Glass–Steagall legislation
Based on Wikipedia: Glass–Steagall legislation
In 1998, one of the largest mergers in American financial history was already underway—technically illegal under laws that had been on the books for sixty-five years. Citibank, the giant commercial bank, was merging with Salomon Smith Barney, one of Wall Street's most powerful securities firms. The marriage was supposed to be forbidden. And yet it happened anyway, because regulators had spent decades quietly hollowing out the law from the inside.
A year later, President Bill Clinton would sign legislation officially repealing the rules that Citibank had already circumvented. "The Glass–Steagall law is no longer appropriate," Clinton declared. He was stating the obvious. The law was already dead. The funeral was just a formality.
But what was Glass–Steagall, exactly? Why did it exist? And did its demise help cause the 2008 financial crisis that nearly brought down the global economy?
The Wall Between Two Kinds of Banking
To understand Glass–Steagall, you first need to understand that there are fundamentally two different kinds of banking—and they work on completely different principles.
Commercial banking is what most people think of when they hear the word "bank." You deposit your paycheck. The bank lends that money to someone buying a house or starting a business. The bank makes money on the difference between the interest it pays you (very little) and the interest it charges borrowers (much more). It's relatively boring, and that's the point. Your deposits are supposed to be safe.
Investment banking is a different animal entirely. Investment banks help companies raise money by selling stocks and bonds to investors. They underwrite securities—meaning they buy them from the company issuing them and then sell them to the public, pocketing the difference. They trade in markets. They make big bets. When things go well, the profits are enormous. When things go badly, the losses are catastrophic.
Before the Great Depression, many banks did both. The same institution that held your savings account might also be gambling in the stock market with securities affiliates. When the market crashed in 1929 and the banking system collapsed—nearly 10,000 banks failed between 1930 and 1933—Americans demanded that someone do something.
Two Southern Democrats Draw a Line
The "something" came from an unlikely pair of Southern Democrats: Senator Carter Glass of Virginia and Representative Henry Steagall of Alabama.
Glass was the more senior of the two, having already served in the House, the Senate, and as Secretary of the Treasury. He was a banking expert who had helped create the Federal Reserve System in 1913. Steagall was a House veteran of seventeen years who cared deeply about protecting small community banks.
They didn't agree on everything. Glass thought small banks were the weakness of the American banking system—too fragile, too numerous, too prone to failure. Steagall wanted to protect them. Their compromise would shape American finance for the next six decades.
Starting in 1930, Glass introduced bill after bill trying to separate commercial and investment banking. Each version got criticized, revised, debated. Finally, on June 16, 1933, President Franklin Roosevelt signed the Banking Act of 1933 into law. Four provisions of that act—sections 16, 20, 21, and 32—became known as "Glass–Steagall."
The rules were straightforward. Commercial banks that were members of the Federal Reserve System could not:
- Deal in most securities for customers (government bonds were an exception)
- Invest in risky securities for themselves
- Underwrite or distribute non-government securities
- Affiliate with companies that did these things, or even share employees with them
Going the other direction, securities firms and investment banks could not take deposits.
Banks had one year to choose their identity. Would they be boring and safe, taking deposits and making loans? Or would they be exciting and risky, playing in the securities markets? They couldn't be both.
Only 10 percent of a commercial bank's income could come from securities. The wall between the two worlds was supposed to be nearly absolute.
The Pecora Investigation and Public Outrage
The law didn't emerge from abstract policy debates. It was forged in the heat of public outrage, much of it generated by a Senate investigation that exposed Wall Street's darkest practices.
The Pecora Investigation—named after its chief counsel, Ferdinand Pecora—hauled banking executives before Congress and made them explain exactly what they had been doing with ordinary Americans' money. The hearings revealed self-dealing, manipulation, and reckless speculation. The public was furious.
Supporters of Glass–Steagall point to the Pecora Investigation as proof that mixing commercial and investment banking was dangerous. Critics argue the evidence didn't actually support that conclusion—that the problems revealed were about fraud and manipulation, not the structure of banking itself.
But in 1933, with thousands of banks having failed and millions of Americans having lost their savings, the distinction hardly mattered. The public wanted action. Glass–Steagall was action.
The Controversy Over Deposit Insurance
Interestingly, the most controversial part of the 1933 Banking Act wasn't the separation of commercial and investment banking. It was deposit insurance.
The idea of the federal government guaranteeing bank deposits—what would become the Federal Deposit Insurance Corporation, or FDIC—was so contentious that President Roosevelt initially threatened to veto any bill containing it. Roosevelt worried it would encourage reckless behavior by banks, since depositors would no longer have reason to care whether their bank was well-managed.
Steagall championed deposit insurance as protection for small banks and their customers. Glass was skeptical. Eventually, Steagall prevailed, and his addition of deposit insurance—along with shortening the timeline for banks to divest their securities operations from five years to one—was the key compromise that got the bill across the finish line.
Today, deposit insurance seems like an obvious feature of modern banking. At the time, it was radical.
The Slow Erosion Begins
Here's the strange thing about Glass–Steagall: within just two years of its passage, even Senator Glass was trying to weaken it.
In 1935, Glass attempted to allow banks to do a limited amount of corporate debt underwriting—precisely what his own law had forbidden. The amendment failed, but it was an early sign that the separation might not be as permanent as it appeared.
For the next few decades, the law held. But starting in the 1960s, bank regulators began reinterpreting it in ways that slowly expanded what banks could do.
