The Divergence in Economies
The Gramm-Leach-Bliley Act of 1999 (The Glass-Steagall Act) is also known as the Banking Act of 1993. The Congress passed the Act in 1993 with the primary aim to prohibit commercial banks from having a piquant wit investment related businesses in United States (US). When more than 5,000 banks had failed to operate in order to meet the fiscal obligation during the great depression, an emergency response was to enact the Act to help curb the situation. The initiation of the Act started as a temporal program but as time went by, it was accepted fully as a permanent measure in 1945. Banks usually operate within the conditions of fractional liquidity reserves.
The Act reinforced certain criteria on regulation of national banks to the Federal Reserve System, laying out strategies towards prohibiting bank sales of securities. They aimed at creating the Federal Deposit Insurance Corporation (FDIC) that ensured that all the deposits that were made were in line with the pool of money reserved for banks. It is evident that what resulted in floating of bond issues and corporate stock issues underwritten were the establishment of security affiliates by commercial banks. The trend continued until the country’s stock market crashed, and later followed the depression. Even though every financial crisis that does happen is usually distinctive in its nature, certain commonalities that often happen strike more severely than the differences (Diamond and Philip 19).
The defaults that are commonly experienced include a massive leverage, a rapid decline in asset price, defaults on loans, a reduced lending, unemployment and a steep decline in economic activities. Nevertheless, besides the financial panics, the financial markets have presented frauds and rigs within the market, that is, financial scandal on the State’s bond where the “wildcat” life insurance companies took premiums from the business’ customers and disappeared before paying the claims. The restrictions that were imposed on banks took various forms. These include the compliance to credit allocation rules, control on the total volume of credit to be expanded, and a requirement to hold government securities among others. The government was able to keep the securities at a low price through holding bonds and having prudential justification as a form of tax.
In most cases, small businesses do obtain the credit products from banks. These come in form of mortgages given to commercial property or through loans. In fact, financial institutions apart from banks have emerged in the market to provide credit products, such as mortgages, leasing to small business. Consequently, the companies that require working capital and credit for their startup will have limited ability to substitute services that banks could offer. The small businesses can also rely on personal loans, which will include mortgage on a personal residence as well as the consumer credit cards that are highly viewed as inferior. Since they are considered high in cost, the personal assets would be traded at risk.
Banks, therefore, question whether they can make a profit when price indexes are raised when small businesses are incorporated. The factual will fully depend on the willingness of firms to obtain credits from the banks at an affordable price that will be competitive and act as an alternative to other financial lenders. Small business may substitute banks’ services with other alternatives in the market, but this does not mean that the alternative institutions would offer an amount that will serve their best interest. Local banks normally have higher chances of identifying small businesses that would offer lower credit risks, thereby compete adequately with other lenders through offering better and favorable lending terms.
The activities the country’s security affiliates created an artificial condition in the market and thus led to the failure of US banks. The banks had to be closed for four consecutive days and followed a permanent closing of over 4,000 banks. It true that the act of closing the banks devastated the economy, therefore, the public confidence in the U.S financial structure also deteriorated. The Congress created the Glass-Steagall Act to restore banking public’s confidence to assure members that banks will undoubtedly follow the reasonable banking practices. The Act that was formed made a clear distinction as well as separated the duties of both commercial and investment banks.
The commercial banks were prevented from underwriting securities though with an exception of the Unite States Treasury and the Federal Agency Securities, and municipal and state general obligation securities (Bryant 756). On the other hand, investment banks were not to engage in any business of receiving deposits. It was the duty of investment banks to underwrite securities and conduct any related activities, such as setting up corporate mergers, making a market in securities, the acquisition, and restructuring. However, the services performed by dealers or brokers in transactions in the secondary market would also fall under investment banking.
The great depression that the country experienced was restored by the Glass-Steagall to regain the public’s confidence in business practices. Much criticism was made stating that the commercial bank securities practices had a minor contribution towards the fall of the economy, thus did not lead to the country’s depression. The bank reformers as well as legislators have questioned the Act pointing that it has become outdated, and therefore needs to be repealed. In spite of minor rebellion on the factual, the Congress had to make an immediate response to Gramm-Leach-Bliley Act of 1999 passage that made significant changes to Glass-Steagall.
The failure of financial institutions can also result in a severe crisis for the investors and clients who fully rely on their services. The collapse of insurance companies, banks or pension funds, for example, can damage and disrupt the financial relationships between the financial institutions and members for the savings they have made on investments. However, such financial risks can be weakened when proper regulations are set in place to monitor their operations within the market. The rules set, therefore, will enhance the economic performance of such institutions and as well provide the financial safety to the market. When safety standards are not put in place, the risks associated with capital market crises cannot be evaded at the long run.
The Financial Regulatory System
The financial regulation has the mandate to ensure that financial market work better for the interest of the American citizens. The main objectives, which financial regulatory body should enact are to provide safety and stability for investors in the market, motivate innovative ideas as well as encourage growth within financial sectors. In order to achieve these set goals, the regulatory system should manage risks; promote fair dealing among market participants, and to facilitate transparency. However, the system that was used failed to meet its obligations within the three mentioned areas.
