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Bachelor Thesis
Risk taking profile of US banks: the importance of the
Glass-Steagall act repeal and considerations on the
aftermath of the Great Recession
"Bruno van Duren 10107940
Faculty of Economics & Business Economics & Finance 6013B0324W.S23.WG01 Supervisor: Nicoleta Ciurila
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Content.
1 Introduction ... 3
2 Historical Background ... 2.1 Run op to the Glass-Steagall Act ... 4
2.2Implementation of the Glass-Steagall Act ... 5
2.3 Erosion of the Glass-Steagall Act... 6
2.4 Enforcement of the Gramm-Leach-Bliley Act ... 8
3 Literature review ... 9 4 Data analysis ... 4.1 Data ... 10 4.2 Methodology ... 10 4.3 Ratio explanation ... 11 4.4 Results ... 12 5 Conclusion ... 14 References ... 16 Appendix ... 18
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1. Introduction
The Great Recession that started in 2007 was an eye-opener to many economists to evaluate the financial policy conducted for several decades. Ever since 1986 - the first time the Glass-Steagall act was revised - the financial system embraced a liberal vision on how to govern commercial banks in their choice of activities. Financial governors cleared the path for commercial banks to create complex financial instruments, which in the end appeared to be fatal for the good-functioning of our financial system.
In this thesis there will be investigated how the financial policy characterized by deregulation affected the risk profile of U.S commercial banks. The research will be conducted on the basis of several risk indicating ratios. Together with earlier research done on this subject, this will give a profound basis to conclude how deregulation, characterized by the repeal of the Glass-Steagall act in 1999, affected the risk profile of U.S commercial banks. The formal research question is draught op as follows:
Did the repeal of the Glass-Stegall Act, which caused commercial banks to embrace activities that used to be seen as non-bank activities, increase the risk profile of U.S commercial banks?
The sample length of the data used is based on two periods. The first period, from 1984 until 2007, is known as an era of deregulation. The Great Recession that emerged in 2007 ended this period of deregulation, requiring financial controllers to adapt the financial system. In the second period, from 2007 to 2014, there will be analyzed how new regulations affected the risk profile of U.S commercial banks. The formal sub-research question related to analysis of the second period is as follows:
To what extent did the financial crisis started in 2007 change the risk profile of U.S commercial banks?
Between 1933 and 1986 financial governors applied strong regulations to separate investment-and commercial activities. The collapse of the U.S stock market in 1929, ending up in the Great Depression, gave financial controllers inducement to prohibit U.S commercial banks to embrace investment activities. Formal legislation came in the form of the Bank Holding Act, better known as the Glass-Steagall Act. Before the analysis on how the repeal of this act influenced the risk profile of U.S commercial banks, some theoretical background will be discussed regarding why the Glass-Steagall act was initially enforced, and what reasons occurred to abate the Act.
The results obtained from the financial risk-ratio analysis combined with earlier research conducted show ambiguous effects on how the period of deregulation affected the risk profile of U.S commercial banks. On the one hand several ratios indeed show that the period of deregulation caused a riskier profile of U.S commercial banks. On the other hand there are also financial risk ratios that indicate the years of deregulation made U.S commercial banks less risky.
The financial-risk ratios immediately reacted on the financial crisis emerged in 2007. The total U.S treasury securities to total assets ratio, which indicates a less riskier profile of U.S commercial banks, almost increased ten times, rising from 0.216% in 2008 to 2.069% 2014. More results will be discussed in the data analysis, which is done in chapter 3. Chapter 2 consists of the above mentioned historical background research, in chapter 4 the results of the financial-risk ratios will be analyzed and in chapter 5 the conclusion on the research question and sub-research question will be drawn.
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2.
Historical Background
2.1Run-op to the Glass-Steagall actDuring the 1920’s the structure of banks began to change. The positive economic circumstances resulted in an enormous increase in the involvement of non-bank firms in capital markets. These relatively new players on the bond- and-securities markets, introduced a new way of lending, where commercial banks are not necessary in the supply side of financing. These non-bank capital firms are often called trust funds. In essence a trust fund is similar to a savings bank, they gather resources from many people to invest in a diversified portfolio. The crucial differences are (1) that these trust funds can freely choose which securities to invest in while saving banks are limited in their securities choice by federal regulation, (2) saving banks experience more governmental supervision and (3) the trust fund does not guarantee a fixed rate of return combined with a limitless return, while saving banks guarantee a fixed return rate and a return ceiling (Sprage & Burgess p.689 1929).
