The Glass-Steagall Act is remembered as a strict prohibition on the mixing of commercial and investment banking. Glass-Steagall is gone and the Dodd Frank Act has arrived to protect our economy against excessive risk taking amongst financial institutions.
Following the 1929 stock market crash, Congress recognized that steps needed to be taken to prevent commercial banks from encouraging depositors to take too much risk and to control speculation. Thus Congress gave us the Banking Act of 1933, often referred to as the Glass-Steagall Act. Congress recognized the conflict that arises when the same bank grants credit to facilitate investment activities.
The act as published consisted of 53 pages. Even though Glass himself expressed reservations about the act not long after it was passed, it remained the law of the land until 1999, when Congress repealed his law.
Let’s move forward to July 2010. The new Dodd Frank Act of Congress is viewed by some as Glass-Steagall 2.0. Let’s consider why:
What does the act call for?
In the act’s 2,300 pages, the law requires the federal government to more closely supervise; in some instances study and later develop new forms of oversight. The Dodd Frank Act is seen as the first step in a major overhaul of our regulation of the financial institutions. Here are some examples:
• The establishment in the future of a Financial Stability Oversight Council that will be charged with the mission of identifying risks to our financial stability. The risks are those that may arise from financial distress or ongoing activities of major banks or non-bank financial companies. A non-bank financial company can be any major company predominantly engaged in financial activities that is important to the successful operation of our financial systems.
• Proprietary trading: Banking entities are prohibited from participating in most speculative proprietary trading activities. Systemically important non-bank financial companies shall be subject to minimum capital requirements by the Federal Reserve as well as any other limitations that the Federal Reserve believes are appropriate.
• Hedge funds and private equity funds: Banking entities are generally prohibited from direct or indirect service to funds except for amounts that are not significant. The Federal Reserve is authorized to consider granting an exemption so that banking entities can enter into “prime brokerage transactions” (to be defined). Once again, systemically important non-bank financial companies to shall be subject to minimum capital requirements by the Federal Reserve as well as any other limitations that the Federal Reserve believes are appropriate.
Expansion of the universe of companies and funds that must register as investment advisers. Also the Securities and Exchange Commission will study and report on the need to enhance examinations of and enforcements against investment advisers.
How does it affect major financial institutions?
The clauses of Dodd Frank are set to be implemented gradually in future years. Here are some ways that our financial institutions will be affected:
A Financial Stability Oversight Council the federal government is charged with anticipating and acting upon developments that could damage the nation’s economy. To accomplish this mission, the council will need to have the right to receive critical information from businesses and sources it deems appropriate. In addition, the council will need to prescribe remedies to any matters that threaten the economy.
The involvement of banking entities in proprietary trading, hedge funds and private equity funds: the affect is to significantly reduce, over time, involvement by banking entities in these activities.
Many large non-bank financial companies will face, for the first time, regulation that will limit their ability to take risks. Working with minimum capital requirements will mean that assets, often in greater amounts than in the past, will need to be separated in order to prevent risk to our economic system.
Investment advisers of all sizes will be subject to more regulation and scrutiny once the SEC acts on its study.
Glass-Steagall 2.0
Both Glass-Steagall and Dodd Frank have been written with a view toward strengthening confidence in our financial systems. The 1933 act sought to reform the banking system then in place. The 2010 act seeks to build confidence by growing the government’s role in oversight.
As we look back at the financial crisis of 2008, one can argue that if the federal government is going to be saddled with the burden of deciding when a business is “too big to fail,” it’s only fair that the government have the opportunity to tackle the problems before they threaten our financial system. And one outcome of expanded oversight is that that those major businesses who control most of the assets of our financial institutions will take fewer of the risks that our economic system is designed to reward.
David Grumer is a partner in the financial services group at Citrin Cooperman, a regional accounting, tax, and consulting firm with offices in Norwalk as well as in New York, New Jersey, Pennsylvania, and the Cayman Islands. Reach him through the firm’s website at www.citrincooperman.com.
