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. This works similarly to firewall software and hardware used in preventing or limiting outside access to a company's internal servers and networks.

BREAKING DOWN '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. There are varying opinions on the purpose of the firewall. Some believe that just as a physical firewall prevents fire from spreading in a building, the financial firewall protects depositors from high risks of investment banking. Others believe the firewall was a political method of keeping sectors of the financial industry from lobbying together and undermining financial regulation. In other words, the financial institutions were prevented from dividing and conquering other sectors of the economy.

Firewall Example

Before the Great Depression, investors borrowed on margin from commercial banks to buy stocks. Anticipated capital appreciation was expected to pay back the loan. Especially during the rapid growth period in the two previous decades, the practice was legal and acceptable. Because banks used regular depositors’ money to fund the loans, the depositors were exposed to high-risk levels. The Great Depression caused much-needed, government-mandated reforms in the financial industry to stop brokerage activities from risking depositors’ money.

Political Impact of the Firewall

Separating investment banking from commercial banking ensured sector battles whenever new products were developed. Congressional members could alienate one sector and still find campaign support from another. Attempts to deregulate a sector was stopped by litigation challenges from other sectors.

Politicians in recent times have pitted industry sectors against each other to also promote regulation. Banks and retailers debated over the 2010 Durbin Interchange Amendment regulating merchants’ debit card swipe fees. Big banks fought large retailers when JPMorgan opposed Wal-Mart. The banks lost in both cases.

When the Glass-Steagall Act was repealed by Bill Clinton in 1999, massive deregulation of the financial services industry began and contributed to the 2008 financial crisis. Financial firms united as subsidiaries of financial holding companies. Industry trade associations united and pushed through large deregulatory legislation. As a result, too-big-to-fail banks are riskier than ever. The politics of financial regulation should be addressed to avoid another economic crisis.

RELATED TERMS
  1. Deregulation

    Deregulation is the reduction or elimination of government power ...
  2. Bank

    A bank is a financial institution licensed as a receiver of deposits. ...
  3. Universal Banking

    Universal banking is a banking system in which banks provide ...
  4. Financial Services Modernization ...

    The Financial Services Modernization Act of 1999 partially deregulated ...
  5. Monetary Control Act

    The Monetary Control Act was a two-title bill that changed bank ...
  6. Durbin Amendment

    A federal measure called the Durbin Amendment introduced limits ...
Related Articles
  1. Investing

    Fortinet Unveils Industry-Leading Firewalls

    Fortinet (NASDAQ: FTNT) stock was already off to a great start to 2017, up 25% year-to-date including a 14% gain since the company announced strong fourth-quarter and 2016 earnings on Feb. 2. ...
  2. Insights

    The Role of Commercial Banks in the Economy

    We interact with commercial banks daily to carry out simple financial tasks. That said, the function and creation of a commercial bank is anything but simple.
  3. Investing

    What Was The Glass-Steagall Act?

    Established in 1933 and repealed in 1999, the Glass-Steagall Act had good intentions but mixed results.
  4. Personal Finance

    Retail Banking vs. Corporate Banking

    Retail banking is the visible face of banking to the general public. Corporate banking refers to the aspect of banking that deals with corporate customers. Check out more on the differences between ...
  5. Insights

    The World's Top 10 Banks

    Learn more about the world's largest banks and how more financial power shifts eastward as China is home to four of the world's largest banks.
  6. Investing

    Analyzing a bank's financial statements

    In this article, you'll get an overview of how to analyze a bank's financial statements and the key areas of focus for investors who are looking to invest in bank stocks.
  7. Small Business

    How Effective Is The Chinese Wall?

    Because underwriters work on one side of the Chinese wall and analysts work on the other side, information gathered by the underwriters is not supposed to be shared with analysts.
RELATED FAQS
  1. Did the repeal of the Glass-Steagall Act contribute to the 2008 financial crisis?

    Understand the argument that the repeal of the Glass-Steagall Act caused the 2008 financial crisis, and learn why the argument ... Read Answer >>
  2. What factors are the primary drivers of banks' share prices?

    Find out which factors are most important when determining the share price of banks and other lending institutions in the ... Read Answer >>
  3. What are the 9 major financial institutions?

    There are nine major types of financial institutions. Understand the major types of financial institutions that exist and ... Read Answer >>
  4. How do interest rate changes affect the profitability of the banking sector?

    Learn how interest rates affect the banking sector. When interest rates rise, the profitability of the banking sector increases. Read Answer >>
Trading Center