The Banking Act of 1933, more commonly known as the Glass-Steagall Act, was one of the pivotal banking reform laws adopted in the aftermath of the 1929 stock market crash. A Congressional investigation into the causes of the crash concluded that reckless and sometimes fraudulent underwriting of securities and risky loans by commercial banks had fed a huge and unsustainable credit bubble, which led to a devastating bust that destroyed the economy, brought down banks, and imposed heavily losses on ordinary depositors and investors. Between 1929 and 1933, more than 4,000 U. S. banks closed, wiping out the savings of depositors. To prevent another crash, lawmakers decided that commercial banking had to be strictly regulated, backed by deposit insurance, and separated from the risky and speculative business of underwriting and trading in securities.
Among its key provisions, the Glass-Steagall Act:
- established the concept of deposit insurance and created the Federal Deposit Insurance Corporation (FDIC),
- capped the interest rates that banks could pay on deposit accounts (known as Regulation Q, which was phased out between 1978 and 1986),
- enhanced the regulatory powers of the Federal Reserve over banks, and
- erected a strict barrier between commercial and investment banking activities.
Under Glass-Steagall, commercial banks (those that accept deposits) were prohibited from engaging in most investment banking activities, including underwriting and selling securities, and from affiliating with investment banks and other companies “engaged principally” in the trading of securities. Likewise, investment banks were barred from accepting deposits. The law gave banks one year to decide which path to take: get out of the securities business and receive the benefits of federal deposit insurance, or forgo accepting deposits and become investment banks.
Congress extended the Glass-Steagall Act in 1956 with the passage of the Bank Holding Company Act, which barred commercial banks and the companies that own them from engaging in non-banking activities, notably insurance. Lawmakers felt that banks should be walled off from the risks inherent in underwriting insurance.
The 50 years following the passage of the Glass-Steagall Act constituted by far the longest running period of financial industry stability in U. S. history. Only a tiny number of banks failed, while the economy as a whole underwent robust growth.
Federal deposit insurance brought an end to the panics and bank runs that had devastated the financial system at regular intervals throughout the 19th and early 20th centuries. Barring depository institutions from engaging in securities trading guaranteed that this backstop could not be used to fund the risky, high-stakes activities of Wall Street investment banks or rescue them when their bets went bad.
One of the benefits of deposit insurance and the stricter regulation that came with it was that commercial banks were able to lower the amount of equity capital they needed to have on hand. Prior to Glass-Steagall, banks typically had a capital ratio of about 20 percent —meaning a bank could make five dollars worth of loans for every dollar in capital put up by its owners. After Glass-Steagall, this ratio dropped to 10 percent, allowing banks to safely double the amount of lending they could do for every dollar in capital.
Another benefit of Glass-Steagall was that it alleviated systemic risk by greatly reducing the danger that a crisis in one part of the financial system would spread to other parts and ultimately cripple the real economy. If investment banks ran into trouble and the capital markets froze, companies could turn to banks for loans. Likewise, if banks suddenly cut back on lending, the capital markets could provide a safety valve.
Separating banks that accept deposits from those that underwrite securities also simplified regulatory oversight. Banking regulators were charged with ensuring the stability of commercial banks by minimizing risk and monitoring the soundness of their lending standards. The aim of the Securities and Exchange Commission, meanwhile, was not so much to safeguard the survival of investment banks, but rather to make sure that they did not defraud investors.
The Erosion of Glass-Steagall’s Firewall
In the late 1960s and 1970s, large commercial banks began lobbying Congress to weaken the Glass-Steagall firewall, but made little headway. They got a more sympathetic hearing from the nation’s chief banking regulator, the Office of the Comptroller of the Currency (OCC), which used its rule-making authority to loosen Glass-Steagall’s restrictions. The agency’s actions, however, were overruled by the courts.
The policy terrain began to shift in the 1980s. Although Congress continued to reject bills to abolish the firewall separating commercial and investment banks, policy-makers, especially at the Federal Reserve, were gravitating toward a ideology that favored radical deregulation of banking under the theory that markets would provide effective discipline to guard against dangerous risk-taking.
In a series of decisions responding to applications by Citicorp, J.P. Morgan, Chase Manhattan and other banks seeking to enter the securities business in 1986-87, the Federal Reserve Board of Governors voted 3-2 to reinterpret Section 20 of the Glass-Steagall Act, which bars commercial banks from owning companies that are “principally engaged” in securities trading. Under the Fed’s new interpretation, this section was read to allow commercial banks (or, more precisely, their holding companies) to derive up to 5 percent of their gross revenue from dealing in certain types of securities, including commercial paper and municipal bonds.
