What Is a Firewall?
A firewall is a legal barrier preventing the transference of inside information and the performance of financial transactions between commercial and investment banks. Restrictions placed on collaborations between banks and brokerage firms under the Glass-Steagall Act of 1933 acted as a form of firewall.
- A firewall refers to stipulations in the Glass-Steagall Act of 1933 that mandate strict separation of banking and brokerage activities in full-service banks and between depository and brokerage institutions.
- During the Great Depression, policymakers sought to weed out the conflict of interest that arose when banks invested in securities with their account-holders' assets.
- In 1999, the Gramm-Leach-Bliley Act (GLBA) was introduced, enabling commercial banks to once again engage in investment banking and securities trading.
- A handful of politicians and economists claim this deregulation contributed to the 2008 financial crisis and have since been calling for the Glass-Steagall Act to be reenacted.
A firewall refers to the strict separation of banking and brokerage activities in full-service banks and between depository and brokerage institutions. Under the Glass-Steagall Act of 1933, a distinct line was drawn between the banking and the investment industry, prohibiting a financial institution (FI) to operate as both a bank and a brokerage.
In the early 1930s, nearly 10,000 U.S. banks failed or suspended operations. To restore public confidence in the system, it was deemed necessary to sever the linkages between banking and investing activities, which were believed to have played an important role in the 1929 market crash and the ensuing depression.
Policymakers recognized the need to weed out the conflict of interest that arose when banks invested in securities with their account-holders' assets. Proponents of the bill argued that banks should be protecting their customer's savings and checking accounts, not using them to engage in excessively speculative activity.
Acting on these observations, a firewall, named after the resistant walls used in construction to prevent fires from spreading in a building, was put in place to separate banking and investing activities. The goal was to thwart banks from issuing loans that served to boost the prices of securities in which they had a stake and using depositors' funds to underwrite stock offerings.
Example of Firewall
Before the Great Depression, investors borrowed on margin from commercial banks to buy stocks. After two decades of rapid growth, people were confident that share prices would continue to rise and that capital appreciation would enable them to repay the loan.
In effect, banks used regular depositors' money to fund the loans, exposing them to high levels of risk. When the Great Depression emerged in late 1929 and stocks got pummeled, this accepted practice came under scrutiny. The government was forced to take action, introducing new reforms in the financial industry that effectively put an end to brokerage activities risking depositors' money.
History of Firewalls
Despite facing some opposition, the Glass-Steagall Act and its firewall went pretty much unchallenged for several decades. However, by the 1980s, several of its provisions began being ignored, amid a rise of giant financial services firms, a roaring stock market, and an anti-regulatory stance within the Federal Reserve and the White House.
Finally, in 1999, the Gramm-Leach-Bliley Act (GLBA) was introduced, enabling commercial banks to once again engage in investment banking and securities trading. Section 16 from the Glass-Steagall Act remained in force, restricting the types of assets banks could invest depositors' funds in, although by then a lot of the other parts of the act had been repealed, essentially permitting banks to act as stockbrokers, and vice versa.
Some politicians and economists claim this deregulation contributed to the 2008 financial crisis, pointing out that a lack of a firewall led U.S. FIs to become too big to fail and too reckless with client funds. Amid this debate, politicians steadily began calling for the Glass-Steagall Act to be reinstated.
In 2015, a group of senators, including John McCain and Elizabeth Warren, initiated a draft for a bill for the "21st Century Glass-Steagall Act," calling for a separation of traditional banking from investment banks, hedge funds, insurance, and private equity activities within a five-year transition period. During his 2016 presidential campaign, Donald Trump also voiced his support for such measures, talking up the need to break up the big banks and financial services "supermarkets."