Glass-Steagall Act
The Glass-Steagall Act is a legislation passed by the US congress in response to the collapsing banking sector to restore publick confidence and stability in the banking sector.
What Is the Glass-Steagall Act?
The Banking Act of 1933, better known as the Glass-Steagall Act (GSA) of 1933, is a seminal piece of legislation made in the financial space of the United States of America.
Congress passed it in response to the collapsing banking sector to restore public confidence and stability in the banking sector.
Public confidence went down the drain after the infamous Great Depression of 1929 when the stock market plummeted sharply, which led to severe economic depression. Consequently, depositors lost their savings in banks.
All this was part of the business cycle. The early 1920s witnessed unprecedented economic prosperity when banks channeled depositors' savings into risky ventures, such as stock markets.
Also, the banks were distributing “easy credit,” which also pumped up the money demand. All this combined yielded to the economy’s collapse.
The U.S. Senate, in 1933, launched the Pecora Investigation headed by Ferdinand Pecora. This investigation was ordered to deal with and determine what caused the crisis.
This investigation made some thrilling revelations about the causes of crises. These are:
- Widespread misconduct
- Misfeasance within the banks
- Conflict of interest
- Insider trading
- Reckless lending
Because of all these factors, the public demanded immediate regulations and stricter policies. GSA was passed by Senator Carter Glass and Representative Henry Steagall to resolve the lingering crisis.
The GSA was aimed at separating commercial banking and investment banking activities. These two institutions were prohibited from dealing with each other and could not enter any transaction.
Hence, the depositors’ funds were now not being used by the investment banks for speculative activities of the stock markets or any other high-risk activity.
Key Takeaways
- The Act was passed to separate commercial and investment banks, as the commercial banks used depositors' funds for risky ventures, just like investment banks.
- The Act was also passed to fight the Great Depression and the banking system's mistakes.
- The Act has also created the Federal Deposit Insurance Corporation(FDIC) to provide insurance to depositors and gain public confidence.
- Commercial banks and investment banks were prohibited from transacting with each other.
- The Act also prohibited interlocking directorates, limiting individuals from simultaneously serving as directors of commercial and investment banks.
- The Gramm-Leach-Bliley Act was passed in 1999, removing the separation wall between commercial banks and investment banks.
History of the Glass-Steagall Act
The GSA was important legislation passed by Congress. First, however, we must delve deeper into the history before the GSA to clarify why this Act was passed.
1. Roaring Twenties
The period between 1929-39 was the most devastating and tragic decade for the American banking sector as the crisis hit it.
The early to mid-20s were known as the “Roaring Twenties” and were characterized by higher economic growth and productivity levels. This was also the peak period of the Industrial Revolution; the people had higher purchasing power and, most importantly, "easy credit."
But, underneath all of this, a catastrophic volcano was brewing, The Great Depression.
2. Speculation by the Commercial Banks
Excessive speculation made by the top financial institutions at the expense of the depositors was a key reason for the banking crisis.
In the 1920s, the U.S. stock market was at its highest levels. As a result, many individuals invested in stocks for speculative purposes, often with borrowed money. The people thought the market would never come down, but it did and wiped out all of their money.
The stock prices began to reach unsustainable levels. On 29th October 1929, the stock market plummeted, which subsequently caused panic selling, and a massive amount of wealth was destroyed. The event is referred to as "Black Tuesday.”
This crash wiped out billions of dollars, and the economic stability was completely shattered.
Note
The U.S. economy witnessed the domino effect in the banking system. Many banks invested their depositors' money, suffering huge losses.
3. Black Tuesday
When Black Tuesday hit the U.S. stock markets, banks experienced a sharp dip in the value of their assets. As a result, they were unable to return their customers' deposits, and depositors found themselves unable to withdraw their own money.
This led to a bank run, which exacerbated the crisis. Public confidence was eroded as the banks could not honor their obligations.
The collapse of various banks led to the unavailability of credit in the market, and the entire economy reached rock bottom.
