Traditional Finance and the Need for Crypto Regulation ~ Part 2

Each major collapse led to both broader economic difficulty and invaluable regulations. All of which brings us back to Luna, and the collapse that has shaken crypto.

History seems to repeat itself. In the previous blog post, we looked back on the financial crisis about 100 years ago that almost crashed the economy. The crisis resulted from the drop in investor confidence, which is surprisingly similar to what we saw in the Terra-UST depeg event that happened in May 2022.

In this article, we will continue to look into how the government responded to get recovered from the depression and walk through major historical events to understand how the banking legislation has been changed since then.

Following the collapse of Bank of United States, similarly devastating bank runs continued into early 1933, when Franklin Roosevelt was inaugurated as president. He soon declared a national bank holiday, during which all banks would be closed until passing federal solvency inspection.

Roosevelt began his series of fireside chats that March with a solemn vow: “We do not want and will not have another epidemic of bank failures.” He called on Congress to devise banking legislation to support the country’s ailing financial institutions and, in June, signed the Banking Act of 1933 into law.

That landmark bit of legislation, also known as the Glass-Steagall Act, separated commercial and investment banking and created the Federal Deposit Insurance Corporation. Among other regulatory duties, the FDIC was tasked with insuring all deposits in eligible banks in the event of bank failure. Meant to end bank runs and restore financial confidence, the FDIC is widely considered a major success.

To be clear, the FDIC was not an absolute success as more than 2400 depository institutions failed just from 1986 to 2007 — it means the government has been able to manage and mitigate the risk of bank failures. There have, however, been two major hiccups.

Twenty years before Bank of United States’ implosion, two Midwest banks merged in 1910 to form the Continental Illinois National Bank and Trust Company. Despite conservative roots, its management implemented a rapid-growth strategy in the 1970s, and by 1981 Continental had become the US’ largest commercial and industrial lender, with $40 billion in assets.

An analysis by Salomon Brothers that same year described Continental as “one of the finest money-center banks going.” The next year, however, the ground began to shift.

As with Bank of United States, “it became clear that the bank had made some risky investments,” according to a Federal Reserve history article. These included $1 billion in energy-related loans from an Oklahoma bank that failed in July 1982 and developing country investments that struggled through the debt crisis brought on by Mexico’s default the next month.

In the first quarter of 1984, the bank’s nonperforming loans jumped $400 million to $2.3 billion. On May 10, rumors of Continental’s insolvency sparked a massive run and depositors pulled out more than $10 billion. The next day the bank borrowed $3.6 billion from the Federal Reserve of Chicago. A few days later Continental accepted a $4.5 billion line of credit from a group of the US’ largest banks.

Still the run continued, and regulators began to fear a massive spillover if the country’s seventh-largest bank were to collapse. “The FDIC estimated that nearly 2,300 banks had invested in Continental Illinois, and nearly half had invested funds greater than $100,000, the deposit insurance limit,” says the Federal Reserve history.

On May 17, the FDIC gave the bank a $1.5 billion infusion of capital. The next day it announced that it would extend its support to depositors with funds beyond its $100,000 limit. Continental Illinois had become insolvent, the largest bank failure in US history up to that point, but governmental support, a sort of soft nationalization, enabled it to survive in a lesser form.

In July 1984 the FDIC said that it had failed to find a buyer and would provide permanent assistance, starting with the purchase of $4.5 billion of the bank’s bad loans. Stockholders were largely wiped out, but the FDIC protected bondholders and depositors, as promised. [The government pulled out of Continental Bank in 1991, and Bank of America purchased it in 1994.]

In Congressional hearings on Continental’s collapse, Congressman Stewart McKinney echoed recent press reports and uttered a phrase we know all too well today. “We have [created] a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank.” The data bore out the sneaking suspicion that bigger banks, because of the broader risk to the economy, had begun receiving preferential treatment.

Since 1950, the FDIC has had a menu of three responses to failing banks: liquidate and pay insured depositors; find a buyer; or provide federal life support. In the late 1980s and early 1990s, the average asset value of FDIC-liquidated banks was $65 million, while the average size of banks that were sold or propped up was $200 million.

The larger the bank, the greater the risk of financial spillover, and thus the greater likelihood of significant governmental support. The problematic impact of this has been that financial institutions, grasping the advantages of size, will aim to grow as quickly as possible, potentially cutting corners and making more problematic investments en route. TBTF incentivizes over-sized banks, and possible risk-taking.

