What is the Glass-Steagall Act?
The Glass-Steagall Act, also known as the Banking Act of 1933, is a piece of legislation that separated investment and commercial banking. It was sponsored by two members of the US Congress, Senator Carter Glass and Representative Henry Steagall.
Members of the House of Representatives passed the bill on May 23, 1933, while members of the Senate passed the bill on May 25, 1933. It was signed into law by President Franklin Roosevelt on June 16, 1933. The Act came as an emergency response to the massive bank failures that had occurred during the Great Depression.
Following the stock market crash, commercial banks were accused of having been too speculative and taking too much risk with depositor’s funds. At the time, commercial banks were heavily engaged in stock market trading, and they used their depositors’ funds in these ventures.
When the stock market crash happened, many banks were unable to return customers’ deposits in full. Many depositors rushed to withdraw their savings while banks still had funds, leading to bank runs that created a domino effect of bank collapses.
Purpose of the Glass-Steagall Act
The Glass-Steagall Act was enacted to solve the problems allegedly caused by commercial banks. There was a shared view that the banking industry had become greedy, investing in risky portfolios using their depositor’s funds. One of the changes created by the act was the separation of commercial banks and investment banking activities.
Banks were given one year to choose if they would engage in commercial banking or investment banking. Commercial banks were prohibited from trading in securities, with the exception of government-issued bonds that were considered low-risk investments. Investment banks were not required to perform the functions of commercial banks, which would put the depositor funds at risk.
The law also formed the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits. Before the formation of the FDIC, state governments were unsuccessful in setting up deposit insurance institutions because doing so was considered a moral hazard. The FDIC was given the authority to insure banks under the Federal Reserve System and act as the regulator of banks chartered by state governments but not under the Federal Reserve System.
At its inception in 1933, the FDIC insured deposits of up to $2,500, and this was increased to $5,000 when the agency became permanent in 1935. The limit has increased over the years to the current $250,000, as of 2019. When a bank has been declared insolvent, the FDIC takes the role of a receiver and it is tasked with protecting depositor funds and recovering debts owed to creditors.
In 1965, the US Congress passed the Bank Holding Company Act as an extension of the Glass-Steagall Act, to tighten regulations on the banking sector. The new law targeted banks involved in underwriting insurance, which was considered too risky. The decision aimed to prevent large banks from amassing too much power to the disadvantage of consumers. The new act separated the insurance activities and banking activities of commercial banks, although banks were still allowed to sell insurance and insurance products.
Repeal of the Glass-Steagall Act
Following the implementation of the Glass-Stegall Act, there was a concern that the legislation created an unhealthy environment in the financial industry. Large US banks were commercially disadvantaged compared to foreign banks that performed both commercial and investment banking activities. As a result, bankers and most regulators agreed that some of the things that the Act aimed to guard were ambiguous, and they started working on ways to overturn the act in the 1980s.
In 1999, Congress passed the Gramm-Leach-Bliley Act, and it was signed into law by then-President Bill Clinton. The new Act overturned the Glass Steagall Act, and it allowed banks to offer both commercial and investment banking services.
The Act also allowed commercial banks to provide insurance underwriting that was previously restricted. The new law encouraged the growth of large banks in the United States, including Citigroup, Bank of America, and JPMorgan.
Aftermath of the Repeal
With the passing of the Gramm-Leach-Bliley bill, commercial banks went back to making risky investments that the Glass-Steagall law had aimed to curtail. What followed was aggressive risk-taking by banks to reap profits from securities trading.
Many economists believe that aggressive risk-taking played a significant role in causing the 2008 financial crisis. Banks that were previously conservative in their approach to investments turned to more risky investment portfolios, such as subprime lending to make quick returns.
Some of the large banks that were enabled by the repeal of the Glass-Steagall Act were among the firms that contributed to the financial crisis and that subsequently received a bailout from the Treasury. Both Citigroup and Bank of America operated commercial banking and investment banking businesses and were among the biggest bailout recipients.
JPMorgan and Wells Fargo survived the crisis better and only received bailout assistance at the insistence of the Treasury and the Federal Reserve. This raises some serious questions about why the government would insist on banks taking billions of dollars in taxpayer funds when those banks insisted that they did not need assistance.
The Volcker Rule
After the financial crisis, some legislators wanted to reinstate the Glass-Steagall Act. Key players in the financial industry argued that the return of the Act would make them too small to compete with foreign banks. Instead, legislators passed the Dodd-Frank Act in 2010 that made efforts to reinstate sections of the Glass-Steagall Act through the Volcker Rule.
The Volcker Rule aims to address the ills that the Glass-Steagall law intended to prevent, without disorganizing the banking industry. The proposer of the rule, Paul Volcker, argued that the speculative trading of banks played a role in the financial crisis and should, therefore, not be allowed.
The Volcker Rule restricts banks from using the depositors’ funds to invest in high-risk speculative investments. The rule also restricts commercial banks from owning more than 3% of the total ownership interests in a private equity fund or hedge fund.
As a way of safeguarding consumer interests, the rule also requires banks to establish internal compliance mechanisms that are subject to supervision by regulatory agencies. The Volcker Rule also restricted banks from trading in derivatives, commodity futures, and options, since such activities do not benefit the consumer.
Both Dodd-Frank and the Volcker Rule are widely unpopular, both in the financial services industry and among individual investors, as heavy restrictions were also placed on them. Some provisions of the Dodd-Frank Act have since been rolled back.
Thank you for reading this explanation and history of the Glass-Steagall Act. The history of the banking industry and banking regulation is important to understand. The following CFI resources will further your financial education in that regard.