The Office of the Comptroller of the Currency—the regulator for nationally chartered banks—issued increasingly aggressive interpretations. Courts struck down many of these early attempts. But by the late 1970s, regulators had found approaches that survived legal challenge, and banks and their affiliates began engaging in more and more securities activities.
The Loopholes Multiply
Glass–Steagall had gaps from the beginning. It only applied to commercial banks that were members of the Federal Reserve System. Savings and loan associations weren't covered. State-chartered banks that stayed outside the Federal Reserve weren't covered either.
Securities firms quickly figured out they could own savings and loans without violating Glass–Steagall. Starting in the 1960s, they created products and affiliated companies that competed directly with commercial banks for deposits and lending business.
Meanwhile, banks themselves found creative ways around the restrictions. Glass–Steagall distinguished between what a bank could do directly and what an affiliated company could do. A bank couldn't underwrite securities, but it could affiliate with a company that did—as long as that company wasn't "engaged principally" in prohibited activities.
What did "engaged principally" mean? That became the crucial question.
In 1987, the Federal Reserve Board decided it meant a bank holding company could own a securities firm, as long as that firm's prohibited activities weren't its main business. How much was too much? The Fed kept raising the threshold. First 5 percent of revenue. Then 10 percent. Then 25 percent.
By 1998, when Citibank merged with Salomon Smith Barney, the Federal Reserve had interpreted the "loophole" so broadly that one of the world's largest securities firms could be absorbed by a banking company. Glass–Steagall was technically still the law. Practically, it was Swiss cheese.
The Final Repeal
Throughout the 1980s and 1990s, Congress debated whether to formally repeal Glass–Steagall's affiliation restrictions. Bill after bill was introduced, debated, and stalled.
Some observers believe the financial industry's political influence was decisive. Major firms lobbied hard for deregulation, cultivating favorable views in both parties. Others argue the repeal was simply catching up to economic reality—that financial products had evolved so much since 1933 that the old categories of "commercial banking" and "investment banking" no longer made sense.
In 1999, Congress finally passed the Gramm–Leach–Bliley Act, officially known as the Financial Services Modernization Act. It repealed sections 20 and 32 of Glass–Steagall—the provisions that had restricted affiliations between commercial banks and securities firms.
Eight days later, President Clinton signed it into law. The wall that had stood since the Great Depression was officially demolished.
Did Repeal Cause the 2008 Crisis?
When the financial system nearly collapsed in 2008, many people looked for culprits. Glass–Steagall's repeal was an obvious candidate.
The case for blame goes something like this: When you allowed commercial banks and investment banks to merge, you created institutions that were both too big to fail and too complicated to manage. The aggressive, risk-taking culture of Wall Street infected the supposedly conservative world of commercial banking. Banks that had once been cautious started chasing higher returns through riskier investments.
Joseph Stiglitz, the Nobel Prize–winning economist, made exactly this argument. "When repeal of Glass-Steagall brought investment and commercial banks together," he wrote, "the investment-bank culture came out on top." Banks that had been managed conservatively for generations suddenly started acting like hedge funds.
But the counterargument is equally compelling. The institutions at the heart of the 2008 crisis—Lehman Brothers, Bear Stearns, AIG—were not commercial banks that had expanded into investment banking. They were investment banks and insurance companies that had always been outside Glass–Steagall's restrictions.
Ben Bernanke, who was chairman of the Federal Reserve during the crisis, argued that the activities that caused the meltdown—subprime mortgage lending, complex derivatives, excessive leverage—were never prohibited or even regulated by Glass–Steagall.
Another Nobel laureate, Paul Krugman, tried to split the difference. Repealing Glass–Steagall "was indeed a mistake," he wrote, but it wasn't the cause of the crisis. The culprits were elsewhere: inadequate regulation of mortgage lending, failure to oversee the derivatives market, and excessive risk-taking across the financial system.
Lawrence White, a financial economist, put it bluntly: "It was not their investment banking activities, such as underwriting and dealing in securities, that did them in."
The Ghost of Glass–Steagall
After 2008, legislators tried to resurrect Glass–Steagall. Bills were introduced to reinstate the separation of commercial and investment banking. None passed.
Instead, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, which took a different approach. Rather than separating banking activities entirely, Dodd-Frank tried to make them safer through regulation. The Volcker Rule, named after former Federal Reserve Chairman Paul Volcker, prohibited banks from certain kinds of speculative trading—a partial, targeted version of Glass–Steagall's broader separation.
Around the world, other countries have debated similar questions. Should commercial banking be "ringfenced"—separated by a wall within the same institution? Should banks be prohibited from certain activities entirely? The Glass–Steagall principles keep coming back, even if the specific American law doesn't.
The Deeper Question
Behind the debate over Glass–Steagall lies a more fundamental question: What is a bank for?
If banks exist primarily to safeguard deposits and allocate credit to productive uses—helping people buy homes, helping businesses expand—then perhaps they should be boring. Perhaps they should be heavily regulated and restricted from risky activities. Perhaps the wall between banking and speculation should be high and thick.
But if banks are just another kind of financial institution, competing to provide services in a free market, then why should they be limited? Why shouldn't they be allowed to evolve with the economy, offering new products and services as technology and markets change?
Glass–Steagall represented one answer to that question. The Gramm–Leach–Bliley Act represented another. The 2008 financial crisis—and the ongoing debates about how to prevent the next one—suggests we still haven't figured out which answer is right.
Perhaps there is no permanent answer. Perhaps every generation has to redraw the boundaries between safety and innovation, between stability and growth, between protecting depositors and enabling risk-takers. Glass and Steagall drew their line in the rubble of the Great Depression. We're still arguing about where to draw ours.