Increased competition on the capital market caused commercial banks to enlarge their activities, they started to embrace riskier securities using affiliates. Affiliates are in fact daughter companies of these national banks, but were not subject to the governmental regulations for saving banks. According to Peach (1941 P.83) the number of national banks involved in the securities business using affiliates rose from 10 in 1922 to 114 in 1932. The number of banks directly involved in the securities markets through bond departments rose from 62 to 123. The diversification of commercial banks led to a new principle of “universal” banking, a banking system where banks combine commercial as well as investment activities.
It is a common vision that this new way of “universal banking” led to the great depression in 1929. According to Glass, the problem of these affiliates, which were in fact comparable to a trust fund, is that they lend without “real” collateral. These affiliates as well as trust funds accepted a loan when a firm was able to show a reputable history of business, without any form of physical collateral. This is in contrast with the “real bills doctrine”, which states that bank loans backed by goods, whether in transit or in inventory, are self-liquidating. When a firm produces a “real” good, she is capable to pay back the loan with sales revenue from the product. Even if the firm lacks to sell the end product, it is able to pay back the loan from selling raw materials. This is the self-liquidating process. Because a “real” good is created this is called “productive”. When a loan is used to obtain a security, and this security also holds as collateral, no real product is created. This is a form of “speculation”. According to Glass commercial banks should only involve in loans backed by “real” goods. Involvement in loans without goods as collateral leads solely to speculation, resulting in financial disaster. (White 1986 p. 115-25).
In the 1920’s underwriting backed with financial assets became increasingly popular under trust funds as well as affiliates. Initially this evolution on the capital markets caused economic progress. The stock market crash in 1929 was the inducement for questioning the evolution on capital markets. The sudden involvement of affiliates on the securities markets which caused the stock prices to increase tremendously is often seen responsible for the collapse of the stock market and failure of the banking system (White 1986 p.37).
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2.2 Implementation of the Glass-Steagall Act
The turbulence on capital markets which eventually caused bankruptcy for 1 out of 5 banks inquires reform of the financial system. This reform came by passing the History Banking Act in 1933, better known as the Glass-Steagall Act. The prime task of this act is that banks must choose to be an investment or commercial bank, making an end to the “universal banking” philosophy. Commercial activities relate to holding deposits an making loans, while investment banks are involved in securities transactions(Crawford 2011).
The Glass-Steagall Act should make an end to the “conflict of interest” that occurred during the years where commercial and investment activities enlaced. This “conflict of interest” arises when a banks has private information about the status of a firm which the bank had lend to. If the commercial bank receives bad news that is only available to the bank, the commercial bank can sell the overvalued stock on the public market. With the proceeds of this sale the firm is able to repay the loan to the bank. Naïve investors bear the brunt of this situation in favour of the commercial banks, that prevent themselves for a default of the borrowing firm. The Glass-Steagall Act makes it impossible for the commercial banks to dump the low-quality securities on the public market. Solving the “conflict of interest”(Kroszner & Raghuram 1997). Another important consequence related to the Glass-Steagall Act was establishment of the Federal Deposit Insurance Corporation, abbreviated the FDIC. This corporation was created as a safety network for insolvent banks. All the associated banks pay premiums to the institution, in return the deposits are insured to a certain amount. That amount has increased from a maximum of 2500$ per deposit by start of the FDIC in 1933 to 250.000$ nowadays(Maues). Opponents of the deposit insurance system, mostly larger banks, argue that they will end up subsidizing smaller banks. For all banks moral hazard is tempting, taking on excessive risk knowing that deposits are insured. But smaller banks will collapse faster when they took on excessive risk, due to their fewer assets. In spite of the criticism of large banks, the deposit insurance system appeared a good instrument against financial panics (Maues).
After the enforcement of the Glass-Steagall Act in 1933 the main four sections were draught as follows and they hold for commercial banks associated to the Federal Reserve:
Section 16: Prohibits dealing in securities that differ from government securities, for customers. Section 20:Prohibits FDIC associated banks to affiliate with institutions whose primary business is
underwriting and dealing in securities.