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The other route — regulators curbing rapid growth — is largely a non-starter in the go-big-or-go-home US. “If the banking system is expanding rapidly,” Federal Reserve Board Governor Charles Partee argued after Continental’s collapse, “for us to try to be too tough with them, to hold them back, is just not going to be acceptable.”

Congress sought to address this growth issue by limiting “too big to fail” rescues with the FDIC Improvement Act of 1991. The law limited the FDIC’s ability to protect creditors and the Fed’s ability to lend to troubled banks. Yet the other key issue raised by Continental’s failure — systemic risk, or the idea that one failure might ripple out, leading to other collapses and broader economic trouble — was left unaddressed for a quarter-century.

This despite the fact that C.T. Conover, Comptroller of the Currency, had warned of the likely outcome had Continental’s failure left depositors and creditors out to dry: “We could very well have seen a national, if not an international, financial crisis the dimensions of which were difficult to imagine.”

Enter Lehman Brothers, with $680 billion in assets, and its landmark bankruptcy filing in September 2008. Like Bank of United States and Continental, not to mention some crypto initiatives, Lehman embraced a high-risk model.

Relying on complicated financial products and presumed real estate growth, the firm needed to raise billions of dollars every day just to stay in business. It had invested heavily in subprime mortgages and, when these markets sagged, Lehman was unable to raise the necessary cash.

In March 2008, the US Treasury and Federal Reserve began looking for a buyer. Since it was an investment fund, the government could not nationalize Lehman as it done with Fannie Mae and Freddie Mac, not to mention Bank of United States. What’s more, Lehman lacked the assets to secure a massive government loan.

After Bank of America and Barclays pulled out of possible last-minute purchases, Lehman filed the largest bankruptcy proceeding in US history on September 15. The Dow Jones saw its worst one-day decline in seven years.

Two weeks later, after Congress rejected the Fed’s proposed $700 billion bail-out of troubled banks, the Dow experienced its largest-ever one-day decline to date. This came days after regulators had seized Washington Mutual (WaMu) and sold it to JPMorgan Chase for $1.9 billion. With $307 billion in assets, WaMu became the largest bank failure in US history, easily eclipsing Continental Illinois.

The economic crisis that followed became known as the Great Recession, a period that still today undermines the financial stability of millennials. They have less wealth, more student debt, and are more likely to live with their parents. As a result, they are more likely to take risks with their finances — a key reason behind the emergence of cryptocurrencies.

Lehman’s collapse also brought about the Dodd-Frank Wall Street Reform Act, the most far-reaching financial legislation since Glass-Steagall. Dodd-Frank, signed into law by Obama in July 2010, created the Financial Stability Oversight Council, which keeps an eye out for systemic risks.

If the FSOC determines that a bank has become too big it can turn it over to the Federal Reserve for inspection. The Fed can then force that bank to increase its reserve requirement to make sure it’s liquid enough to prevent bankruptcy. Dodd-Frank also made permanent the FDIC’s move to increase its maximum insurable investment amount from $100,000 to $250,000, providing greater security to a much broader swathe of investors and institutions.

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To recap, the high-wire act of Bank of United States led to failure, spurring the creation of the US’ crucial financial oversight body, the FDIC; the problematic investments of Continental Illinois led to governmental stewardship, which created concerns about “too big to fail”; and the fall of Lehman and the resulting financial crisis paved the way for broader investor security and greater oversight of TBTF and systemic risk.

Each major collapse led to both broader economic difficulty and invaluable regulations. All of which brings us back to Luna, and the collapse that has shaken crypto.

“When a protocol that’s worth billions fails, it has a massive impact on the rest of the ecosystem,” Peter Yang said on Twitter in May. “This is the Lehman Brothers moment for DeFi. I think it will take many years to recover.”

Things may well get worse before they get better. But if history is any guide, it will be increased regulations that ensure a full recovery, and a bright future for crypto.

The FDIC is far from perfect, but it serves its purpose, providing a crucial safety net in choppy financial seas. That’s just one reason stablecoin issuers like GMO Trust keep 100 percent of their reserves in cash or cash equivalents.

In Part 3 of this series, we will take a closer look at how regulators in developing countries are acting toward cryptocurrency, and with the development of regulation, why the crypto industry needs to adjust paces to find a way for the greater good. Stay tuned!

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