Among many other more important factors, one of the precursors to the financial crisis was the lifting of a long-standing legislative prohibition on investment banks simultaneously operating as commercial banks, and vice versa. Since the passage of the Glass-Steagall Act (1933) during the time of FDR and the New Deal, these two functions were kept exclusive from one another. In other words, firms were barred from engaging in both divisions.
This group of provisions from the Banking Act of 1933 was repealed in 1999, opening the door for banks to mix both activities. Yet, these restrictions were already largely moot by the time they were officially done away with by Congress.
Now, the Federal Reserve is calling for the legislature to impose a new ban on a somewhat similar practice known as merchant banking.
The Merchant Banking Majors
The alleged problem with pitching aside the Glass-Steagall restrictions was a matter of conflict of interest and, essentially, market monopolization. The “combination banks” like Citibank became a flashpoint for the debate over banks growing too large and powerful.
Similarly, merchant banking is seen by many as an overstep of bank behavior that ought to be subject to closer regulatory scrutiny. Under the current rules, there’s nothing that stops banks from investing in—or outright acquiring—other businesses. In its appeal for new regulations, the Fed points out that these banks should be lending to such businesses rather than acquiring a stake in them.
This is most rampant in the commodities sector. For instance, Goldman Sachs has been heavily involved in the industrial metals market while it sells financial instruments and makes investments impacted by those markets. A few years ago, Goldman came under fire for overcharging for storage and purposely delaying shipments of aluminum from its storage tankers—an “aluminum scandal” investigated by the U.S. Senate—in order to drive up the metal’s price for its own benefit. This kind of practice disrupts normal market activity and can be harmful to consumers, competitors, and other entities involved in the supply chain.
Morgan Stanley and JPMorgan are two more big banks that have been engaging in merchant banking in commodities. It is often alleged, for example, that JPMorgan uses its access to the silver trade to manipulate the normal functioning of the market and virtually corner the physical silver market. Though some banks have scaled back these merchant banking operations, Goldman Sachs remains committed to it as a “core” part of their business model.
As a general rule, it’s obvious that banks will pursue their self-interest in the name of profit, even if it violates the spirit of the law. The evidence from the financial crisis to the present day abound. In the most recent example, Wells Fargo forked over a record $185 million fine to the Consumer Financial Protection Bureau (CFPB) because its employees were opening fake bank accounts in client’s names. Bank employees were apparently pressured and incentivized to meet sales quotas, so it was only natural for them to resort to this form of fraud.
Thousands of Wells Fargo employees were fired as a result of the CFPB probe—but of course the bank itself admitted no wrongdoing. For once, it may make sense for the Fed to meddle with the congressional agenda in this case.
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