Section 21: It is prohibited for firms involved in securities business to accept deposits. Section 32: Employees of a FDIC bank are prohibited to combine their work with a job at an
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2.3 Erosion of the Glass-Steagall Act
Immediately after the Glass-Steagall Act came into force the financial community lobbied for a liberalized interpretation. Ever since the seventies their effort became truly successful, firstly the act was several times modified in favour of the financial community, until the act was repealed in 1999(Crawford 2012).
Before the modification of the Glass-Steagall act commercial banks had to find innovative measures to circumvent the provisions of the Glass-Steagall Act. They succeeded by using Bank Holding Companies. These Holding Companies did not have a banking licence, so banks could execute non-bank activities through these daughter enterprises. As a response to this manoeuvre the U.S government came up with the Bank Holding Company Act in 1956. The law prohibits multibank holding companies, companies that are major shareholder of at least two banks, to get involved with non-bank activities(Liang & Savage 1990 p.280-81).
Because of the Bank Holding Company Act banks had to come up with a new solution to circumvent the rules related to non-bank activities. This solution came in the form of one-bank holding companies. A holding that has a minor share in one bank combined with activities in another industry. Due to the minor share these firms could not be addresses as “real banks”. From the sixties this construction became increasingly popular. In 1968 there were 783 one-bank holding companies managing deposits worth 108.2 billion dollars, compared to 117 one-bank holding companies controlling deposits worth 11.2 billion dollars in 1955(Ling & Savage 1990 p.281-82).
Congress responded to this form of circumventing the rules by adjusting the 1956 Bank Holding Act. The 1970 amendments made the provisions applied to multi-bank holding companies also applicable for one-bank holding companies (Liang & Savage 1990 p.282).
The competitive position of commercial banks in relation to non-bank financial firms became worse due to financial innovation on the capital markets, the limitations set by the Glass-Steagall and Bank Holding Act caused the failure of commercial banks to keep up with non-bank financial firms. One such limitation was regulation Q. This rule sets an in interest ceiling on demand deposits, from the start of the Glass-Steagall act in 1933 until the fifties the ceiling was set at 2.5%. At first instance this ceiling did not influence the competitive position of commercial banks because the interest on Treasury securities was below this rate. In 1956 the rate on Treasury securities rose for the first time above this ceiling. As a response the ceiling for saving deposits was increased several times. The rise in the ceiling was not able to keep up with the rising interest on money markets, partly due to the rising inflation. This caused depositors to withdraw their money and invest it in the money market. Because of regulation Q commercial banks could not offer a competitive interest rate to prevent depositors investing their money on the money market. The events occurred on the financial market caused so called “credit crunches” at the start of the seventies, depositors withdraw in large numbers their deposits to reinvest the money on the money market (Weiher 2001).
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Source: Federal Reserve Bank of Minneapolis
Looking at figure one we see that banks were indeed heavily affected by these new financial intermediaries, who gain from the rising interest rate on the money market. To meet the needs of commercial banks to be competitive again Congress came up with the Depository Institution Deregulation and Monetary Control Act in 1980. This law dismantled the interest rate ceiling on checking as well as savings accounts (Weiher 2001). Unfortunately for commercial banks it could not withhold the enormous rise in share of non-bank financial intermediaries.
The Federal Reserve decided in the 1980’s that a liberalized reinterpretation of the Glass-Steagall Act was in line with the current financial environment due to the enormous increase in involvement of non-bank financial intermediaries. This liberalized interpretation was applied in 1986 on section 20 of the Glass-Steagall act. The alteration made it possible for holdings who own a share in a commercial bank to enhance in securities underwriting. The maximum revenue out of ineligible securities was set at 5% of the gross revenues of the holding’s securities subsidiary. Ineligible securities are securities in which commercial banks are prohibited to deal in according to the Bank Holding Act of 1933. In 1989 the maxim was raised to 10% of the subsidiary’s gross revenues, combined with a greater diversity of ineligible securities that bank holding’s subsidiary may use.(Simon Kwan 1997)
In 1996 the bar was again raised to 25% of the subsidiary’s gross revenue. This third increase was a sign that complete repel of the act was close. In 1998 when Citicorp and Travels Insurance Company were allowed to merge into Citigroup there was no escape of repeal possible, because this merger was non in line with the provisions of the Glass-Steagall Act. In 1999, with enforcement of the Gramm-Leach-Bliley act, the 1933 Bank Holding Act was officially repelled (Crawford 2011).
