Glass-Steagall 2.0

During his presidential campaign in 2016, US President Donald Trump voiced support for the promulgation of a 21st century version of a Depression-era law known as the Glass-Steagall Act, which would once again see the separation of commercial and investment banking. The original Act – passed in 1933, shortly after the stock market Crash of 1929 – was effectively repealed by the passing of the Gramm-Leach-Bliley Act (GLBA) of 1999 by former President Bill Clinton, who agreed with those who argued that the legislation was outdated and hindering the competitiveness of US banks in the global market.

Trump’s position on the Glass-Steagall Act amplified the voices of many – both Republican and Democrat – who had been calling for its reinstatement in some form since the 2008 financial crisis, with a set of proposals circulating amongst lawmakers that has informally become known as Glass-Steagall 2.0. However, in May 2018 Trump instead seemed to move in the opposite direction on the issue of bank regulation by reducing banking legislature in the US. This was achieved through a significant rollback of the banking rules enshrined in the Dodd-Frank Act of 2010, which was devised by the Obama administration to redress the devastating effects of the financial crisis and safeguard the banking system against another collapse. For almost a century the debates surrounding banking regulation have waged on, and it seems that this battle over whether banking should be allowed all the freedoms implied by the free market is not losing any momentum.

During the Great Depression, one in four Americans lost their life savings when more than 10 000 banks shut down. These banks had been using depositors’ money to pursue high-risk investments, and when the stock market crashed in 1929 the consequences were widespread and devastating. US Senator Carter Glass argued that the roots of the US’s economic collapse could be found in the rash actions of the financial industry and called for greater regulation – a move that was supported by many, including fellow Democrat Henry Steagall. Together, the two men sponsored a piece of legislation that advocated the separation of commercial and investment banking to protect depositors from the business of securities sales and trading. The provisions covered by the Glass- Steagall Act – which was signed into law by President Franklin D. Roosevelt as part of the Banking Act of 1933 – prohibited investment firms from taking deposits and prevented commercial banks from dealing in nongovernmental securities for customers. Crucially, it also counteracted the conflicts of interest that arose when banks used deposits to underwrite securities and then sell them to their own customers. In fact, it had been this very activity – in which banks provided leverage to their customers – that had led to the stock market bubble and the Crash of 1929.

The Glass-Steagall Act also prevented investment firms from investing in non-investment grade securities for themselves; underwriting or distributing nongovernmental securities; and affiliating with companies involved in these activities. The Act was essentially implemented to insulate commercial banks from the risks associated with financial speculation and to guard against their collapse. However, during the 1970s, banks began to object strongly to the Glass-Steagall Act on the grounds that it was making them uncompetitive in international markets. If commercial banks could also participate in investment activities, they argued, they could improve the return for their banking customers, especially their depositors, whilst reducing risk by diversifying their products. The argument was based on the theory that people tend to put money into investments when the economy is doing well, but into savings accounts when the economy takes a dip. By having the freedom to involve themselves in both investments and savings, banks could ensure that their businesses remained intact during both good and bad economic periods. It was the most idealistic argument that could be expected of free market thinking, and the idea quickly took hold.

During the 1980s and 1990s, banks increasingly started to look for loopholes in the Glass-Steagall Act that could be exploited to essentially allow them to once again join commercial and investment banking. This endeavour was aided by the fact that the US Federal Reserve – then chaired by Alan Greenspan – was strongly in favour of expanding banking powers, leading the Fed to favour broad interpretations of the Act. Most famously, in 1998, leading banking firm Citicorp merged with Travelers Insurance – which had previously taken over investment banks Salomon Brothers and Smith Barney – producing the diversified financial services conglomerate Citigroup. The Fed granted a temporary waiver to allow the merger to take place, with all parties involved certain that the Glass-Steagall Act would be repealed before the standard two-year review period for proposed mergers was up.

