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 introduced an act, known today as the Glass-Steagall Act (GSA), that would separate investment and commercial banking activities.
At the time, improper banking activity–the overzealous commercial bank involvement in stock market investment–was deemed the main culprit of the financial crash. It was believed that commercial banks took on too much risk with depositors' money. Additional explanations for the cause of the Great Depression evolved over the years, which led many people to question whether or not the Glass-Steagall Act hindered the establishment of financial services firms that could equally compete against each other.
- The Glass-Steagall Act was passed in 1933 and separated investment and commercial banking activities in response to the commercial bank involvement in stock market investment.
- This mixing of commercial and investment banking was considered to be too risky and speculative, and widely considered to be a culprit that led to the Great Depression.
- Banks were thus given the mandate to choose either commercial banking or investment banking; however, an exception allowed commercial banks to underwrite government-issued bonds.
- The Gramm-Leach-Bliley Act eliminated the Glass-Steagall Act's restrictions against affiliations between commercial and investment banks in 1999, which some argue set-up the 2008 financial crisis.
Glass-Steagall Act (GSA)
Commercial banks were accused of being too speculative in the pre-Depression era because they were diverting funds to speculative operations. Thus, banks became greedy, taking on huge risks in the hopes 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.
Creating a Barrier Between Commerce and Banking
Senator Carter Glass, a former Treasury secretary and the founder of the United States Federal Reserve System, was the primary force behind passing the Glass-Steagall Act along with Henry Bascom Steagall. 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, which was responsible for creating the Federal Deposit Insurance Corporation (FDIC).
In response to one of the worst financial crises at the time, the Glass-Steagall Act set up a regulatory firewall between commercial and investment bank activities. Banks were given a year to choose between specializing in commercial or investment banking. Only ten percent 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 thus, one of the main sources of their income. By creating this barrier, the Glass-Steagall Act was aiming to prevent the banks' use of deposits in the case of a failed underwriting job.
The Glass-Steagall Act was also passed to encourage banks to use their funds for lending rather than investing those funds in the equity markets. This was intended to increase commerce. However, the stipulations of the act were considered harsh by most in the financial industry, and it was very controversial.
Further Regulations on the Banking Sector
Despite the lax implementation of the Glass-Steagall Act by the Federal Reserve Board, the regulator of U.S. banks, Congress made a further effort to regulate the banking sector in 1956. In an effort to prevent financial conglomerates from amassing too much power, the Bank Holding Company 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 by this legislation.
The Gramm-Leach-Bliley Act and the 2008 Financial Crisis
The limitations imposed on the banking sector by the Glass-Steagall Act sparked a debate over how much restriction can be considered healthy for the industry. Many argued that allowing banks to diversify their activities offers the banking industry the potential to reduce risk. They argued that the restrictions of the Glass-Steagall Act could actually have an adverse effect, making the banking industry riskier rather than safer. Furthermore, the transparency measures of big banks lessen the possibility that they will assume too much risk or that they will be able to cover up unsound investment decisions.
To the approval of many in the banking industry, Congress repealed the Glass-Steagall Act in November 1999. The establishment of the Gramm-Leach-Bliley Act eliminated the Glass-Steagall Act's restrictions against affiliations between commercial and investment banks.
After the passing of the Gramm-Leach-Bliley bill, commercial banks resumed taking on risky investments in order to boost their profits. Many economists believe that this increase in speculative and risky activities, including the rise in subprime lending, led to the 2008 financial crisis. Despite its tendency to be scapegoated, proponents of the repeal argue that the Glass-Steagall Act was, at most, a minor contributor to the most recent financial crises. Instead, they claim that at the heart of the 2008 crisis was nearly $5 trillion worth of basically worthless mortgage loans, among other factors. Although the repeal allowed for much bigger banks, it can't be blamed for the crisis.
The Bottom Line
Many people agreed that the stock market collapse of 1932 and the depression that ensued was the result of banks being overzealous with their investments. The idea was that commercial banks were taking on too much risk with their money, and their clients’ money.
The GSA made it harder for commercial banks, which were in the business of lending money, to invest speculatively. Banks were limited to making just 10% of their income from investments (except government bonds). The goal was to put limitations on these banks to prevent another collapse. The regulation was met with a lot of backlash, but it held firm until repeal in 1999.