Tip of the Iceberg: J.P. Morgan Chase and Bear Sterns

What does the balance sheet of a commercial bank look like in 1973?

What does the balance sheet of an investment bank look like?

In 2007, what does Bears Stearns look like?

Banking has various sectors.  It can be broken down into two major sectors: commercial banks and investment banks.  Over the years, the banking industry has gone through significant changes.  These changes occur due to the modernization of the economy as a whole.  Modernization is the transformation from a traditional agricultural based society to an urban industrial based society.    For this reason, regulations must be created and/or changed, usually in response to economic conditions and trends.

The largest financial crisis in the history of the United States occurred during the Great Depression (1929).  After just a few years of economic collapse, the U.S. government stepped in to aid the situation. This resulted in the Glass-Steagall Act of 1933. The main purpose of this act was to protect depositors from risk related to underwriting securities. This act prevented a single financial entity from performing both commercial and investment bank operations.  As a result, the composition of their balance sheets changed noticeably.

Commercial banks are banks that accept deposits and make consumer, commercial, and real estate loans.  They are regulated by the Federal Deposit Insurance Corporation (FDIC). Commercial banks provide an important source of funds for certain segments of the economy that do not have access to other lending sources, such as small businesses, agriculture, and home loans.  

The primary function of an Investment bank is to raise capital for large corporations.   They do this by underwriting primary securities, which are regulated by the SEC, for these corporations. Underwriting provides reliable valuations and guarantees the quality of the securities.  Another key function of Investment Banks is acting as Broker-Dealers.  They act as intermediaries between 2 parties.  This results in lower monitoring and transaction costs.  Investment banks also facilitate mergers and acquisitions. This involves the need to have a buyer and a seller.   Investment banks provide financing, expertise (providing independent valuations), and the connection of buyers and sellers.

In 1973, a major oil shock occurred.  Due to the spike in oil prices, corporate capital requirements for energy needs were not being met. The crisis arose from political tensions between the Middle Eastern and western nations. This tension caused Organization of Arab Petroleum Exporting Countries (OAPEC) to impose an embargo on the U.S. and other western countries, which resulted in widespread economic uncertainty. As a result of the embargo, the price of oil quadrupled from $3 to $12 per barrel. This sharp price change had a dramatic impact on the economy, which caused a worldwide recession. Small businesses particularly suffered due to the increased credit spread and increased cost of capital.