The Glass-Steagall Act was passed in 1933 to prevent another Great Depression.
It was partially repealed in 1999, less than a decade before the Great Recession.
What Is the Glass-Steagall Act?
The Glass-Steagall Act (GSA) is a piece of legislation written in 1933 by Senator Charles Glass and Representative Henry Steagall. It addresses what most people considered (then and now) to be major causes of the Great Depression: an unhealthy crossover between investment banks and high-risk investing, and vulnerability of deposits to bank runs.
A part of the Banking Act of 1933, the Glass-Steagall Act has a few key features:
- It created federal bank deposit insurance, leading Congress to found the Federal Deposit Insurance Corporation
- It banned commercial banks from acting as investment entities. A bank had to choose whether it would continue on as an investment bank, which could not accept deposits and perform other forms of consumer banking, or commercial banks, which could not take more than 10% of their revenue from securities investments.
- In 1956, the GSA was amended to also prevent commercial banks from underwriting insurance as well.
The goal of the GSA is to get consumer banks out of the securities business and prevent another Great Depression.
Causes of the Great Depression
The causes of the Great Depression are tied up in how modern banks do business. While commercial banking was not the only reason why America's economy crashed, speculation played an extremely important role.
Anyone who has seen "It's A Wonderful Life" may remember the scene in which George Bailey (James Stewart) tries to convince an angry mob that their money actually exists. It is, essentially, an accurate statement of how a bank works. When you make a deposit you are giving the bank a loan. They take your money and invest it in other products such as personal lending. The bank charges interest for these loans and pays you interest in return for the use of your cash.
As a result, a bank always has far less cash in hand than it has on deposit. To operate this way the bank must ensure that it always keeps enough cash in reserves to cover customer withdrawals. If the bank has more money locked up in loans than it has in cash on hand, customers will have to wait for those loans to pay off before they can withdraw their money.
If those loans default, the bank has lost its customers' money altogether.
The trouble with commercial loans is that they tend to be financially boring. While a mortgage or an auto loan is typically a safe investment, it also lacks the big payoff that can come from investing in the stock market. During the 1920s, banks increasingly began to prefer securities such as stocks and other speculative assets over traditional commercial loans. These had the potential for much higher profits even while they also carried far more risk. (Among other problems, securities such as a stock or commodity are unsecured. They can go completely to zero while a mortgage at least allows the bank to recover and sell the property.)
Banks would sometimes make these investments directly. They would also lend money to speculators, who would invest in the stock market with this borrowed money. If the speculator invested well, everyone profited. If the investment did poorly the bank risked losing the entire loan.
Finally, banks would often do both, lending money to speculators to invest in securities that the bank also had an interest in. Those banks would also try to direct their customers toward these same products. This behavior mimics what economists call a "pump and dump," when an adviser steers investors into a specific product in order to drive up the price so that the investor can take advantage of an artificial high and cash out.
Regardless of the motive, it created a conflict of interest.
Bankers often did not see the risk or the conflict, however. They saw only the profits from a stock market that had soared by almost 400% in 10 years. As a result, by the late 1920s, commercial banks had moved heavily away from traditional loans and into speculation lending.
This left them vulnerable. Commercial banks had placed significant portions of their customers' money into high-risk investments, and when the stock market fell the banks began to lose all of that money. This caused the stock market to fall further leading the banks to lose more money in a destructive cycle.
Consumers quickly became aware that their money was no longer safe. Individuals rushed to pull out their savings while their local bank was still solvent enough to meet the deposit, leading to banking panics that lasted for several years. These runs, during which consumers evacuated as much money as they could get, pushed even healthy, solvent banks out of business, as they quickly lost all of their operating capital.
All of this led Congress to write a law which would address two key issues.
How the Glass-Steagall Act Worked
The Glass-Steagall Act, as noted above, originally did two things: It created the FDIC and it put limits on how commercial banks could make money. Each element of this law addressed a specific concern from the Great Depression.
The banking limits were designed to prevent banks from rolling the dice with consumer money. Make banking boring again. This was the philosophy behind the GSA.
This element of the Glass-Steagall Act was designed to ensure that banks stopped making high-risk investments with money that consumers thought was safely deposited. It was also intended to break up the conflicts of interest that arise when a bank can direct depositors into investments and financial products that actively profit the bank.
It did all of this by creating two distinct entities: commercial banks and investment banks. An investment bank can deal in securities and other forms of investment and can use consumer money to do so because those consumers understand the risks. It cannot, however, take deposits.
A commercial bank, while it can take deposits and make commercial loans, can only make a very limited amount of money from non-loan securities and other forms of speculative investments. Commercial banks also could not advise their customers on investments or otherwise act as a securities broker.
The goal was to separate savings from speculation, reduce conflicts of interest, increase the capital available for commercial loans, and limit the risk that a bank would lose its customers' money.
The creation of the FDIC was meant to prevent future bank panics.
The FDIC is a federal agency which insures all deposits in a commercial bank up to a limited amount. This means that if your bank goes out of business or otherwise loses the money you had on deposit, the federal government will reimburse your losses. At time of writing this insurance cap was $250,000.
This agency was created to protect both banks and consumers from future bank panics.
One of the most understated causes of the Great Depression was the impact of the banking runs that lasted from 1929, arguably, through 1933. This wave of panic pushed many local banks out of business entirely, further destabilizing local economies and wiping out the savings of families across the country. In turn, losing that money eliminated a wide consumer base whose spending could have helped make the Great Depression less severe.
By insuring deposits the FDIC helps make sure that banks can stay solvent and that consumers can keep their money if a bank goes out of business.
Repeal of the Glass-Steagall Act
The GSA remained largely unchanged from 1933 until the 1990s with the one exception of a 1956 amendment to prevent commercial banks from underwriting insurance. (This, too, was intended to limit risk-seeking behavior with depositors' money.)
Over the course of the 1980s, however, large commercial banks increasingly wanted to take part in the decade's stock market boom. Regulators began turning a blind eye to the GSA's provisions, allowing commercial banks to make larger and larger investments in the stock market and other forms of regulated securities.
In 1990, due to intense lobbying, Congress passed the Graham-Leach-Bliley Act which partially repealed the GSA. Specifically this law repealed Sections 20 and 32, which limited how commercial banks could invest their own assets and their ability to advise clients on investments. Banks still could not invest with depositors' money, but could now invest in securities with their own profits and act as securities brokers for their clients.
Critics at the time argued that this would return the conflict of interest that the Glass-Steagall Act was specifically written to prevent, allowing commercial banks to invest in high-risk assets and steer customers toward those same products. Congress did not repeal the sections of the GSA which prohibit commercial banks from investing with depositor assets, nor did it disband the FDIC.
The Glass-Steagall Act and the Recession
Economists continue to debate the role that repealing the Glass-Steagall Act had in the Great Recession.
Few, if any, mainstream economists argue that the GSA's partial repeal directly caused the subprime mortgage crisis of 2007-2010. There are many who argue that it played virtually no role whatsoever, as the banking crisis of 2007-2008 occurred within investment banks rather than commercial institutions.
Economists who argue for the importance of the GSA's repeal claim that allowing commercial banks to act as both investors and advisers exposed depositors to the risks of investment banks. Big commercial banks increasingly demanded the kind of returns that can only come from higher risk products, and they exposed their clients to those same investments.
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