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Glass-Steagall Act

How banking got so messed up



Security guards open the door for Nasim Ahmed and his one-year-old daughter Roed as hundreds of nervous customers wait in line to get into an IndyMac Bank, open for the first time since the July 11 federal government takeover of the thrift, on July 14, 2008 in Pasadena, California. IndyMac, which was already in trouble because of it's subprime mortgages with people with bad or no credit history, was shut down three hours early on a Friday and remained closed over the weekend after customers withdrew $1.9 billion. Regulators say it is the second-largest bank failure ever in the US. As all 33 IndyMac branches reopen, customers with home-equity credit lines will reportedly find their accounts frozen while transactions involving deposit accounts will be conducted as normal under the name, IndyMac Federal Bank. Over the weekend, the Federal Reserve also worked on shoring up lenders Fannie Mae and Freddie Mac which control almost half of the national mortgage debt and are in danger of collapse as well.

Photo by David McNew/Getty Images
Glass-Steagall Act

The Glass-Steagall Act sought to curb the banking excesses that led to the Great Depression.

Photo: Dorothea Lange/National Archives
Bankers who took the bailout

(L-R) Goldman Sachs CEO Lloyd Blankfein, JPMorgan Chase CEO Jamie Dimon, Bank of New York Mellon CEO Robert Kelly, Bank of America CEO Ken Lewis and State Street CEO Ronald Logue

Photo: Chip Somodevilla/Getty Images

Definition: The Glass-Steagall Act, also known as the Banking Act of 1933, separated investment banking from retail banking. It prevented banks from using depositors' funds for risky investments such as the stock market. Glass-Stegall gave tighter regulation of retail banks to the Federal Reserve, prohibited bank sales of securities, and created the Federal Deposit Insurance Corporation (FDIC).

Investment banks help corporations raise money by organizing the initial sales of stocks, facilitating mergers and acquisitions, and operating hedge funds.

Retail or commercial banks take deposits, manage checking accounts and make loans. Commercial banks are protected by the government. Their deposits are insured by the , and they are regulated by the Federal Reserve.

Glass-Steagall History

Glass-Steagall was enacted as an emergency response to the failure of nearly 5,000 banks during the Great Depression. In 1933, all U.S. banks closed for four days - when they reopened, they only gave depositors 10 cents for each dollar. Where did the money go? Many banks had invested in the stock market, which crashed in 1929. When depositors' found out, they all rushed to their banks to withdraw their deposits. Even the good banks usually only keep one tenth of the deposits on hand. They will lend out the rest, because they know that normally that's all they need to keep on hand to keep their depositors' happy. However, in a bank run, they must quickly find the cash.

Today, we don't have to worry about bank runs because all deposits are insured by the federal government through the FDIC. Since people know they will get their money back, there generally isn't the panic that creates a bank run.

Glass-Steagall was part of Roosevelt's New Deal and became a permanent measure in 1945.

Repeal of Glass-Steagall

Glass-Steagall was repealed in 1999 by the Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act was passed along party lines by a Republican vote in the Senate. The banking industry had been lobbying for the repeal since the 1980s, complaining it couldn't compete with other securities firms. The banks said they would only go into low risk securities, and this would reduce risk for their customers by diversifying their business. By consolidating investment and commercial banks, repeal of Glass-Steagall led to banks being too big to fail. This required their bailout in 2008-2009 to avoid another depression.

Should Glass-Steagall Be Reinstated?

Congressional efforts to reinstate Glass-Steagall have not been successful. In 2011, H.R. 1489 was introduce to repeal the Gramm-Leach-Bliley Actand effectively reinstate Glass-Steagall. If these efforts were successful, it would result in a massive reorganization of the banking industry. The largest banks include commercial banks with investment banking divisions, such as Citibank, and investment banks with commercial banking divisions, such as Goldman Sachs. A reinstatement of Glass-Steagall would better protect depositors, but would also create organizational disruption in the banking industry. This might be a good thing, as these banks would no longer be too big to fail, but it should be managed effectively.

The banks argue that reinstating Glass-Steagall would make them too small to compete effectively with global competitors. Therefore, the Dodd-Frank Wall Street Reform Act was passed instead. A portion of the Act, known as Volcker Rule, puts restrictions on banks' ability to use depositors' funds for risky investments. It does not require them to change their organizational structure. If a bank becomes too big to fail, and threatens the U.S. economy, Dodd-Frank requires that it be regulated more closely by the Federal Reserve. For more on the provisions of this Act, see Dodd-Frank Wall Street Reform Act.

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