The Great Depression of 1929 was devastating to the U.S., and millions of Americans lost their jobs. A quarter of the population lost their life savings, and more than 4,000 bank failures happened between 1929 and 1933.
Banks were investing in stocks before the Great Depression because the stock market had risen almost 20% a year since 1922. But when the market crashed in 1929, individuals rushed to take out their savings. Banks couldn’t survive the losses, and as a result, millions lost most or all of their money.
To prevent something tragic like this from happening again, lawmakers passed the Glass-Steagall Act, part of the Banking Act of 1933, meant to separate Wall Street from Main Street and protect individuals’ savings. In 1999, lawmakers repealed part of this act, and in 2007-2008, the U.S. suffered a severe economic crisis. Some economists argued the law could have prevented the recession if it had remained intact.
What Is the Glass-Steagall Act?
The Glass-Steagall Act is part of the 1933 Banking Act that separated investment banking from retail banking or community banks. When the stock market crash of 1929 plunged the nation into the Great Depression, President Herbert Hoover asked Congress to investigate the banking industry.
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Sen. Carter Glass and Rep. Henry B. Steagall sponsored legislation to tighten the financial services industry regulations. The law stated retail banks couldn’t participate in investment banking. On June 16, 1933, President Franklin D. Roosevelt signed it into law as part of the New Deal.
It became permanent in 1945, and the separation meant that investment banks handled mergers and acquisitions and could operate hedge funds and delve into risky investments. But retail banks took deposits, oversaw checking accounts, and made loans for individuals.
Retail banks weren’t allowed to use individuals’ funds for risky investments. Glass-Steagall also forbade bank officers from borrowing heavily from their banks. Only 10% of retail banks’ total income came from securities. Retail banks were allowed to underwrite government-issued bonds.
Purpose of the Glass-Steagall Act
The Glass-Steagall Act was designed to protect individuals from losing their savings due to banks’ risky investments, ultimately preventing another Depression.
The act required banks to steer away from volatile equity markets and let investment banks take on risky investments. Lawmakers believed that by separating the two entities, the financial services industry would be healthier in the long term. It also reduced conflicts of interest.
The act also added tighter banking rules and regulations to the Federal Reserve System to regulate retail banks. It required banks to make annual reports outlining their finances to protect Americans’ savings. The law also created the Federal Open Market Committee, which set interest rates and essential policies for the banks to follow.
Significantly, the act created the Federal Deposit Insurance Corporation (FDIC), the primary goal of which is to monitor banks and supervise financial institutions to ensure they’re sound and protect consumers. The goal was to ensure that thousands of banks didn’t shutter their doors if another financial crisis occurred.
Effect of the Glass-Steagall Act
The most significant impact of the Glass-Steagall Act was to reassure individuals that they could trust banks and begin stockpiling their savings using banks once again. The act helped reassure consumers who’d lost faith in the U.S. financial system.
Economists disagree about whether the act helped assist economic recovery long term or if it hampered banks because they had a laundry list of costly regulations they had to follow.
Some economists argued that the act harmed banks because it prevented economic growth. But others believed it stopped market volatility and helped growth.
Repeal of the Glass-Steagall Act
The Glass-Steagall Act was widely accepted when it became law, but groups began protesting it over the years, especially in the 1990s. Politicians argued the regulations of the Glass-Steagall Act caused overregulation of the banking industry and made it costly for banks to operate.
In 1999, during President Bill Clinton’s tenure, several Glass-Steagall rules were repealed as part of the Gramm-Leach-Bliley Act after years of lobbying. The new law allowed institutions to participate in commercial and investment banking without the separation.
The Gramm-Leach-Bliley Act, also known as the Financial Modernization Act of 1999, was approved on Nov. 12, 1999. This act repealed large sections of the Glass-Steagall Banking Act of 1933. It allowed banks, brokerage houses, and insurance firms to merge. It eliminated restrictions against commercial and investment banks, which some say set up the 2007-2008 financial crisis.
U.S. Sen. Phil Gramm introduced the act in the Senate alongside Rep. Jim Leach in the House. Rep. Thomas J. Bliley Jr. was also associated with the law. The act required the Federal Trade Commission to implement several regulations regarding financial privacy.
This act required companies that offer consumers products like loans and financial advice to explain their privacy practices to consumers and create a security program to protect consumers’ nonpublic personal data, such as Social Security numbers and account details.
The Great Recession of 2007-2008
Less than a decade after the repeal of the Glass-Steagall Act, the U.S. suffered the Great Recession of 2007-2008, also called the subprime mortgage crisis.
