Bank of America Corp (BAC), Wells Fargo & Co (WFC), and How Banks Became Too Big to Fail

When politicians express outrage toward too-big-to-fail banks, I can’t help but laugh a little on the inside. “Wall Street megabanks aren’t just too big to fail, they’re increasingly too big to jail,” vented Senators Sherrod Brown and Chuck Grassley after learning that the Justice Department had opted against prosecuting Wall Street banks for unscrupulous lending practices, illegally foreclosing on homeowners, and laundering money for Iran’s Revolutionary Guard and South American drug lords. If you didn’t know any better, it’d be tempting to conclude that Brown and Grassley are truly surprised and incensed at the amount of power amassed by a small number of financial institutions. The problem with this interpretation is that it doesn’t square with the facts. Banks are too big to fail because we — or, more accurately, our representatives in Washington with the help of the financial industry’s lobbyists — made them that way.

Over the last 40 years, Americans have been force-fed the notion that oversight of the financial industry was unnecessary because, as then-Federal Reserve Chairman Alan Greenspan put it in 1998, participants in financial markets are “predominantly professionals that simply do not require the customer protections that may be needed by the general public.” One year later, Congress voted overwhelmingly in favor of the Gramm-Leach-Bliley Act, which repealed what was left of the Glass Steagall Act’s prohibitions against the intermingling of commercial and investment banking activities. “We have learned that government is not the answer,” Senator Phil Gramm said at the time. “We have learned that freedom and competition are the answers.”

To be fair, the Gramm-Leach-Bliley Act did not cause the financial crisis. It was instead the culmination of a decades-long push to give the nation’s biggest banks freer reign. For much of the 20th century, banks were severely constrained in terms of growth. The McFadden Act of 1927 prohibited nationally chartered lenders from establishing branches outside of their states of incorporation. The Banking Act of 1933 (the aforementioned Glass-Steagall Act) separated commercial from investment banking. And the Bank Holding Company Act of 1956 extended the same prohibitions to bank holding companies, which had sprouted to circumvent the restrictions against interstate banking.

Thus, by the early 1970s, it was clear that interstate banking was out of favor from both a legal and political perspective. There was just one problem. A key provision of the Bank Holding Company Act, known as the Douglas Amendment, left a crack in the anti-interstate banking edifice. According to the amendment, a bank holding company located in one state could acquire a bank or bank holding company in a second state if the acquisition was “specifically authorized” by the laws of the state in which the soon-to-be-acquired bank was located. But because no state had enacted such a law at the time it was passed, the Douglas Amendment essentially banned interstate banking altogether. Until 1972, that is, when Iowa decided to do so.

What started as a whimper with a single Midwestern state’s decision to allow interstate banking, quickly transformed into the same roar that can be heard today. Multiple states rushed to follow Iowa’s lead throughout the 1970s. Alaska, Maine, and Arizona were early adopters, and New York soon followed suit. The trend gained momentum during the 1980s with the introduction of regional banking compacts, which were fueled, in large part, by a U.S. Supreme Court decision upholding their constitutionality. This gave way to the Riegle-Neal Interstate Banking and Branching Act of 1994, which removed all federal impediments to interstate banking and ignited a series of “mergers among equals” that gave us the banking behemoths we know today, including Bank of America Corp (NYSE:BAC) and Wells Fargo & Co (NYSE:WFC) . And the final piece of the puzzle, the crowning achievement if you will, was the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which made it possible for the likes of JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc. (NYSE:C) to take on their present forms.

For investors who weren’t cognizant of the changes under way, and particularly throughout the 1990s, it’s difficult to appreciate the speed and magnitude of the banking industry’s transformation. The closest analogy I can think of is the transcontinental railroad. Within hours of learning about the Supreme Court’s decision in 1982, bank CEOs were on the phone arranging interstate merger deals. In 1994, the year Riegle-Neal was passed, only 62 out-of-state branches existed in a small number of states. A decade later, the number had grown to 24,728. And by 1999, Citicorp was so confident in the industry’s sway over Washington that it didn’t even wait for Congress to repeal the Glass-Steagall Act before violating it by merging with Travelers Group. As the combined company’s chairman and CEO Sandy Weill said at the time, “We have had enough discussions to believe this will not be a problem.”