In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commercial banking activities. At the time, "improper banking activity," or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors' money. Additional and sometimes non-related explanations for the Great Depression evolved over the years, and many questioned whether the GSA hindered the establishment of financial services firms that can equally compete against each other. We will take a look at why the GSA was established and what led to its final repeal in 1999.
Reasons for the Act - Commercial Speculation
Commercial banks were accused of being too speculative in the pre-Depression era in part because they were diverting funds to speculative operations. Thus, banks became greedy, taking on huge risks in the hope of even bigger rewards. Banking itself became sloppy, and objectives became blurred. Unsound loans were issued to companies in which the bank had invested, and clients would be encouraged to invest in those same stocks.
Glass-Steagall Act (GSA)
Effects of the Act - Creating Barriers
Senator Carter Glass, a former Treasury secretary and the founder of the United States Federal Reserve System, was the primary force behind the GSA. Henry Bascom Steagall was a member of the House of Representatives and chairman of the House Banking and Currency Committee. Steagall agreed to support the Act with Glass after an amendment was added permitting bank deposit insurance creating the FDIC or Federal Deposit Insurance Corporation.
As a collective reaction to one of the worst financial crises at the time, the GSA set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled. Banks were given a year to decide on whether they would specialize in commercial or in investment banking. Only 10% of commercial banks' total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds. Financial giants at the time such as JP Morgan and Company, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, the main source of their income. By creating this barrier, the GSA was aiming to prevent the banks' use of deposits in the case of a failed underwriting job.
The GSA was also passed to encourage banks to use their funds for lending to increase commerce versus investing those funds in the equity markets. However, the act was considered harsh by most in the financial community, and it was heavily debated.
Building More Walls
Despite the lax implementation of the GSA by the Federal Reserve Board, which is the regulator of U.S. banks, in 1956, Congress made another decision to regulate the banking sector. In an effort to prevent financial conglomerates from amassing too much power, the new Act focused on banks involved in the insurance sector. Congress agreed that bearing the high risks undertaken in underwriting insurance is not good banking practice. Thus, as an extension of the Glass-Steagall Act, the Bank Holding Company Act further separated financial activities by creating a wall between insurance and banking. Even though banks could, and still can, sell insurance and insurance products, underwriting insurance was forbidden.
Were the Walls Necessary? - The New Rules of the Gramm-Leach-Bliley Act
The limitations of the GSA on the banking sector sparked a debate over how much restriction is healthy for the industry. Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk, so the restrictions of the GSA could have actually had an adverse effect, making the banking industry riskier rather than safer. Furthermore, big banks of the post-Enron market are likely to be more transparent, lessening the possibility of assuming too much risk or masking unsound investment decisions. As such, reputation has come to mean everything in today's market, and that could be enough to motivate banks to regulate themselves.
Consequently, to the delight of many in the banking industry in November of 1999, Congress repealed the GSA with the establishment of the Gramm-Leach-Bliley Act, which eliminated the GSA restrictions against affiliations between commercial and investment banks.
With the passing of the Gramm-Leach-Bliley bill, commercial banks went back to getting involved in risky investments to boost profits. Many believe that the additional risk-taking, in particular, subprime lending, lead to the 2008 financial crisis.
Although the barrier between commercial and investment banking aimed to prevent a loss of deposits in the event of investment failures, the reasons for the repeal of the GSA and the establishment of the Gramm-Leach-Bliley Act show that even regulatory attempts for safety can have adverse effects.