The Glass-Steagall Act Explained
The Glass-Steagall Act of 1933, passed during the Great Depression, prevented commercial banks from trading securities with their clients’ deposits and created the FDIC as a guard against bank runs. Passed in 1933 as the Banking Act, Glass-Steagall was chipped away over the years and eventually repealed during the Clinton Administration with the Gramm-Leach-Bliley Act of 1999. Some experts believe that the act’s repeal contributed to the 2008 financial crisis, and the law served as a basis for the Volcker Rule of the 2009 Dodd-Frank reform bill.
- Definition: What is the Glass-Steagall Act?
- Precursors to Glass-Steagall
- The firewall’s gradual weakening
- Glass-Steagall and the 2008 crisis
- The Volcker Rule: Watered-down Glass-Steagall
Definition: What is the Glass-Steagall Act?
The Banking Act, now known as Glass-Steagall, was sponsored by Senator Carter Glass (D-VA) and Representative Henry Steagall (D-AL) with the intent of forestalling bank runs and preventing future crises. The legislation had two main provisions:
1. Creation of the FDIC
The period from 1929 to 1933 saw a number of bank runs, which destabilized the American (and world) economy. Fearful that their banks would fail, people pulled their deposits out, which actually caused those banks to fail. To stop that self-perpetuating cycle, Glass-Steagall created the Federal Deposit Insurance Corporation, which guaranteed bank deposits up to a certain amount (initially $2,500, now $250,000).
2. Separation of Commercial and Investment Banking
As important as the FDIC’s creation was, the term Glass-Steagall usually refers to the set of rules that kept a savings-and-loan type bank from engaging in speculative, risky training with customers’ deposits. If a bank took deposits, it could not trade in anything other than government bonds; if it underwrote securities or engaged in market-making, it could not take deposits.
The motivation for this separation rested on alleged conflicts of interest. Glass and Steagall, as well as others, accused banks of partnering with affiliates which later sold securities to repay banks’ debts, or accepted loans from banks to buy securities. They also worried that banks engaged in risk-taking speculation, rather than investing in corporations to promote growth.
Five provisions of the Banking Act pertained to this separation:
- Section 19: Federally chartered banks could not buy or sell securities, unless they were investment securities, government bonds or trades made on behalf of a customer.
- Section 5(c): Glass-Steagall would also apply to state-chartered banks.
- Section 20: Banks could not be affiliated with firms whose primary purpose was trading securities.
- Section 21: If a bank did trade securities, it could not take deposits.
- Section 32: Officers and directors of commercial banks (banks part of the Federal Reserve System) were barred from holding advisory positions in companies whose primary purpose was trading securities.
Other notable but less well-known provisions include:
- The creation of the Federal Open Market Committee. The FOMC includes the Federal Reserve Board’s 7 members, 4 rotating members of the regional Federal Reserve Banks, and the president of the New York Fed. It establishes target interest rates to help increase employment and curb inflation.
- Regulation Q. Banks could not pay interest on demand deposit (business checking) accounts. Interest rates were capped on certain other deposit products, like savings and NOW accounts. Regulation Q is now repealed, but plays a key rolein the story of Glass-Steagall.
Precursors to Glass-Steagall
Senator Glass actually introduced numerous versions of what became Glass-Steagall between 1930 and 1932. These bills had common threads:
- Bringing more banks under the Federal Reserve’s supervision
- Separating commercial and investment banking
- Controlling speculative trading by banks
These versions, however, did not seek to establish an FDIC-like institution. Instead, Glass envisioned a federal agency that could buy a failing bank’s assets at a reasonable price, providing the capital to reassure or repay depositors. For example, if a bank had $1,000 in deposits (liabilities) that it used to make $1,000 in loans (assets), and its depositors feared it would collapse, the federal agency could buy that $1,000 in loans to essentially guarantee the bank’s solvency.
On the other hand, Representative Steagall and many other House members supported the creation of the FDIC. Despite opposition of both Glass and President Franklin Roosevelt, the provision was included in the reconciled House and Senate bills.
The firewall’s gradual weakening
Over the years, legislators and regulators chipped away at Glass-Steagall, culminating in its repeal in 1999.
1935: Glass tries to repeal his own bill
Presumably, separating commercial and investment banking would prevent the conflicts of interest that led banks to make risky loans or securities affiliates to make inefficient trades. However, a 1934 study found that securities underwritten by bank affiliates fared no better and no worse than those underwritten by non-affiliates.
In 1935, Glass introduced an amendment that would permit commercial banks to trade securities again. President Roosevelt spoke out against the amendment, and though it passed the Senate, it was tossed out during the House-Senate reconciliation process.
1963: OCC on the offensive
Following World War II, banks faced increasing competition from non-bank entities not subject to Glass-Steagall. General Motors, Sears and others began offering consumer credit, thus competing with banks for loans.
James Saxon, then the Comptroller of the Currency, feared that Glass-Steagall undermined commercial banks’ competitiveness, putting them at a disadvantage to non-banks. Under his guidance, the Office of the Comptroller of the Currency (OCC) issued regulations that would have watered down Glass-Steagall, allowing banks to:
- Offer commingled accounts, in which investors poll their funds to buy stocks and bonds (similar to a mutual fund)
- Buy and sell muni bonds
1966: Inflation exceeds interest rate cap on Reg. Q
Regulation Q, an often-forgotten provision of Glass-Steagall, capped interest rates paid on savings and other deposit accounts. When the rate of inflation surpassed the maximum interest yield, consumers pulled out their deposits in favor of bonds and other safe but better-paying products.
