Who guards the guards when guards are let down? Shadow Banking - Part II

Part I of this article is available at http://www.dhimanchowdhury.com/Blog/Who-guards-the-guards.pdf

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I began my conception on sustainability (http://www.dhimanchowdhury.com/research.html ) drawing pragmatic and qualitative assumption on the behavioral competence but little I knew that our very economic system in which to basis our survival is plagued by unsustainable practices (Chowdhury, 2011a, b & c).  At the helm of this politico-institutional medley, cultism controls senses, behaviors and attitudes.  Part I of this article ( http://dhimanchowdhury.blogspot.com  ) provided a glimpse of how such unsustainable practices developed and supported by human actions and inactions; this continuation will provide you further insights to the unprecedented economic collapse of the USA specifically emphasizing on shadow banking system. Those could have prevented America’s financial debacle and those who are privileged by our trust did not take into consideration how their pretty indulgences have been hurting the Nation and her people.

A Nation that was built by bloods and sweats of so many pioneers, honest, humble, noble and brilliant minds came so close to lay in shamble, “thanks-a lot” to the behavioral pathology of cults of politico-institutional medley.  Though corruption did not spill over in the streets of America, it was deep and prevailing in our financial system very early. The gradual abolishment of static banking system paved the way for questionable governance and unsustainable practices to take root in our financial system. 

Figure 1. The history of American Banking System.

 American Banking system in the early 1800s depended on cyclic practice of collecting consumer deposits and lending to consumer from that deposited money pull – a static model. The lending practice was constrained by deposited money pull and when increase number of consumers drawn their money for one reason or the other, banks ended up in runs. A series of Bank runs in 1873, 1884, 1890, 1899 and 1907 forced US Congress to establish Federal Reserve in 1913 as the lender for bank guaranteeing money reserve (FCIC, 2011). However, such guarantee of printing money and allowing banks to continue proven futile attempt as bank runs continued in 1920s and 1930s (figure 1).  The situation of great depression in 1920s and 1930s has many accounts.  The worldwide depression begin in 1920s but its’ affect to USA was significant and continued in 1930s removing 25 percent of all workers from job by 1933 (Smiley, n.d.).  Without discounting worldwide depression as the reason, some scholars argue that deflation was catalyst of the great depression (Cole & Ohanian, 2001) in 1920s and 1930s. However, the enactment of Glass-Steagall Act (Gup, 2007) in 1933 depicts something different than that of deflation as the causal factor of great depression. The Glass-Steagall’s findings revealed questionable governance and behavioral pathology in banking industry from speculative financing to high risk securitization that proven to be devastating for American economy (Gup, 2007; Investopedia, 2011; Francis, Trimble & Chekwa, 2010). The GSA (Glass-Steagall Act) was a necessary step (Francis, Trimble & Chekwa, 2010) to protect Nation’s economy as it created barrier walls, separated commercial Banking and Investment Banking. The “Investment Banking” which led to the creation of shadow banking system in 1970s was then and still considered risk undertaking.  Another aspect of GSA was that it allowed formation of FDIC (figure 1) asserting that depositor’s money at commercial bank and not at the investment bank will be protected under FDIC under certain guidelines. In addition, the separation of commercial and investment banks was intended to lessen the powers that would otherwise allowed underwriting firms to intensify competitions and supersede commercial banks through unfair competitive practices (Jackson, 1987).  The GSA also paved the way for Bank Holding Company Act of 1956 (PBS, 2003) extending further restrictions on banks including bank holding companies owning two or more banks (see figure 1).

However, Bank found many ways to go around doing their questionable business practices through the loophole of GSA and also started behind the scene lobbying against GSA. Banks even created a subculture against GSA to influence congressional representatives. The result came in the form of a series of act designed to loosen GSA restrictions. The first in this series was DIDMC (Depository Institution Deregulation and Monetary Control Act) of 1980 that repeal the limit on interest for deposits among other things and gradually phased-out “Regulation Q” that restricts interest ceilings under section 11 of GSA (Gilbert, 1986; PBS, 2003) by 1986. In 1982, congress enacted Garn-St. Germain Depository Institutions Act (GSGDI) divulging yet another attempt towards deregulation and allowing thrift institution to offer among other things the adjustable mortgage rate (ARM) loan.  This was one of the two major revisions of US financial system and the other was DIDMC (Cornett & Tehranian, 1990).  In 1994, congress further allowed banks to effectively expand beyond state lines and also made it possible for bank holding companies to acquire banks anywhere in the nation (McLauhlin, 1995). 

In 1999, congress enacted yet another law known as “Gramm-Leach-Bliley Act” that repeal GSA and abolished most the restrictions imposed by it. As many legislations began to undercut GSA, a new group of Industry sprung up in 1970 when a group of investing firm initiated money market fund (please view figure 2).

