One of the subjects that is often covered in the financial news, especially as talking heads try to figure out what can be done to avoid another financial crisis, is the Glass-Steagall Act.
Many people don’t exactly understand why this old law — parts of which were repealed in 1999 — is still a topic of conversation, and why it matter so much.
Brief Overview of the Glass-Steagall Act
Passed during the Great Depression, the Glass-Steagall Act is also called the Banking Act of 1933.
Glass-Steagall was designed to prevent some of the problems that caused the Great Depression, mainly the difficulties caused by the widespread failure of banks. The Banking Act of 1933 included the creation of the FDIC and it also expanded the role of the Federal Reserve.
However, the item that is most emphasized about the Glass-Steagall Act, particularly in a post-2008 world, is the prohibition of commercial banks from participating in investing.
Part of the problem ahead of the Great Depression was that Main Street banks began underwriting corporate stocks, and even floated bond issues. With all of these Main Street banks exposed to Wall Street, the crash of 1929 was hugely devastating.
The idea of Glass-Steagall was that banks separate themselves out by the type of banking they did.
Investment banks weren’t supposed to make loans to consumers, or accept deposits. Commercial banks weren’t supposed to invest, or underwrite investments. Glass-Steagall drew a fairly clear line between commercial banking and investment banking, and was designed to keep them separate so that consumers’ money wasn’t being used to take risks that could result in bank failure.
Repealing Parts of Glass-Steagall
Things began to change in 1999.
The Gramm-Leach-Bilely Act of 1999 didn’t repeal all of the Glass-Steagall Act, but it did repeal parts of it. Gramm-Leach-Bilely amended the parts of Glass-Steagall that required a clear separate between commercial banking and investment banking. The hope was that getting rid of the line would help modernize banking, and expand the products that could be offered by all banks.
When the new Act was passed in 1999, there was a lot of insistence that banks wouldn’t take too big of risks, and that market forces would regulate the situation far better than something like a law. The financial meltdown of 2008, and the lead up to it, made it clear that banks were perfectly willing to take those bigger risks.
As policymakers try to figure out what they can do to shore up the financial system again, Glass-Steagall is being talked about because there are those who would like to see the repealed portions re-instituted. This seems like a viable solution to many because they don’t think that new regulations are necessary, or terribly effective. Instead, they argue that returning to a state of affairs that worked for more than 65 years would be the most practical solution.
Why Glass-Steagall Keeps Coming Up
Glass-Steagall keeps coming up because it is considered tried and true, and it is considered one way to “reform” the financial industry in a way to once again separate the risks of investment banking from the commercial banking that so many consumers rely on.
Another reason that Glass-Steagall comes up in the news is because pundits are still doing post-mortem studies on the financial crisis of 2008. Was the repeal of Glass-Steagall the cause of the financial crisis? Or would the crisis have happened anyway? The debate goes forward, since it has bearing on whether or not the repealed provisions of the Act would be re-instated.
There are even those that argue that the financial crisis probably would have happened — to some degree — even with Glass-Steagall fully intact. However, they insist that things wouldn’t have been as bad without the tangling of commercial and investment banking.
Barry Ritholtz compared Glass-Steagall to the lifeboats on the Titanic.
The Titanic had enough room for adequate lifeboats, but that space wasn’t utilized. So, there weren’t enough lifeboats. As a result, there were 1,502 deaths.
Even if there had been enough lifeboats, the Titanic still would have struck the iceberg and sunk. However, with adequate lifeboats, the casualties would have been much, much fewer. With a fully implemented Glass-Steagall, the number of banks failing and the damage to the financial system, would have been limited quite a bit.
Talk of Glass-Steagall has been put on hold for a little bit. But, since the elections are over, and early next year as a new Congress gets to work, there is a good chance that Glass-Steagall will be back in the news.
Roger @ The Chicago Financial Planner says
Nice post Miranda, I think it is no coincidence that the decade 2000-09 was such a financial disaster in the wake of the repeal of Glass-Steagall. The separation of commercial and investment banking makes sense and repealing this act was a serious mistake in my opinion.
Chris @StumbleForward says
As you mentioned in your titanic example I feel the market would have gone down regardless of whether the Glass-Steagall Act, but with the law in place it could have saved more of the casualties.
As result a lot of banks made some really bad decisions by giving out loans that were way to risky for the consumer and the lenders and putting them both at risk.
William @ Drop Dead Money says
Sandy Weill seems to have been the big mover behind the repeal of the Glass-Steagall act, mainly because he wanted to keep building his empire. Earlier this year he admitted that was a mistake. The admission, of course, comes AFTER he made his hundreds of millions. Reinstating Glass-Steagall is simple and proven, but there are too many lobbyists to make it happen, so it won’t. Too big to fail will be with us forever, because those big banks have the highest paid lobbyists.