2008 Upheaval of the United States Financial System

2008 Upheaval of the United States Financial System

The crisis has clearly favored the financial holding company structure for the large financial conglomerates. The financial holding company came into legal existence in 1999 with the passage of the Financial Services Modernization Act, generally known as Gramm-Leach-Bliley. Gramm-Leach-Bliley was an official ratification of a consolidation that had been occurring in the financial world, where different kinds of financial institutions (i.e., commercial banks, broker-dealers, insurance companies) were operated under a holding company. The holding company could take advantage of cross-marketing of products and other synergies and could offer its clients the full range of financial services, as well as benefit from diversification of financial operations. Gramm-Leach-Bliley thus added an option for a holding company owning a commercial bank (traditionally regulated as a bank holding company) to elect to become a financial holding company, which could then engage in, or own companies that engaged in, activities financial in nature or incidental to such financial activity as well as any activity that is complementary to a financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. Moreover, the definition of financial activities not only included activities such an investment banking and insurance, but it was also open-ended, for the statute contemplated that financial holding companies should engage in whatever activities in the future would fall into the financial category as a result of developments in the competitive marketplace. So long as a bank holding company’s banks were well capitalized and managed, and compliant with the Community Reinvestment Act (CRA; more about this later), it could elect the financial holding company status and become a true financial conglomerate. Every major banking group made this election.

However, the bulge bracket investment banks, which were also financial conglomerates, did not elect this regulatory structure for various reasons. They were not bank holding companies and thus not under the jurisdiction of the Federal Reserve, and so they had to make an affirmative decision to accept new regulation. As it was, the broker-dealer subsidiaries in an investment banking group were regulated by the SEC, and its other financial institutions were regulated by their respective regulators. These conglomerates even had considerable banking operations, which, however, did not make them bank holding companies since they fell outside the definition of bank for banking law purposes. However, Gramm-Leach-Bliley amended the Securities Exchange Act of 1934 to allow large investment bank groups to elect to be an investment bank holding company supervised, on a consolidated basis, by the SEC. The bulge bracket firms all made this election, which made them supervised investment bank holding companies under the SEC’s supervisory program.

Now, the financial holding company structure is the only one left standing. There had been only five investment bank holding companies, and two (Bear Stearns and Merrill) were sold to financial holding companies; one (Lehman) went bankrupt; and two (Goldman and Morgan Stanley) themselves became financial holding companies (to be technical, they became bank holding companies and then elected the financial holding company status). The reasons given for this change of heart are that the Federal Reserve can provide the kind of emergency financial support that is outside the SEC’s powers and that financial holding companies have a more stable source of funding through their nationwide bank networks. There has been a trend towards large financial institutions controlling a larger share of financial assets both in banking and in the brokerage world, and this triumph of the financial holding company is likely to exacerbate it. [footnotes omitted]

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