal of Glass-Steagall or expect its wall of separation to return. Steven Kyle, associate professor of economics at Cornell University, says re-imposing that wall with the "sledgehammer or meat-axe approach of the 30s" would not be advisable, but for Congress to have "cut that wall and replaced it with nothing was a bad idea."
"There's no question in my mind that there was inadequate regulation which led to this mess," says Kyle. "If you look at financial history, certainly the private market does self-regulate, but with periodic crashes, and we don't like that." Kyle and others are also quick to warn that tying the hands of financial firms too tightly will further blunt America's competitive edge and hamper economic momentum once the storm subsides. "You have swings in public policy and you always have some degree of overreaction in either direction," says Alan L. Madian, a director at LECG, investment banker and policy adviser. "There probably will be some regulation that will be imposed that will restrict economic activity that otherwise would be beneficial." But as the market has dropped 38% over the past 52 weeks, with falling home prices, rising unemployment, inflation fears and declining wealth, concerns about heavy-handed government action have largely evaporated. Firms that were heavily weighted in housing assets -- whether investment banks like Bear Stearns, Lehman Brothers and Merrill Lynch ( MER), banks like Washington Mutual, Wachovia ( WB) and IndyMac, the insurance giant AIG ( AIG) or mortgage-finance behemoths Freddie Mac ( FRE) and Fannie Mae ( FNM) -- failed or were rescued by the government or competitors. Those actions have sent tremors through the market, exacerbating stock declines and restricting lending for businesses and consumers who would ordinarily receive it. There are a few key areas likely to receive greater scrutiny by authorities in the coming months and years, says Robert Litan, an economist and lawyer at the Brookings Institution who has served in various roles of the legislative, regulatory and judicial branches of government.
First, underwriting standards will be improved so that there is not a repetition of the subprime lending spree that kicked off the current melee. Secondly, a comprehensive approach to regulate risk-management will also likely come to fruition. That may include restrictions on leverage ratios -- which have already started to come down, from the 30:1 level at some firms -- as well as higher requirements for capital reserves. And finally, greater transparency will likely be at the forefront of the initiative, which means that firms holding complicated financial instruments, like credit-default swaps and other derivatives, will have to disclose more about the underlying assets and potential risk. The Securities and Exchange Commission's recent rule forcing hedge funds to disclose their short positions may be evidence that more scrutiny will be placed on that highly-leveraged, risk-hungry industry as well. Litan suggests that new financial instruments may have to go through a screening process before being introduced to the market. He also says there should be a clearinghouse for credit default swaps and other complicated financial instruments that sealed the fate of several firms. "In retrospect, they probably would have limited investment banks' ability to leverage themselves so much, and probably should have given more attention to derivatives, and to credit default swaps in particular," says Litan. "That was at the heart of the failure of AIG, Bear Stearns and Lehman." Sciacca, the former banking supervisor, is sympathetic to Congress and regulators who failed to recognize that the risks that flowed through the veins of the financial system threatened to send it into a coma. But he agrees there was not enough debate and discussion before the wall of Glass-Steagall came down, and that authorities should have been scrutinizing the financial system more closely to prevent the chaos it faces today.
"I was a banking supervisor for several years and I understand there are times when you don't do as good a job as you should have done," says Sciacca. "But you hope that you learn from that... Sometimes when you're knee-deep in alligators your job is to remember that you have to drain the swamp."