With “reinstatement” of the Glass-Steagall Act back in the news, it’s useful to untangle (yet one more time) the web of confusion and misinformation that surrounds the Glass-Stegall Act and the suggestions by some that we return to 20th century industrial policy through the wholesale separation of commercial banking and investment banking.
Contrary to popular misconception, Glass-Steagall was not “repealed” in 1999; its core protections remain in place, and deposits do not fund securities activities.
The Banking Act of 1933 (also known as the Glass-Steagall Act), among other things, created a strict (but not absolute) barrier between traditional banking and securities underwriting and dealing. It did so through four key provisions. First, sections 16 and 21, which prohibited a depository institution from engaging in securities underwriting and dealing activities and a securities firm from accepting deposits. These sections effectively separated the risk of securities activities, like underwriting or trading in stock and bonds, from the deposits that banks take and the FDIC insurance that backs them – the heart of the issue being debated today. The other two sections at issue, 20 and 32, prohibited a depository institution from merely affiliating with a firm engaged in securities activities.
Although many typically characterize the Gramm-Leach-Bliley Act of 1999 as having “repealed” Glass-Stegall, that’s not actually the case. Sections 20 and 32 were repealed, with the result that companies engaged in commercial and investment banking were thereafter allowed to affiliate. But sections 16 and 21 were not. It remains the law of the land that FDIC-insured banks can’t engage in investment banking, and securities firms can’t take deposits. The result of this enduring restriction is that neither deposits (nor the FDIC as their insurer) are subject to the risks posed by securities activities. Any such activities must be conducted in a legally separate broker-dealer, with sections 23A and 23B of the Federal Reserve Act serving as a robust firewall through strict limitations on transactions between a bank and its affiliates.
Affiliations between commercial banks and securities firms after 1999 did not cause the financial crisis – though they may well have helped to stabilize it.
Another common assertion is that repeal of the prohibition on affiliations between commercial banks and securities firms in 1999 somehow caused or contributed to the financial crisis. But the evidence suggests the opposite – it was rather the monoline commercial banks (Countrywide, Washington Mutual, etc.), monoline investment banks (Bear Stearns, Lehman Brothers, Merrill Lynch, etc.) or nonbanks (AIG) that fared the worst in the recent financial crisis. And indeed, it is worth remembering that one of the principal steps the Federal Reserve took to stabilize the industry in 2008 was to aggressively encourage further affiliations between commercial and investment banks, including (i) the acquisition by banks of large securities firms – Bear Stearns, Lehman Brothers, and Merrill Lynch, and (ii) the shift of the remaining standalone investment banks (Goldman Sachs and Morgan Stanley) into the prudential bank regulatory framework. All of these stabilizing affiliations would have been prohibited had sections 20 and 32 of Glass-Steagall remained in effect. And none of these acquisitions subjected deposits (or the FDIC as insurer) to the risks posed by investment banking, as sections 16 and 21 of Glass-Stegall still prohibits depository institutions from engaging in those activities.
Affiliations between commercial banks and securities firms don’t heighten risk – they diversify it.
Another common Glass-Stegall canard is that affiliations between banks and securities firms are inherently risky and undermine the safety and soundness of the institution. First, as noted above, sections 23A and 23B of the Federal Reserve Act effectively ring-fence insured depository institutions from the risks of their securities and other affiliates. More generally, this assertion flunks basic economics – having a broader range of revenue sources and risk exposures promotes risk diversification and enhances the financial stability of the firm. And for numerous real world examples of that principle in action, one need look no further (again) than the relative performance of undiversified, monoline investment banks and commercial banks in the 2008 crisis. If anything, the experience of the crisis demonstrates that a mistake of Gramm-Leach-Bliley may have been not requiring investment banks to affiliate with commercial banks, rather than merely allowing them to do so.
“Reinstating” Glass-Steagall’s prohibition on affiliations between banking and securities activities would radically restructure an entire sector of the U.S. economy.
It is no accident that those advocating for a full return to Glass-Steagall’s prohibitions spend little to no attention on the particulars of implementation. That’s because restoring the prohibition on affiliations between banks and securities firms would dramatically reshape the existing banking industry. For example, and not acknowledged by proponents, a reinstatement of Glass-Steagall’s prohibitions would entail the radical restructuring of the U.S. banking landscape, breaking apart, downsizing or otherwise restructuring not just a few large banks, but rather over sixty financial holding companies that currently engage in both commercial banking and securities activities. Proponents of “reinstatement” also fail to acknowledge that dismantling and restructuring the U.S. banking industry in this way would have very real and negative consequences, including the elimination of large economies of scale and scope, substantial costs and disruptions to bank customers who would be forced to discontinue long-standing relationships with existing financial institutions and establish new relationships with multiple financial institutions, and the pronounced economic headwinds that would accompany the long period of uncertainty that would prevail as the industry restructured. Not to mention the competitive advantage that would accrue to non-U.S. banks, whose jurisdictions continue to maintain a fully integrated, universal bank model.
Federal Reserve Gov. Daniel Tarullo has aptly described the substantial costs of reinstating Glass-Steagall:
The reinstatement of Glass-Steagall would mean that bank clients could no longer retain one financial firm that would have the capacity to offer the whole range of financing options–from lines of credit to public equity offerings – depending on a client’s needs and market conditions. Moreover, many banks that are far too small ever to be considered TBTF do provide some capital market services to their clients – often smaller businesses – a convenience and possible cost savings that would be lost under Glass-Steagall prohibitions. With the present state of research, it is virtually impossible to quantify the social benefits of these economies. However, what seems the likelihood of nontrivial benefits from current affiliations is a good reason to be cautious about adopting this proposal.
Disclaimer: The views expressed in this post are those of the authors and do not necessarily reflect the position of The Clearing House or its membership.