The Plight of Modern Markets: How Universal Banking Undermines Capital Markets

Abstract

This paper explains the process of competitive deregulation that led both the U.S. and the U.K. to embrace universal banking and to abandon the functional separation of financial activities that had long characterized their financial systems. The paper argues that some of the consequences of favoring universal banking over functional separation that were understood in the 1930s were rarely voiced in years preceding deregulation. The principal argument offered in favor of separation was that the commercial banking system, which is supported by a government “safety net,” needs to be protected from the risks inherent in investment banking. By contrast, this paper argues that functional separation played an important role in protecting capital markets from the banking system.Universal banking is associated historically with thinly traded stock markets, and this paper argues that universal banking promotes the formation of a small group of large dealer-banks which dominate the financial system and whose interests are best served by trading on non-public over-the-counter markets. The paper finds that just such a group played a key role in the growing importance of such over-the-counter markets in the U.S. over the past few decades.The paper then argues that the benefits of the greater liquidity that large universal banks can provide to capital markets are offset by the dangers they create when they err. Because mistakes at these large banks are often allowed to grow in size to match the size of the banks, they distort prices on financial markets and sometimes create systemic risk. Two recent examples are given: J.P. Morgan Chase Bank’s “London whale” fiasco and UBS, Merrill Lynch and Citibank’s exposures to subprime mortgages.Finally, the paper explains that the Senate Report on the Glass Steagall Act indicates that the Act was designed in part to limit commercial bank participation in the margin loan market, as this activity makes possible a feedback loop between increases in the money supply and increases in asset prices, which in turn can generate an asset price bubble in capital markets. The recent crisis has led modern researchers to rediscover the relationship between margin lending, feedback loops, and asset price bubbles that was well understood by at least some legislators in the 1930s. The paper argues that the recent crisis demonstrates that modern banking regulation needs to be informed by an understanding of the consequences that may arise when a financial system is dominated by universal banks.