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When the Glass-Steagall Act was repealed by Bill Clinton in 1999, massive deregulation of the financial services industry began and contributed to the 2008 financial crisis.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.

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