Reversing Course, Investment Banks Seek Shelter

In Depth

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Whatever else this tumultuous economic week brings, it has already spelled the near end of a particularly American way of banking, specifically the business of independent investment banks.

Six months ago, the nation had five of them: Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs. Last week, there were four. As of Monday morning, there were three, and by Monday afternoon, only two investment banks remained.

Now, it looks like there will soon be just one, Goldman Sachs.

The core nature of an investment bank remains a mystery to many. Their defining purpose is to steer clear of Americans doing daily business. When most people hear the word bank, they're not picturing an investment house.

"No, they're thinking of a commercial bank — the local bank where they write checks, draw deposits, ATMs," says Ragu Rajan, a former chief economist at the International Monetary Fund and current professor at the University of Chicago Business School.

He explains that investment banks help companies issue new stocks or bonds, and they find customers who want to buy them. "They essentially are the middlemen on the markets," he says.

Before 1933, before the Great Depression, banks could legally take deposits and make loans — and they could also create and sell stocks and bonds. When the nation's financial system suffered that epic collapse, a popular theory blamed those big, combined banks. The idea was that so-called universal banks could foist lousy stocks and bonds on their unwitting checking and savings account customers.

"That was the view, that these conflicts of interests were terrible and that was why there was a crash in 1929 and these terrible things happened to the economy," says Eugene White, an economist at Rutgers University who has made an extensive study of bank failures during the Depression.

White says the theory turns out to be flat wrong. "All the academic studies came to the conclusion that the banks that were combined were actually safer and they issued better bonds," he says. "There weren't terrible conflicts of interest by combining them."

In the misery of the Depression, lawmakers took steps to separate investing and saving. Many in Congress then — and specifically Sen. Carter Glass and Rep. Henry Steagall — thought differently. In 1933, they passed the Glass-Steagall Act outlawing universal banks. No longer could a single institution take deposits while also issuing and selling stocks and bonds.

Not surprisingly, the banks did not like this mandatory breakup plan. They soon worked out a deal with Congress. Under the new agreement, the commercial banks would get government guarantees — FDIC insurance — but they had to follow stricter rules. The investment banks had a lot more freedom but no guarantees.

For most of the 20th century, at least some of those high-risk, no-guarantee investment banks thrived, including the five that existed at the start of this year. In fact, when Glass-Steagall was repealed, in 1999, the big investment banks all objected. They didn't want to merge with the stodgier savings banks.

That all changed this week. After seeing Lehman Brothers collapse, Merrill Lynch and Morgan Stanley decided to seek commercial bank partners, too. Now only Goldman Sachs is left on its own.

White says the country is turning back toward universal banks. "The interesting thing is we end up almost where we were in the 1920s," he says.

Rajan and White agree that reversing 75 years of economic history in one week might be painful. But in the long run, they say, it could turn out to be a good thing that investment banks and commercial banks are free to get back together.

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