This led to widespread unemployment, poverty, economic hardships, and businesses shutting down.
Objectives of the Glass Steagall Act
The GSA was passed in 1933 because of the shattered past of the economy, the failure of the banking system, and to regain public confidence.
1. The Pecora Investigation
The Pecora Investigation, launched by the U.S. Senate in 1933, played a crucial role in exposing the misconduct and malpractices that contributed to the crisis.
Led by Ferdinand Pecora, the investigation uncovered shocking revelations about conflicts of interest, insider trading, and risky speculation by banks.
These findings fueled public outrage and created a strong demand for comprehensive reforms to restore stability and integrity to the banking sector.
2. Separation of Commercial and Investment Banks
The commercial and investment banks were separated and prohibited from dealing with each other. This was the GSA's foundational provision. Commercial banks are primarily involved in accepting deposits and making advances.
And on the flip side, investment banks operate in a riskier business model by providing services such as underwriting, trading, hedging, etc. Therefore, the GSA laid down the foundational provision regarding the non-dealing between these two institutions.
By separating these two, the Act helped and protected the depositors’ funds from speculative activities and incurring losses.
3. Federal Deposit Insurance Corporation (FDIC)
The Act also created the Federal Deposit Insurance Corporation (FDIC), which had to provide for insurance of deposits.
FDIC guarantees depositors that if a bank fails, their deposits will not be at risk as the FDIC will return them. The creation of the FDIC increased public confidence.
Before the Act was passed, the U.S. banking system functioned in a free environment following the laissez-faire approach, but this approach led to a crisis. To resolve this issue, the Act implemented regulations in this sector to ensure there will never be another such incident.
Note
Laissez Faire is a type of economic system where the private sector produces the goods and services, and the government does not intervene in the production, distribution, and consumption process. It is capitalist in nature.
Provisions of the Glass-Steagall Act
The Glass-Steagall Act was one of the most important laws passed in the entire U.S. history of legislation. It impacted the entire U.S. financial system in every aspect.
1. Separation of Investment Banks and Commercial Banks
The Glass-Steagall Act of 1933 contained giant provisions addressing systemic banking issues and promoting balance inside the financial system.
Analyzing relevant economic figures for the duration of and after the Act's implementation gives valuable insights into its effect on the banking industry.
One key provision of the Glass-Steagall Act was the separation of commercial and investment banking. This separation aimed to protect depositors' money from the dangers of speculative investments.
Analyzing financial figures reveals a decline in financial institution failures following the Act's implementation. For example, in the succeeding four years after passing the Act, over 9000 banks failed. But in the decade following the Act, only 100 banks failed.
This decline demonstrates the Act's effectiveness in enhancing the security of the banking system.
2. FDIC
Another big provision was the establishment of the Federal Deposit Insurance Corporation (FDIC). The FDIC aimed to repair public self-assurance inside the banking device by supplying deposit insurance.
Note
This provision is reflected in economic figures because implementing deposit insurance brought about elevated consideration and confidence among depositors.
Consequently, individuals were more inclined to save and invest their money, contributing to economic prosperity.
3. Interlocking Directorships
Furthermore, the Glass-Steagall Act imposed regulations on interlocking directorates to lessen conflicts of interest and concentration of power inside the banking industry.
It is important to remember the long-term impact of the Glass-Steagall Act on the banking sector. While the Act promoted balance, it also faced criticisms for limiting banks' potential to innovate and compete in the dynamic financial landscape.
Note
Some argue that the Act's regulations hindered the growth of American banks, potentially impacting their profitability and capability to evolve to marketplace situations. However, concrete economic data addressing those issues are only sometimes available.
Effects of the Glass Steagall Act
The Glass-Steagall Act of 1933 profoundly affected banking enterprises and the financial industry, shaping the landscape of American finance for decades to come.
The Act's provisions, aimed at promoting stability, protecting depositors, and mitigating risks, affected various aspects of the financial sector.
One of the sweet spot outcomes of the Glass-Steagall Act was the separation of commercial and investment banking activities.
