Glass-Steagall Would Not Have Prevented the Financial Crisis

This post is the second in a 3-part series on banking regulation and the Glass-Steagall Act of 1933. Glass-Steagall was partially repealed by the Financial Services Modernization Act of 1999, also known as the Gramm–Leach–Bliley Act after its three chief sponsors. Read the first part, “Lawmakers Should Shun Long-Repealed Bank Restrictions,” here.

If the Glass-Steagall Act had not been partially repealed in 1999, the 2007-08 financial crisis would have unfolded in largely the same way. The primary cause of the crisis had little to do with the Gramm–Leach–Bliley Act amendments, just as the original conception of the law failed to deal with the cause of the 1929 financial crisis. Bank losses occurred in mortgage lending and securitization, completely legal practices that had little to do with Glass-Steagall.

Examining the banks that failed during the crisis strongly suggests that firewalling commercial from investment banking would have done little to stop the downfall. As Peter Wallison of the American Enterprise Institute notes:

None of the investment banks that have gotten into trouble—Bear, Lehman, Merrill, Goldman or Morgan Stanley—were affiliated with commercial banks…the banks that have succumbed to financial problems—Wachovia, Washington Mutual and IndyMac, among others—got into trouble by investing in bad mortgages or mortgage-backed securities, not because of the securities activities of an affiliated securities firm.

As our own John Berlau notes, “In reality, it was poorly written mortgage loans, spurred on by the government-sponsored enterprises Fannie Mae and Freddie Mac, and low-income housing lending quotas imposed by the Community Reinvestment Act that were at the heart of the mortgage crisis.” The commercial bank failures of the 2007-08 financial crises were largely driven by credit losses on real estate loans. Glass-Steagall would not have prevented this.

However little blame the repeal of Glass-Steagall holds for the recent financial crisis, a revival of the act will greatly damage both Main street banks and our financial system as a whole. As John has further argued, “since Glass-Steagall forbade ‘Main Street’ commercial banks from venturing into investment banking, it actually protected Wall Street investment banks from competition, enabling them to get bigger.”

Those that rally against Wall Street by arguing for more and more regulation are actually hurting Main Street, regulating Wall Street’s competition away through burdensome compliance costs. In addition, restoring Glass-Steagall would also increase risk in the financial system. Prohibiting Main Street banks from offering both commercial and investment banking will lead small businesses seeking to raise capital to have to go through large investment-only firms, such as those that failed during the crisis.

Rather than looking toward burdensome and outdated regulations, Congress should pursue greater competition in the financial sector, in order to help bring stability, innovation, and choice.

The Glass-Steagall Act was an ineffective and harmful regulation for a bygone era. Not only were the removal of certain firewall provisions unrelated to the cause of the financial crisis, but to re-impose them now would be to inject additional risk into the financial system. As Oonagh McDonald rightly concludes in her rigorous analysis for the Cato Institute, “those who see a simple solution to our contemporary financial woes in repealing Gramm-Leach-Bliley and reimposing Glass-Steagall only betray their misunderstanding of both pieces of legislation. The causes of financial crises – past, present, and future – lie elsewhere.”