Glass-Steagall Act — The Wall Between Commercial and Investment Banking
Why Glass-Steagall Was Passed
During the 1920s, banks used depositors’ money to speculate in the stock market and underwrote risky securities they then sold to their own customers. When the 1929 crash hit, thousands of banks failed, wiping out depositors’ savings. Congressional investigations (the Pecora Commission) exposed massive conflicts of interest between commercial lending and securities activities.
Key Provisions
| Provision | Description |
|---|---|
| Banking Separation | Commercial banks (deposits/loans) prohibited from investment banking (underwriting/trading) |
| FDIC Creation | Established the Federal Deposit Insurance Corporation to insure bank deposits (initially $2,500 per account) |
| Regulation Q | Prohibited banks from paying interest on demand deposits; capped rates on savings accounts |
| Section 16 | Banks can deal in government securities but not corporate stocks or bonds |
| Section 20 | Banks cannot affiliate with firms “principally engaged” in securities activities |
| Section 32 | Prohibited interlocking directorates between banks and securities firms |
The Separation in Practice
Glass-Steagall forced the breakup of the financial industry into two distinct camps:
| Activity | Commercial Banks | Investment Banks |
|---|---|---|
| Core Business | Taking deposits, making loans | Underwriting securities, M&A advisory, trading |
| Revenue Source | Net interest margin | Fees, commissions, trading profits |
| Risk Profile | Conservative, FDIC-insured | Higher risk, no deposit insurance |
| Example (pre-1999) | Chase Manhattan, Bank of America | Goldman Sachs, Morgan Stanley |
| Regulation | Fed, OCC, FDIC | SEC |
Erosion and Repeal
Starting in the 1980s, regulators and banks chipped away at Glass-Steagall’s restrictions:
- 1987: The Fed allowed bank holding companies to earn up to 5% of revenue from securities activities
- 1989: The limit was raised to 10%, then 25% in 1996
- 1998: Citicorp merged with Travelers Group (which owned Salomon Smith Barney) — technically illegal under Glass-Steagall, granted a temporary waiver
- 1999: The Gramm-Leach-Bliley Act officially repealed Glass-Steagall’s separation provisions
The Repeal Debate
The repeal of Glass-Steagall remains deeply controversial, especially after the 2008 financial crisis:
| Argument | For Repeal | Against Repeal |
|---|---|---|
| Competition | U.S. banks needed to compete with universal banks in Europe and Asia | Created “too big to fail” institutions |
| Efficiency | Combined banks can offer one-stop financial services to clients | Conflicts of interest between lending and underwriting |
| 2008 Crisis | Most crisis players (Lehman, Bear Stearns, AIG) were not commercial banks | Megabanks used insured deposits to fund risky trading |
| Risk | Diversified banks are more stable than pure-play firms | Taxpayers backstop gambling through deposit insurance |
Key Takeaways
- Glass-Steagall (1933) separated commercial and investment banking and created the FDIC
- It was passed in response to bank failures during the Great Depression
- The Gramm-Leach-Bliley Act repealed it in 1999, enabling universal banks
- The repeal remains controversial — critics argue it contributed to the 2008 crisis
- The Volcker Rule (2010) partially restored some of its principles
Frequently Asked Questions
What did the Glass-Steagall Act do?
It prohibited commercial banks from engaging in investment banking activities (underwriting, trading securities) and created the FDIC to insure bank deposits.
Why was Glass-Steagall repealed?
Banks lobbied for repeal to compete with international universal banks, regulators had already weakened the restrictions, and the Citicorp-Travelers merger in 1998 made repeal politically inevitable. The Gramm-Leach-Bliley Act formally repealed it in 1999.
Did the repeal cause the 2008 financial crisis?
This is debated. Critics argue repeal created “too big to fail” banks. Defenders note that key crisis players (Lehman Brothers, Bear Stearns) were pure investment banks, not commercial banks. The truth likely involves multiple factors beyond Glass-Steagall alone.
What is the FDIC?
The Federal Deposit Insurance Corporation, created by Glass-Steagall, insures bank deposits up to $250,000 per depositor per bank. It protects ordinary depositors from losses if their bank fails.
Has Glass-Steagall been restored?
Not fully. The Volcker Rule (part of the Dodd-Frank Act) partially restored Glass-Steagall’s spirit by restricting proprietary trading at banks, but commercial and investment banking remain combined.