Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Firewalls

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Firewalls

Article excerpt

(R)egulations may, no doubt, be considered as in some respects a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of a whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, [emphasis added] is a violation of natural liberty exactly of the same kind with the regulations of the banking trade which are here proposed.

- A discussion of restrictions on bank note issuance in Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

In his 1776 Wealth of Nations, Adam Smith likened the regulation of bank note issues to the construction of walls that prevent the spread of fire. Smith's application of the notion of firewalls to banking seems remarkably prescient, for the subject of firewalls has surfaced repeatedly in recent discussions of proposals to reform banking. In such discussions firewalls refer to statutory and regulatory limitations on financial transactions between banks and their affiliates.l These limitations are analogous to fire-proof barriers in that they are meant to prevent the spread of financial difficulties within a banking company. Specifically, the restrictions should prevent a banking company from shifting financial losses from its nonbank subsidiary to its insured bank subsidiary and potentially to the federal deposit insurance fund.

The current interest in firewalls has its roots in the banking crisis of the early 1930s. Passed in response to the crisis, the Banking Act of 1933 (also known as the Glass-Steagall Act) prohibited commercial banks from conducting investment banking activities and from being affiliated with investment banking firms.2 At the time, congressmen argued that the prohibitions were necessary (1) to prevent deposits from funding stock market speculation, (2) to limit conflicts of interest, and (3) to protect bank safety.

Many bankers, regulators, and legislators now argue that these concerns are unjustified or that they can be mitigated by regulations allowing more integration of commercial and investment banking. During 1995 and 1996, Congress considered various proposals to expand the investment banking activities allowed to banking organizations by reforming the Glass-Steagall Act. Under the proposals, investment banking activities would be conducted in a subsidiary separate from the insured bank, thus isolating the bank from investment banking losses. Besides Glass-Steagall reform, each proposal included firewalls restricting transactions that might be used to shift the investment bank's losses to the affiliated bank. No proposal gathered sufficient support for enactment, but discussions continue on the issues of Glass-Steagall reform and suitable firewalls for expanded activities.

For many students of banking, the subject of firewalls raises certain pertinent questions: What are firewalls? Why do we have them? How are they enforced? In what situations are they useful? This article answers these questions. Section 1 examines firewalls. It discusses their origins and development. It examines Congress's and regulators' stated purposes in establishing such firewalls. When firewalls were initially enacted as a provision of the Glass-Steagall Act, Congress provided little explanation. Later, congressional and regulatory pronouncements clarified the goal of the restrictions: to prevent banks from undertaking transactions with nonbank affiliates on terms disadvantageous to the bank. The concern was that these transactions might be intended to rescue a troubled affiliate or to drain the bank for the benefit of its affiliate. The banking crisis of the early 1930s and later notable bank failures contributed to the concern. One such failure, discussed below, occurred in 1953 when a Dallas company, owning a chain of nonbank loan companies, purchased two small banks and proceeded to unload the loan losses of its nonbanks on these two banks. …

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