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2.4 Enforcement of the Gramm-Leach-Bliley Act
The Gramm-Leach-Bliley Act, abbreviated GLBA, was a counter current against the vision of the Glass-Steagall Act. GLBA is also called the Financial Services Modernization Act, due to its innovations on the financial markets. This time the objective was not financial contraction, instead Congress declared that combining investment as well as commercial activities from now on is permitted. Commercial banks, investment banks and insurance companies merge into one financial conglomerate(Mamun & Kabir 2005).
Figure 2 : Source FDIC
Looking at figure 2 we see that this innovation on the financial market caused a severe decrease in the number of commercial banks. Banks were merging to these so called “financial conglomerates”, or were competed out of the industry by this massive firms (Mamun & Kabir 2005).
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3. Literature Review
According to Mamur & Kabir(2005) enforcement of the GLBA, associated to repeal of the Glass-Steagall Act, created diversification benefits due to removal of the merger prohibition. Mamur & Kabir(2005) suggest that diversification benefits caused by the possibility to combine activities in different industries will make commercial banks less vulnerable to systematic risk. Akhigbe & White(2004) agree with the research of Mamur & Kabir(2005)about the decrease in systematic risk for commercial banks, they add that this also counts for investment banks and insurance companies. Despite the decrease of systematic risk Akhigbe & White(2004) find empirical evidence that total risk and firm-specific risk increased for commercial banks due to the provisions of GLBA. They argue that involvement of commercial banks in the securities business is always likely to increase total risk, because the line of business of security firms requires taking more risk than with commercial activities. The assumed decrease in risk due to diversification benefits is not enough to compensate for increased risk due to involvement in the securities business.
Geyfman & Yeager(2009) conducted a research about the risk taking of universal banks versus traditional banks. Using a three-asset portfolio regression they concluded that in the period between 1970-2007 a higher participation grade in undertaking investment activities does not have a significant effect on decreasing systematic risk, but increases total as well as idiosyncratic risk. Geyfman & Yeager(2009) found modest diversification benefits in the post-GLBA era, but again the diversification benefits are insufficient to compensate for the increased idiosyncratic risk as well as total risk.
Although most of the research conducted about implementation of the GLB Act shows that the implementation caused a reduction in systematic risk and an increase in idiosyncratic as well as total risk, some scientist think it is the other way around. Allen et al (2001) conducted a natural experiment on how the market reacted when Bank Holding Companies converted into Financial Holding Companies, so how the market reacted when commercial banks got more involved in the “ineligible” securities business, which is possible under FHC regulation but not under BHC. They concluded that the increased involvement in investment activities by commercial banks rose systematic risk to shareholders, but the diversification possibilities caused by the increased investment activities which commercial banks may undertake decreased idiosyncratic risk.
De Young & Torna(2013) investigate whether the increase in income earned with non-traditional activities influenced the failure of hundreds of U.S commercial banks during the Great Recession. In other words, did repeal of the Glass-Steagall act resulting in a deregulated financial market increased the risk profile of U.S commercial banks. Before De Young & Torna(2013) other academic research is conducted related to the same question. Fahlenbach et al(2011) and White & Cole(2012) studied the structure of U.S commercial banks during the great recession. Both researches concluded that the financial weak spots of U.S commercial banks who were hit by the Great Recession were not different from how pre GLB-era crises affected U.S commercial banks. This suggests that the deregulation on financial markets did not change the structure of U.S commercial banks, leaving the risk profile unaffected.
De Young & Torna(2013) conduct their research with an innovative model. In contrast to earlier work they split non-interest income into three different categories, these categories all have other risk-return ratios and hence a different impact on the risk profile of U.S commercial banks. The category related to non-interest income earned with non-traditional “stakeholder” activities is interesting for the financial-risk ratios analysis conducted in chapter 4 of this thesis. Non-traditional “stakeholder”
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activities are activities where commercial banks themselves are holding risky assets, in contrast with traditional banking activities where commercial banks were not allowed to embrace involvement in investment activities for their own account. De Young & Torna(2013) conclude that for commercial banks who are already facing financial distress, which was the case for many commercial banks during the great recession, a high percentage income earned with holding risky assets increases the risk profile of those commercial banks.
