Systematic Crisis and Regulation

Systematic Crisis and Regulation

What is a “systemic banking crisis”?   What is ‘banking contagion”? What was the rationale for the creation of ‘fire-wall’ of separation between investment banking and commercial banking in USA that was institutionalized by the Banking Act of 1933?  Why did the regulators weaken and phase out that ‘fire-wall of separation’ in 1990s? Identify the major Deregulatory Acts and its role in the meltdown of the investment banking industry?  In your opinion, based on lessons from past global banking crisis, what steps should regulators institute now to address similar future problems?

What is a “systemic banking crisis”?  

Systemic Risk, this phrase came up a lot during the 2008 banking crisis. The possibility that one event can bring down the whole market. This was the big worry when, the crisis was just starting off. Some felt that the failure of one of these big banks could start the collapse of the markets and bring down the whole economy. Isolated bank failures can help maintain efficiency in the market because they allow resources to be moved from inefficient to efficient banks^[1].  However in a systemic crisis, multiple banks fail simultaneously^[2]. This in turn has a substantial impact on the economy, which calls for drastic measures such as government intervention. If the capital of the banking system is almost entirely wiped out, this will be considered a systemic banking crisis. These predicaments calls for drastic action to resolve it. However, the Savings and Loans crisis in the 1980s for the U.S is not considered systemic^[3]. The U.S government at that time did not have to use much capital (as compared to the country’s economy) to resolve the problem.

What is ‘banking contagion”?

Contagion risk is the risk that financial difficulties at one or more bank(s) spill over to a large number of other banks or the entire financial system^[4]. Contagious bank runs are the source of systemic instability under systemic banking crises^[5]. The failure of one bank, especially one that’s integral to the financial market, can start a domino effect that can bring down the whole banking system. If one bank cannot hold to its liquidity, it can cause pressure on other banks in the system. The fear of losing liquidity rises if a bank goes under, and if they are all interconnected, as was the case during the crisis the problems may unfold.

What was the rationale for the creation of ‘fire-wall’ of separation between investment banking and commercial banking in USA that was institutionalized by the Banking Act of 1933?  

The Banking Act of 1933 (also known as the Glass-Steagall Act) prohibited commercial banks from participating in the investment banking business^[6]. Prior to the act being established the country was in the midst of the Great Depression, and over 5,000 banks were on the verge of failing^[7]. The government believed that the relationship between commercial and investment banks were the cause for the 1929 stock market crash that set off the Great Depression. The main purpose of this act was to separate these two entities completely. They believed that banks being engaged in both commercial and investment activities caused a conflict of interest that resulted with these same banks working for their own benefit. Upon the signing off on the act commercial banks would no longer be able to underwrite securities, and investment banks would no longer have connections with commercial banks,