​Here is a fun little story for you!  Inadequately regulated banking systems experience severe boom and bust cycles, where the enormous risks taken during the boom times inevitably lead to tremendous losses during the busts.  From the early 1800s until 1929, the U.S. financial system experienced banking panics every five to ten years.  These events culminated in the disastrous collapse of U.S. stock market prices on October 29, 1929 — Black Tuesday — which signaled the beginning of the Great Depression.  

 

After the Wall Street Crash of 1929, tight regulations were put into place to prevent another catastrophe. These included the formation of the Securities and Exchange Commission and the enactment of the Banking Act of 1933, commonly known as the Glass-Steagall Act. 

 

Glass-Steagall prevented banks from engaging in risky investment banking activities and prohibited any one institution from acting as any combination of an investment bank, commercial bank or insurance company.  After these firewalls were established, the U.S. enjoyed over 40 years of economic growth without one major financial crisis.

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Over time, many of the significant protections that were put into place between traditional commercial banking, investment banking and brokerage industries were systematically dismantled.  Meanwhile, banks were required to keep fewer cash reserves on hand and the government, banks and rating agencies all lowered their mortgage standards to entice more Americans to purchase homes. 

 

Financial deregulation was a bipartisan endeavor.

 

In the late 1970s, savings & loans (S&Ls) were in crisis, hit hard by high interest rates and inflation (S&Ls are cooperative financial institutions that accept deposits and make mortgage, auto and other personal loans to members).  Although interest rates at that time spiked as high as 21.5%, S&Ls could only offer a 5.25% interest rate, a number established by the government.  In an effort to help S&Ls compete, Congress passed — and President Jimmy Carter signed into law — the Depository Institutions Deregulation and Monetary Control Act, which gave S&Ls broader authority and phased out limits on what S&Ls and banks could pay out for consumer deposits. 

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Although the S&L crisis was in full swing when President Ronald Reagan took office, for some reason he signed the Garn-St. Germain Depository Institutions Act, which only accelerated S&L deregulation.  In fact, this action basically deregulated S&Ls entirely.  Of the bill, Reagan said, “This bill is the most important legislation for financial institutions in the last 50 years…All in all, I think we hit the jackpot.” 

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Yeah, he hit the jackpot alright!

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S&Ls were now freer than ever to make riskier investments with depositors’ money.  Essentially, they were allowed to operate like banks without being regulated like them.  Because there was little oversight, fraud spun out of control.  In the end, over 1,100 bankers were prosecuted by the Justice Department in response to the S&L scandal and, unsurprisingly, many imploded.  Ultimately, 1,043 savings & loans failed at a cost of $124 billion to the American taxpayer (read more here).   

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Even still, President Bill Clinton doubled down on financial deregulation.  In 1998 Citicorp, a commercial bank holding company and Travelers Group, an insurance company, merged to form Citigroup.  Citigroup instantly became the largest financial services company in the world combining banking, securities and insurance services.  However, the merger violated the Glass-Steagall Act. 

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No worries!  Congress simply passed — and President Clinton signed into law — the Financial Services Modernization Act, commonly known as the Gramm-Leach-Bliley Act.  Although Glass-Steagall had been diminished over the years, it was gutted with this legislation that allowed commercial banks, investment banks, securities firms and insurance companies to consolidate.  In the absence of Glass-Steagall, financial institutions could grow larger, become more entangled and take far greater risks…and boy did they ever!

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The financial sector soon consolidated into just a few huge firms, any one of them so large and interconnected that their individual failure would threaten the entire system.  In other words, they became too big to fail.​