What is The Glass-Steagall Act?

Many believed that the mixing of retail and investment bankingInvestment BankingInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more was one of the core reasons for the devastating stock market crashStock Market CrashA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst.read more of 1929 and the subsequent great depressionGreat DepressionThe Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939.read more. Following the stock market crash, policymakers restructured banking institutions’ responsibilities towards their clients and reshaped financial history.

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Explanation

The Glass Steagall act tried to regulate the financial sector and imposed regulations on the financial sector. Signed by June 13, 1933, by President Franklin D. Roosevelt, it was the first step towards trust in its banking system.

Key Takeaways

  • The Glass Steagall Banking Act created separation between commercial and investment banks for the first time after the stock market crash of 1929.Commercial banks could loan out money and hold deposits, and investment banks could raise capital and issue securities – but neither could do both.Historic legislation shaped our financial future and decided how modern-day banks operate.Its repeal is largely credited with the Great Recession. Dodd-Frank was enacted in its place but with similar guidelines.

In addition to the separation of investment and commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more, the purpose of Glass-Steagall was to create the FDIC. The Federal Deposit Insurance Corporation or FDIC protected consumer bank deposits

of up to $2,500. This number has increased over time, and FDIC insurance is currently $250,000 per deposit account. One of the main functions of FDIC insurance is to prevent the bank from placing client money into speculative investments. 

The overall “schism” created by the Glass Steagall banking reform act was that bankers could hold deposits and give out loans while investment banks could increase capital and issue loans, but no person at one firm could do both.

Purpose

Banking looked very different before 1933 than it does today. In the early 1900s, the federal government did not insure any money. And there was no separation between risky investment banks and safe community banks like today.

In the lead-up to the crash of ’29, the American economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more was experiencing a period of rapid expansion which fuelled investor confidence. The stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more rose by nearly 20% each year from 1922 to 1929. A soaring economy led to investor “overconfidence,” and people began to buy margin stocks, putting down as little as 10%. They were unbothered by the debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more as the morale was high. People with little to no financial experience could borrow money from their stockbrokersStockbrokersA stockbroker is an individual or company qualified enough to trade securities in the financial markets on behalf of financial institutions, individual and institutional investors, and organizations. They can work either independently as a professional trader or broker-dealer or associate with a brokerage firm.read more for such trades. This sent both sides into a flurry of reckless investing. 

The banks, in turn, invested client money into the stock market while also easing credit lending and borrowing. As a result, the market and people overall were overconfident – and overleveraged. The Federal reserve then raised interest rates, shares fell, and nervous investors withdrew money from banks. But the banks had already re-invested money into falling markets.

This led to a domino effect that left investors, banks, and companies depleted their savings. What followed was the worst economic event in history. The stock market crashed, banks liquidatedLiquidatedLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more, and the worldwide Great Depression followed.  

How Glass Steagall Act came into effect?

The Glass Steagall act of 1933 was driven into realization by Henry Steagall, a former treasury secretary, and Carter Glass, the chairman of the house banking and currency committee. Congress concluded that the banking system needs safer and more effective reforms. The reforms should protect citizens’ assets and prevent random economic failures in the future. The act went through wide debates and discussions before the president signed it in 1933. The act ensured that people no longer put money in risky investments.

Repeal of Glass Steagall Act

On November 12, 1999, President Bill Clinton signed the Financial Services Modernization Act that effectively repealed the Glass-Steagall banking reform act. In the lead-up to the Glass Steagall act repeal, economists and Fed members criticized the restrictions imposed on the banking sector some six decades prior. The main arguments were that if banks could invest their client’s money, they could increase the rate of return for their customers and hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an assetread more risk by diversifying their overall business practices.

History once again repeated itself, though, and the loosening of the financial reins led to the second-worst economic event in history – the Great Recession of 2008. Then, less than ten years after the Glass-Steagall act repeal, the merging of investment banking practices with customer deposits fuelled another financial meltdown. 

Nobel laureate in economics Professor Joseph Stiglitz wrote in 2009 that “when we brought investment and commercial banks together, the investment-bank culture came out on top.” He also said there was a need for great returns that higher risk-taking can bring forth.

What followed was passing the legislation of Dodd-Frank. In many ways, Dodd-Frank was the 2008 version of Glass-Steagall. Once again, the government had to put restrictions on banks that took advantage of regulatory leniency.

This has been a guide to the Glass Steagall Act of 1933 and its definition. Here we discuss the purpose and repeal of the Glass Steagall act with a detailed explanation. You can learn more from the following articles –

The Glass Steagall banking reform act separated investment banking from commercial banking. In addition, it implements many other regulations that ensure that money is no longer put into risky investments and citizens’ assets are protected.

The Glass Steagall banking act was introduced following the infamous stock market crash of 1929 and the subsequent Great depression. As a result, Congress concluded that safer and more effective banking reforms are needed to safeguard the country’s economy from further unpredictable crises.

The Glass Steagall act was partially repealed in 1999 by President Bill Clinton. However, many economists and Fed members argued for taking out some of the restrictions imposed on the banking sector by the Glass Steagall act before its repeal. This brought about the Glass Steagall act repeal.

  • Bank DepositDeregulationDeregulationDeregulation is repealing existing industry-specific regulations in an advanced industrial economy. Removing inefficient laws reduces government control over the industries, allowing businesses to operate more freely in the international market.read moreDifference Between Commercial Banking and Merchant BankingDifference Between Commercial Banking And Merchant BankingCommercial Banking refers to the form of the banking service where commercial banks offer various types of monetary services to anyone who wants to avail its services including the general public as well as the corporations whereas Merchant Banking refers to the form of the banking service where the merchant banks offer financial services to a large company or wealthy individuals.read more