Historically focused on traditional lending and deposit-taking, commercial banks were no longer allowed to engage in excessive-risk securities underwriting and trading.
This separation aimed to protect depositors' funds from the volatility and potential losses associated with investment banking activities. As a result, commercial banks became extra focused on taking deposits and providing loans, leading to different conservative banking surroundings.
Establishing the Federal Deposit Insurance Corporation (FDIC) was another significant impact of the Glass-Steagall Act. The FDIC supplied deposit insurance, ensuring the protection of depositors' money in case of financial institution disasters.
This measure restored public confidence in the banking industry and decreased the chance of bank runs. As a result, individuals felt reassured that their financial savings were safe.
The Glass-Steagall Act additionally had effects on the shape of the banking enterprise. The Act prohibited interlocking directorates, limiting individuals from simultaneously serving as directors in each commercial and investment bank.
This provision aimed to prevent conflicts of interest and concentration of power inside the banking industry.
By preventing individuals from simultaneously holding positions of influence that affect multiple sorts of financial establishments, the Act sought to promote transparency and prevent abuses of power.
Note
It's important to note that the Glass-Steagall Act faced criticism and eventual repeal in 1999 with the passage of the Gramm-Leach-Bliley Act.
The impact of the Glass-Steagall Act extended past the on-the-spot outcomes of commercial and investment banking. The Act's regulatory framework and emphasis on stability stimulated subsequent monetary legislation and regulations.
The Act laid the muse for future economic reforms, including establishing the Securities and Exchange Commission (SEC) in 1934 and implementing stricter regulatory measures in the post-2008 financial recession.
Critics argued that the Act's restrictions confined the competitiveness and innovation of American banks mainly to a much less versatile and globally competitive financial space.
The repeal allowed for the consolidation of financial services, which led to the introduction of conglomerate financial institutions that combined commercial and investment banking activities.
The 1999 Repeal and the Gramm-Leach-Bliley Act
The GSA was repealed partially, and the Gramm-Leach-Bliley Act of 1999 was passed, marking a massive turnaround in U.S. financial regulation.
This legislative exchange allowed for the consolidation of financial services and the merging of commercial and investment banks, ultimately contributing to the financial crisis 2008.
The repeal also sparked a renewed debate regarding the relevance and effectiveness of the Glass-Steagall Act.
The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act, effectively repealed key provisions of the Glass-Steagall Act.
This Act removed the separation between commercial and investment banks; now, they could deal with each other and transact business. As a result, commercial banks can take up risky ventures such as underwriting securities, trading, etc.
Repeal supporters believed it would promote higher innovation and a stronger financial system with greater bank power.
However, the financial crisis of 2008 uncovered flaws in the deregulated financial panorama the repeal had created.
The disaster, characterized by the fall of most important financial institutions and the following financial downturn, highlighted the risks associated with banks conducting complicated and excessive-risk activities.
Note
This Act allowed commercial banks to operate in the insurance sector.
The interconnectedness of those institutions and the exposure to unstable mortgage-backed securities contributed to the quick revelation of financial misery.
In the aftermath of the crisis, the relevance of the Glass-Steagall Act has returned to consideration and focus. Critics argue that the repeal had eliminated critical safeguards and contributed to the excessive risk-taking and speculative conduct within the banking space.
The absence of a separation between commercial and investment banking allowed for mingling traditional banking activities with high-stakes speculative sports, amplifying the systemic risks.
The debate surrounding Glass-Steagall's relevance has intensified, with calls for its reinstatement or the implementation of comparable measures to prevent future crises.
The GSA supporters think separating commercial and investment banks would help promote higher financial stability and affect the depositors.
However, warring parties of a full reinstatement of Glass-Steagall contend that the financial landscape has developed since the Act's enactment, with new strategies for regulation being needed.
They argue that a more comprehensive regulatory framework, focusing on threat control, capital necessities, and enhanced supervision, can be more powerful in ensuring the financial space's stability and integrity.
or Want to Sign up with your social account?