How The Glass-Steagall Act Shaped Modern Banking

Nearly a century after the Great Depression, its effects are still evident in American life. People-centric policies like minimum wage and Social Security are the most well-known, but the changes implemented in response to this crisis also extended to the banking industry.

The piece of legislation that had the most profound impact on banking was the Glass-Steagall Act, also known as the Banking Act of 1933. Many of the specific provisions of this act have been repealed over time, but the foundational ideology it imposed continues to shape modern perceptions and policy.

Background: The Banking Industry and the Great Depression

Prior to the Great Depression, many large financial institutions operated as “universal banks,” which combined depository and securities functions under one roof. Some of these institutions even used depositor funds to make risky, speculative investments.

The rampant speculation by banks and individual investors, combined with a deteriorating economic situation, led to a massive financial bubble. In 1929, the bubble burst, and by 1932, publicly traded companies had lost a staggering 89% of their value. Approximately 9,000 banks failed, and most Americans lost faith in the banking system.

During the crisis, the federal government intervened to restore public faith in financial institutions. This process culminated with the passing of The Banking Act of 1933, better known as the Glass-Steagall act.

The Banking Act of 1933 – Glass-Steagall

Glass-Steagall legislation represented a significant overhaul of the U.S. banking system. Several versions of the rules were proposed between 1930 and 1932 by Senator Carter Glass who sought to separate investment banking and commercial banking.

The Banking Act of 1933 included provisions championed by Representative Henry Steagall that provided for deposit protection, and it was signed into law on June 16, 1933. This legislation contained 4 key solutions to issues that were thought to have exacerbated the effect of the Great Depression on banking.

1. Separation of Investment and Commercial Banking

The 1933 legislation created an important distinction between commercial banking and investment banking. Commercial banking functions are those we typically associate with banks – like holding deposits and lending funds. Investment banking, on the other hand, is typically related to securities trading and underwriting.

In essence, banks were forced to choose whether they wanted to provide safety for depositors or facilitate risky trades. This separation protected the commercial system by shielding it from the high-risk, speculative nature of securities markets.

2. Creation of the FDIC

One of the most enduring and important pieces of the act was the establishment of the Federal Deposit Insurance Corporation [FDIC]. This independent agency of the U.S. government originally guaranteed $2,500 in depositor funds from bank failure.

Deposit insurance from the FDIC was integral to reestablishing trust in the American banking system and greatly reduced the prevalence of bank runs. It ushered in an era of stability that lasted decades, during which consumers and businesses could confidently entrust banks with their cash.

3. Regulation of Interest Paid

Another key feature of the Glass-Steagall Act was Regulation Q, which prohibited banks from paying interest on checking accounts. It also capped interest on other types of accounts, like savings and Certificates of Deposit.

The original goal of Regulation Q was to prevent excessive competition between banks. This seems counterintuitive in a capitalist system, but lawmakers at the time feared that banks offering high interest rates would be forced to engage in riskier behavior to generate enough revenue to pay the interest. By negating this potential for risky behavior, the act helped to refocus commercial banks on their core responsibility of safeguarding funds.

4. Federal Reserve Oversight

The Federal Reserve was created in 1913, and 8,000 banks were part of the system when the Great Depression began. However, twice as many banks were not under the jurisdiction of the Federal Reserve at that time, so they operated with fewer safeguards.

The Glass-Steagall Act solidified the Fed’s role as a governing body, including extending its oversight to bank holding companies and affiliates. This brought more banks under the Fed’s oversight and created a stable framework for monitoring the nation’s financial health. This further renewed trust in the banking system.

Repeals and The Lasting Impact of The Glass-Steagall Act

The Glass-Steagall Act was integral in restoring stability to the banking industry, but the U.S. financial system has continued to evolve since 1933. During this time, some provisions of the act have been strengthened, while others have been weakened or completely repealed.

Regulation Q Repealed

The first major repeal began in the early 1980s as money market mutual funds became popular. These funds were “cash equivalent” investments and investors could write checks against them. These features lured many customers away from commercial banks which were not allowed to compete with the returns available with the new money market instruments.

In response, Regulation Q limitations were largely phased out throughout the 1980s, allowing banks to pay market interest rates for savings and time deposit accounts. Then the interest rate restrictions were completely repealed in 2011 by the Dodd-Frank Act, which allowed banks to freely compete on demand deposits – like checking accounts – as well.

Separation of Commercial and Investment Banking Functions Removed

The Gramm-Leach-Bliley Act of 1999 repealed the separation of commercial and investment banking functions. This allowed banks to expand and merge, creating the global systemically important banks of today.

Regulatory Oversight

Another ideological shift that persists from the Glass-Steagall Act is the importance of regulatory oversight. Americans saw the consequences of leniency and most remain committed to oversight that protects the soundness of the financial system.

The Federal Reserve is still entrusted with completing this oversight in conjunction with other regulating bodies like the FDIC and OCC. Support for regulation and supervision has seen its ups and downs over the decades since the Glass-Steagall Act, with recent surveys showing that Americans today largely support more oversight rather than less.

Deposit Insurance from the FDIC has Grown

The FDIC is arguably the most important and enduring element of the act, and it still operates today to protect deposits. The amount of insurance available to depositors has increased significantly, from $2,500 to $250,000 today.

With the protection of the FDIC, personal and business depositors alike can rest assured that their insured funds are safe, even if the banking holding them is in trouble. It is difficult to determine how history may have been different without the FDIC protecting deposits, but it is clear that bank runs have dramatically decreased since the concept of deposit insurance was introduced.

Overall, the Glass-Steagall Act had a profound influence on the modern banking system, changing not just how we regulate banks, but also how we view their role in society. Some provisions have been repealed, but the importance of a sound, well-regulated banking system has stood the test of time.

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