New Glass-Steagall Act Key to Ending Too Big to Fail

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Last week, four senators that include Elizabeth Warren (D-Mass.) and John McCain (R-Ariz.) introduced a bill to reinstate the Glass-Steagall Act.

The 21st Century Glass-Steagall Act, as it's called, would bring back many of the provisions of the former law and strengthen language to limit financial speculation by the big banks, reduce risk, and attempt to end "Too Big to Fail" once and for all.

The original legislation, called The Banking Act of 1933 but commonly referred to as Glass-Steagall, was partly repealed by Congress in 1999 and signed into law by President Bill Clinton. But by the time Glass-Steagall was repealed, the law had already been watered down and full of loopholes that left the U.S. economy highly vulnerable to a financial crisis.

Many economists believe that the partial repeal of this law was responsible for the recent financial crisis.

But the reintroduction of a Glass-Steagall law would do one critical thing that should provide comfort to any American.

It would make it impossible for the Big Banks to access FDIC-insured savings and deposits, and then speculate with ordinary Americans' money. In addition, it would aim to end Too Big to Fail and reduce the size of the mega-banks, in essence break them up.

The History of Glass-Steagall Act and its Benefits

Following the stock market Crash of 1929, Congress sought in 1933 to reduce risk in the financial sector.

Four key provisions were central to the Depression-era law. Here is what each of them did for more than 60 years:

  • Section 16 made it illegal for national commercial banks (banks overseen by the Office of the Comptroller of the Currency) from engaging in securities trading. It would be illegal for a company like Bank of America to engage in speculation of commodities and derivatives.
  • Section 20 banned state-chartered or national banks that are Federal Reserve members from being engaging in operations with investment banks that were engaged in securities dealing.
  • Section 21 banned investment banks from accepting deposits. It would be illegal for a company like Goldman Sachs to allow customers to open a savings or checking account.
  • Section 32 made it illegal for Federal Reserve member banks from sharing corporate board members with investment banks.

Sections 20 and 32 are the primary firewalls that many mention when speaking of this law.

From the 1980s until its repeal, numerous loopholes were chiseled out.

As financial institutions became publicl- traded companies, the interest in short-term profits overcame the desire for long-term stability. The creation of exotic securitization products and widespread subprime lending became critical parts of the banking industry's profits from the late 1970s on.

And we know how well that went.

The banks' ability to engage in insurance and credit default swap trading was, at the time, far more controversial than the movement to replace this law. But the emphasis on share prices drove banking leaders to eye Glass-Steagall as a significant limitation on their profit potential using taxpayer insured deposits.

And there was big potential for profits in their line of business.

Commercial banks wanted to be able to take increased risks with the money they had in their vaults, while investment banks, the real risk takers, wanted access to the deposits of traditional banks in order to maximize their profits.

At the time, a number of loopholes were discovered in the law, which corporate lawyers and banks exploited, and the banks increased lobbying to weaken the legislation.

While the impact of the law's repeal is hotly debated among economists, it's hard to argue against one thing: The investment banking culture significantly overtook the conservative models of commercial banking.

A New Firewall

The proposed bill is only 30 pages long and is rather explicit in its language that would reinstate these core provisions and seek to increase oversight of financial instruments like credit default swaps, which were not part of the financial industry in the 1930s.

Re-implementing this famous firewall between the banking divisions would likely lead companies like Citigroup and JPMorgan to spinning off portions of their businesses, and reduce communication between commercial banks and companies that engage in securities trading like investment banks and hedge funds.

The war drums for Glass-Steagall have been booming since the $6 billion-plus loss reported by JPMorgan caused by the trades of the "London Whale" in 2012.

But Glass-Steagall wouldn't have prevented this loss, as the problems actually occurred on the commercial side of the bank. In addition, companies that collapsed in 2008, Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, and the American International Group (AIG) would not have been regulated by Glass-Steagall, as they have no commercial banking arms to regulate.

While Glass-Steagall would reduce companies like Citigroup, JPMorgan, Goldman Sachs, among others from getting "Too Big to Fail," the regulators still need to engage in proper regulation to address vulnerabilities in the derivatives markets.

The Dodd-Frank bill in 2010 was supposed to draw greater attention to the Financial "Weapons of Mass Destruction," as termed by investment legend Warren Buffett.

However, Dodd-Frank has been an abysmal failure, a law essentially written by corporate lobbyists. JPMorgan, which convinced Americans through a robust grassroots movement in 2010 that it was innocent in taking part in the faulty derivatives game, has come out far stronger and better poised to capitalize in the commodity derivatives markets.

Ironically, JPMorgan was named Derivatives House of the Year in 2012 by Risk Awards. The company then proceeded to lose $6 billion on derivatives.

Yet a renewed Glass-Steagall will reduce the influence of investment banking speculation on commercial banking. The bill also should seek to increase bank capital requirements and reduce leverage ratios.

Want to know more about this new Glass-Steagall Act will work? Here's the lowdown on the 21st Century Glass-Steagall