By Dismantling Banking Rules, U.S. Government Has Guaranteed Future Financial Travails

U.S. banking-industry regulators have long understood that there needed to be a carefully delineated separation between such low-risk activities as deposit-based banking, and much higher-risk activities as investment banking.

But the regulatory walls that separated the two have been steadily dismantled through the years, an intentional act that had the unintentional consequence of helping spawn the worst financial crisis since the Great Depression.

Not unlike the Depression era Glass-Steagall Act, which was enacted to keep FDIC-insured commercial banks separate from the riskier businesses of investment banks and securities broker-dealers, regulators determined that bank ownership should be limited to bank holding companies. The Bank Holding Company Act of 1956 further ensured separation of commerce and banking by prohibiting bank holding companies from engaging in non-financial activities. The essence of the regulations was to prevent banks from failing by not allowing owners to deplete bank resources by diverting them to prop up other businesses they owned or controlled.

Setting the Table for Trouble?

In 1998, in what many experts agree was the starting line in the race to worldwide financial collapse, Citibank Inc. merged with Travelers Group, which owned the Solomon Smith Barney and Shearson investment-banking and securities broker-dealer businesses, to create what is now Citigroup Inc. (NYSE: C). It was a move marked by extraordinary bravado that was made in direct contravention of the existing Glass-Steagall and Bank Holding Company acts.

The flaunted marriage was subsequently blessed a year later when an ocean of lobbying money floated the Gramm-Leach-Bliley Financial Modernization Act, which repealed parts of Glass-Steagall and circumscribed regulations in the Bank Holding Company Act.

The merger that created Citigroup was touted as necessary to compete with other universal banks. Now private equity is touting its burgeoning coffers and the distressed state of undercapitalized banks as a marriage whose time has come – as well as one that will benefit the U.S. economy. Not unlike Citibank and Travelers forcing legislative changes after the fact, private equity is pushing hard against every law and regulation standing in the way of its ultimate prize. The push began more than a year ago and under the weight of last summer’s devastating events finally succeeded in getting a first foot in the door last Sept. 22.

That day, according to a series of memos prepared by powerhouse law firm Simpson, Thacher & Bartlett LLP, the U.S. Federal Reserve issued a long-awaited policy statement that details the new terms under which investors can take stakes in bank holding companies without having been deemed to have acquired actual “control” – which would force the investor to become a bank holding company, too. Those three changes consisted of:

• An investor who will have a seat on the bank holding company’s board could now own as much as 24.9% of the outstanding voting shares of the bank holding company, an increase from the prior limit of 10%.
• An investor could not own as much as 33% of the total equity of a bank holding company – versus the prior limit of 24.9% – provided that the investment does not include ownership of 15% or more of any class of voting securities of the target company.
• And the investor would now be permitted to actively attempt to influence certain governance matters of the bank holding company and was no longer be required to be a completely passive investor.

As if that weren’t enough, on Dec. 22 of last year federal banking regulators adopted a shelf-approval process to facilitate bidding by private equity funds on failing and failed depository institutions Simpson, Thacher said.

“In order to increase the pool of bidders … federal banking regulators recently adopted special pre-clearance procedures to enable parties that do not already own an insured depository institution, most notably private equity funds, to qualify as bidders,” the law firm wrote in a memo.

Up Steps Private Equity

And while private equity firms without a doubt appreciate the openings they’ve been given, none of the shops want to become bank holding companies. The reason: A firm that’s labeled as a “bank holding company” is also deemed to be a “source of strength” to the banks it owns or controls. That means the holding company has to make available its resources to support its banks. Private equity companies don’t want to expose their vast pools of capital to any one investment. Just as Cerberus Capital Management LP refused to put any more money into its failed Chrysler LLC investment – leaving taxpayers to bail it out – firms are loathe to be put into a position to support a bank holding with anything more than what was deemed as a suitable capital investment at the outset.

Just last spring, for instance, The Blackstone Group LP (NYSE: BX) was sued by one of its prospective investment targets when it backed out of buying credit-card processor Alliance Data Systems Corp. (NYSE: ADS). Blackstone’s concern was over conditions imposed by the Office of the Comptroller of the Currency, which required Blackstone to provide at least a $400 million backstop to support Alliance Data’s credit-card bank, which is regulated by the OCC.

"No private equity firm wants to [be labeled as a “source of strength” to companies it controls] since it is an unlimited call on capital," Hal Scott, a Harvard Law School professor who also serves as director of the Committee on Capital Markets Regulation, recently told CNNMoney.com.

The Committee on Capital Markets Regulation recently published a series of regulatory recommendations, including one that would have regulators remove restrictions on private equity firms owning banks.

[Editor’s Note: To read a related story on “regulatory arbitrage,” which appears elsewhere in today’s issue of Money Morning, please click here. The story is available free of charge.]

News and Related Story Links:

• Wikipedia:
  Glass-Steagall Act.
• The Securities Industry and Financial Markets Association:
  Bank Holding Company Act of 1956.
• U.S. Senate Committee on Banking, Housing and Urban Affairs:
  Gramm-Leach-Bliley Financial Modernization Act.
• Wikipedia:
  Citigroup.
• Simpson, Thacher & Bartlett LLP:
  Law Firm Web Site.
• Money Morning News:
  Blackstone Misses Estimates, Profit Dives 89% .

Shah Gilani

About the Author

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Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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