4. Data analysis
To answer the research question a risk-ratio analysis will be conducted. The ratios computed will give an insight on how the risk profile of banks evolved in the pre-and post- GLBA era. The research question that will be investigated is:
Did the repeal of the Glass-Stegall Act, which caused commercial banks to embrace activities that used to be seen as non-bank activities, increase the risk profile of U.S commercial banks?
The financial crisis started in 2007 did affect the whole financial industry. In this thesis there will be investigated if this shock affected the ratios related to the risk profile of banks. The sub-research question is:
To what extent did the financial crisis started in 2007 changed the risk profile of U.S commercial banks?
4.1 Data
The data from which the ratios are computed comes from the consolidated bank balance of the FDIC. It displays financial information of all the FDIC connected commercial banks in the period between 1984 and 2014. All other financial institutions are excluded.
4.2 Methodology
Using financial indicators it is possible to compute the financial status of a firm. In this research these same indicators that usually apply to a single firm, are used to investigate the risk level of U.S commercial banks as a whole. The following risk indicators are used in this research: Total bank equity to total assets ratio, total bank equity to total liabilities ratio and total securities to total assets ratio. Also several specific securities to total asset ratios will be investigated to see if they have a significant influence on the risk profile of U.S commercial banks. The specific securities to total assets used are: Total U.S treasury securities to total assets, total equity securities to total assets and total mortgage backed securities to total assets. The ratios are computed on market wide basis, including all FDIC insured commercial banks, taking this into account there can only be said something about “systematic risk”. A different analysis is necessary to investigate idiosyncratic risk. When the term “risk” or “riskiness” is mentioned, this is related to “systematic risk”.
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4.3 Ratio explanation
Total bank equity to total assets ratio
This ratio computes a firms’ own capital in relation to total capital available to the firm. This ratio is used to evaluate whether a firm possesses enough own capital to cover for possible losses in the future. The FDIC norm for an adequately capitalized firm is set at a minimum of 8%, if a firm lacks to pass this minimum it is called “undercapitalized”. A low value will increase the riskiness of a firm.
Total securities to total assets ratio
This ratio computes the part of total capital invested in securities. Because the risk associated to a security differs, the relevant securities will be evaluated separately. Commonly a high value of this ratio means that a firm is heavily involved in investing, which increases the riskiness.
Total U.S. treasury securities to total assets ratio
This ratio computes the amount invested in government bonds in relation to all assets. Government bonds are seen as “safe” investments, a decrease in this ratio is likely to increase the riskiness of a firm.
Total equity securities to total assets
This ratio computes the amount of total assets invested in stocks. An increase in this ratio means that a larger amount of all the assets is invested in stocks. As stocks are considered to be risky, an increase in this ratio is associated with an increase of overall riskiness of a firm.
Total net income to total assets
This ratio computes the relation between total net income and total assets. An increase of the ratio indicates a profit increase of all the U.S commercial Banks.
Total non-interest income to total assets ratio
A high value of this ratio indicates that U.S commercial banks embrace more non-interest activities. Non-interest activities are noncore activities as investment banking, venture capital and trading. Most of the financial specialists argue that an increase in non-interest income makes U.S commercial banks more riskier, due to its greater volatility than with traditional activities.
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4.4 Results
The results obtained by computing the financial risk ratios are ambiguous. Looking at figures 1 ab), q steady growth is visible for the total bank equity to total assets ratio. Total bank equity to total assets increases from 5.23% in 1984 to 11.2% in 2014. This outcome indicates a decrease in the risk of U.S commercial banks.
The Basel 1 accord published in 1988 could be a reason for the increase. The accord sets minimum capital requirements for commercial banks. In figure 1a) it is visible that the containment of the accord immediately paid off in terms of an increase in overall bank equity from 1988 and so forth, while in the years between publication of the accord and 1984 the ratios show a stagnant trend. Another reason for the total bank equity increase could be due to increase in profits from the nineties until the start of the financial crisis in 2007. Figure 7ab) in the appendix shows the total net income to total assets ratio. Indeed a stable growth is visible from 1990 until the start of the financial crisis. Not all the profits obtained are reinvested or paid out to stockholders, which causes an increase in equity capital.
