The repeal of the Glass–Steagall Act and the Federal Reserve’s extraordinary intervention during the global financial crisis

Abstract:

Before the global financial crisis, the assistance of the lender of last resort was thought to be limited to commercial banks. During the crisis, however, the Federal Reserve created a number of facilities to support brokers and dealers, money market mutual funds, the commercial paper market, the mortgage-backed securities market, the triparty repo market, and so on. In this paper, we argue that the elimination of specialized banking through the eventual repeal of the Glass–Steagall Act (GSA) has played an important role in the leakage of the public subsidy intended for commercial banks to nonbank financial institutions. In a specialized financial system, which the GSA had helped to create, the use of the lender-of-last-resort safety net could be more comfortably limited to commercial banks. However, the elimination of GSA restrictions on bank-permissible activities has contributed to the rise of a financial system where the lines between regulated and protected banks and the so-called shadow banking system have become blurred. The existence of shadow banking, which is directly or indirectly guaranteed by banks, has made it practically impossible to confine the safety to the regulated banking system. In this context, reforming the lender-of-last-resort institution requires fundamental changes within the financial system itself.

Key words::

• banks
• central banking
• deregulation
• Federal Reserve
• financial crises
• Glass–Steagall Act
• lender of last resort
• Minsky
• regulation
• securitization
• shadow banking

JEL classifications::

• B50
• E50
• E58
• G10
• G18

Notes

¹It is worth mentioning that most of the beneficiaries of the Fed’s largesse were not previously under the Fed’s direct regulatory purview.

²For a detailed discussion of the mechanics of the shadow banking system, see Pozsar et al. (2010, 2013).

³FDIC Statistics on Depository Institutions and author’s calculations.

⁴See abalert.com for detailed information on banks’ securitization activities.

⁵Liquidity support is different from credit enhancements. Liquidity lines protect the totality of the issue, excluding the value of defaulted collateral, against rollover risk, whereas credit enhancements protect against default risk and usually amount to 8–10 percent of the issue.

⁶A triparty repo transaction involves three entities: the borrower, usually a broker-dealer; a lender, usually institutional investors; and a clearing bank. The clearing bank takes the collateral, determines the haircut and transfers the payments to the appropriate entities when the transactions are entered into and when they are unwound.

⁷Such a run seemed to have occurred in October 1987, when block traders withdrew from the market (Minsky, 1988, p. 3).

⁸Data are from the U.S. Flow of Funds Accounts.

⁹The index is the weighted average of the haircuts on nine privately issued assets from corporate securities to CDOs (see Gorton and Metrick, 2012, table 2, panel D for the assets included in the index).

¹⁰Even though no loans were made through the Money Market Investor Funding Facility, the design and purpose were similar to the AMLF, but with broader eligibility for borrowers.

¹¹Minsky (1991) argued that allowing the value of depository institution liabilities to fall below par was an important ingredient in the debt deflation during the Great Depression.

¹²This option no longer seems to be on the table as the Emergency Economic Stabilization Act of 2008 now explicitly prohibits the secretary of Treasury from “from using the Exchange Stabilization Fund for the establishment of any future guaranty programs for the United States money market mutual fund industry.” (Emergency Economic Stabilization Act of 2008, Public Law 110-343, 122 Stat. 3765 § 131).

Additional information

Notes on contributors

Yeva Nersisyan

Yeva Nersisyan is an assistant professor in the Department of Economics at Franklin and Marshall College.