Figure 2. The role of Shadow Banking System in America’s financial crisis.

 

Whether regulation is good or bad for the economy that’s a different type of debate altogether, however, what has transpired through deregulation redux is matter of grave concern.  Many scholars (Kacperczyk & Schnabl, 2010; Grogan & Fisher, 2010) questioned shadow banking practices specifically in commercial papers, repurchase agreements and mortgage securitization. Kacperczyk & Schnabl (2010) went as far as claiming that commercial paper played central role in financial collapse from 2007-2009. FCIC (2011) also indicated that commercial are often sold without adequate collaterals and much of these money are drawn from money market fund which grew from USD$3 Billions in 1977 to USD$1.8 trillions by 2007. Though many other factors contributed to economic meltdown of 2007-2009, role of Shadow banking industry remain elusive.  A report published by Grogan & Fisher (2010) claimed Shadow Banking industry contributed to the financial crisis in “unprecedented ways”.

Figure 1 & 2 above (red lines indicates adverse impacts of certain measure), however, depict a yet more complex issue, a sure sign that politico-institutional medley are counterproductive, as it detrimental to nation and common goods so do to the very institutions who sponsored such action to begin with. 

It’s  the behavioral pathology that we need to consider putting a barrier on and not the progress. I since long contended that regulatory measures sometimes help and other times counter productive. What is needed a formulation that puts barrier in the development of behavioral pathology and my formulation of OCBS (Organizational Citizenship Behavior towards Sustainability) would be of great tool to this aspect.  Should you be interested, please visit my website at http://www.dhimanchowdhury.com .

To be continued………

Reference

1. Chowdhury, D., 2011a. Organizational Citizenship Behavior towards Sustainability (OCBS). Aberdeen Business School, The Robert Gordon University.
2. Chowdhury, D., 2011b. Corporate Sustainability Survey: 2011. Available online at http://www.dhimanchowdhury.com/research.html.
3. Chowdhury, D., 2011c. What is the root cause of Corporate failure? – A linkedin Poll. Available online at http://www.linkedin.com/osview/canvas?_ch_page_id=1&_ch_panel_id=1&_ch_app_id=80&_applicationId=1900&_ownerId=2665170&osUrlHash=fKaa&trk=hb_side_apps
4. Cole, L.H. & Ohanian, E.L., 2001. Re-Examining the Contributions of Money and Banking Shocks to the U.S. Great Depression. NBER Macroeconomics Annual 2000, Volume 15. MIT Press. Available online at http://www.nber.org/chapters/c11057.pdf .
5. Cornett, M.,M. & Tehranian, H., 1990. An Examination of the Impact of the Garn-St. Germain Depository Institutions Act of 1982 on Commercial Banks and Savings and Loans. The Journal of Finance, Vol. XLV, NO. 1;  March, 1990.
6. FCIC, 2011. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Official Government Edition. The Financial Crisis Inquiry Commission. Superintendents of Documents. USGPO.
7. Francis, C., Trimble, A. & Chekwa, C., 2010. Changes in Financial Institution Regulations Associated with the Repeal of the Glass-Steagall Act of 1933. 2010 IABR & ITLC Conference Proceedings, Orlando, Florida.
8. Gilbert, A.R., 1986. Requiem for Regulation Q: What It Did and Why It Passed Away.  Federal Reserve Bank of St. Louis.
9. Gup, E.B., 2007. Corporate Governance in Banking: A Global Perspective. Edward Elgar Publishing Ltd.
10. Grogan, J., & Fisher, I., 2010. The financial Crisis: 2010.
11. Investopedia, 2011. What Was The Glass-Steagall Act? Available online at http://www.investopedia.com/articles/03/071603.asp.
12. Jackson, William D., 1987. Glass-Steagall Act: Commercial vs. Investment Banking. Congressional Research Service Report IB87061. Available online at http://digital.library.unt.edu/ark:/67531/metacrs9065/m1/1/high_res_d/IB87061_1987Jun29.pdf .
13. Kacperczyk, M. & Schnabl, P., 2010. When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009. Journal of Economic Perspectives – Volume 24, Number 1.
14. McLaughlin, S., 1995. The Impact of Interstate Banking and Branching Reform: Evidence from the States. Current Issues in Economics and Finance. Federal Reserve Bank of New York.
15. PBS, 2003. The Long Demise Glass-Steagall: A chronology of tracing the life of Glass-Steagall Act, from its passage in 1933 to its death throes in the 1990s, and how Citigroup’s Sandy Weil dealt the cope de grâce. WGBH Educational Foundation.  Available online at http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html.
16. Smiley, G, n.d. The concise Encyclopedia of Economics: Great Depression. Library of Economics and Liberty. Available online at http://www.econlib.org/library/Enc/GreatDepression.html .