Glass Steagall Act of 1933, Its Purpose and Repeal
This 1933 Law Would Have Prevented the Financial Crisis
The Glass-Steagall Act is a law that prevented banks from using depositors' funds for risky investments, such as the stock market. It was also known as the Banking Act of 1933 (48 Stat. 162). It gave power to the Federal Reserve to regulate retail banks. It also prohibited bank sales of securities. It created the Federal Deposit Insurance Corporation.
Glass-Steagall separated investment banking from retail banking.
Investment banks organize the initial sales of stocks, called an initial public offering. They facilitate mergers and acquisitions. Many of them operated their own hedge funds. Retail banks take deposits, manage checking accounts and make loans.
When Was It Passed?
Glass-Steagall was passed by the House of Representatives on May 23, 1933. It was passed by the Senate on May 25, 1933. It was signed into law by President Roosevelt on June 16, 1933. It was originally part of his FDR's New Deal. It became a permanent measure in 1945.
Glass-Steagall was the emergency response to the failure of nearly 5,000 banks during the Great Depression. In 1933, all U.S. banks closed for four days. When they reopened, they only gave depositors 10 cents for each dollar. Where did the money go? Many banks had invested in the stock market, which crashed in 1929. When depositors' found out, they all rushed to their banks to withdraw their deposits.
Even sound banks usually only keep one-tenth of the deposits on hand. They will lend out the rest because they know that normally that's all they need to keep on hand to keep their depositors' happy. In a bank run, they must quickly find the cash. Today, we don't have to worry about bank runs because the FDIC insures all deposits.
Since people know they will get their money back, they usually don't panic and create a bank run. The exception was when Washington Mutual closed in 2008. Depositors created a bank run because they didn't think they were protected by the FDIC.
On November 12, 1999, President Clinton signed the Financial Services Modernization Act that repealed Glass-Steagall. Congress had passed the so-called Gramm-Leach-Bliley Act along party lines, led by a Republican vote in the Senate. The banking industry had lobbied for the repeal of Glass-Steagall since the 1980s. They complained they couldn't compete with foreign securities firms. The banks said it restricted them to low-risk securities. They wanted to increase the return while lowering the overall risk for their customers by diversifying their business.
The first beneficiary was Citigroup. It had begun merger talks with Travelers Insurance in anticipation of Glass-Steagall's repeal. In 1998, it announced the successful merger under a new company called Citigroup. Its move was audacious, given that it was technically illegal. But banks had been taking advantage of loopholes in Glass-Steagall since the Reagan administration. By the time the act was repealed, it was virtually toothless.
The repeal of Glass-Steagall consolidated investment and retail banks through financial holding companies. The Federal Reserve supervised the new entities. For that reason, few banks took advantage of the Glass-Steagall repeal. Most Wall Street banks did not want the additional supervision and capital requirements.
Those that did became too big to fail. This required their bailout in 2008-2009 to avoid another depression.
Should Glass-Steagall Be Reinstated?
A reinstatement of Glass-Steagall would better protect depositors. At the same time, it would create organizational disruption in the banking industry. This might be a good thing, as these banks would no longer be too big to fail, but it should be managed effectively.
Congressional efforts to reinstate Glass-Steagall have not been successful.
In 2011, H.R. 1489 was introduced to repeal the Gramm-Leach-Bliley Act and reinstate Glass-Steagall. If these efforts were successful, it would result in a massive reorganization of the banking industry. The largest banks include commercial banks with investment banking divisions, such as Citibank, and investment banks with commercial banking divisions, such as Goldman Sachs.
The banks argued that reinstating Glass-Steagall would make them too small to compete on a global scale. The Dodd-Frank Wall Street Reform Act was passed instead.
A part of the Act, known as Volcker Rule, puts restrictions on banks' ability to use depositors' funds for risky investments. It does not require them to change their organizational structure. If a bank becomes too big to fail and threatens the U.S. economy, Dodd-Frank requires that it be regulated more closely by the Federal Reserve.