The banks therefore have a role to ensure there is a reduced transaction costs through monitoring the investors and providing liquidity. Distinction can be made between the parts of banks as regulatory and supervisory body for performance of the above tasks. Banks should ensure there is a reduced transaction cost for the services they render. The services can be through transformation, which comes in two aspects; first, the deposits should be transformed with no restrictions and if any, with few restrictions on minimal amount, and has the shortest maturity period to minimize risk related issues that may arise.
Secondly, as Benston and George (237) states, payment systems should be used to help banks provide payment services. The services to be rendered are usually costly for individuals who trade within the market. Investors, for example, would have a burden to write debt contracts directly with the firms since the agreements do possess restrictive clauses on firm activities. Consequently, investors would also prefer diversification of risks that would multiply transaction costs as well as contracts engagement. Verification of transactions is costly especially in the case of payment services where an individual receiving a cheque is not entitled to verify the solvency of its issuer. This could be minimized when financial institutions are incorporated.
The banks should also act as a bridge in the credit markets through monitoring. Indeed, they can improve the efficiency through reducing the agency costs. As Freixas and Laffont (44) states, the banks will first screen all the potential borrowers using the collateral or loan size. Subsequently, banks audit or threaten to cut off credits to minimize borrowers’ behaviors of taking opportunity. The banks services offering loans and securities complement each other, that is, one cannot substitute the other in promoting economic development. The two has a role to channel funds from savers to investors.
Banks also act as a lending resort. In order to minimize risks associated with lending, banks need to develop options that reduce such crisis. In developing countries, the banks have incorporated other specialized credit institutions that use unconventional methods to lend to the poor, especially through microfinance. Eccentric lenders can lend to borrowers at considerable repayment rates and in terms of self-efficiency that no conventional banks could offer. Borrowers that jointly form a group have witnessed the success. Individuals have a joint liability, and therefore cases of defaults are less experienced.
Therefore, it is evident that the financial crisis triggered much tension to the economy of the United States. The rating agencies accustomed negligence in their operations as customers became very naïve. The brokers, as well as borrowers, also did not play their part very well to maintain the economy. However, there were blames that emanating from various sources, the central party linked the banks. All the state happen since banks provided finances to the mortgage brokers and underwriting securities to the partisans. The crisis was mainly triggered by the Glass-Steagall action of preventing banks from using the insured depositories in underwriting private securities.
The criteria that banks used in their operation led to a big loss than ever, thereby failing to maintain the economy. The credit rating provides access to the global capital market. As Langohr (67) states, the credit rating can be referred as the gatekeeper in the capital market’s arena. Lack of rated government bonds could create a shortage in assets to be used as collateral when borrowing funds. The information between the debt issuers and investors is also another major reason credit rating was vital. The state (asymmetry) would occur when the seller has superior information to buyers about the product quality. However, the seller cannot convey the same information to consumers. One of the factors that contribute to the massive misprice in the market is due to rating inflation and investment decisions that are not considerate with the economic trends.
What causes inflation of credit rating is usually the incentive problem. The interests of credit rating agencies, therefore, should be more aligned with the issuers than the public investors. The rating is to offer guidance in order to expand the security markets hence allowing investors to be equipped with the market ratings within the market. The financial systems serve as the most valuable tool in the economy. However, banking industries form part of the cycle and within the core of economic regimes.
The changes made towards business systems as well the frequencies caused a dire crisis within the banking systems. Every country should strive at choosing the best bank regulatory guided by an understanding of fiscal choices that best suit the country’s operation. Currently, banks regulations have become less permeate, shifting from the structural controls to the market-oriented forms. In fact, competition is emerging in the areas of allocation of credit to make more improvement on the financial services rendered to investors within the market. Reliable frameworks need to be created to act as a development agent within banking sectors. This will eventually boost the economy.
Benston, George and George Kaufman, “Is the Banking and Payments System Fragile?” Journal of Financial Services Research, vol 4, p 209-240, 1995
Bryant, J. “A model of Reserves, Bank Runs and Deposit Insurance.” Journal of Banking and Finance, 43, 749-761, 2006.
Diamond, Douglas and Philip Dybvig. “Bank Runs, Deposit Insurance, and Liquidity.” Federal Reserve Bank of Minneapolis Quarterly Review 24, p.4-23. 2000.
Freixas, Xavier and Jean-Jacquees Laffont. “Optimal Banking Contracts, in Essays in Honor of Edmond Malinvaud: Volume 2: Macroeconomics, ed. Paul Champsaur, et al., p.33-61. Cambridge, MA: M.I.T. Press, 1990.
Langohr, Herwig. “The Rating Agencies and their Credit Ratings, What They Are, How They Work and Why They Are Relevant.” John Wiley & Sons Ltd, p.65-72. 2008.