One of the dissenting votes came from Fed Chairman Paul Volcker. In late 1987, he was replaced by Alan Greenspan, a strong proponent of deregulation.
In 1989, the Federal Reserve Board expanded the types of securities commercial banks could deal in to include debt and equity securities. The Board also raised the cap from 5 to 10 percent of gross revenue.
In 1991, Congress rejected a bill to repeal the Glass-Steagall firewall. Nevertheless, the Federal Reserve continued to chip away at it. In 1996, the Fed gutted the law by once again reinterpreting Section 20, this time allowing commercial banks to derive up to 25 percent of their revenue from investment banking activities. Two years later, more than 45 commercial banks, including all 25 of the largest U. S. banks, operated investment banking subsidiaries.
The Fed’s quest to expand the powers of big banks was seconded by the OCC, which, in 1996, issued its own reinterpretation of a long-standing law, the National Banking Act of 1864, by ruling that that the law allowed operating subsidiaries of banks to engage in activities that their parent banks were barred from, so long as the activities were “incidental” to banking. The OCC also concluded that certain financial products, such as annuities, were not insurance products and therefore could be offered by banks without violating the firewall separating banks and insurance companies.
Although severely eroded, Glass-Steagall’s separation provisions remained the law of the land in April 1998, when Citicorp, the parent of Citibank, and Travelers, which operated both an insurance business and an investment house, announced that they would merge to form Citigroup, a massive conglomeration of insurance and securities underwriting, and commercial banking. It was a defining historical moment because the merger was illegal at the time but the parties had two years to consummate the deal. Travelers CEO Sandy Weill was confident that the banking industry could spend enough on lobbying and campaign contributions to convince Congress to change the rules in the interim. Prior to announcing the merger publicly, Weill tested the waters by making calls to Fed Chairman Alan Greenspan, then Treasury Secretary and future Citigroup board member Robert Rubin, and President Bill Clinton. All three responded favorably to the merger and indicated support for repealing the firewall provisions of Glass-Steagall that stood in the way.
By the time Congress took up the Gramm-Leach-Bliley Act (GLBA), which fully repealed Glass-Steagall’s firewall, in 1999, the country’s most powerful banks and their allies in Washington were able to present the 66-year-old law’s demise and the mingling of investment and commercial banking as a fait accompli. Not only had regulatory action by the Federal Reserve and the OCC already greatly expanded the ability of commercial banks to deal in securities, but failure to repeal what remained of the firewall would mean scuttling the biggest merger in U. S. history and forcing the newly formed Citigroup to sell off large parts of its operations. Seizing a long-sought moment, the financial industry spent over $300 million on campaign contributions and lobbying to ensure GLBA’s passage.
The financial system had changed considerably in the preceding 25 years. The main policy argument for repealing Glass-Steagall’s firewall was to enhance the ability of commercial banks to compete against so-called “shadow banks.” Shadow banks are non-depository financial firms that hold assets similar to commercial banks (such as mortgages and other loans) but rely on funding sources like those of investment banks (i. e., the capital markets). The term covers a diverse array of companies, including pension funds, money-market funds, government-sponsored enterprises like Fannie Mae and Freddie Mac, finance companies like GE Capital and GMAC, and securities firms.
Shadow banks began to supplant the commercial banking system in the 1970s, as rising interest rates induced savers to shift from bank accounts, which were subject to regulator caps on interest rates, to mutual funds; mortgages migrated to Fannie Mae and Freddie Mac; corporations abandoned bank loans for commercial paper that carried better terms, and auto and other consumer loans moved to finance companies. Although the commercial banking sector continued to grow, its dominance of the financial system receded. Commercial banks’ share of total financial assets declined by more than half in the 25 years leading up to GLBA.
As Raj Date and Michael Konczal noted in a recent paper:”Before GLBA, and on into the credit bubble, shadow banks could secure funding at lower cost than commercial banks, while constructing similar asset portfolios. This funding advantage over banks was often compounded by a leverage advantage, as credit rating agencies, for many asset classes, required less capital support than would be required by bank regulators. With both funding and capital advantages in hand, shadow banks grew to more than half of the U. S. financial system.” Faced with this evolving financial system, Congress might have concluded that the smartest path forward was to better regulate shadow banks, holding them to the same capital requirements and other standards imposed on depository institutions. Instead, lawmakers decided to release commercial banks from the constraints of Glass-Steagall, allowing them to trade in securities, derivatives, and other high-risk products, even as these institutions continued to benefit from the safety net provided by federal deposit insurance.
Throughout the debate, Glass-Steagall was derided as an old-fashioned law out of step with modern finance. Indeed, the formal name for Gramm-Leach Bliley was the Financial Modernization Act. It passed both the House and Senate by overwhelming margins. Only eight Senators voted no: seven Democrats —Barbara Boxer, Byron Dorgan, Richard Bryan, Russ Feingold, Tom Harkin, Barbara Mikulski, and Paul Wellstone — and one Republican, Richard Shelby.
