What You Absolutely Need to Know About Money (Part 7) – Shah Gilani – Money Morning

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By the start of the 1960s, banking in America was in a state of flux.

Boundaries were being blurred – especially those separating “commercial banks” and “investment banks” under Depression-era Glass-Steagall parameters. The banking landscape was shifting. In fact, it was about to go volcanic.

The Truman Administration had championed the break-up of bank cartel arrangements, whereby a powerful coterie of commercial-bank bond underwriters controlled how corporations financed debt and who got to distribute bond offerings. Subsequent regulatory changes (requiring bidding for underwriting assignments) broke up the “Gentleman Bankers Code,” which had been code for cartel.

A more competitive landscape drove banks to expand. Branch banking spread through shopping malls and onto prime locations on America’s Main Streets.

The hunt for deposits was on.

And it got ugly fast…

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Commercial banks needed more and more deposits to supply funds to rapidly growing corporations. And they wanted to make small business and consumer loans, wherever they could.

Intense banking competition was driving down lending profitability. At the same time, corporations were self-financing themselves through retained earnings and increasingly turning to insurance companies with whom they could directly place their bonds.

Commercial banks were losing their predominant position as providers of capital… while investment banks were growing rapidly.

The investment banks, with insignificant amounts of their own capital, were raising equity capital for corporations and trading blocks of stock accumulating in pension plans, which were mushrooming as a result of 1950s tax law changes and collective bargaining victories by labor unions.

Commercial banks had to grow rapidly to offset declining profit margins in the lending business. And they had to figure out how to compete with more aggressive and more profitable investment banks, as well as their institutional investor clients, who were rapidly becoming suppliers of capital.

So they did.

Under Glass-Steagall, commercial banks were allowed to deal and trade in U.S. Treasury securities, municipal bonds (which were considered safe by virtue of issuers’ taxing authority), and foreign exchange.

Historically, banks didn’t so much trade foreign currencies as they did manage exchanging one currency for another in the spot market and on a “forward” basis. This service, which banks had a monopoly over, facilitated borrowing clients, who were increasingly U.S. multinational corporations, overseas corporations, and foreign governments in need of currency exchange services.

They weren’t supposed to underwrite equity issues, distribute them or trade in them. But they did.

Commercial banks set up trust departments and, in some cases, controlled separate trust banks. The old Bankers Trust, backed by J.P. Morgan’s interests, was a prime example.

Trust departments were “entrusted” with safeguarding client assets. That included equity securities. As securities trading increased, for reasons about to become apparent, banks blatantly circumvented Glass-Steagall prohibitions and actively facilitated trading.

Two seminal events in the 1960s paved a one-way path from traditional banking to casino banking.

First, in 1961, George Moore and Walter Wriston of First National City bank brilliantly sidestepped regulatory prohibitions against banks paying interest to depositors. Their brainchild was the “negotiable certificate of deposit,” simply referred to as CDs.

By structuring a deposit as at least a 30-day “loan” to the bank, interest could be paid to the lender. The word “negotiable” was the magic ticket. Depositors’ CDs and the “liabilities” (deposits) they represented could be traded.

The invention spawned a world-wide hunt for deposits, as banks could raise money virtually anywhere and compete for “hot money” by offering competitive interest rates.

Excess deposits – those that banks couldn’t lend out and those that exceeded regulatory reserve requirements – were traded to other banks in the overnight federal funds (bank to bank) market.

The transition from primarily managing assets (loans) to liabilities (deposits) was almost instantaneous.

Trading floors were built and staffed to speculate on interest rate products. Those instruments, CDs, Treasuries, municipal bonds, and foreign exchange, were all interest rate-based. With the ability to aggressively attract depositor capital – to be used as trading capital – commercial banks embarked upon a hugely profitable new business…

The business of speculation.

Now here’s the second thing that changed.

Commercial banks traditionally offered mergers and acquisition advice, usually as a free service to their bond underwriting clients. But not for long.

Investment banks in the 1960s went on the offensive. To generate mergers and acquisitions fees, they actively put corporations in play. Soliciting takeovers from prospective clients was part of the new mantra of “conglomeratization.”

Putting corporations into play had become easy.

Large blocks of stock were spread among trust banks, held directly by pension plans and in the hands of institutional investors. Investment banks had access to these blocks of securities through their relationships with their institutional clients, as well as having access to stock residing at brokerage affiliates. Commercial banks had access to blocks of stock through their trust departments and brokerage operations they were setting up through the bank holding companies they manufactured to hold commercial bank businesses and separate brokerage businesses that commercial banks, on their own, weren’t allowed to operate.

Because blocks of stock were held for individuals by their pension managers, the institutional managers got to vote the shares in their safekeeping. M&A bankers used their institutional relationships to maneuver voting blocks of stock to their advantage in the new war games.

Seeing their corporate clients under attack and recognizing the pull investment banks were having over fee-paying corporate giants, commercial banks recast their M&A bankers as swashbuckling, fee-generating do-gooders.

Which, of course, they weren’t.

M&A bankers rode roughshod over and corralled thousands of American corporations in the Go-Go 60s – for increasingly larger and larger fees. More than 25,000 businesses were merged, acquired, or “vanished” in the 1960s.

Commercial M&A bankers and investment bankers had forever been transformed into commando-bankers, acting like generals on the ever-widening casino floor.

And this was only the beginning of “transactional banking.”

Events in the 1970s would act like an accelerant, igniting a fire under bankers that would further their power and lead to the implosion of a tiny shopping mall bank in Oklahoma.

That “off the radar” event, in a matter of days, led to the failure of a single money-center bank. Its losses were greater than all the failed banks in the Depression, combined.

Only, it didn’t fail. It was the bank that directly led to the American banking doctrine of too-big-to-fail.

And you know what happened next…

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