And, indeed, they were proven right when in 1999 the Glass-Steagall Act was effectively repealed by the passing of the GLBA. By this point, the reality was that commercial banks were already increasingly engaging in activities associated with investment banking and so to many, the passing of the GLBA was little more than a formality. To others, however, it represented a watershed moment, where government had failed to safeguard the economy from another crisis. The Act was approved by Senate with a vote of 90 to 8 and in the House of Congress by 362 to 57, and subsequently signed into law by President Bill Clinton. Named after its sponsors, Senator Phil Gramm, and representatives Jim Leach and Thomas Bliley, the GLBA removed the market barriers that the Glass-Steagall Act had instituted, effectively enabling a single holding company to own both investment firms and commercial banks and to have directors from both entities on its board. The new Act also allowed investment banks to take deposits, to sell directly to retail customers, and to package and sell mortgage-backed securities.

Spearheading the implementation of the GLBA was renowned economist and then Treasury Secretary Larry Summers, who claimed that the Act showed that the US was ready to move on from outdated laws and embrace “a system for the 21st century”. Summers was also central in driving the Commodity Futures Modernisation Act, passed in 2000, which essentially deregulated the over-the-counter (OTC) derivatives market, whilst simultaneously ensuring that OTC contracts themselves were legally enforceable. Investment banks had managed to manoeuvre themselves into a position where they were free to go about their business unchecked, but where they had the full backing of the law should their counterparties fail to hold up their side of the deal. The Commodity Futures Modernisation Act essentially gave investment banks access to all the legal apparatus that is synonymous with trading through an exchange as far as it pertains to claims against defaulting counterparties, whilst also maintaining the opacity of OTC derivatives trading.

However, the decision to repeal the Glass-Steagall Act also resulted in vehement criticism from many parties, who warned that the deregulation of the financial system would prove disastrous, producing the same conflicts of interest that had caused the stock market Crash of 1929, which had precipitated the Great Depression. In response to the passing of the GLBA in 1999, Senator Byron L. Dorgan stated, with enormous prescience, in the New York Times: “I think we will look back in 10 years’ time and say we should not have done this, but we did because we forgot the lessons of the past, and that that which is true in the 1930s is true in 2010.” The prophecy of his words would prove uncanny, given the financial crisis that ensued nine years later.

Almost 20 years after the GLBA was passed, the contention surrounding the repeal of the Glass-Steagall Act has only grown more intense, as politicians and economists debate the role that it played in the 2008 financial crisis. Many remain steadfast in their belief that the repeal of Glass-Steagall had almost no bearing on the crisis. These commentators have pointed out that integrated banks, such as Citigroup, Bank of America and J.P. Morgan Chase were not the ones that were hardest hit during the financial crisis, as they were protected because of their diversification. Rather it was Lehman Brothers, Bear Sterns and Morgan Stanley – classic examples of investment banks – which suffered the most. Former President Bill Clinton further pointed out that the GLBA had helped to stabilise the financial landscape after the crisis, by enabling banks to purchase failing investment firms – such as Bank of America’s purchase of Merrill Lynch and J.P. Morgan’s acquisition of Bear Sterns.

However, others – such as Nobel Prize-winning economist Joseph Stiglitz – argue that the repeal was a major cause of the crisis, as it introduced an untenable amount of risk into the financial system. Stiglitz highlights that the high-leverage, big risk-taking ethos of investment banks had overshadowed the conservative approach that commercial banks are entrusted to take in managing other peoples’ money. He stressed that investment banks were accustomed to managing rich people’s money – “people who can take bigger risks in order to get bigger returns” – and had failed to consider the dire consequences that such high-risk endeavours could have for the average citizen, who depends on more modest savings to survive.

Others highlighted that mergers had also endowed banks with more capital to invest, some of which ended up in the subprime mortgage market. Commercial banks thus played a key role in growing the derivatives market, through the buying and selling of mortgage-backed securities and credit-default swaps. Had Glass- Steagall still been in place, the banks would have been excluded from most of these activities, shrinking the size of the risk that ultimately derailed the system. The repeal of the Glass-Steagall Act had, moreover, represented a key move in a general pattern of deregulation, and had increased the number of very large institutions that were simply “too big to fail.”

