The Glass–Steagall Act was a part of the 1933 Banking Act. It placed restrictions on activities that commercial banks and investment banks (or other securities firms) could do. It effectively separated those activities, so the two types of business could not mix, in order to protect consumer's money from speculative use. The Banking Act of 1935 clarified and otherwise amended Glass–Steagall.
Over time, private firms and their regulators found novel ways to weaken the barriers envisioned in the legislation. Eventually, the protections became very weak.
From its start, there were many economists, businessmen, and politicians who did not find the restrictions to be productive, and wished to do away with them altogether. It took about 66 years, but the legislation was eventually completely repealed. Subsequent financial crises have resulted in attempts to revive the legislation, and even make it stronger than originally envisioned.
Glass–Steagall developments from 1935 to 1991 Commercial banks withdrew from the depressed securities markets of the early 1930s even before the Glass–Steagall prohibitions on securities underwriting and dealing became effective.Garten 1989, pp. 515-516. Hendrickson 2001, p. 860. Peach 1941, p. 160. However, those prohibitions were controversial. A 1934 study of commercial bank affiliate underwriting of securities in the 1920s found such underwriting was not better than the underwriting by firms that were not affiliated with banks. That study disputed Glass–Steagall critics who suggested securities markets had been harmed by prohibiting commercial bank involvement. A 1942 study also found that commercial bank affiliate underwriting was not better (or worse) than nonbank affiliate underwriting, but concluded this meant it was a "myth" commercial bank securities affiliates had taken advantage of bank customers to sell "worthless securities."
Senator Glass's "repeal" effort In 1935, Senator Glass attempted to repeal the Glass–Steagall prohibition on commercial banks underwriting corporate securities. Glass stated Glass–Steagall had unduly damaged securities markets by prohibiting commercial bank underwriting of corporate securities.. Wilmarth 2008, p. 590. The first Senate passed version of the Banking Act of 1935 included Glass's revision to Section 16 of the Glass–Steagall Act to permit bank underwriting of corporate securities subject to limitations and regulations.Burns 1974, pp. 170-171. Patrick 1993, pp. 265-266. Wilmarth 2008, pp. 590-591.
President Roosevelt opposed this revision to Section 16 and wrote Glass that "the old abuses would come back if underwriting were restored in any shape, manner, or form." In the conference committee that reconciled differences between the House and Senate passed versions of the Banking Act of 1935, Glass's language amending Section 16 was removed.Burns 1974, pp. 170-171. Perkins 1971, p. 269.
Comptroller Saxon's Glass–Steagall interpretations President John F. Kennedy's appointee as Comptroller of the Currency, James J. Saxon, was the next public official to seriously challenge Glass–Steagall's prohibitions. As the regulator of national banks, Saxon was concerned with the competitive position of commercial banks. In 1950 commercial banks held 52% of the assets of US financial institutions. By 1960 that share had declined to 38%. Saxon wanted to expand the powers of national banks.White 1992, p. 7.
In 1963, the Saxon-led Office of the Comptroller of the Currency (OCC) issued a regulation permitting national banks to offer retail customers "commingled accounts" holding common stocks and other securities.Pitt and Williams 1983, p. 142. Investment Company Institute v. Camp, 401 U.S. 617, pp. 621-622 (for OCC actions) (1971). Retrieved February 18, 2012. This amounted to permitting banks to offer mutual funds to retail customers.Langevoort 1987, pp. 688-690. . Saxon also issued rulings that national banks could underwrite municipal revenue bonds.. White 1992, p. 13. Courts ruled that both of these actions violated Glass–Steagall.White 1992, pp. 13 and 15. Reinicke 1995, p. 31.
In rejecting bank sales of accounts that functioned like mutual funds, the Supreme Court explained in Investment Company Institute v. Camp that it would have given "deference" to the OCC's judgment if the OCC had explained how such sales could avoid the conflicts of interest and other "subtle hazards" Glass–Steagall sought to prevent and that could arise when a bank offered a securities product to its retail customers.. Courts later applied this aspect of the Camp ruling to uphold interpretations of Glass–Steagall by federal banking regulators. As in the Camp case, these interpretations by bank regulators were routinely challenged by the mutual fund industry through the Investment Company Institute or the securities industry through the Securities Industry Association as they sought to prevent competition from commercial banks.Macey 2000, p. 717. Reinicke 1995, p. 31
1966 to 1980 developments
Increasing competitive pressures for commercial banks Regulation Q limits on interest rates for time deposits at commercial banks, authorized by the 1933 Banking Act, first became "effective" in 1966 when market interest rates exceeded those limits.. This produced the first of several "credit crunches" during the late 1960s and throughout the 1970s as depositors withdrew funds from banks to reinvest at higher market interest rates.Minsky 1982, pp. xii-xiv. When this "disintermediation" limited the ability of banks to meet the borrowing requests of all their corporate customers, some commercial banks helped their "best customers" establish programs to borrow directly from the "capital markets" by issuing commercial paper.. Over time, commercial banks were increasingly left with lower credit quality, or more speculative, corporate borrowers that could not borrow directly from the "capital markets."Garten 1989, pp. 522-524. Wilmarth 1990, pp. 1147-1148.