Looking at figure 4a) and 5a) the influence of the years of deregulation resulting in repeal of the Glass-Steagall Act are distinct from 1994 until 2000. Total U.S treasury to total assets declined from 5.93% in 1994 to 1.35% in 2000, total equity securities to total assets ratio shows an opposite effect increasing from 0.45% in 1994 to 1.35% in 2000. The deregulation resulted in a switch from “safer” U.S treasury securities to a larger involvement in investment activities. Remarkable is the decrease of the total equity to total assets ratio after 2000. One should expect a further increase due to the liberalized policy related to investment activities set by the GLBA act in 1999. A reason for this could be that commercial banks embraced other investment securities more heavily, such as mortgage-backed securities. Looking at figure 5ab) it is indeed visible that the usage of mortgage-mortgage-backed securities rose. In 1984 the mortgage-backed securities to total assets ratio amounted 4.068%. In the years following, which are denoted by deregulation, the mortgage-backed securities to total assets ratio increased to 9.837% in 2007. Even after the financial crisis emerged and stronger regulations came regarding investment activities by U.S commercial banks, the mortgage-backed securities to total assets ratio increased to 11.239% in 2014. This increase could be explained by the failure of off-balance sheet activities, which will be analyzed later.
Evaluating the above statements there is an increase in risk visible in figure 3a) and 4a) between 1994 and 2000. The decrease in total U.S treasury to total assets ratio continues until 2008, just after the financial crisis started. The continuation of this decrease indicates a riskier profile for U.S commercial banks until right before the start of the crisis. In contrast, the decrease in the total equity securities to total assets ratio after 2000 indicates a decrease in the risk profile of U.S commercial banks. In figure 3b) is visible that U.S commercial banks adapted instantaneously to the Great Recession, from 2008 until 2014 the usage of treasury securities increased almost 6 times.
The results obtained out of earlier research by Mamur & Kabir(2005) and Akhigbe & White(2004) partly agree with the results obtained with the financial-ratio analysis. The increased total bank equity to total liabilities and total bank equity to total assets ratio makes commercial banks less vulnerable to market shocks, which decreases systematic risk. Using a financial-ratio analysis on risk it is difficult to observe benefits obtained out of diversification. The unexpected decrease of the total equity securities to total assets ratio after enforcement of the GLBA possibly indicates diversification benefits. These benefits could occur when money flowing out of equity securities is invested in other
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securities, when those other securities cause the total portfolio to be less sensitive to market shocks, systematic risk decreases.
The decline in total U.S treasury securities to total assets are in line with the results obtained by the research of Allen et al.(2001). Allen et al. (2001) argued that the increase in banking power caused by the liberalized investment regulations related to commercial banks set by the GLB Act, will increase systematic risk. The decline in U.S treasury securities is probably caused by the increased banking power. U.S treasury securities, often in the form a government bond, are not sensitive to market shocks. If U.S treasury securities are replaced by other “riskier” securities, which was the case due to deregulation, the risk profile of U.S commercial increases.
Looking at figure 7ab) the total non-interest income to total assets ratio increased in the period between 1984 and 1999 with nearly 46%, from 2.105%in 1984 to 3.083% in 1999. This result is in line with the expectation obtained out of earlier literature. The years of deregulation which gave commercial banks the possibility to embrace non-interest activities, caused the income generated out of non-interest income to grew faster than total assets. Remarkable is the decrease of the total-non interest income to total assets ratio after enforcement of the GLB Act in 1999. One should expect a further increase of the total interest income to total asset ratio due to the legalization of non-interest activities set by the GLB Act. According to the research of De Young&Torna (2013), explained in the literature review, the decrease of the non-interest income to total assets ratio between 1999 and 2008 indicates a decrease in risk for commercial banks in that period. The Great Recession occurred in that same period, taking into account the assumed decrease in risk, something else contributed to the financial distress faced by many commercial banks.