Former President Barack Obama noted during his 2008 campaign that the GLBA “was more about facilitating mergers than creating an efficient regulatory framework,” adding that this approach had encouraged “a winner takes all, anything goes environment that helped foster devastating dislocations in [the US] economy.” However, Obama’s proposal for overhauling the financial regulatory system – devised under the guidance of, among others, Larry Summers who served as a senior economic advisor to the president – included no mention of separating commercial and investment banking activities.

Many, including Treasury Secretary Steven Mnuchin, Senator Elizabeth Warren, Senator Bernie Sanders and the late Senator John McCain, believe this to have been a mistake, calling for the spirit of Glass-Steagall to be reconstituted in a modernised version of the law that will not only separate commercial and investment banking, but also reduce the size of institutions that have been deemed “too big to fail.” In addition, separating commercial and investment banks would ensure that in the event of a crisis, the governmental safety net is extended only to traditional banks. Investment banks would be free to continue to take high-risk positions, but if they lose, it will not be the taxpayer’s responsibility to bail them out. Rather than simply undoing the GLBA, supporters of the 21st century Glass-Steagall Act are thus seeking to establish a new regulatory framework that will structure a financial system that they believe capable of withstanding erosion and able to provide sound protection.

Still, others have dismissed this as a fruitless endeavour, arguing that it was not the repeal of Glass-Steagall that resulted in the 2008 crisis, but rather the rise of shadow banking in the preceding years. They argue that even if Glass-Steagall had still held sway over banking activities in the 2000s, it would have made no difference, as investment banks were not required to adhere to the regulations that governed commercial banks. It was these investment banks that encouraged commercial banks to take their mortgage loans off-balance sheet and into special purpose vehicles, to create securities out of them, which the investment firms would then sell. And to compound the problem further, these securities could be wagered on in the credit default swap market, multiplying the exposure to these assets in the greater financial system. In late 2008, however, any large investment firms that were still left standing – such as Goldman Sachs and Morgan Stanley – won approval from the Fed to become bank holding companies, which enabled them to access funding from the Fed’s Troubled Asset Relief Program, providing reassurance to their investors.

This argument, that the Glass-Steagall Act would have had no bearing on the financial crisis, because the increase in leverage occurred in a shadow banking environment, is problematic and somewhat circuitous. The entire purpose of the Glass-Steagall Act was to separate commercial banking and deposit-taking from investment banking and underwriting. As such, investment banking as it is defined by the spirit of the original Glass-Steagall Act is what is now being called shadow banking. Shadow banking, in fact, only existed because of the murkiness that resulted out of the Gramm-Leach-Bliley Act. The clear and simple definitions of the 1930s would perhaps have been far more useful than the thousands of pages of legislation, often somewhat conflicting in nature, that emerged post-crisis. However, the complex realities surrounding attempts to enforce Glass-Steagall in the 21st century are already playing out in the implementation of the Volcker Rule – Section 619 of the Dodd-Frank Act – which came into effect in 2015. The rule stops banks from engaging in proprietary trading and restricts their ability to own, invest, or sponsor hedge fund and private equity funds, essentially ensuring that bank activities are client-focused and positioned to drive economic growth.

However, at one thousand and eighty pages long, the rule is proving difficult to implement, especially in an industry where many resent the overzealous willingness to regulate business activities. In 2018, the Office of the Comptroller of the Currency, the Federal Reserve, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and Commodity Futures Trading Commission proposed a rewrite of the rule to streamline its stipulations, making it simpler and less costly for banks to implement, but many point out that this will effectively negate the objectives of the rule entirely and introduce more risk into the banking system.

Should commercial and investment banking be separated again by something like Glass-Steagall, major banks such as J.P. Morgan Chase, Bank of America and Citigroup would all face the difficult – and perhaps impossible – task of trying to disentangle the various aspects of their business from one another. If Glass- Steagall 2.0 does not materialise, however, the reality is that these mammoth institutions may only continue to grow, magnifying the concentration risk in the global economy. If certain economic historians are correct, the failure to implement Glass-Steagall 2.0 would ultimately result in something like another Great Depression. 

This article is from the Monocle Quarterly Journal, A Short History of Banking. Visit our "Journals" section to read the full issue.