The Glass-Steagall Act: What You Need to Know

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Summary: The Glass-Steagall Act was mentioned several times during last night’s Democratic debates. In case you’re rusty on the now-repealed banking law, we’ve got your primer here.

If you watched the Democratic debate last night, you probably noticed the candidates discuss the Glass-Steagall Act. According to The New York Times, the Act, which was passed by Franklin Delano Roosevelt in 1933 and repealed 16 years ago, was mentioned a total of eight times. Although you likely deduced that this legislation involved banks, you may be wondering what it’s all about—and why Bernie Sanders and Martin O’Malley want to reinstate it.

  

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The so-called Glass-Steagall Act was enacted in the aftermath of the 1929 stock market crash, when banks were failing left and right. The Act refers to four provisions from the Banking Act of 1933. To reduce the risk of another crash, these provisions divided investment and commercial bank activities, banning deposit-taking institutions from dealing in securities for their own profit and preventing securities-dealing firms from taking deposits.

According to experts at the time, “improper banking activity” is what caused the Great Depression in the first place. Many felt the banks were being too risky with their customers’ money. Questionable loans were given to companies the banks had invested in. In turn, customers were urged to invest in these companies.

Banks have around $65 billion in outstanding legal costs from the 2008 Recession.

The law also limited the amount of a bank’s income that could be derived from securities to 10%, though banks were still allowed to underwrite government-issued bonds. In addition to creating a divide between commercial and investment bank activities, Glass-Steagall set up monitoring functions and controls for both groups. Banks had one year to decide whether they would primarily be an investment bank or a commercial one.

A little over twenty years later, in 1956, Congress added more regulations to the banking sector. The Bank Holding Company Act provided additional separations by creating a schism between insurance and banking. Though banks could still sell insurance and insurance products, they could not actually underwrite the insurance itself.

The next round of suits against banks is expected to begin in London.

As time went on and the economy grew stronger, many questioned whether Glass-Steagall was stifling competition and slowing the development of financial services firms. Many wondered how much restriction was appropriate, and argued that allowing banks to diversify their investments in moderation would actually help them reduce risk.

In 1999, Congress repealed the Glass-Steagall Act and replaced it with the Gramm-Leach-Bliley Act, eliminating the divide between investment and commercial banks. The Gramm-Leach-Bliley Act allows banks to provide an array of services, including underwriting and dealing activities.

Deutsche Bank is paying for its role in the recent financial crisis.

While no one is sure whether the repeal of the Glass-Steagall Act contributed to the Recession of 2008, or to what extent, many financial experts believe it was a huge factor in the downturn. The repeal of Glass-Steagall ultimately allowed financial institutions to leverage their federally guaranteed deposits, which set off a culture of more and more risk-taking. It didn’t help that Wall Street bonuses were (and continue to be) solely tied to maximizing profits. Soon bankers were playing with our money around the clock, engaging in swaps, trades, and loan sales in nearly every time zone.

To make matters worse, banks weren’t required to keep enough assets on hand to protect against speculative investments going belly up. Meanwhile, financial institutions were issuing mortgages to high-risk bowers and selling the loans right away, so they wouldn’t be caught holding the bad assets when the music stopped. Ultimately the same lending and securitization schemes that were dangerous for commercial banks were lining the pockets of investment bankers.

SunTrust agrees to $1 billion settlement for mortgage loan abuses. 

Some detractors argue that the repeal of Glass-Steagall did not contribute to the Recession, and that things might have worse if the law had still been on the books. According to one Morningstar columnist, Scott Cooley, if Glass-Steagall had been in effect, Goldman Sachs and Morgan Stanley might have failed. According to this columnist, if institutions like Goldman and Morgan believed their banks could really fail, they would be more likely to engage in high-risk behaviors, which could ultimately damage the health of our economy.

Family net worth fell 40% during the Recession.

This May, Fortune’s Stephen Gandel reported on a survey by law firm Labaton Sucharow and the University of Notre Dame, saying, “About a third of Wall Streeter’s higher paid employees say they have witnessed or know of illegal activity at their firms. One in five of the survey’s respondents said they believed a little bending of the rules, either ethical or legal, was necessary to be successful on Wall Street.”

In the end boards of directors are responsible for setting the risk appetite of their banks. According to Fortune, since the Recession of 2008, boards at banks with both depository and investment banking arms have had the chance to show us they can effectively manage this tricky balance, “and they have failed to do that.” Fortune continues, “the largest U.S. Banks have treated us to a continual stream of operations failures and manipulations du jour.”

Settlement reached with some banks for Forex manipulation.

In July 2013 an unlikely set of senators, including Democrat Elizabeth Warren and Republican John McCain, proposed “The 21^st-Century Glass-Steagall Act.” The proposal would have brought back the Depression-era regulations that drove a wall in between commercial and investment banks, along with some new provisions for the modern age. Most of the supporters of the bill were from the progressive left and the populist right. To no one’s shock, most of the opposition came from the financial industry.

Now that the presidential race is heating up, Martin O’Malley and Bernie Sanders have expressed their intent to break up the country’s biggest banks and restore the Glass-Steagall Act. Apparently they fall into the camp of people who believe that reinstating the law would keep banks from gambling with our deposits and decrease our chances of another collapse. In last night’s debates, Bernie added, “The three largest banks in America are much bigger than they were when we bailed them out for being too big to fail; we have got to break them up.”

Meanwhile Hillary Clinton remains in the camp of people who want to keep things as they are. She doesn’t believe Glass-Steagall would bring stability to our financial systems, and opposes reinstating the law. Many Democrats are criticizing her stance. They says she’s pandering to her wealthy donors and that she doesn’t want to overturn her husband, who was President when the Act was repealed.

According to Bloomberg View, “Whatever Clinton’s motivations are, she’s got the policy right: Glass-Steagall would not have prevented the 2008 financial crisis, and bringing it back may give false hope that the next one can be prevented.”

Here’s guessing we’ll be hearing the term “Glass-Steagall” a lot between now and next November.

 

Sources: Investopedia, Fortune, US News, Bloomberg View, Morningstar

Photo credit: Daily Surge