Glass-Steagall Act

The Banking Act of 1933 (also known as the Glass-Steagall Act) established deposit insurance in the United States and prohibited banks from underwriting or dealing in securities.

The repeal of the Glass-Steagall Act in November 1999 has been linked by some commentators to the increased risk-taking during the Great Recession. Others have argued that the activities linked to the financial crisis were not prohibited (or, in most cases, even regulated) by the Glass-Steagall Act.

Workings
In the wake of the stock market crash of 1929, the failure of thousands of commercial banks between 1929 and 1933, and the descent of the United States economy into the Great Depression, Congress saw the need for substantial reform of the banking system, initially embodied in the Banking Act of 1933. Because the securities activities of commercial banks were thought to have contributed to the stock market crash and to the subsequent flood of bank failures, Congress included the Glass-Steagall provisions.

In Section 16, commercial banks, and in Sections 20 and 32, their holding companies and affiliates, were forbidden to undertake investment banking activities. Also, in Section 21, investment banking companies (in Section 21) were forbidden from accepting deposits and thereby acting like commercial banks. In essence, commercial banks, which took in deposits and made business loans, and their holding companies could not underwrite or deal in securities; and investment banks, which underwrote and dealt in securities, could not offer deposits.

Those financial firms that embodied both functions were expected to divest (i.e., spinoff or sell) or shut down one or the other.

Arguments for the passing of the Act
Proponents of the Glass-Steagall Act argued that separating commercial and investment banking would increase the safety and reduce bank and customer conflicts of interest.

However, many securities (stocks and bonds) are less risky than are loans. Security investments are also liquid and publicly observable. Liquidity lets banks quickly rebalance their portfolios to avoid runs, and public observability improves the efficiency of bank monitoring by depositors and bondholders. Even if all securities were riskier than all loans, forbidding banks to invest in securities could increase bank risk because of the benefits of diversification.

Another argument against unified banking is that a bank with security affiliates has a conflict of interest. Senator Bulkley, a strong supporter of the Glass-Steagall Act put the argument as follows:


 * "Obviously, the banker who has nothing to sell his depositors is much better qualified to advise disinterestedly and to regard dilligently the safety of depositors than the banker who uses the list of depositors in his savings department to distribute circulars concerning the advantage of this, that, or the other investment on which the bank is to receive an originating profit or an underwriting profit or a trading profit."

This argument might apply to a fly-by-night outfit, but once long-run profits and reputation are included in the analysis, the conclusion is reversed. The more an investment advisor has to lose by offering bad advice, the less likely this is to occur. Poor investment advice on the part of a securities affiliate is likely to lead investors to leave that affiliate and to withdraw their funds from the parent bank. Investors, therefore, are able to threaten stronger punitive action if they invest with a unified bank than if they invest with an investment bank alone.

The conflict of interest argument is also contradicted by investor behavior. Unified banks (banks with affiliates or security operations) were rapidly increasing their share of the bond issuing market in the 1920s. In 1927, for example, commercial banks and their affiliates were responsible for 36.8 percent of all issues, and in 1930 for 61.2 percent of all issues. If the conflict of interest argument were true, one would expect rational investors to abandon unified banking rather than flock to it. More consistent with this evidence is the finding of Kroszner and Rajan (1994) that unified banks issued higher quality securities (ex post) than did investment banks acting alone.

Links

 * Banks on the Dole by Llewellyn H. Rockwell, Jr., November 1995
 * Banks on the Dole by Llewellyn H. Rockwell, Jr., November 1995