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The Great Depression

The Legacy of Glass-Steagall

Pomegra Learn

What Was Glass-Steagall and Why Does It Still Matter?

The Glass-Steagall Act of 1933—formally the Banking Act of 1933—produced two transformative financial institutions: the FDIC (Federal Deposit Insurance Corporation) and the prohibition on combining commercial banking with investment banking. The FDIC's success is uncontested; the commercial-investment banking separation is one of the most debated policy decisions in financial regulatory history. The separation was maintained for 66 years before being repealed by the Gramm-Leach-Bliley Act of 1999. The 2008 financial crisis—which involved the combination of activities that Glass-Steagall had separated—revived the debate about whether its repeal was a mistake. Understanding Glass-Steagall requires understanding what problem it was designed to solve, whether it actually solved that problem, and what its repeal did and did not cause.

Quick definition: The Glass-Steagall Act's commercial-investment banking separation (Sections 16, 20, 21, and 32 of the Banking Act of 1933) prohibited commercial banks—those taking deposits and making loans—from engaging in investment banking activities (underwriting and dealing in securities), and prohibited investment banks from taking deposits, on the theory that the combination created conflicts of interest and exposed insured deposits to speculative risk.

Key takeaways​

  • The Glass-Steagall separation was created in response to the Pecora Investigation's evidence that commercial banks had used affiliate investment banking operations in ways that harmed depositors.
  • The separation held for 66 years; regulatory erosion through the 1980s and 1990s gradually hollowed it out before Gramm-Leach-Bliley formally repealed it in 1999.
  • The FDIC provision of the same 1933 Act is universally regarded as the New Deal's most successful financial reform; its legacy is more significant than the separation provision.
  • The causal relationship between Glass-Steagall repeal and the 2008 financial crisis is debated; the crisis's primary institutions (Lehman Brothers, Bear Stearns, AIG) were not Glass-Steagall-beneficiaries.
  • The modern "too big to fail" problem—where large universal banks combining commercial and investment banking cannot be allowed to fail—reflects the combination's risks that Glass-Steagall had prevented.
  • Various post-2008 proposals to reinstate Glass-Steagall-style separation have not been enacted; the Volcker Rule represents a partial substitute.

What problem Glass-Steagall addressed​

The Pecora Investigation (1932-1934) revealed that commercial banks had used their affiliate investment banking operations in ways that harmed depositors:

Dumping bad securities on depositors: National City Bank (Citibank's predecessor) had used its securities affiliate, National City Company, to underwrite securities—including bonds from Latin American countries that National City knew were problematic—and then sold those securities to National City Bank depositors and trust accounts. Depositors who trusted the bank to manage their finances were given substandard securities that the bank was trying to unload.

Conflicts of interest in lending and underwriting: Banks that both lent to companies and underwrote those companies' securities had inherent conflicts: the incentive to underwrite could lead to loans to companies to fund projects the bank would then underwrite, generating fees regardless of whether the projects were sound.

Risk transmission: Losses in investment banking activities could threaten the commercial bank's deposit base—risks taken with "OPM" (other people's money in the form of deposits) subsidized by federal deposit insurance.

The Glass-Steagall separation addressed these problems by requiring that commercial banks and investment banks be separate entities with separate capital and no affiliated relationships. J.P. Morgan & Co. split into J.P. Morgan (commercial banking) and Morgan Stanley (investment banking); others made similar separations.

How the separation worked in practice​

The separation did not prohibit banks from all securities activities. Commercial banks could still:

  • Buy and sell Treasury securities
  • Underwrite general obligation municipal bonds
  • Buy and sell securities for their own account (as investors)

Investment banks (securities firms) could not:

  • Accept deposits insured by the FDIC
  • Make commercial loans in the traditional sense

The practical effect was that JP Morgan Chase's commercial bank and Goldman Sachs's investment bank operated in different regulatory universes with different capital requirements, different permissible activities, and different government backstops.

Over time, regulatory interpretation eroded the separation. The Federal Reserve, using its "insubstantial" clause interpretation, allowed bank holding companies to have investment banking affiliates as long as the investment banking revenues constituted no more than a specified percentage of total revenues—a percentage that was repeatedly raised from 5 percent (1987) to 10 percent (1989) to 25 percent (1996). By 1999, when Gramm-Leach-Bliley formally repealed the remaining restrictions, the separation had already been substantially eroded.

The FDIC: the more important provision​

The Glass-Steagall Act is named after its Senate sponsor (Carter Glass) and House sponsor (Henry Steagall). Steagall's primary concern was not commercial-investment separation but deposit insurance—the FDIC provision that bears the Act's name in banking history.

The FDIC provision—insuring deposits up to $2,500 initially—was the more practically transformative element. Its immediate effect was to end the bank run cascade: the FDIC's creation in January 1934 was followed by no general banking panics for the next nine decades. The commercial-investment separation reduced specific conflicts of interest but did not address the bank run mechanism; the FDIC addressed the bank run mechanism directly.

In retrospect, the FDIC's importance dwarfs the commercial-investment separation's: the former eliminated the most catastrophic Depression mechanism; the latter reduced conflicts of interest that were genuine but not catastrophic.