Eventually, even lower credit quality corporations and (indirectly through "securitization") consumers were able to borrow from the capital markets as improvements in communication and information technology allowed investors to evaluate and invest in a broader range of borrowers.Wilmarth 1990, pp. 1142-1143. Banks began to finance residential mortgages through securitization in the late 1970s. During the 1980s banks and other lenders used securitizations to provide "capital markets" funding for a wide range of assets that previously had been financed by bank loans.. . In losing "their preeminent status as expert intermediaries for the collection, processing, and analysis of information relating to extensions of credit", banks were increasingly "bypassed" as traditional "depositors" invested in securities that replaced bank loans.Wilmarth 1990, pp. 1142-1144.
In 1977 Merrill Lynch introduced a "cash management account" that allowed brokerage customers to write checks on funds held in a money market account or drawn from a "line of credit" Merrill provided.Mayer 1984, pp. 34-45. The Securities and Exchange Commission (SEC) had ruled that money market funds could "redeem" investor shares at a $1 stable "net asset value" despite daily fluctuations in the value of the securities held by the funds. This allowed money market funds to develop into "near money" as "investors" wrote checks ("redemption orders") on these accounts much as "depositors" wrote checks on traditional checking accounts provided by commercial banks..
Also in the 1970s savings and loans, which were not restricted by Glass–Steagall other than Section 21, were permitted to offer "negotiable order of withdrawal accounts" (NOW accounts). As with money market accounts, these accounts functioned much like checking accounts in permitting a depositor to order payments from a "savings account.". Litan 1987, p. 34. .
Helen Garten concluded that the "traditional regulation" of commercial banks established by the 1933 Banking Act, including Glass–Steagall, failed when nonbanking firms and the "capital markets" were able to provide replacements for bank loans and deposits, thereby reducing the profitability of commercial banking.Garten 1989, pp. 508-509 and 521-525. Garten 1991, pp. 8-14. Richard Vietor agreed that traditional bank regulation was unable to protect commercial banks from nonbank competition. However, he noted that significant the economic and financial instability began in the mid-1960s. This slowed economic growth and savings, which reduced demand and supply of credit; it also induced financial innovations that undermined commercial banks.Vietor 1987, pp. 33-39.
Hyman Minsky agreed financial instability had returned in 1966 and had only been constrained in the following 15 years through Federal Reserve Board engineered "credit crunches" to combat inflation followed by "lender of last resort" rescues of asset prices that produced new inflation. Minsky described ever worsening periods of inflation followed by unemployment as the cycle of rescues followed by credit crunches was repeated. Minsky, however, supported traditional banking regulationMayer 1974, pp. 523 and 531-535. and advocated further controls of finance to "promote smaller and simpler organizations weighted more toward direct financing."Minsky 1982, p. 201 Writing from a similar "neo-Keynesian perspective," Jan Kregel concluded that, after World War II, non-regulated financial companies, supported by regulatory actions, developed means to provide bank products ("liquidity and lending accommodation") more cheaply than commercial banks through the "capital markets.", p. 66 (Section 3.10 "The regulatory dynamic of innovation and protection"). Kregel argued this led banking regulators to eliminate Glass–Steagall restrictions to permit banks to "duplicate these structures" using the capital markets "until there was virtually no difference in the activities of FDIC-insured commercial banks and investment banks.".
Comptroller Saxon had feared for the competitive viability of commercial banks in the early 1960s. The "capital markets" developments in the 1970s increased the vulnerability of commercial banks to nonbank competitors. As described below, this competition would increase in the 1980s.
Limited congressional and regulatory developments In 1967, the Senate passed the first of several Senate passed bills that would have revised Glass–Steagall Section 16 to permit banks to underwrite municipal revenue bonds.. Reinicke 1995, p. 59. In 1974 the OCC authorized national banks to provide "automatic investment services," which permitted bank customers to authorize regular withdrawals from a deposit account to purchase identified securities.. . In 1977 the Federal Reserve Board staff concluded Glass–Steagall permitted banks to privately place commercial paper. In 1978 Bankers Trust began making such placements.Pitt and Williams 1983, pp. 154-155. As described below, in 1978, the OCC authorized a national bank to privately place securities issued to sell residential mortgages in a securitization