Glass–Steagall Act

The expression "Glass-Steagall Act" is commonly used to refer to the provisions of the US Banking Act of 1933, relating to the separation between commercial banks and investment banks (see Norton, 1987).

Although they have been only partially implemented, the Glass-Steagall Act limi- tations to commercial banks' involvement in security activities had a profound and long-lasting influence on banking in the United States. With the Great Depression of the 1930s, the share of corporate securities in commercial bank security portfolios shrank considerably, and in the following decades never returned to its pre-1929 levels. The share of government securities grew correspondingly. The Glass-Steagall Act is considered to be the main determinant of this trend, even more than the Great Depression and the enormous increase in the issuance of government bonds needed to finance the Second World War - indeed, it is the only one of these three factors whose influence was not of a temporary nature (see Ramirez and DeLong, 2001, pp. 97-101).

The effects of the Glass-Steagall Act on the business of investment banking were also relevant. Before the reform, investment banks and commercial banks constituted financial conglomerates, owned by the same financiers and run by the same directors: the huge pool of deposits was thus enslaved to the needs of investment banking, making commercial banks the passive underwriters of the securities to be placed, and allowing investment banks to cash disproportionately high fees without bearing any risk. After the reform, investment bankers had to "organize" themselves the money in order to carry the securities, and then find non-bank long-term investors willing to buy them (see Carosso, 1970, pp. 427-32).

The Glass-Steagall Act had as its main purpose to prevent commercial banks from entering the capital market: public authorities - through deposit insurance and access to the lender of last resort - accorded commercial banks the privilege to operate the transformation of a short-term riskless funding into longer-term risky loans. In no event would this privilege be used to purchase securities, thus fanning the flames of financial speculation.

The end of the arrangement given to US banking by the Glass-Steagall Act dates back to long before the formal repeal of that Act in 1999 (see Barth et al., 2000). Since the 1970s, a new and growing wave of unchecked developments of financial transactions channelled short-term liquid loans into capital markets, in a way, however, different from that of the pre-Glass-Steagall Act era. The link between the money market and the capital market has not been recreated through the practice of the interlocking banking manage- ments and the commercial bank subscription of bonds and stocks, but rather through the development of money market instruments alternative to deposits. Investment banking has become a highly leveraged business financed in a completely unregulated money market - the so-called shadow banking system - dominated by financial institutions without banking licences, which carried out a role similar to that of traditional banks.

Behind these non-bank intermediaries there are of course also the traditional banks themselves, which, since the early 1980s, were permitted by public authorities to engage in transactions prohibited by the Glass-Steagall Act. At the beginning of this new, very profitable and completely unregulated financial circuit, commercial banks played only a marginal role - something much to the taste of investment banks, which in fact campaigned against the progressive emptying of the compartmentalization measures. Commercial banks, on the other hand, pushed for the abolition of a set of rules that, instead of promoting their traditional field of action, had come to exclude them from the market-based financial intermediation that was impetuously developing with the blessing of public authorities.

The global financial crisis that erupted in 2008 has put an end to two decades during which practitioners and academics produced a huge number of studies to demonstrate that the introduction of the Glass-Steagall Act in 1933 was an emergency measure without any rational justification, and had adversely affected the development of American capitalism (see, for example, Benston, 1990). Since then, many voices, even within financial orthodoxy, have been raised against the repeal of the Glass-Steagall Act, calling for a return of its provisions. The usefulness of this return is controversial, not only because the climate of hostility against every form of financial regulation that prevailed over the last decades has been little changed by the crisis. The unholy con- centration of power and wealth in the hands of a few who control the financial system and, through it, the whole industrial and political system of the United States is today undoubtedly similar, if not even more pernicious, than the one that occurred at the beginning of the twentieth century. However, the nature of this concentration of power and the ways in which it operates have since then radically changed, and it is not at all obvious that old-style Glass-Steagall prohibitions can be as effective today as they were at the time.

The reintroduction of prohibitions as formulated in 1933 would restrict the traditional activities of commercial banks, without impairing "non-bank" activities, thus simply restoring the unsatisfactory pre-1999 state of affairs. While in 1933 the separation of commercial banks from investment banks was sufficient to separate money market activi- ties from capital market activities, today this is obviously not the case. A new and effec- tive Glass-Steagall Act could hardly refrain from making impractical any gimmick that makes long-term investor commitment perfectly "liquid". From a legal standpoint, this goal could be accomplished by restricting the access of investment banks to the money market, irrespective of the intermediary and the financial instrument used. This solution raises the problem of how to accommodate the demand for short-term liquid assets that offer a safe return. The way to deal with this problem today seems to be the same as in the decades before the 1980s, when the main financial instrument of the money market was the Government debt.

See also:

Financial crisis; Investment banking; Lender of last resort; Narrow banking; Shadow banking.