Size Matters: Commercial Banks and the Capital Markets
49 Pages Posted: 18 Nov 2015 Last revised: 15 Dec 2015
Date Written: November 1, 2015
The conventional story is that the Gramm-Leach-Bliley Act broke down the Glass-Steagall Act’s wall separating commercial and investment banking in 1999, increasing risky business activities by commercial banks and precipitating the 2007 financial crisis. But the conventional story is only one-half complete. What it omits is the effect of change in commercial bank regulation on financial firms other than the commercial banks. After all, it was the failure of Lehman Brothers — an investment bank, not a commercial bank — that sparked the meltdown.
This Article provides the rest of the story. The basic premise is straightforward: By 1999, the Glass-Steagall Act’s original purpose — to protect commercial banks from the capital markets — had reversed. Instead, its main function had become protecting the capital markets from new competition by commercial banks. Once the wall came down, commercial banks gained a sizeable share of the investment banking business. To offset lost revenues, investment banks pursued riskier businesses, growing their principal investments and increasing the amounts they borrowed to finance them. In effect, they assumed the features of commercial banks — a reliance on short-term borrowing to finance longer-term (and riskier) investments. For the investment banks, combining the two was lethal and eventually triggered the financial meltdown.
The divide between two sets of regulators, those regulating commercial banks and those regulating investment banks, enabled the change. The need for greater regulatory coordination has grown with convergence in the financial markets. Although new regulation has addressed some of the concern, the gap between regulators continues today — raising the risk of repeating mistakes from the past. Acknowledging the role of bank regulation (and de-regulation) in reshaping the capital markets is a key step in the right direction.
Keywords: Gramm-Leach-Bliley, Glass-Steagall, financial crisis, investment banks, commercial banks, risk management, financial regulation
JEL Classification: G18, G21, G24, G28, G38, K22
Suggested Citation: Suggested Citation