The 2008 crisis and the Glass-Steagall debate​

The 2008 financial crisis revived Glass-Steagall debate. Critics of the 1999 repeal argued that allowing commercial and investment banking to combine had contributed to the crisis by creating institutions large enough to be "too big to fail," by mixing deposit-funded stability with investment banking risk-taking, and by creating complex institutions that regulators could not effectively monitor.

The historical analysis is more nuanced. The major institutions at the center of the 2008 crisis were:

  • Bear Stearns: An independent investment bank, not a beneficiary of Glass-Steagall repeal
  • Lehman Brothers: An independent investment bank, not a beneficiary of Glass-Steagall repeal
  • AIG: An insurance company, not a bank
  • Citigroup: A Glass-Steagall repeal beneficiary (universal bank) that did experience severe problems
  • Wachovia: A commercial bank that acquired a mortgage lender (Golden West), not investment banking

The case that Glass-Steagall repeal directly caused the 2008 crisis is not supported by the identity of the crisis's central institutions. The case that repeal contributed to the "too big to fail" problem—by creating massive universal banks whose failure could threaten the whole system—has more support.

The Volcker Rule as partial substitute​

The Dodd-Frank Act of 2010 did not reinstate Glass-Steagall separation but enacted the Volcker Rule—a provision named after former Fed Chairman Paul Volcker that prohibited banks with federal deposit insurance (and their affiliates) from "proprietary trading" (trading for the bank's own account, not for customers). The Volcker Rule targets the risk that deposit-backed banks would take excessive risks through trading; it does not separate commercial and investment banking generally.

The Volcker Rule's implementation has been contested: defining the boundary between prohibited proprietary trading and permitted market-making (trading to serve customer needs) required complex regulations that have been repeatedly revised.

Real-world examples​

The debate over Glass-Steagall reinstating continues as a recurring political argument. Senators Bernie Sanders and Elizabeth Warren have introduced legislation to reinstate the separation; some conservative economists have also supported separation as reducing "too big to fail" moral hazard. The debate illustrates that Depression-era regulatory decisions remain live political issues nine decades later.

Canada's banking system—which maintained more restrictions on banking activity than the United States even after Gramm-Leach-Bliley and which did not experience bank failures in 2008—is sometimes cited as evidence that activity restrictions reduce systemic risk. The comparison is complicated by many other differences between Canadian and American banking systems.

Common mistakes​

Treating Glass-Steagall repeal as the primary cause of the 2008 crisis. The crisis's central institutions were primarily independent investment banks and insurance companies, not universal banks enabled by the repeal. The repeal contributed to the "too big to fail" problem but was not the primary cause of the crisis's specific mechanisms.

Treating Glass-Steagall as primarily about the FDIC. The common usage of "Glass-Steagall" refers to the commercial-investment banking separation provisions; the FDIC was also in the same act but is not what people mean when they debate "restoring Glass-Steagall."

Ignoring the international competitive dimension. By the 1990s, European and other international banks were universal banks competing in American markets. American investment banks argued—successfully—that maintaining the separation put them at a competitive disadvantage. Whether this competitive pressure was a valid reason for repeal or a financial industry rationalization for removing inconvenient restrictions is part of the ongoing debate.

FAQ​

Did the Glass-Steagall separation make banks safer during the 1933-1999 period?​

The period from 1933 to 1999 had no general banking panic, but this was primarily attributable to FDIC deposit insurance rather than the commercial-investment separation. Commercial banks during this period did not suffer investment banking losses because they were prohibited from investment banking; but the mechanism preventing crisis was FDIC insurance preventing runs, not the separation preventing losses. The counter-factual—whether commercial banks would have taken more excessive risk without the separation during 1933-1999—is genuinely uncertain.

Would reinstating Glass-Steagall prevent future financial crises?​

Reinstating the separation would reduce but not eliminate systemic risk from universal banking. A pure investment bank (like Lehman Brothers) can still create systemic risk without access to insured deposits; a pure commercial bank (like IndyMac) can still fail from bad mortgage lending. The "too big to fail" problem—institutions whose failure threatens the whole system—would remain even with separation if the separated institutions were each too large to fail individually.

What is the Volcker Rule's current status?​

The Volcker Rule was enacted in 2010 and has been subject to multiple rounds of implementation, revision, and simplification. The Trump administration's 2019 revision relaxed several requirements; the Biden administration announced but did not fully implement a return to stricter standards. The rule's current implementation is less restrictive than the original 2013 version. Details of current Volcker Rule requirements are available from the relevant regulatory agencies.

Summary​

The Glass-Steagall Act of 1933 produced two distinct legacies of very different durability: the FDIC (essentially unchanged and universally effective for nine decades) and the commercial-investment banking separation (gradually eroded and formally repealed in 1999). The separation addressed real conflicts of interest exposed by the Pecora Investigation but was a less important systemic protection than the FDIC. Its 1999 repeal via Gramm-Leach-Bliley contributed to the "too big to fail" problem by enabling massive universal banks, but was not the primary cause of the 2008 crisis—whose central institutions were independent investment banks and insurance companies, not universal banking beneficiaries. The Volcker Rule represents a partial post-2008 substitute targeting proprietary trading specifically. The debate over whether to reinstate Glass-Steagall-style separation continues, illustrating that the 1933 regulatory decisions remain live issues in contemporary financial policy.

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