Is This Glass-Steagall Half Empty?
Jason Williams Photo By Jason Williams
Written Friday, May 5, 2017
Since the financial collapse of 2008, we’ve heard lots of talk about depression-era legislation referred to as Glass-Steagall.
We’ve been told it would have prevented the crisis. We’ve also been told it had nothing to do with the things that caused the crisis.
Depending on whom you listen to, it was either the greatest legislation ever or a complete waste of time.
And since Donald Trump started campaigning for the U.S. presidency, we’ve heard even more talk about it. He says he’s for it. A lot of the people who put him in office are for it.
Maybe he’s really a proponent of breaking up big banks. I doubt that.
Maybe he just wants to garner support from voters who are still clamoring for a reinstatement of the legislation. I think that’s more likely.
Maybe he’s just blowing wind. Probably the most likely explanation.
I’m not here to talk about that or try to guess what’s going on behind the bluster. I’ll leave that to the talking heads on the 24-hour news networks.
I’d rather get into what Glass-Steagall really was and talk about how it worked (or failed) to prevent another banking collapse.
What’s is Glass-Steagall?
The Glass-Steagall Act is actually the Banking Act of 1933 in its entirety. But when people refer to Glass-Steagall these days, they’re only talking about four provisions.
And when people talk about a reinstatement of Glass-Steagall, they’re only referring to one of those four provisions.
When you really get down to it, most people are only talking about two sections of that one provision.
You see, two of the four provisions are still intact. And everyone seems to be happy about one of them being gone…
The legislation created the Federal Deposit Insurance Corporation (FDIC). This was to prevent another run on the banks like what happened in 1929.
It’s why customers don’t have to be worried about their accounts — at least not any that are under $250,000. Those are insured by the FDIC, and pretty much every bank offers that kind of protection.
That was never repealed. And it was a big part of the legislation.
Interestingly enough, Glass-Steagall also laid the foundation for the Federal Open Markets Committee (FOMC). That’s the group that meets eight times a year and sets interest rates.
I say “interestingly enough” because a lot of the people out there talking about how great Glass-Steagall was also think the FOMC has too much power. Those are the same people who complain about the easy money policy of the Federal Reserve. And they’ve forgotten it was Glass-Steagall that gave the FOMC that kind of authority.
Then there’s the one part that nobody cares was repealed. It forbade banks from paying interest on “demand accounts.” Those are accounts that can be accessed by savers at any time. So, your checking or savings account couldn’t accrue any interest.
The only way to get interest was by having a term deposit like a certificate of deposit. If you couldn’t easily get to the money, banks could pay interest on it.
That was repealed in 2011 — long after the recession. And nobody seems to be hankering for a return to the days of old there.
What Does Everyone Want?
There’s only one part of Glass-Steagall anyone cares about these days, and it’s the one that separated commercial banking from investment banking. Well, sort of separated it.
You’re probably wondering why I said “sort of.” Worry not. I’ll get to that a little later. First let’s talk about those sections of the regulation.
Section 16: This part of the legislation prohibited national banks from buying or selling securities except for a customer’s account. It also prohibited them from underwriting or distributing securities — except U.S. government, state, and local bonds. Section 5 (c) applied these rules to state banks that were members of the Federal Reserve System. Still in effect.
Section 20: This kept any Federal Reserve member bank from being affiliated with a company that “engaged principally” in “the issue, flotation, underwriting, public sale, or distribution” of securities. This was repealed in 1999.
Section 21: This is the part that prohibited any company or person from taking deposits if it was in the business of “issuing, underwriting, selling, or distributing” securities. That means investment companies like Smith Barney or Merrill Lynch can’t also have a savings wing. Also, still in effect.
Section 32: This section made it illegal for a Federal Reserve member bank’s officers and directors to have a role at any of the companies noted in Section 21. But the Federal Reserve Board could grant exemptions on a case-by-case basis. This section was also repealed in 1999.
So, What Do You Mean, “Sort Of?”
Now you’ve got a little background on the parts of Glass-Steagall some people want back. So, let’s talk a bit about how it was already dead long before being repealed.
There were so many loopholes in Glass-Steagall that it never really had a big impact on banks.
You see, except for Section 21, the legislation only applied to Federal Reserve member commercial banks. To put that into perspective, only about 38% of U.S. banks are currently members of the Federal Reserve System.
That means most of these rules never applied to savings and loans, state nonmember banks, and any other firm or individual in the business of taking deposits.
Also, Sections 16 and 21 prohibit banks from selling securities and prevent securities firms from taking deposits. But the legislation’s affiliation provisions didn’t have those absolute prohibitions.
Section 20 merely prohibited a bank from directly affiliating with a firm “engaged principally” in underwriting, distributing, or dealing in securities. It didn’t say anything about the bank’s parent company not doing the same thing.
Section 32 said a bank couldn’t share employees or directors with a securities firm. And that could be circumvented with an exemption from the Federal Reserve Board.
It was those two differences that led to a lot of regulatory actions. And those actions pretty much took the teeth out of Glass-Steagall long before it was ever repealed.
Plus, no part of the legislation but Section 21 applied to all institutions. And that gave plenty of opportunities for banks and their lawyers to exploit the loopholes.
Starting back in the 1960s, regulators’ interpretations of the law let commercial banks engage in more and more securities activities. Banks were able to create financial products that blurred the distinction between banking and security products. That led to even more leniency from courts and eventually the merging of banking and securities companies.
One of largest examples of failure came in 1998. Citigroup (the owner of Citibank) bought Solomon Smith Barney (a securities firm). The interpretation of Glass-Steagall at the time did nothing to stop it. By that point, Glass-Steagall was effectively dead.
That was a year before the Gramm-Leach-Bliley Act repealed Sections 20 and 32 of Glass-Steagall and put the final nails in the coffin.
Don’t Call It a Comeback
Glass-Steagall may make a comeback. I don’t know. There are a bunch of people who think it would be a good idea. There are also a bunch who think it would be a waste of time.
Judging by how effective it was the first time, I’m probably a member of the latter group.
Any reenactment of Sections 20 and 32 of Glass-Steagall would likely be no more than a symbolic gesture to garner voter support. If it wasn’t enforced last time, what makes people think it’ll be enforced this time?
I’m all for protecting the American taxpayer from funding another bailout. I just don’t think this kind of legislation will do it.
I’m sure there are a lot of folks out there with a different opinion. But, hey, that’s mine.
Plus, I’m inclined to agree with my colleague, Briton Ryle, when he says big banks are a good thing.
They can back huge lines of credit for corporations. They can offer cost savings to their customers. They can diversify their risk better than small ones. They’re something we need.
I’ll be keeping an eye on the news for what’s going to happen with all this talk. I’m sure you will, too. But I’m convinced nothing will come to fruition.
And if it does, I certainly don’t think it’s going to break up the banks the way we’re being told. Honestly, I hope it doesn’t.
To investing with integrity (and a grain of salt),
Jason Williams
Wealth Daily