Is the Glass-Stegall Act No Longer Relevant?

by Harry Emerick 18. October 2012 09:30
The following is intended to provide a long term perspective to banking in the U.S. as one context for our current economic problems.  A sequel will discuss how we may learn from the lessons of history. After the epidemic of U.S. bank failures during the great depression, the 1933 Banking Act was passed as New Deal legislation to establish economic order and banking reforms that would end the depression and provide a basis for economic recovery and growth.  A key part of this legislation often referred to separately as the Glass-Steagall Act prohibited commercial banks from engaging in investment banking activities.  Under this model commercial banks would accept individual and business deposits and grant loans to that same individual and business community, operating in the retail and wholesale markets and assuming little more than credit and interest rate risk.  Limiting the risk in commercial banks enabled the U.S. government to insure deposits in commercial banks through the Federal Deposit Insurance Corporation adding unprecedented stability and confidence to the U.S. banking system.  Investment banking on the other hand, was and is, a much higher risk banking model with considerable leverage, speculation and risk involved in underwriting and trading securities and derivatives that often have volatile prices.  Internationally and historically, only the U.S. and Canada have forced separation of commercial and investment banking.      With the Glass-Steagall separation in place, the U.S. economy experienced over 60 years of strong and stable growth and prosperity that included: ending the great depression, financing victory in World War II, fostering post war economic expansion in the U.S. as well as in Europe (under the Marshall Plan) and Japan that was unprecedented in the history of the world, putting men on the Moon, ending the Cold War by essentially being able to outspend the former Soviet Union on military development; and making the U.S. economy – at least at one time – the dominant global economy. However, over time there was growing concern about the competitive standing of U.S. banks.  In 1960, six of the ten largest banks in the world were U. S. based.  By 1980 only two U.S. banks were in the top ten, and by 1989, none was in the top twenty five.  International banking was being dominated by the Universal Banking Model, which combines commercial and investment banking into high risk banking behemoths.  It was argued that while Glass-Steagall may have once been justified, its time had come and gone and the distinction between commercial and investment banking had been blurred by world market and banking developments since the 1960’s.  Pressure mounted to do something to make U.S based banks more competitive in the global economy and gradually, piece by piece, the Glass-Steagall separation was eroded.  Finally, in 1999, the Gramm-Leach-Bliley Act was passed formally repealing Glass-Steagall, prompting President Clinton, as he signed the legislation, to declare “The Glass Steagall Act is no longer relevant.”     Was the erosion and ultimate repeal of Glass-Steagall a contributing factor to the current U.S. economic and financial crisis?  Here are some arguments that it was: Securitization (once an investment banking function) of home mortgages (once held exclusively by commercial banking) and the gradual erosion of Glass-Steagall enabled the U.S. housing bubble,  Applying credit swaps (a questionable investment banking innovation) to home mortgages made the widespread sub-prime underwriting and securitization possible, The erosion and repeal of Glass-Steagall has promptly led to super banks in the U.S. following the Universal Banking Model which has been blended with and clearly changed the culture of large commercial banking operations to a much higher risk environment when compared to the Glass-Steagall era, It’s hard to ignore the timing involved---over 60 years of stable economic growth and unprecedented prosperity under Glass-Steagall versus a U.S. financial and economic crisis of a magnitude not seen since the 1930’s following less than 10 years after the ultimate erosion and repeal of Glass-Steagall.   Additionally, there have recently been a number of ex-bankers in the U.S, who have grown and managed Universal banks in the U.S. that have had a change of mind following retirement and now call for breaking up the megabanks that they once built and managed.  These include Sandy Weill, who largely created the current configuration of Citigroup, John Reed and Richard Parsons, former chairmen of Citigroup, and David Komansky a former chief executive of Merrill Lynch. Internationally in June, Mervyn King, the governor of the Bank of England said that he saw “real merit in pursuing the separation of this utility-type (commercial) banking from investment banking.” Can the genie be put back into the bottle? Can we or should we bring back Glass-Steagall? Let us know your comments.
Categories: Advisory