The Glass-Steagall Act

The Glass-Steagall Act was a 1933 U.S. law signed by President Franklin Roosevelt shortly after he took office that effectively separated commercial banking from investment banking. The act is named for its sponsors, Sen. Carter Glass, D-Virginia, a former Treasury secretary, and Rep. Henry Steagall, D-Alabama, the chairman of what was then called the House Banking and Currency Committee.^[1]

Glass-Steagall was largely repealed in 1999 by the Gramm-Leach-Bliley Act, which was known formally as the Financial Services Modernization Act of 1999. This once again allowed banks to own securities firms and vice versa.^[2]

Although the name Glass-Steagall is now better known, the measure was part of the broader Banking Act of 1933 that was enacted in the wake of the stock market crash of 1929 and the Great Depression that followed. The Banking Act also created the Federal Deposit Insurance Corp. This resulted in bank deposits being insured by the federal government in order to restore public confidence in American banks, thousands of which failed during the Depression or were subject to runs by people concerned about the safety of their money.^[1]

The act also established the Federal Open Market Committee (FOMC), which is the Federal Reserve's monetary policy-making board. It included Regulation Q as well, which banned banks from paying interest on checking accounts and limited how much they could pay on other deposit products.

Why Was The Glass-Steagall Act Created?

The main motivation behind the passage of Glass-Steagall was concern that banks were using depositors' money to lend to stock speculators who were blamed for the market crash, especially where the banks owned a stake in those same securities. Essentially, the act prohibited commercial banks, which take deposits and make loans, from underwriting or dealing in securities. Likewise, investment banks, which underwrite and trade in securities, were prohibited from commercial banking activities. The two different kinds of companies were also banned from having common ownership or overlapping directorships in each other.

Following enactment of the law in June 1933, banks were given a year to decide between commercial or investment banking. Commercial banks were restricted from earning more than 10% of their income from securities, although they were allowed to underwrite government bonds.^[1]

Why Was The Glass-Steagall Act Repealed?

As time passed and memories of the Great Depression faded, both U.S. banks and securities firms began to complain that Glass-Steagall prevented them from competing with banks in Europe and Japan, which had no similar restrictions, and limited their profit-making potential. During the 1980s and '90s, financial institutions began to gradually chip away at the law, taking advantage of various loopholes to broaden their businesses.

In 1998, the final nail in the coffin of Glass-Steagall was driven in by the merger of Citibank, a commercial bank, with Travelers Insurance, which owned investment companies Salomon Brothers and Smith Barney. The combined entity became Citigroup, which at the time was the largest financial services company in the world, offering commercial and investment banking services as well as insurance.^[3]

In 1999, President Clinton signed into law the Financial Services Modernization Act, better known as the Gramm-Leach-Bliley Act. It effectively repealed Glass-Steagall's prohibitions on commercial and investment banking under one roof.^[2]

In 2005, there was speculation that J.P. Morgan, a commercial bank, and Morgan Stanley, an investment banking firm, may reunite. The two were once part of the same company but were forced to split after Glass-Steagall became law. However, that deal never came to pass, as Morgan Stanley is still an independent company and J.P. Morgan merged with Chase Manhattan to become JPMorgan Chase.^[4]

Criticism Of Glass-Steagall Repeal

The repeal of Glass-Steagall has been blamed in some circles for fomenting the 2008 financial crisis and resulting Great Recession. Many people believe that the crisis may not have happened at all, or wouldn't have been so bad, had the Glass-Steagall restrictions on mixing commercial and investment banking remained in place.^[5]

However, during the financial crisis, several investment banks firms were merged into commercial banks at the insistence of the U.S. government. For example, JPMorgan Chase took over the failing Bear Stearns,^[6] Bank of America bought Merrill Lynch, and Barclays acquired several parts of Lehman Brothers after it went bankrupt.^[7]

Volcker Rule

After the crisis, the Dodd-Frank Wall Street Reform Act was passed in 2010 that put some restrictions on banks' investment banking activities. A part of the Act, known as the Volcker Rule, prohibits American commercial banks and foreign banks that do business in the U.S. from trading for their own account.

More specifically, it prevents them from owning or investing in hedge funds or private equity funds. Banks are permitted to trade when it's necessary to run their business, such as to offset foreign currency or interest rate risk. They are also allowed to make trades for their customers and to trade in bonds issued by the U.S. Treasury and other government agencies.

Summary

The Glass-Steagall Act was a 1933 U.S. law signed by President Franklin Roosevelt during the Great Depression that separated commercial banking from investment banking. The main motivation of the act was to stop risky business activity by banks, specifically enabling people to speculate on stocks, which was one of the main causes of the 1929 stock market crash and the ensuing Great Depression. The act was largely repealed in 1999 by the Gramm-Leach-Bliley Act, which once again allowed banks to own securities firms and vice versa.