This paper explains the process of competitive deregulation that led both the U.S. and the U.K. to embrace universal banking and to abandon the functional separation of financial activities that had long characterized their financial systems. The paper argues that only a few rare voices in the debate over universal banking that started in the late-1970s and continued for over a decade understood what was truly at stake. The principal argument in favor of separation, then as now, was that the commercial banking system, which is supported by a government “safety net,” needs to be protected from the risks inherent in investment banking. By contrast, this paper argues that functional separation plays an important role in protecting capital markets from the banking system.

Universal banking is associated historically with thinly traded stock markets, and this paper argues that universal banking promotes an oligopoly of large dealer-banks whose interests are best served by trading on non-public over-the-counter markets. I find that such an oligopoly played a key role in the growing importance of such over-the-counter markets in the U.S. over the past few decades.

The paper then argues that the benefits of the greater liquidity that large universal banks can provide to capital markets are offset by the dangers they create when they err. Because mistakes at these large banks are often allowed to grow in size to match the size of the banks, they distort prices on financial markets and sometimes create systemic risk. Two recent examples are given: UBS and Citibank’s exposures to subprime mortgages, and J.P. Morgan Chase Bank’s “London whale” fiasco.

Finally, the paper explains that Senator Carter Glass sought passage of the Glass Steagall Act, because he believed it was necessary to limit commercial bank participation in the margin loan market, as this activity makes possible a feedback loop between increases in the money supply and increases in asset prices, which in turn can generate an asset price bubble in capital markets. The recent crisis has led modern researchers to rediscover the relationship between margin lending, feedback loops, and asset price bubbles that was well understood by the legislators of the 1930s. The paper argues that the recent crisis closely mirrored the stock market bubble of the late 1920s and that we need a Glass-Steagall Act for the 21st century in order to protect capital markets from the banking system. *


Banking and Finance Law | Comparative and Foreign Law | European Law | Law | Law and Economics | Marketing Law

Date of this Version