What Was the Glass-Steagall Act?

The Glass-Steagall Act, also known as the Banking Act of 1933 is a law that separated investment banking from retail banking. Investment banks organized the initial sales of stocks, called an initial public offering. They facilitated mergers and acquisitions. Many of them operated their own hedge funds. Retail banks took deposits, managed checking accounts, and made loans. In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commercial banking activities. At the time, "improper banking activity," or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors' money. Additional, and sometimes non-related, explanations for the Great Depression evolved over the years, and many questioned whether the GSA hindered the establishment of financial services firms that can equally compete against each other. We will take a look at why the GSA was established and what led to its final repeal in 1999. By separating the two, retail banks were prohibited from using depositors' funds for risky investments. Only 10% of their income could come from selling securities. They could underwrite government bonds. Most important to depositors, the act created the Federal Deposit Insurance Corporation. The law gave power to the Federal Reserve to regulate retail banks. It created the Federal Open Market Committee, allowing the Fed to better implement monetary policy. Glass-Steagall prohibited investment banks from having a controlling interest in retail banks. They had to find another source of funds separate from depositors' accounts. It prohibited bank officials from borrowing excessively from their own bank. The act introduced Regulation Q. It prevented banks from paying interest on checking accounts. It also allowed the Fed to set ceilings on interest paid on other kinds of deposits. Glass-Steagall sought to permanently end bank runs and the dangerous bank practices that created them. Congress passed Glass-Steagall to reform a system that allowed the failure of 4,000 banks during the Great Depression. It had debated the bill during 1932. It redirected bank funds from fueling stock speculation to building industrial capacity. The Reasons for the Act—Commercial Speculation . Commercial banks were accused of being too speculative in the pre-Depression era in part because they were diverting funds to speculative operations. Thus, banks became greedy, taking on huge risks in the hopes of even bigger rewards. Banking itself became sloppy, and objectives became blurred. Unsound loans were issued to companies in which the bank had invested, and clients would be encouraged to invest in those same stocks. Glass-Steagall restored confidence in the U.S. banking system. It increased trust by only allowing banks to use depositors' funds in safe investments. Its FDIC insurance program prevented further bank runs. Depositors knew the government protected them from a failing bank. During the Reagan administration, the banking industry complained the act restricted them too much. They said they couldn't compete with foreign financial firms that could offer higher returns. The U.S. banks could only invest in low-risk securities. They wanted to increase the return while lowering the overall risk for their customers by diversifying their business. Citigroup had begun merger talks with Travelers Insurance in anticipation of Glass-Steagall. In 1998, it announced the successful merger under a new company called Citigroup. Its move was audacious, given that it was technically illegal. But banks had been taking advantage of loopholes in Glass-Steagall. Effects of the Act—Creating Barriers . Senator Carter Glass, a former Treasury secretary and the founder of the United States Federal Reserve System, was the primary force behind the GSA. Henry Bascom Steagall was a member of the House of Representatives and chairman of the House Banking and Currency Committee. Steagall agreed to support the act with Glass after an amendment was added permitting bank deposit insurance creating the FDIC or Federal Deposit Insurance Corporation. As a collective reaction to one of the worst financial crises at the time, the GSA set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled. Banks were given a year to decide on whether they would specialize in commercial or in investment banking. Only 10% of commercial banks' total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds. Financial giants at the time such as JP Morgan and Company, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, a main source of their income. By creating this barrier, the GSA was aiming to prevent the banks' use of deposits in the case of a failed underwriting job. The GSA was also passed to encourage banks to use their funds for lending to increase commerce versus investing those funds in the equity markets. However, the act was considered harsh by most in the financial community, and it was heavily debated. Building More Walls . Despite the lax implementation of the GSA by the Federal Reserve Board, which is the regulator of U.S. banks, in 1956, Congress made another decision to regulate the banking sector. In an effort to prevent financial conglomerates from amassing too much power, the new Act focused on banks involved in the insurance sector. Congress agreed that bearing the high risks undertaken in underwriting insurance is not good banking practice. Thus, as an extension of the Glass-Steagall Act, the Bank Holding Company Act further separated financial activities by creating a wall between insurance and banking. Even though banks could, and still can, sell insurance and insurance products, underwriting insurance was forbidden. Were the Walls Necessary?—The New Rules of the Gramm-Leach-Bliley Act The limitations of the GSA on the banking sector sparked a debate over how much restriction is healthy for the industry. Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk, so the restrictions of the GSA could have actually had an adverse effect, making the banking industry riskier rather than safer. Furthermore, big banks of the post-Enron market are likely to be more transparent, lessening the possibility of assuming too much risk or masking unsound investment decisions. As such, reputation has come to mean everything in today's market, and that could be enough to motivate banks to regulate themselves. Consequently, to the delight of many in the banking industry in November of 1999, Congress repealed the GSA with the establishment of the Gramm-Leach-Bliley Act, which eliminated the GSA restrictions against affiliations between commercial and investment banks. With the passing of the Gramm-Leach-Bliley bill, commercial banks went back to getting involved in risky investments to boost profits. Many believe that the additional risk-taking, in particular, subprime lending, lead to the 2008 financial crisis. Although the barrier between commercial and investment banking aimed to prevent a loss of deposits in the event of investment failures, the reasons for the repeal of the GSA and the establishment of the Gramm-Leach-Bliley Act show that even regulatory attempts for safety can have adverse effects. Should Glass-Steagall Be Reinstated? Reinstating Glass-Steagall would better protect depositors. At the same time, it would disrupt the banks’ structures. Banks would no longer be too big to fail, but it could slow growth as they reorganize. Congressional efforts to reinstate Glass-Steagall have not been successful. In 2011, H.R. 1489 was introduced to repeal the Gramm-Leach-Bliley Act and reinstate Glass-Steagall. If these efforts were successful, it would result in a massive reorganization of the banking industry. The largest banks include commercial banks with investment banking divisions, such as Citibank, and investment banks with commercial banking divisions, such as Goldman Sachs. The banks argued that reinstating Glass-Steagall would make them too small to compete on a global scale. The Dodd-Frank Wall Street Reform Act was passed instead. A part of the Act, known as Volcker Rule, puts restrictions on banks' ability to use depositors' funds for risky investments. It does not require them to change their organizational structure. If a bank becomes too big to fail and threatens the U.S. economy, Dodd-Frank requires that it be regulated more closely by the Federal Reserve.









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