One driving factor was national banks offering subprime mortgage loans with balloon payments at adjustable rates to consumers with low credit scores. They caused significant problems when the housing bubble fell, and millions faced foreclosure.
Financial firms took a massive hit with the foreclosures because they shared the risk. When those firms foreclosed on people’s houses, many owed more than the houses were worth. Unemployment rose, and businesses stopped investing, which caused large financial institutions to suffer. Banks such as Lehman Brothers and Bear Stearns failed entirely.
Some economists argued that repealing parts of the Glass-Steagall Act allowed banks and brokerages to become so much larger and created giant national corporations that some consider “too big to fail,” meaning they may benefit from taxpayer bailouts if they experience a crisis.
But economists argued the repeal of the Glass-Steagall Act allowed banks, securities firms, and insurance firms to merge once again, causing problems. Economist and Nobel Prize-winner Joseph Stiglitz wrote publicly that the Glass-Steagall repeal was an indirect cause of the 2007-2008 financial crisis.
But the former chairman of the Federal Reserve, Ben S. Bernanke, said the Glass-Steagall Act wouldn’t have prevented the 2007-2008 crisis because the act didn’t cover the mortgage institutions whose risky loan behaviors contributed to the crisis.
Attempts to Restore the Glass-Steagall Act: The Dodd-Frank Act
Since the 2007-2008 crisis, politicians have argued that more rules are necessary to prevent such havoc from harming investors again. Legislation introduced since the 2007-2008 crisis has been hotly debated.
Sen. Chris Dogg and Rep. Barney Frank introduced The Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Barack Obama signed in 2010.
The act was created after the 2007-2008 crisis and targets all aspects of the financial services industry blamed for that crisis. It requires consumers to understand the terms of a mortgage before signing the dotted line.
The law also prevents mortgage brokers from earning steeper commissions for adding higher fees and interest rates to mortgage loans. It prevents brokers from earning steep commissions and high fees. Lenders were required to use easy-to-understand terms that spelled out interest rates and payment information.
Critics of this law argue that U.S. financial institutions suffered by overspending on regulations and became less competitive than their international counterparts. In 2018, Congress passed another law that rolled back some of these regulations.
There are two facets of the Dodd-Frank Act that are particularly important.
The Consumer Financial Protection Bureau
When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, it included the creation of the Consumer Financial Protection Bureau (CFPB). This government-run organization enforces rules for financial firms. It examines banks and financial firms, monitoring them and tracking consumer complaints.
The organization opened a website in February 2011 to accept suggestions from consumers via social media. Any financial institution with $10 billion in assets falls under the rules and regulations of the CFPB. The entity will scrutinize the financial firm to comply with regulatory rules.
The Volcker Rule
The Volcker Rule is part of the Dodd-Frank Wall Street Reform Act, and it went into effect on April 1, 2014. It was named after Paul Volcker, a former Federal Reserve chairman who wanted to cut U.S. Banks’ speculative trading activities.
The rule aims to help reduce financial risks to individuals and the economy. The rule prevents banks from acquiring or owning hedge funds and private equity funds. The goal is to prevent banks from taking on too much speculative risk.
For example, the rule doesn’t allow banks to use their accounts for the proprietary trading of derivatives, futures, and securities. In August 2018, the Comptroller of the Currency Office voted to tweak this rule to explain what securities trading was allowed and what wasn’t.
On June 25, 2020, the FDIC loosened some of the restrictions, allowing banks to invest in venture capital.
The U.S. Chamber of Commerce criticized the rule, saying no one ever completed a cost-benefit analysis and the costs of the Volker Rule were more expensive than the benefits.
Given the heated debate regarding regulation and deregulation of financial firms among Republicans and Democrats, legislation will likely continue to be highly contested and can change based on which party controls the House of Representatives, U.S. Senate, and the presidency.
During Democrat Obama’s tenure, he worked hard to ensure the financial services industry had to meet more stringent criteria, namely, passing the Dodd-Frank legislation under his tenure. He wanted staunch bank regulators.
But a few years later, during Republican President Donald Trump’s tenure, he helped roll back some of the regulations from the Dodd-Frank Act. His goal, along with the Republicans, has been deregulation.
Currently, Republicans maintain that regulations on banks are cumbersome and hurt the fabric of the economy. But Democrats argue that investors need to be protected and financial institutions need harsh rules and regulations. Otherwise, investors will be victims of financial scams.