In December 1863, H. McCulloch, U.S. Comptroller of the Currency and later Secretary of the Treasury, wrote to all national banks. Here are some of the paragraphs.

“Let no loans be made that are not secured beyond a reasonable contingency. Do nothing to encourage speculation. Give facilities only to legitimate and prudent transactions.

“Distribute your loans rather than concentrate them in a few hands. Large loans to a single individual or firm, although sometimes proper and necessary, are generally injudicious, and frequently unsafe. Large borrowers are apt to control the bank.

“If you doubt the propriety of discounting an offering, give the bank the benefit of the doubt and decline it. If you have reasons to distrust the integrity of a customer, close his account. Never deal with a rascal under the impression that you can prevent him from cheating you.

“Pay your officers such salaries as will enable them to live comfortably and respectably without stealing; and require of them their entire services. If an officer lives beyond his income, dismiss him; even if his excess of expenditures can be explained consistently with his integrity, still dismiss him. Extravagance, if not a crime, very naturally leads to crime.

“The capital of a bank should be reality, not a fiction; and it should be owned by those who have money to lend, and not by borrowers.

“Pursue a straightforward, upright, legitimate banking business. ‘Splendid financing’ is not legitimate banking, and ‘splendid financiers’ in banking are generally either humbugs or rascals.”

The McCulloch teaching is as relevant today as it were in 1863. Accepting and managing society’s saving is a sacred responsibility bestowed by the legislator exclusively upon commercial banks. Investment, insurance, and brokerage firms are not banks and their executives are not bankers. That investment firms are called “banks” is a misnomer. 

The deposit-taking culture of commercial banking contrasts with the culture of investment companies. As custodians of society’s saving, commercial banks are highly regulated. Their funding is sourced primarily from people's deposits. By contrast, investment firms are prohibited from seeking customers’ deposits (they fund their operations from the money markets); thus, they are less regulated. Different funding sources and regulations evolved into two very different cultures, value systems, temperaments, and personality types. The differences attract two different kinds of people. Commercial banking appeals to cautious individuals. Commercial bankers are generally dedicated to steady, long-term banking relationships with depositors and borrowers. Bankers are taught to observe prudence in risk management and avoid speculation. Bankers grow to view risk control structures with respect. They earn relatively modest but comfortable salaries. On the other hand, investment managers are aggressive risk-takers. They are transaction-by-transaction short-term operators. With performance-bonus schemes and scant training in risk analysis, investment managers regard control structures as an impediment to profitable deals. To such individuals, commercial bankers are “boring” and “unimaginative.”

The root cause of the trouble

The liberalization years of the Reagan administration (1981-1989) led to the repeal in 1999 of the Glass-Steagall Act of 1933. The repeal removed the wall between commercial banks and the other types of financial organizations. The banking meltdown of 2008 is in a great measure the product of deregulation and eight years (2001-2008) of a Bush administration contemptuous of regulation. Commercial banks were cobbled together with investment, insurance, and brokerage companies despite their very different cultures. Non-bankers, “rascals” and “splendid financiers” took charge of the billions in people’s saving to gamble away in speculative trades. The merged businesses became wildly diversified in terms of risky products and colossal in size--impossible to manage successfully; notwithstanding, the "geniuses" who sit in their executive suites. In pursuit of huge performance bonuses, an era of go-go banking was ushered into the previously well controlled commercial banking, with the result that many of the once highly respectable deposit-taking institutions became irreparably damaged. 

Compensating senior executives with mainly performance bonuses has had disastrous repercussions. Performance bonuses can be soul destroying. In pursuit of self-enrichment, executives are tempted to dilute professional standards, ignore the spirit of the law, even violate the law in the hope that they’ll never be caught. The monumental losses that surfaced in 2008 render the billions of bonus dollars paid to executives a travesty. 

 

Performance bonuses have also created obscene disparities in compensation between the managers of the investment divisions and the managers of the commercial banking divisions. Such disparities replaced the old institutional culture of loyalty, commitment, and collegiality by a culture of disloyalty, exploitation, and I-only-work-here syndrome.

 

The new culture is best propounded by executives of Goldman Sachs.Speaking to an audience at St Paul’s Cathedral in London about morality in the marketplace on October 20, 2009, Brian Griffiths, vice-chairman of Goldman Sachs International pontificatedthat the British public should “tolerate the inequality as a way to achieve greater prosperity for all”.His Chairman, Lloyd Blankfein, even invoked divine inspiration. He told a reporter for the Sunday Timesof London on November 8, 2009 that he’s just a banker “doing God’s work”. The head of Goldman's German operations, Alexander Dibelius, proclaimedin January 2010 that banks "do not have an obligation to promote the public good." 

 

The 2008 banking debacle is a result of the collective failure of "rascals", "splendid financiers", greedy lenders, negligent government supervisors, obsequious internal auditors, submissive external auditors obsessed in lucrative consulting contracts with the companies they audit, as well as rating agencies, always a step or two behind the events and get paid by the firms they rate.

Solution
To protect national saving, investment firms must be kept away from commercial banks. The repeal of Glass-Steagall Act was the primary misstep in creating the conditions, which resulted in the crisis we face today. Astonishingly, in the midst of this unraveling crisis, Goldman Sachs and Morgan Stanley, the two leading firms of an industry that contributed greatly to the banking disaster, were upgraded to full commercial banking status by the Federal Reserve Bank. Notwithstanding the short-term arguments in favor of the upgrade, I predict that the long-term effects of this action will prove to be a grave mistake.

Politicians, bankers, and lobbyists who argue against the reinstatement of Glass-Steagall because no major bank had collapsed in 2008--only investment companies, like Bear Stearns and Lehman Brothers are disingenuous. The argument ignores important facts. 

 

First, the major banks would have collapsed had it not been for government rescue. US Secretary of the Treasury, Timothy Geithner revealed in December 2009 that “the entire U.S. financial system and all the major firms in the country, and even small banks across the country, were at that moment at the middle of a classic run, a classic bank run". Geithner said further that "without the government’s extraordinary rescue measures, the entire financial system was on the verge of collapse", and that "none of them would have survived” had the government stood aside and let the crisis run its course.  

 

Secondly, the collapse of investment companies generally happens because such companies do not have a lender of last resort, nor a customer deposit base to rely upon when their loans mature and no lender would roll-over maturing loans or extend new credit. Further, yesterday's investment companies that merged with banking institutions to become investment departments within those banks were protected by trillions of dollars in customers’ deposits plus central banks’ protection. 

The protective wall around commercial banking must be rebuilt. Reviving the provisions of Glass-Steagall Act is crucial. It is significant that five former US Treasury Secretaries, Republicans and Democrats, said in a letter to The Wall Street Journal in February 2010 that banks benefiting from public support by means of access to the Federal Reserve and FDIC insurance should not engage in speculative trading activities unrelated to essential bank services.

Strict governmental control over commercial banks must be restored. External auditors should perform one function only: Auditing. Management consultancies should be separated from audit firms. Shareholders should take banks that hand out excessive compensation packages to task. The distribution of profits between shareholders and employees has gone too far in recent years against the interest of shareholders. That investment managers earn multiples of the earnings of physicians, engineers, and university professors is wrong. 

 

Government regulators should ensure that senior bank executives and board members are “fit” to serve. To be fit, a banker must not only be qualified technically but also psychologically suitable. The current approval process conducted by central banks of senior bankers is cursory. This process should include behavioral psychological testing and background checks to keep gamblers away. If drunks are not allowed to drive cars why should gamblers be allowed to play the markets with society's saving?!

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