The increased usage of off-balance activities by commercial banks (Nijsens & Wagner 2013), launched by the process of securitization, could be a cause of the financial distress faced by commercial banks. Securitization is the process of pooling specific assets together, often in the form of loans, and sell parts of that pool as interest-bearing securities to investors (Jobst 2008). The originator, the firm that securitizes, sells those pooled assets of their own balance to an issuer, typically a “special purpose vehicle “. The issuer, which is legally separated from the originator but in essence part of the originator firm, pays the originator with money collected from issuing the pooled assets as interest-bearing securities to capital market investors(Jobst 2008). In most of the cases the originator still collects the interest payment of the initial borrower, passing it through to the special purpose vehicle less a service fee. The capital market investors receive interest payments generated by the cash flow of the pooled assets, which are kept by the special vehicle. Securitization makes it possible for originator firms to earn the service fee on collecting the loans, without bearing any risk. The risk is transferred away to capital market investors, which are compensated with interest payments.
At first instance the securitization process was very successful, banks were able to decrease idiosyncratic risk by transferring the risky assets to special purpose vehicles which issued those assets as interest-bearing securities to capital market investors. The Great Recession in 2008 caused a collapse of the securitization market. The special purpose vehicles faced liquidity problems due to borrowers who were not able to pay their loan-interest, causing the originator banks to provide liquidity to the special purpose vehicles or to re-obtain the issued assets. The value of those assets decreased tremendous, causing the originator commercial banks ending up with enormous amounts of assets on their balance sheets which they could not sell on the market. The risk transferred away to
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special purpose vehicles was flowing back to the banks themselves, resulting in financial distress of commercial banks (Nijsens & Wagner 2013).
Due to the process of securitization, which was firstly successful in shifting idiosyncratic risk away from commercial banks, in the ending appeared to increase market risk for commercial banks involved in securitization.
5. Conclusion
This research was conducted with the goal of answering the following question:
Did repeal of the Glass-Stegall Act, which caused commercial banks to embrace activities that used to be seen as non-bank activities, increased the risk profile of U.S commercial banks?
Although final repeal of the Glass-Steagall Act, associated with enforcement of the GLB Act, occurred in 1999, the steps of deregulation taken to this final decision already started in 1986. Due to the long run-up where already liberalized steps were made regarding investment activities by commercial banks, there are no abrupt consequences visible in the computed financial-risk ratios.
The analysis of the financial-risk ratios shows ambiguous effects. On the one hand several of the computed financial-risk ratios agree with the eminent vision related to risk consequences caused by repeal of the Glass-Steagall Act, the eminent vision argues that involvement of U.S commercial banks in investment activities increases their total risk.
The severe decrease in the total U.S treasury securities to total assets ratio, in the years preliminary to the Great Recession the ratio did not rise above 1%, indicates that U.S commercial banks more heavily invested in riskier securities increasing the risk of U.S commercial banks. The increase of the total non-interest income to total assets ratio of nearly 46% in the period between 1984 and 1999 indicates an increased involvement of U.S commercial banks in investment activities. The non-interest income activities are usually more vulnerable to market movements, causing the risk of U.S commercial banks to increase.
Potentially a part of the total bank equity to total assets ratio increase contains benefits obtained out of diversification. Due to the repeal of the Glass-Steagall act U.S commercial banks were able to embrace more activities than under the preliminary set of rules, the increased profits are partly retained as bank equity capital. The persistent growth of the total net income to total assets ratio until the start of the Great Recession shows evidence that the diversification possibilities paid out in terms of higher profits, part of these profits are retained as bank equity capital resulting in a stronger position of U.S commercial banks, making commercial banks less vulnerable if times of financial distress occur.
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Because the Great Recession had an enormous impact on the financial system as a whole this thesis dedicates attention to the consequences of this financial bust, the following sub-question is drawn up to investigate the consequences:
To what extent did the financial crisis started in 2007 changed the risk profile of U.S commercial banks?
Looking at figure 5b) it is visible that after 2008, the year the financial crisis stroke the economy most severe, commercial banks switched back to the usage of “safer” U.S treasury securities. The decline in the total equity to total assets ratio after 2008 also indicates that U.S commercial banks anticipated on the financial crisis. It appeared to be that the years of increasing profits taking on more risk due to involvement in investing activities does come at a cost, the U.S commercial banks learned their lesson and switched back to safer securities.