More and more, consumers turned to non-bank entities for their loans. By 1972, in fact, the nation’s three largest banks provided less credit than either the three largest retailers or the three largest manufacturers. Prime customers bypassed commercial banks, going straight to capital markets for their borrowing needs or to get a higher yield on their savings. Banks were left with the sub-prime customers that capital markets wouldn’t lend to.
1966: Interest Rate Adjustment Act passes
In the same year, the Federal Reserve allowed savings and loan associations (S&L’s, or thrifts) to pay higher savings account interest rates than commercial banks. They could also offer negotiable order of withdrawal (NOW) accounts, which function like checking accounts but are not subject to interest rate caps. S&L’s were not covered by Glass-Steagall.
1971: Investment Company Institute v. Camp
After 1963, the OCC’s relaxed rules wound their way through the justice system. Finally, in 1971, the Supreme Court ruled that the OCC had overreached. They argued that the new rules violated the spirit of Glass-Steagall, and struck them down.
1977: Merrill Lynch introduces the cash management account
Capping nearly a decade of deposit-account innovation, Merrill Lynch launched a “cash management account,” which allowed customers to write checks against funds held in a money management account. Cash management accounts were functionally similar to checking or savings accounts, but Merrill could use those deposits to trade securities, while banks couldn’t.
Increasingly, investment banks offered products typically seen in commercial banks, and at better rates. The FDIC and OCC declined to regulate these bank-like entities, however, so Glass-Steagall began to lose relevance.
1978: The birth of the mortgage backed security
Bank of America issued the first mortgage-backed security, in which it pooled mortgages and sold them to investors.
1980’s: Commercial acquires investment, and vice versa
In the 1980’s and 1990’s, commercial banks increasingly traded in over-the-counter derivatives, such as interest rate swaps. Moreover, during the Reagan and Bush administrations, the FDIC and OCC approved a number of mergers between commercial banks and securities firms:
- 1982: The OCC allowed Citibank to offer a collective investment trust, essentially re-issuing Saxon’s directive.
- 1982: The FDIC issued a policy statement allowing state-chartered, non-Federal Reserve banks to affiliate with securities firms, even if they had FDIC insurance.
- 1983: The Federal Reserve authorized Bank of America to buy Charles Schwab, then the nation’s largest brokerage firm.
- 1987: The Federal Reserve allowed Bankers Trust, Citigroup and JPMorgan to trade mortgage-backed securities, muni bonds and commercial paper.
After numerous attempts to repeal Glass-Steagall spanning the Bush and Clinton administrations, President Clinton signed the Gramm-Leach-Bliley Act that repealed the provisions preventing banks from affiliating with security firms. Though the line between commercial and investment banking was already blurring, the passage of Gramm-Leach-Bliley accelerated the pace.
Commercial banks traded in increasingly risky and complex securities, continuing to buy and sell mortgages, collateralized debt obligations and other derivatives. Because of the instruments’ complexity and institutions’ vulnerable positions, many banks faced stark losses during the 2008 financial crisis. Commercial institutions received emergency loans from the Federal Reserve, and investment banks Goldman Sachs and Morgan Stanley were actually designated as bank entities so they could take advantage of those loans. The vulnerability of commercial banks, revealed by the crisis, has resurrected the debate over Glass-Steagall.
Glass-Steagall and the 2008 crisis
Some argue that Glass-Steagall’s repeal contributed to the 2008 financial crisis. Joseph Stiglitz of the Roosevelt Institute, a Nobel Prize winner, contended:
Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively…Investment banks, on the other hand, have traditionally managed rich people’s money — people who can take bigger risks in order to get bigger returns.
When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risk-taking.
Senators Maria Cantwell (D-WA) and John McCain (R-AZ) advocated the return of Glass-Steagall as well:
So much U.S. taxpayer-backed money is going into speculation in dark markets that it has diverted lending capital from our community banks and small businesses.
The Volcker Rule: Watered-down Glass-Steagall
Check out our detailed explanation of the Volcker Rule here.
Given the difficulty in separating investment and commercial banks entirely, as some advocated, legislators instead passed the Volcker Rule, named after former Fed Chairman Paul Volcker. The Volcker Rule prevented banks from speculation, or trading securities with the intent of making a profit. However, Volcker allows banks to hedge existing positions. Since the affected banks are so large and have such complex portfolios, critics argue that there is no way to differentiate a trade from a hedge.
Elizabeth Warren, former Harvard Law professor and de facto head of the Consumer Financial Protection Bureau, argued strongly for the full re-implementation of Glass-Steagall:
[Determining trading and hedging] is the strongest argument for a modern Glass-Steagall. Glass-Steagall said in effect that hedge funds should be separated from commercial banking. If a big institution wants to go out and play in the market, that’s fine. But it doesn’t get the backup of the federal government.
However, the current fight centers on weakening even the Volcker Rule, not strengthening it.