Glass Steagall Act

The Glass Steagall Act of 1933 was a historic legislation in the U.S that separated commercial banking from investment banking. As a result, for the first time, banks were required to protect a portion of their client's money, widely known today as FDIC insurance. It also restricted the commercial banks with customer deposits from making certain investments.

Many believed that the mixing of retail and investment banking was one of the core reasons for the devastating stock market crash of 1929 and the subsequent great depression. Following the stock market crash, policymakers restructured banking institutions' responsibilities towards their clients and reshaped financial history.

• The Glass Steagall Banking Act separated commercial and investment banks for the first time after the stock market crash of 1929.
• Commercial banks could loan out money and hold deposits, and investment banks could raise capital and issue securities – but neither could do both.
• Historic legislation shaped our financial future and decided how modern-day banks operate.
• Its repeal is largely credited with the Great Recession. Dodd-Frank was enacted in its place but with similar guidelines.

The Glass Steagall Act imposed rules to regulate the financial sector. Signed on June 13, 1933, by President Franklin D. Roosevelt, it was the first step towards trust in its banking system.

In addition to the separation of investment and commercial banks, the purpose of Glass-Steagall was to create the Federal Deposit Insurance Corporation (FDIC) to protect consumer bank deposits of up to $2,500. This number has increased over time, and FDIC insurance is currently $250,000 per deposit account. One of the main functions of FDIC insurance is to prevent the bank from placing client money into speculative investments. 

The overall schism created by the Glass Steagall banking reform act was that bankers could hold deposits and give out loans while investment banks could increase capital and issue loans, but no person at one firm could do both.

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Banking looked very different before 1933 than it does today. In the early 1900s, the federal government did not insure any money. And there was no separation between risky investment banks and safe community banks like today.

In the lead-up to the crash of ’29, the American economy was experiencing a period of rapid expansion which fuelled investor confidence. The stock market rose by nearly 20% each year from 1922 to 1929. A soaring economy led to investor "overconfidence," and people began to buy margin stocks, putting down as little as 10%. They were unbothered by the debt as the morale was high.

People with little to no financial experience could borrow money from their stockbrokers for such trades. This sent both sides into a flurry of reckless investing. 

The banks, in turn, invested client money into the stock market while also easing credit lending and borrowing. As a result, the market and people overall were overconfident – and overleveraged. The Federal Reserve then raised interest rates, shares fell, and nervous investors withdrew money from banks. But the banks had already re-invested money into falling markets.

This led to a domino effect that left investors, banks, and companies depleted of their savings. What followed was the worst economic event in history. The stock market crashed, banks liquidated, leading to worldwide Great Depression.  

Henry Steagall, a former treasury secretary, and Carter Glass, the chairman of the house banking and currency committee, realized the need for The Glass Steagall Act of 1933. Congress concluded that the banking system needs safer and more effective reforms. The reforms should protect citizens' assets and prevent random economic failures in the future. The act went through wide debates and discussions before the president signed it in 1933. The act ensured that people no longer put money in risky investments.

President Bill Clinton signed the Financial Services Modernization Act on November 12, 1999, to effectively repeal the Glass-Steagall banking reform act. In the lead-up to the Glass Steagall act repeal, economists and Fed members criticized the restrictions imposed on the banking sector some six decades prior. The main arguments were that if banks could invest their client's money, they could increase the rate of return for their customers and hedge risk by diversifying their overall business practices.

History once again repeated itself, though, and the loosening of the financial reins led to the second-worst economic event in history – the Great Recession of 2008. Then, less than ten years after the Glass-Steagall act repeal, the merging of investment banking practices with customer deposits fuelled another financial meltdown. 

Nobel laureate in economics Professor Joseph Stiglitz wrote in 2009 that "when we brought investment and commercial banks together, the investment-bank culture came out on top." He also said there was a need for great returns that higher risk-taking can bring forth.

What followed was the passing of the Dodd-Frank legislation. In many ways, Dodd-Frank was the 2008 version of Glass-Steagall. Once again, the government had to put restrictions on banks that took advantage of regulatory leniency.

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This has been a guide to what is the Glass Steagall Act. Here we explain why it was repealed along with its purpose, significance, and complete explanation. You can learn more from the following articles –

• Bank Deposit
• Deregulation
• Difference Between Commercial Banking and Merchant Banking