The Financial Crisis
The repeal of Glass-Steagall’s firewall has been the subject of much debate since the meltdown of the financial system in 2008. Some argue that retaining the firewall would have made little difference. A combination of commercial banks, investment banks, and a host of other financial firms would have still made, sold, and securitized risky mortgages, all the while fueling a massive housing bubble and building a highly leveraged, Ponzi-like pyramid of derivatives on top.
But such an analysis fails to recognize the significance of 1999 as the pivotal policy-making moment leading up to the crash. For years, the Federal Reserve and other banking regulators had, with ever greater conviction, embraced the idea that government oversight of the financial system was unnecessary. Rules that constrained the structure, size, and interconnectedness of banks and other financial firms were particularly suspect. Big “supermarket” banks would deliver significant benefits to consumers, the thinking went, and these firms’ own internal risk models, their highly engineered financial instruments, and the market itself were far better at measuring and mitigating risk than regulators.
Congress had a clear opportunity in 1999 to reject this view and confront the changing financial system by reaffirming the importance of effective structural safeguards, such as the Glass-Steagall Act’s firewall and market share caps to limit the size of banks; bringing shadow banks into the regulatory framework; and developing new rules to control the dangers inherent in derivatives and other engineered financial products.
Instead, in nullifying Glass-Steagall’s firewall, Congress gave a ringing endorsement to deregulation and the idea that big banks could more or less monitor themselves. This formed the core of federal banking policy and paved the way for several key deregulatory decisions, including, most crucially, the OCC’s decision to exempt national banks from state laws that regulated mortgage lending and the actions of the Federal Reserve and subsequently Congress (via the Commodity Futures Modernization Act of 2000) to shield over-the-counter derivatives, such as credit default swaps, from any sort of oversight or regulation.
Less than a decade after GLBA’s passage, shadow banks were at the epicenter of the financial crisis. These lightly regulated firms, which rely on short-term capital market funding rather than the slow accumulation of deposits, had grown explosively during the run-up to the crisis. Their success was often cited as evidence of the benefits of limited regulation. But in 2008, many, including GE Capital, GMAC, Fannie Mae, Freddie Mac, Bear Stearns and Merrill Lynch, imploded, as their assets turned toxic and their short-term funding fled, nearly triggering a full-scale run on money market funds and the commercial paper market, which led the federal government to intervene before the basic financial mechanisms that non-financial companies rely on ceased functioning altogether.
Meanwhile, the big “supermarket” banks created by the repeal of Glass-Steagall, such as Citigroup, also suffered catastrophic losses. These banks were among the top buyers and sellers of mortgage-backed securities and dealt heavily in credit default swaps and other derivatives tied to the housing market. Had Glass-Steagall remained in place, they would have been barred from these activities. That may have reduced demand for derivatives and curbed the overall scope of the crash. It almost certainly would have left commercial banks in a much more stable position even as the rest of the financial system collapsed.
Restoration of Glass-Steagall
In the aftermath of the financial crisis, many people, including prominent economists, policymakers, and even bankers, have called for once again erecting a wall between commercial and investment banking. As Joseph Stiglitz, Nobel prize winner and the former chief economist of the World Bank, wrote, “Any institution that has the benefits of a commercial bank — including the government’s safety nets — has to be severely restricted in its ability to take on risk. There are simply too many conflicts of interest and too many problems to allow commingling of the activities of commercial and investment banks. The promised benefits of the repeal of Glass-Steagall proved illusory and the costs proved greater than even critics of the repeal imagined.”
In December 2009, Senators Maria Cantwell and John McCain proposed an amendment to the financial reform bill that would have reinstated Glass-Steagall’s separation of commercial and investment banking. But their proposal failed to win sufficient support in Congress.
The Dodd-Frank financial reform bill did include a version of the “Volcker rule,” named after Paul Volcker, who argued not for reinstating Glass-Steagall, but for enacting a kind of updated variation. The final Volcker provisions (sections 619-621), which are weaker than his original proposal, will restrict banks’ proprietary trading (dealing in securities and other financial instruments for the firm’s own profit, rather than on behalf of customers), impose additional capital requirements on shadow banks engaged in proprietary trading, and restrict banks’ ownership stakes in hedge funds and private equity funds. How effective these provisions will be at separating commercial banking from risky securities trading will largely depend on the specific rules that regulatory agencies write over the coming months to implement the restrictions, and how soon those agencies require compliance (the law allows for banks to request extensions for up to 12 years).