Lawmakers Should Shun Long-Repealed Bank Restrictions
The Glass-Steagall Act is the bad idea that never seems to die. A longtime favorite of the Democratic Party, its recent incarnation has found favor amongst some Senate Banking Committee Republicans (including Sens. Richard Shelby (R-AL), Mike Rounds (R-SD), Bob Corker (R-TN), and David Perdue (R-GA)) who last week indicated that they are open to its revival. With the Depression-era banking act’s return to prominence, it is important to review the history and impact of Glass-Steagall, and just why it should be left in the past.
What was the Glass-Steagall Act?
The Glass-Steagall Act generally refers to specific sections of the Banking Act of 1933 that established a firewall between commercial and investment banking: commercial banks could not underwrite or deal in securities, and investment banks could not accept deposits. Named after Rep. Henry Steagall (D-AL) and Sen. Carter Glass (D-VA), the Act also created the Federal Deposit Insurance Corporation (FDIC), which guaranteed bank deposits up to a specified limit, amongst other provisions.
Why was it introduced?
The Glass-Steagall Act was established in response to both the banking crises of the 1920s and the Great Depression of the early 1930s. The legislation tried to address two primary concerns:
- Stop the unprecedented run on banks, which saw 5,795 U.S. banks fail between 1929 and 1932, and to restore public confidence in the nation’s banking system.
- Prevent bank depositors from additional exposure to risk associated with stock market volatilities through severing the link between commercial and investment banking, which the authors believed to have been responsible for the market crash of 1929.
Was this an appropriate response to the crisis?
Unfortunately, the concerns of both Glass and Steagall failed to address the fundamental causes of the 1929 financial crisis. As George Benston argues in The Separation of Commercial and Investment Banking, “The evidence from the pre-Glass-Steagall period is totally inconsistent with the belief that banks’ securities activities or investments caused them to fail or caused the financial system to collapse.”
Moreover, Rutgers University economist Eugene White has shown that, between 1930 and 1933, banks that engaged in both commercial and investment banking had lower failure rates than others due to the greater opportunities for diversification and economies of scale.
Furthermore, as former financial regulator and UK Treasury minister Oonagh McDonald argues, the majority of the 9,096 banks that failed between 1930 and 1933 were small banks that were unable to diversify loan risk in struggling agricultural towns, in part due to overarching financial regulation. Rather than commercial bank’s engaging in speculation, it was the fragility of the banking system itself that caused the Great Depression. Glass-Steagall was the wrong answer to the wrong problem.
Why was it repealed?
By the late 1990s, it was clear that the decades-long separation of commercial and investment banking had done nothing to remove the risk of bank failures, but rather limited consumer choice and harmed U.S. competitiveness. For much of the 20th Century, bank clients had to use an investment firm for investing in assets like stocks and bonds, a separate commercial bank for checking services, and an insurance company for insurance services.
International comparisons showed that all these things could be done under one roof. As The Economist wrote in 1998, Glass-Steagall “has long been recognised as a cause of inefficiency that prevents financial firms providing the full range of products wanted by their customers.” Repeal supporters said that it would enable American institutions to engage more effectively in world markets and provide consumers and corporate customers greater service at a better price.
The Glass-Steagall Act was partially repealed by the Gramm-Leach-Bliley Act (GLBA), signed into law by President Clinton in 1999. Receiving widespread bipartisan support, passing the Senate 90-8 and the House 362-57, it left many Glass-Steagall provisions in place, repealing only section 20 and 32. These amendments primarily ended the affiliation restrictions, which freed up holding companies to own both commercial and investment banks.
Under GLBA, banks could still not underwrite or deal in securities outside of certain carefully defined categories, such as marketable debt obligations which are not predominantly speculative in nature, and obligations issued by a state, political subdivision or agency of that state. Post-GLBA banks and securities dealers remained legally separate from each other, even if a bank holding company was allowed to control both a bank and a securities dealer. As the Heritage Foundation’s Norbert Michel writes, “U.S. law – both before and after the GLBA – forbids insured depository institutions, commonly known as banks, from underwriting or dealing in securities. It also means that U.S. law prohibits securities dealers from taking demand deposits and making loans.”
Lawmakers should think long and hard before repudiating the modest reforms of GLBA. In a separate post we will examine the question of whether or not Glass-Steagall would have prevented the financial crisis that began in 2007.
This post is the first in a 3-part series on banking regulation and the Glass-Steagall Act of 1933.
- Part I: Lawmakers Should Shun Long-Repealed Bank Restrictions (4/11/17)
- Part II: Glass-Steagall Would Not Have Prevented the Financial Crisis (4/12/17)
- Part III: A “21st Century Glass-Steagall” Would be Bad for the Financial System (4/13/17)