The legislation commonly known as Glass-Steagall provided simple, yet effective, regulations to our banking system. It separated commercial banking and investment banking activities and entities. It was that simple. This topic was also discussed in an earlier article in 2012 entitled Strengthen Our Financial System With Effective Regulations. The final repeal of Glass-Steagall occurred in 1999, although regulators had approved specific exceptions to the provisions of the act starting decades before.
Under the Glass-Steagall act, commercial banks were prohibited from engaging in the risky activities of dealing, underwriting, or distribution of non-governmental securities. Securities firms and investment banks could engage fully in those activities. Commercial banks could take deposits, which were insured up to a limit per account by the FDIC. Securities firms and investment banks could not take deposits. Commercial banks could also be members of the Federal Reserve System, which could provide liquidity and stability in emergency situations.
Glass-Steagall created a strong wall between commercial banks, upon which the safety and soundness of the banking system were based, and investment banks, which were free to engage in the more risky, yet more profitable, business of securities. Investors in the two types of entities could decide which risk profile fit their needs best. However, the two types of entities were prohibited from investing in each other, and they could not share employees or executives, including board members. Glass-Steagall completely separated the two major types of financial services entities, and as a regulation, it was highly efficient. There were no excess reporting or examination burdens placed on the organizations. The two types of activities were simply separated. That is significantly different than what we have today.
Why Was Glass-Steagall Repealed?
In my opinion, a major cause of the repeal of the Glass-Stegall act was a build-up of greed in the banking system. It is no secret that investment banks had long coveted the large stable government insured deposit base of commercial banks. The deposit base would allow them to take on higher risk levels, largely eliminate their sensitivity to interest rate changes, provide a large captive market for the distribution of investment products, and reduce their need to fund themselves in the public markets. However, commercial banks were also envious of the high profit margins and high executive compensation associated with investment banks. Executives in commercial banks were paid a fraction of what their counterparts in investment banks were paid, and they desired the ability to engage in more profitable business and to make more money. Even the regulators were greedy. The regulators looked at the large universal banks of Western European countries and Japan, and they wanted US banks to be as large and as complex as those of other countries. In their view, regulating large complex financial organizations enhanced their relative position globally.
What Do We Have Today?
So, there was pressure on Congress from many different stakeholders to completely deregulate the banking system, and that is exactly what happened. There were few cries of caution from any of the major players in the banking system. The new large complex banking organizations that evolved from deregulation indeed did take on new levels of risk unlike anything that had been seen previously. Trading and distribution profits soared, as did executive compensation across the industry. New financial instruments were created to support increased trading volume. Many of these new financial instruments were far removed from any type of real underlying financial transaction, and they proved difficult to quantify from a risk perspective. This is the banking environment that we have today. It is directly responsible for the near financial meltdown that we witnessed in 2008, the deep recession and slow recovery that we are still living through, and the trillions of dollars that US taxpayers had to bear to save our economy.
There have been several attempts to apply new regulations to these new financial organizations. However, the new regulations have focused on increased documentation and reporting. They are extremely costly for organizations that must comply. However, most importantly, they have proven to be totally ineffective. The Glass-Steagall act was simple and effective. We desperately need to re-institute Glass-Steagall. A strong economy depends on being able to rely on a sound and safe banking system. Glass-Steagall provided that assurance for decades before it was repealed. In my opinion, our economy will not recover to full strength until Glass-Steagall, or something like it, is back in place.