The financial crisis of 2007-2009 caused the most severe global economic downturn since the Great Depression. The recent crisis has generated renewed interest in the Glass-Steagall Banking Act of 1933, which Congress adopted in response to the collapse of the U.S. banking system and the freezing of U.S. capital markets during the Great Depression. Glass-Steagall was designed to stabilize the U.S. financial system by separating commercial banks from the capital markets and by prohibiting nonbanks from accepting deposits.
Since the financial crisis, scholars have debated the question of whether the removal of Glass-Steagall's structural barriers during the 1980s and 1990s played a significant role in promoting the destructive credit bubble that led to the financial crisis. Some authors have argued that Glass-Steagall's demise was an important factor that helped to fuel the financial crisis, while others have contended that Glass-Steagall's disappearance did not contribute to the crisis in any significant way. This article sheds further light on that debate by describing Glass-Steagall's positive impact on the stability of the U.S. financial system from World War II through the 1970s as well as the adverse consequences of Glass-Steagall's disappearance.
As explained in Part I.A, the Glass-Steagall Act and the Bank Holding Company Act of 1956 (BHCA) helped to maintain the stability of the banking industry and capital markets from World War II through the 1970s. Domestic and international developments began to challenge the post-New Deal system of financial regulation in the 1970s. However, the structural barriers established by Glass-Steagall and BHCA maintained a significant degree of separation between commercial banks and other financial sectors until Congress removed those barriers in 1999. Glass-Steagall and BHCA limited the risks of contagion across the banking, securities, and insurance industries, thereby helping to ensure that problems arising in one sector would not spill over into the other sectors.
As discussed in Part I.B, large banks and nonbank financial institutions opened loopholes in Glass-Steagall and BHCA after 1980 by persuading federal regulators to approve limited exceptions to their structural prohibitions. Part I.B highlights three of the most important ways in which federal agencies undermined Glass-Steagall and BHCA. First, nonbank financial institutions were allowed to fund their operations by offering short-term financial instruments that were redeemable at par and served as functional substitutes for deposits, including money market mutual funds, commercial paper, and securities repurchase agreements. The largest commercial banks also began to rely significantly on "shadow bank deposits" after they were allowed to establish securities affiliates beginning in 1987. Second, banks received permission to convert their consumer and commercial loans into asset-backed securities through the process of securitization. Third, banks were permitted to develop over-the-counter (OTC) derivatives, which provided synthetic substitutes for securities, exchange-traded options and futures, and insurance. Shadow bank deposits, securitization, and OTC derivatives weakened Glass-Steagall and BHCA and became catalysts for the toxic credit bubble that led to the financial crisis of 2007-2009.
As described in Part II, big banks were not satisfied with the limited victories they achieved by opening loopholes in Glass-Steagall and BHCA. The big-bank lobby pursued a long campaign to repeal Glass-Steagall's and BHCA's provisions that restricted banks from expanding across state lines and prevented banks from establishing full-scale affiliations with securities firms and insurance companies. Congress authorized nationwide banking and branching by enacting the Riegle-Neal Act in 1994. Ambitious bank executives created giant megabanks, which sought to expand their reach into the securities and insurance sectors. When securities firms and insurance companies realized that they could no longer stop product-line expansion by large banks, both sectors abandoned their longstanding defense of Glass-Steagall's and BHCA's structural barriers.
In 1998, the Federal Reserve Board approved a merger between Travelers, a large insurance and securities conglomerate, and Citicorp, the largest U.S. bank. That merger created Citigroup, the first "universal bank" to operate in the United States since the 1930s. The merger relied on a temporary loophole in the BHCA, and it placed great pressure on Congress to repeal Glass-Steagall's and BHCA's anti-affiliation rules.
Citigroup and other large financial institutions launched a massive lobbying campaign that finally persuaded Congress to adopt the Gramm-Leach-Bliley Act (GLBA) in 1999. GLBA authorized the creation of financial holding companies, which could own banks, securities firms, and insurance companies, thereby confirming the legality of Citigroup's universal banking strategy. The twenty-year campaign by big banks to destroy the barriers separating them from the capital markets culminated in the Commodity Futures Modernization Act (CFMA) in 2000. CFMA authorized large financial institutions to offer a complex array of OTC derivatives without any substantive regulation by federal or state authorities.
GLBA and CFMA ratified and significantly expanded the deregulatory measures that federal authorities had implemented on an incremental, piecemeal basis during the 1980s and 1990s. By providing legal certainty for those measures and by expanding their scope, Congress established a new regime of regulatory laxity that enabled giant financial conglomerates to operate with relatively few constraints.
This article contends that Riegle-Neal, GLBA, and CFMA were highly consequential laws because they (i) allowed large banks to become much bigger and more complex, and to undertake a much wider array of high-risk activities, and (ii) permitted securities firms and insurance companies to offer bank-like products (including deposit substitutes), all of which helped to fuel the catastrophic credit boom of the early 2000s. I therefore disagree with commentators who argue that those laws did not have any significant connection to the financial crisis.
This article does not include detailed reforms to address the unstable and crisis-prone financial system created by Riegle-Neal, GLBA, and CFMA. I have discussed possible reforms in previous work, and I will develop a more detailed set of potential reforms in future work. At a minimum, those reforms should accomplish two goals. First, they should shrink the shadow banking system -- and reduce the threat of "runs" by creditors in that system -- by prohibiting nonbanks from offering short-term debt instruments that are payable at par and function as substitutes for bank deposits. Second, they should establish a regime of strict separation between FDIC-insured banks and the capital markets, and they should prohibit FDIC-insured banks from entering into derivatives, except for bona fide hedges against risk exposures arising out of traditional banking activities.
GW Paper Series
GWU Law School Public Law Research Paper No. 2017-61; GWU Legal Studies Research Paper No. 2017-61
Wilmarth, Arthur E., The Road to Repeal of the Glass-Steagall Act (2017). GWU Law School Public Law Research Paper No. 2017-61; GWU Legal Studies Research Paper No. 2017-61. Available at SSRN: https://ssrn.com/abstract=3026287