Lessons from history IV: Banking separation (2/3). The true history of the Glass-Steagall Act of 1933 | Finance Watch

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Lessons from history IV: Banking separation (2/3). The true history of the Glass-Steagall Act of 1933

The Glass-Steagall Act was adopted by US Congress in 1933. It separated investment banks and commercial banks. The Act was repealed amidst the big wave of financial deregulation of the 1990s, but there is now strong interest in reintroducing separation. So it is important to remember why banks were separated in the first place.

In the 19th century, Americans designated the British banking system as a model of soundness and efficiency. In Britain, markets had naturally evolved into making a sharp difference between investment and commercial banks because people perceived investment banking as inherently risky. On the contrary, continental and especially German banks tended to be multifunctional.

Diversification of banks in the 1920s

After World War I, faced with the competition of trust funds, American banks began to diversify. Regulation was very hard to implement because banks could be chartered either at the national level or at the state level. This competition was the main feature of the early American banking system and it enabled banks to pick the most lenient states for incorporation. Senator Glass, (after whom the Glass-Steagall Act is named) deplored that: “instead of creating a national standard of sound banking which the state systems might be induced to follow, we have introduced into the national banking some, if not many, of the abuses of the state systems, in order to enable national banks to compete with state banks”.

Under the principle of separation of banking and commerce, which was presented in an earlier article, dealing in stocks was prohibited to banks, i.e. financial institutions that take deposits. But there was a major loophole. In the 1910s, banks started to create fully-owned affiliates, and those affiliates traded all kinds of securities. The separation became purely formal. However, financial markets were not too developed and regulators tacitly accepted the trick.

During World War One, financial markets grew rapidly because government needed to finance the war and distribute loans to a wider public. In the 1920s, the development of bond markets enabled companies to finance themselves directly by issuing stocks instead of borrowing from banks. To offset the reduction in loan revenues, more banks created securities affiliates. In 1927, the McFadden Act authorized the securities affiliate system. In parliamentary debates, Glass declared: “We have again the infrequent occurrence of being asked to legalize something that has been done without authority of law”.

Senator Glass’s revenge

Boosted by official recognition, commercial banks became the dominant force in investment banking by 1930. Senator Glass, who used to boast intellectual fatherhood of the Federal Reserve System, was appalled by the 1929 crash. He had thought that his system would be sufficient to build a solid financial structure. So he dedicated the early 1930s to fixing the work of his life.

Glass knew that reform of the banking structure was not a panacea. He “had no illusory dreams that his proposed reform would cure the depression. His reforms were designated for the long run health of the financial community and the country as a whole. They were not meant to repair the current breakdown, but to prevent a future catastrophe sometime in the future. He was remarkably free from any anti-business bias and throughout the controversy over his bill maintained his close relationships with many respected Wall Street figures” [Perkins, 1971]. Finance Watch’s views today are similar: bank separation will not entirely remove the problem of too-big-to-fail banks but it would make a major contribution towards that goal and to the long-run health of the economy (see our position paper “The Importance of Being Separated”).

Between 1929 and 1933, Glass fought to overcome political barriers and have his bill adopted. In 1932, he reinforced the pressure by revealing that the Justice Department had found out that the affiliate system was a violation of federal law in 1911 and had never prosecuted the banks. The election of Franklin Roosevelt in 1933 helped a lot. James Couzens, a former partner of Henry Ford’s, brought support from the progressive faction of the Republican party. But banks argued that separation would be deflationary because it would lead to fire sales of assets. Furthermore, “with the economy already in a depressed state, it was not the proper time to erect impediments to the future recovery of the securities market” [Perkins, 1971]. Banks have been using the same line of argument since 2008 to prevent any substantial reform from being enacted.

However in the 1930s, Wall Street was divided. J.P. Morgan & Co, the then-declining empire of investment banking, saw separation as an opportunity to get rid of competition by aggressive commercial banks. JPM didn’t even bother to send anyone to Washington for the debates. This would be unthinkable today. According to the Center for Responsive Politics, a US non-profit, J.P. Morgan spent $8,060,000 in lobbying in Washington in 2012 (overall, the financial industry spent $482m on lobbying in 2012, more than any other sector of the economy, source http://www.opensecrets.org).

Another interesting feature of the debate of the 1930s is the fact that the banking industry was unable or unwilling to produce substantial arguments. “Advocates of the status quo generally defended the unified arrangement of banking services only because it already existed and had been found useful. In no instance did they offer a theoretical support for their views” [Perkins, 1971]. They adopted a strategy that seems remarkably familiar today: do not enter the debate publicly, privately reject separation as ‘dangerous for the economy’, and lobby intensely. Last time round, it worked to hold off reform for four years and only succumbed when pressure for Roosevelt’s New Deal became irresistible.

So eventually, the Glass-Steagall Act was voted in May 1933. It gave banks a one-year phase-out period, instead of the three years initially proposed. National City Bank and Chase National Bank anticipated the law: they had already announced that their securities affiliates would be separated in March. The New York Times suggested it was a way to prevent further investigation into the practices of the late 1920s. In any case, the Glass-Steagall Act was a major pillar of financial regulation, until it was repealed in the big wave of deregulation of the 1990s (see forthcoming article). But how was the Act interpreted when it was adopted?

The myth of the Glass-Steagall Act

In fact, the Glass-Steagall Act doesn’t even exist. It is only the name that was given to a few sections of the “Banking Act of 1933”. The main provision of the act was not banking separation. It was the creation of the Federal Deposit Insurance Corporation (FDIC), the government system that provides insurance for private deposits. Deposit insurance was promoted by US Representative Henry B. Steagall (1873-1943). It was a response to the frequent and destructive bank runs and financial panics, a well-known weakness of the American banking system then. Today, deposit insurance is still regarded as necessary for a stable financial system.

Senator Glass was in fact deeply opposed to deposit insurance. It was one of the reasons why he became one of Roosevelt’s fiercest opponents. So, contrary to the myth of the coherent Glass-Steagall Act, it is purely incidental that bank separation and deposit insurance were implemented in the same act. Glass came from a whole different intellectual background, which has a lot to do with the antitrust mood of the time and the denunciation of banking concentration. Separation was the minor provision within the Banking Act. In 1971, a scholar could fairly write that: “the divorcement of investment and commercial banking has been almost totally neglected by both financial historians and economists” [Perkins, 1971]. People forgot the rationale of that provision. This is why, as will be explained in the next article, banking separation looked completely outdated in the 1990s, when it was repealed.

For more on Finance Watch’s views on bank separation today, click here.

Fabien Hassan

References:

  • PERKINS, Edwin J. The divorce of commercial and investment banking: A history. Banking LJ, 1971, vol. 88, p. 483.
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