The Glass-Steagall Act: A Short Explanation
Summary: Glass Steagall was a bi-partisan, 37-page law signed by President Franklin Roosevelt in 1933, and actively promoted by powerful Wall Street bankers following the Crash of 1929, and closure of ALL banks during the Great Depression. Throughout its 66 year history, Glass Steagall prevented ANY systemic banking collapse. In its absence, the financial system collapse of 2008-09 led to a Great Recession that devastated the American economy, and took years from which to recover. Today, five Mega Banks banks are so highly leveraged, so highly interconnected, and still holding assets in bubble territory, that a wrong bet by of any one of them could bring the entire financial system crashing down (and with it your job, your bank deposits, and your retirement savings)!
Above: President Franklin D. Roosevelt at the signing ceremony for the Glass-Steagall Act in 1933. Standing from left are Sen. Carter Glass, D-Va., Sen. Duncan Fletcher, D-Fla., Treasury Secretary Henry Morgenthau Jr. Jesse Jones of the Reconstruction Finance Corp. and Rep. Henry Steagall, D-Ala. (Associated Press)
How It Worked: Glass-Steagall prevented “the undue diversion of funds into speculative operations.” Speculation refers to the use of depositors’ money buy stocks, bonds, today’s derivatives, or businesses through underwriting, with the hope that their value will rise, but with the risk their value might also fall.
- Commercial banks, that take in deposits and make loans to small businesses and households, could not use depositors’ money to speculate. To further protect citizens’ savings, Glass-Steagall created the Federal Deposit Insurance Corporation, to insure bank deposits up to of $250,000 (today’s maximum) in the event that one or more individual banks might fail.
- Investment banks, that create and hold derivatives, buy and sell stocks and bonds, and underwrite large financial deals, had to be separated into an entirely separate bank, with no common boards of directors, shared deposits, etc. If those banks failed, there would be no government bailout.
- Commercial banks could purchase securities for their clients, but not for their own account (i.e. proprietary trading, the subject to today’s Volcker Rule) reducing even the appearance of betting.
Push to De-regulate Banks: In the 1980-90s, the wall between investment and commercial banking was dismantled, and banks were allowed to own brokerage firms and mutual funds, and act as both agent and principal in securities trading.
- In 1987, Greenspan allowed Bank Holding Company subsidiaries to deal in derivatives; the need for a partial bailout of banks connected to Long Term Capital quickly followed.
- In 1999 Glass Steagall was repealed. Commercial and investment banks merged, and became Too Big to Fail Banks (TBTF).
- In 2000, Congress passed the Commodities Futures Modernization Act, deregulating derivatives.
- Thereafter, the issuance of derivatives (mostly mortgage backed securities (MBSs) associated with the housing bubble) soared, and banks and insurance companies competed to purchase them by increasing their leverage (or borrowing) from other banks. Thus, financial sector debt skyrocketed, from 25% of GDP to 125% of GDP between 1985 and 2008, and the interconnectedness-of-debt, and risk of systemic failure, rose alongside.
The Great Recession of 2008-09: The system began to crash in the Fall of 2007, as home mortgage defaults, short sales, and falling house prices, caused Citigroup’s toxic financial paper to tank. By October 2008, 12 of the 13 most important banks were “at risk of immediate failure”, according to Federal Reserve Chair Ben Bernanke, and were bailed out. The myth that the crash was caused by the implosion of investment banks not subject to Glass Steagall is UNTRUE. Citigroup, e.g., ultimately received $45 billion in taxpayer bailout, $340 billion in asset guarantees, and $2 trillion in near-zero percent Federal Reserve loans.
The recession’s impact on America was devastating: the economy contracted by 5.1%, 80.7 million jobs were shed, upwards of 10 million families lost their homes to foreclosure, the net worth of American households fell by 22%, the stock market lost 57% of its value, government debt doubled to $20 trillion (on account of low tax receipts and high unemployment claims), and the Federal Reserve, the Treasury, and the FDIC, spent an additional $5 trillion at public expense to keep the financial system afloat.
Today we are more vulnerable than ever: The US banking system holds $255 trillion in derivatives on the books of federally insured banks. Underlying these derivatives, new price bubbles have re-appeared in the housing market, stocks, and bonds. Derivatives and stocks bought on margin (or with leverage) continue to be significant, and are financed through loans from other banks. A new bubble is the $14 trillion corporate debt — larger than the subprime mortgage bubble of 2007. Corporate Debt to Earnings ratios are at near record highs; and corporate defaults are building to 2009 levels.
According to a 2015 report by the Office of Financial Research on the SYSTEMIC RISK imposed by US banks, the higher a bank’s leverage, the more prone it is to default under stress. And the greater its connectivity other banks, the greater is the risk the default will spread to other banks. The report identified five mega-banks with particularly high contagion index values — Citigroup, JPMorgan-Chase, Morgan Stanley, Bank of America, and Goldman Sachs. A default in any one could bring the entire financial system down. And that would overwhelm the capacity of the FDIC to protect citizens’ deposits.
Re-instating a 21st Century Glass-Steagall is a National Imperative: In recognition, Glass Steagall was endorsed by both major parties in their 2016 platforms. There are bi-partisan bills in both Houses of Congress (S.881 and H.R.790). 17 state legislatures have introduced support resolutions. And many citizens’ organizations (Public Citizen, AFL-CIO, Americans for Financial Reform, and Our Revolution Affiliates) are actively lobbying on its behalf. Won’t you join us in supporting passage of a 21st Century Glass-Steagall Act now?