Could Glass-Steagall Act have saved us from Recession?

Contributed By:
Kushal Masand, IIFT Batch of 2012

The economic recession from which we are still recovering from, has brought with it a number of questions. Some of these questions will remain unanswered,not because we don’t have enough statistical data to prove it, but it will be impossible to expect economists from around the world to agree upon a single reason.
Moreover, in today’s complex economic world, there is only one thing on which economist can agree upon, and that is, a number of reasons joined force together to bring the recession of this level seen only during Great Depression. Some of these factors are sub-prime mortgage crisis, over-complicated financial instruments, bubble in commodity prices and real estate, unbalanced economic trade, easy credit conditions, regulations not able to keep pace with financial innovation, increased importance of shadow banking. These are some of the many reasons which contributed in recession.
One of the factors which lead to the economic recession has been the havoc the investment banking business, seen by many as risky,on to the commercial banking business, seen as traditional and not risky. To an idea how the securities played an important role in the recession can be understood by the fact that how mortgages were converted into AAA ranked debt securities under names as collateral debt obligation (CDO), Mortgage based securities (MBS), assets bases securities (ABS). But when another fact is added to this scenario that these securities were created not only from the good quality mortgages but also consisted of poor quality securities. By converting the mortgages to securities the banks havee removed the risk from their balance sheets and at the same time have created more liquidity to give more sub-prime mortgages, thus further increasing the risks for the people buying these securities. This all went well till the real estate prices were increasing and once the bubble burst all these securities turned into toxic assets which had to be pruned at the cost of tax-payers money.
Now let us see what were the changes brought by the Banking Act of 1933 popularly known as the Glass-Steagall Act.
Glass-Steagall act was introduced in 1933 by Senator Carter Glass and Congressman Henry Steagall. This act came after the Great Crash of 1929, during which one of every 5 American banks failed. Many people thought that the market speculation created by banks as the cause of this crash. This act was created to separate the investment banking business of the traditional commercial banks. It prohibited bank sales of securities and created Federal Deposit Insurance Corporation (FDIC), which insures deposits which guarantees the safety of deposits in member banks. In the early 1900’s, many commercial banks created there investment banking arms which corporate stock issues. This continued till great crash of 1929, after which a number f banks failed and the people confidence in US financial structure was low. To restore the public confidence, the Glass-Steagall Act was enacted. It prohibited the banks from using their own assets to invest in various securities. In 1920’s , a number of commercial banks were found guilty of misusing the depositors fund to acquire and trade into stocks and bonds.
So what Glass-Steagall act did was to strengthen the Federal Reserve. Member banks of Federal Reserve have to report all investment transactions and loans. Also it was mandatory for banks belonging to federal reserve to join FDIC and in order to join FDIC the had to be in sound financial position. Thus in the hindsight the act brought Darwin’s law of “ Survival of the fittest “ in the financial world of US banks where only the strong banks were able to survive. Thus by 1934, the failures of banks stopped and many banks reopened after joining the FDIC.
Now let us see how the Glass-Steagall Act was repealed layer by layer. The first effort started when some brokerage firms began encroaching in the banks territory by offering accounts that pay interest and offer credit and debit cards. Then in 1986, the Federal Reserve, under the pressure from Wall Street and intense lobbying, reinterpreted the section 20 of the Glass-Stegall Act, which bars commercial banks from engaging in the security business. It decided that banks can have 5 percent of their gross revenues from investment banking business.
Then in 1987, the fed board hears a proposal from the Citicorp, J.P. Morgan and Bankers Trust to allow banks to underwrite several securities like MBS and commercial paper. In the same year the Fed allows Chase Manhattan to underwrite the commercial paper. And at the same time it indicated that it may increase the limit that investment banking business can contribute in the gross revenues of the banks to the order of 10 percent.
In 1989, the Fed board approves the application from a number of banks to deal not only in commercial paper and municipal securities but also in debt and equity based securities.



In 1996, the Federal Reserve Board, under the Chairmanship of Alex Greenspan, a former director of J.P. Morgan, comes out with the rule that the investment banking business can contribute a hefty 25% to the gross revenues of the banks. Without considering that any bank holding company can remain under stipulated 25% norm.
Finally on 22nd October 1999, after 12 attempts iin 25 years, Congress repealed the Glass-Steagll Effect. A number of reasons were given to repeal the act. Some of them were that the investors are more knowledgeable today, and the existence of the sophisticated agencies, and the fact that banks of other countries doesn’t have to work under any regulations of such kind.
Now we come to question, had the Glass-Steagall Act had not been repealed, could we have saved ourselves from the economic downturn we are suffering from?
Some people say that it is most obvious to reinstate the Act, and the fact if it had not been repealed, the we couldn’t have seen the banks engaging themselves in so much of business relating to securities and creating toxic assets not only for themselves but also for the investors worldwide. And we didn’t had to save the so-called “ too big to fail “ banks which cost taxpayers their dearer money and could have been used to strengthen the public system, during the turnmoil.
Others advocate that the shadow banking system i.e. is nonblank lenders like Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan Stanley sits at the epicenter of this turnmoil and that the fact these resides outside thee jurisdiction of Glass-Steagall Act. Also that banks like Washington Mutual, which collapsed even without the investment banking arm.
Economist can support either of the cause, but it is hard to remember any big banks which have failed during the time period of the Glass-Steagall Act. So it is to be decided by the conscience of the bankers and the tougher regulations from the governments that the world doesn’t have to suffer from a recession of such scale.