What Does the Banking Deregulation Bill Mean? (Fool on the Hill) October 27, 1999

An Investment Opinion

What Does the Banking Deregulation Bill Mean?

By Bill Mann (TMF Otter)
October 27, 1999

Geez, Otter, why don't you just read to us out of the phone book?

Really, this stuff is important, and I promise not to cite Federal Record in my story. (Talk about dry, I'd rather cuddle a rattlesnake than read the old CFR.)

Late last Friday night the two houses of Congress came to an agreement on the Financial Services Act of 1999. This bill, which President Clinton is expected to sign, will simplify a set of laws and regulations that have kept American commercial banking, investment banking, and insurance separated from one another for the past six decades. Congress has, after 20 years of trying, finally replaced the Glass-Steagall law, a hideously outdated piece of legislation from 1933 that was passed in response to the stock market crash of 1929 and the ensuing Great Depression.

Although Glass-Steagall has been chipped away at over the last 20 years, it has until now survived almost annual onslaught by legislators. In the end, it became increasingly clear that the legal divisions in the financial services industry caused by Glass-Steagall were a hindrance to America's retaining its leadership in global finance. This complex web of piecemeal laws inhibited the economic benefits inherent in a system allowing consumers to get their financial products from a single source.

Upon passage of the Financial Services Act into law, it is likely that we will see a raft of interdisciplinary mergers between several of the largest companies in each branch of the business, similar to Citicorp's combining with Traveler's Group last year to form Citigroup (NYSE: C). The Citigroup merger may have provided the example needed to show Congress just how illogical the existing laws were. In that case, the companies went ahead with the merger anticipating that the law would be changed, but they took on considerable financial risk given the track record of 20 years of futility in addressing the problem.

But now Citigroup will be able to remove the "Chinese Wall" between its banking and insurance components and offer all of these services under one roof. Other large commercial banks such as Bank of America (NYSE: BAC) and Chase Manhattan (NYSE: CMB) are expected to hit the acquisition trail to bring these services in house as well.

What we will end up with are several "one-stop" companies to handle all of our financial needs. These may come in the form of the Citigroup-type model, where enormous companies attempt to create an economy of scale by offering cookie-cutter type services at reasonable prices. Or now America may see more Internet companies attempting to create a full range of services, with an America Online (NYSE: AOL) or Yahoo! (Nasdaq: YHOO) acquiring certain financial properties to offer a convenient alternative. Note that such companies will not be able to operate as "banks," as the new laws close a loophole that allowed non-financial companies to get into the banking business.

So what's the effect going to be? Well, for one, the U.S. will become a much more attractive place for foreign nationals to keep their cash assets. Already the United States is the world's chosen destination for equity investments given the strong protection afforded by the SEC to investors. But in banking, the antiquated laws on the U.S. books, most notably Glass-Steagall, have served to suppress the same dominance. These laws not only created strong artificial monopolies as well as atrocious inefficiencies, but they also helped create such financial disasters as the Savings and Loan Crisis and the Farm Credit system insolvency. What the laws did was force financial companies to depend on single streams of revenue; they were not allowed to diversify into products and services that they could logically offer.

So what made the change happen this time? One sarcastic wag from the The Wall Street Journal opined that the White House finally got firmly behind banking reform when it realized that "scuttling [it] was no way to run for Senator from the state of New York." Political considerations aside (well, cynical ones at least), the rationale for repeal of Glass-Steagall stems as much from issues of competition, both among companies and for the U.S. banking industry as a whole in regard to foreign investment.

The original law was enacted to protect American citizens from a threat that, by and large, no longer exists. Where commercial banks held, by some estimates, 60% of U.S. financial assets in 1930, today they hold less than a quarter. The risk of commercial banks developing inordinate political and financial power over the economy has dropped significantly, owing to the growth of household stock investments, mortgage securitization, and an open market for commercial paper.

Moreover, Glass-Steagall was issued at a time when cross-border financial transactions were laborious affairs that required significant government oversight. Contrast this scenario with the reality of today, with hundreds of billions of dollars denominated in one of a hundred currencies zip across the globe electronically, blurring the borders they cross in the process. In effect, Wall Street was being saddled with deadweight laws that put it at an increasing disadvantage to the financial service companies located outside the U.S.

That loophole after loophole was circumventing the more illogical provisions of Glass-Steagall meant that change was inevitable, though, after 20 years of discussion, maybe not imminent. The consumer benefits derived from deregulation in airline travel and several other industries have served as repeated messages to Congress that the free market has the ability to determine the most efficient path.

After the S&L crisis, banking regulators allowed banks into both the brokerage and insurance businesses through the use of subsidiaries. First Union (NYSE: FTU), for example, has purchased or launched entities in both areas to compliment its core commercial banking activities, First Union Brokerage Services and First Union Insurance Group, though the cross-marketing between the subsidiaries has been restricted.

But no longer. First Union, Citigroup, and other companies that took advantage of the loopholes afforded them in the past will now have much freer reign in coordinating the activities among their banking and insurance groups.

This leads to what turned out to be the last hurdle to a compromise being reached on Capitol Hill last Friday. Many consumer groups were concerned about a potential threat on personal privacy caused by financial institutions sharing account information between banking and insurance components. In the end, Congress rejected the notion that this constituted an unreasonable threat to privacy, but called for banks to have "opt-out" programs so their customers could keep their names and personal data from being sold to other companies.

So the end result is that we have streamlined regulation, chances for economization, additional rationale for foreign money to be invested and kept here, AND I can block telemarketers from getting my information?

Sounds good to me.

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