The unexpected increase of non-interest income to assets ratio after 2008, combined with the decrease of the same ratio in the years between repeal of the Glass-Steagall Act in 1999 and 2008, indicates respectively the breakdown and rise of the securitization process. The increase in the total securities to total assets ratio after 2008 could also indicate a breakdown of the usage of off-balance sheet activities, The years preliminary to the financial crisis in 2008 the usage of off-balance sheet activities by U.S commercial banks became increasingly popular( Nijsens & Wagner 2013), as earlier explained this was made possible by the process of securitization. Associated to the Great Recession the process of securitization started to fail, causing U.S commercial banks to embrace the more traditional securities, this effect is visible in an increase in the total securities to total assets ratio. While off-balance sheet activities at first succeeded in transferring idiosyncratic risk away from U.S commercial banks to capital market investors, in the ending it appeared to make U.S commercial banks to be more vulnerable to market shocks. The risk that was shed away to capital market investors was flowing back, the special purpose vehicles were not able to sell the assets on the market, the U.S commercial banks had to buy back the pooled assets from the special purpose vehicles. The fact that U.S commercial banks had to buy back the securitized assets, increased their vulnerability to market movements, increasing the overall risk of U.S commercial banks.
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Appendix
Figure 1a) Figure 1b) 4% 5% 6% 7% 8% 9% 10% 11%Total bank equity to total assets ratio
Total bank equity to total assets ratio
Linear (Total bank equity to total assets ratio )
8.50% 9.00% 9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 2007 2008 2009 2010 2011 2012 2013 2014
Total bank equity to total assets ratio
Total bank equity to total assets ratio
Linear (Total bank equity to total assets ratio )
19 Figure 2a) Figure 2b) 14% 16% 18% 20% 22% 24%
Total securities to total assets ratio
Total securities to total assets
Linear (Total securities to total assets) 14% 16% 18% 20% 22% 24% 2007 2008 2009 2010 2011 2012 2013 2014
Total securities to total assets ratio
Total securities to total assets
Linear (Total securities to total assets)
20 Figure 3a) Figure 3b) 0% 1% 2% 3% 4% 5% 6% 7%
Total US treasury securities to total assets ratio
Total US treasury securities to total assets Linear (Total US treasury securities to total assets)
0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 2007 2008 2009 2010 2011 2012 2013 2014
Total US treasury securities to total assets ratio
Total US treasury securities to total assets Linear (Total US treasury securities to total assets)
21 Figure 4a) Figure 4b) 0.00% 0.10% 0.20% 0.30% 0.40% 0.50% 0.60% 0.70% 0.80%
Total equity securites to total assets
Total equity securites to total assets
Linear (Total equity securites to total assets)
0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 2007 2008 2009 2010 2011 2012 2013 2014
Total equity securites to total assets
Total equity securites to total assets
Linear (Total equity securites to total assets)
22 Figure 5a) Figure 5b) 0% 2% 4% 6% 8% 10% 12% 14%
Tot morgage backed securities to total assets
Tot morgage backed securities to total assets Linear (Tot morgage backed securities to total assets)
8% 9% 10% 11% 12% 13% 2007 2008 2009 2010 2011 2012 2013 2014
Tot morgage backed securities to total assets
Tot morgage backed securities to total assets Linear (Tot morgage backed securities to total assets)
23 Figure 6a) Figure 6b) 0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40%
Total net income to total assets ratio
Total net income to total assets ratio
Linear (Total net income to total assets ratio)
-0.20% 0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 2007 2008 2009 2010 2011 2012 2013 2014
Total net income to total assets ratio
Total net income to total assets ratio
Linear (Total net income to total assets ratio)
24 Figure 7a) Figure 7b) 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
Total non interest income to total assets ratio
Total non interest income to total assets ratio Linear (Total non interest income to total assets ratio) 2.20% 2.30% 2.40% 2.50% 2.60% 2.70% 2.80% 2.90% 2007 2008 2009 2010 2011 2012 2013 2014
Total non interest income to total assets ratio
Total non interest income to total assets ratio Linear (Total non interest income to total assets ratio)
