Banks, Bailouts, and Bulls**t: Part I

Over the past few months the news has been largely dominated by two stories, the outcome of the U.S. Presidential Election and the turmoil in the world-wide economy. Since the former appears to have been resolved in favor of Senator Obama, we can turn our attention to gaining an understanding of exactly what is occurring in the global financial markets.

Since the financial crisis began, everyone is concerned about the well-being of their money, which means that they want to know how that their money will be protected by their bank. To answer that question, we need to give a few definitions and a bit of history.

A Few Definitions

Merchant Banks are the oldest banks and can trace their historical existence back to Renaissance Italy. Merchant banks have traditionally limited themselves to international financial affairs of multi-national corporations and arranging loans to governments. Although certainly important to international finance matters, they will only be mentioned in passing in our discussions.

Investment Banks, traditionally, were involved in raising money for ongoing businesses and governments (national, state, and local) by selling new stock (for businesses) and bonds (for both businesses and governments) to investors. These investors range from private individuals to large pension funds to everything in between. The importance of the "traditionally" in the previous sentence will be explained below.

Commercial Banks are the type of banks that everyone is familiar with. These are the banks where you have a checking and/or savings account, the banks that maintain all those ATMs, and where you go to apply for a loan. Most commercial banks either sponsor credit cards or offer them as part of their banking services.

A Bit of History

Everyone has heard of the Stock Market Crash of 1929 and the Great Depression that followed. Banks got into trouble during this period for two reasons.

First of all, people stopped borrowing money to purchase things like houses and automobiles even though credit money was available and at very reasonable rates. The automobile, housing, and durable goods (things that last longer than a few years, such as household appliances) industries began to suffer. These industries began to lay off workers who, in turn, were unable to meet their bank payments on things that they had purchased on credit. The slowdown in demand meant that those employed in the lumber, mining, transportation, and other related sectors began to lose their jobs as well and the economy hit a downward spiral that resulted in the Great Depression.

Secondly, the banks of pre-Depression America were not subject to as much oversight and regulation as they are today. This meant that banks were allowed to do business as they saw fit and, as long as the economy was strong and the banks' profits were coming in, everyone was happy. In fact, some of the larger banks were so caught up in the drive to cash in on the then-booming economy that they began to make risky loans to people who were investing in the stock market.

If someone wanted to buy a block of stock in a given company he or she could approach a bank for a loan, which the bank would make and hold the stock itself as collateral. In fact, many banks were acting as stock brokers in addition to their banking functions. So long as the stock market was strong, the banks were protected against default on their loan because they could simply sell the collateral stock and make up their loss on the loan. It was a good system until the market crashed and stock prices fell to unprecedented lows.

By early 1933 the situation was desperate. People were defaulting on loans and banks were failing. Even those who had simply deposited their money in bank accounts were losing their savings. Into this dire situation stepped the "Man with the Plan" in the person of Franklin Delano Roosevelt.

Historians and legal scholars are still debating whether or not Roosevelt's responses to the banking crisis were entirely legal. What matters is that he forced a total reorganization of the American economy and the financial industry. Of these changes, the most relevant to our discussion is something called the Glass-Steagall Act of 1933.

Under Glass-Steagall the federal government established, among other things, the Federal Deposit Insurance Corporation (FDIC), which protected bank depositors against losses should their bank fail. In order to pay off those that would take a loss when the government ordered a bank to close its doors, the Treasury Department simply printed more money in the form of Federal Reserve Notes rather than Gold or Silver Certificates (neither of which the government had enough of to back up the then-tremendous amounts of money needed to pay for the New Deal).

More importantly, the Federal Reserve, the "Fed," was given authority to regulate the activities of its member banks. This regulation included making a sharp, unbreakable distinction between commercial banking and investment banking. In other words, banks were forced to decide what type activity they wanted to specialize in "and never the twain shall meet."

This arrangement persisted for well over 50 years. Commercial banks had their sector of the financial markets and investment banks had theirs, until the government decided that the "traditional" separation of banks wasn't very efficient and could be "improved."

The results of that decision will be explained in my next posting.