Glass-Steagall Act

The Glass-Steagall Act of 1933 was the law that separated commercial banking from investment banking. A bank could either take deposits and make loans, or underwrite securities and trade for its own account, but not both. The Act was meant to prevent conflicts of interest and excessive risk-taking. It was repealed in 1999 by the Gramm-Leach-Bliley Act, allowing the re-merger of commercial and investment banking. The question of whether the repeal contributed to the 2008 financial crisis remains contentious.

The crisis context: 1933

Glass-Steagall was enacted during the Great Depression, after the 1929 stock market crash and subsequent bank failures. The theory was that commercial banks had engaged in speculation — taking deposits and using them to fund risky securities trading — and when the market crashed, the banks were left insolvent. Congress concluded that the solution was separation: commercial banks should be conservative (taking deposits and making loans), while investment banks (funded by equity and debt, not deposits) could take more risk.

The architecture of separation

Glass-Steagall required that commercial banks divest or spinoff their investment banking operations. A bank like National City Bank (later Citibank) had to choose: either become a commercial bank or an investment bank. Most major banks chose to be commercial banks (more stable, deposit insurance) and spun off investment operations. National City’s securities subsidiary became First Boston Corporation, a major investment bank.

The Act did not allow securities affiliates (a common structure where a bank held a separate securities company as an affiliate). Over time, regulators created exceptions — the “investment company activities” exemption allowed banks to underwrite certain securities. The result was a regulatory framework that was complex and leaky — by the 1980s, Glass-Steagall was more porous than many appreciated.

Why the separation mattered

The theory behind Glass-Steagall was that investment banking conflicts with commercial banking. An investment banker has incentives to underwrite risky securities and sell them to customers, because the fees are lucrative. A commercial banker wants conservative customers with steady income to repay loans. Combining these in one firm creates a conflict: the bank’s investment banking division might pressure the commercial division to hold risky assets, or to pressure customers to buy risky securities.

Additionally, if an investment bank speculates and loses, it can impose losses on the bank’s depositors (who are FDIC-insured but whose money is tied up in the failed bank). Separation was meant to quarantine investment risk.

The drift toward repeal: 1980s onward

Starting in the 1980s, Glass-Steagall began to erode. The Federal Reserve began granting exemptions, allowing bank holding companies to own investment banking affiliates (firewalls between the bank and affiliate were supposed to prevent conflicts). Regulators interpreted the exemptions broadly. By the 1990s, large banks like Citibank were effectively offering both commercial and investment banking through affiliate structures.

The drive for repeal was financial — banks argued Glass-Steagall was antiquated, that modern finance required scale and diversification, and that European banks had no such restrictions and were winning business. Investment banks wanted to own deposit bases (stable funding). The SEC and other regulators quietly agreed with repeal.

Gramm-Leach-Bliley and the end of Glass-Steagall

The Gramm-Leach-Bliley Act (Financial Modernization Act), enacted in 1999, formally repealed Glass-Steagall. Banks could now openly combine commercial and investment banking. Large banks immediately began consolidating — merging commercial banking arms with investment banking operations. By 2007, the largest US banks (JPMorgan, Bank of America, Citigroup) were universal banks offering all services.

The crisis and the repeal debate

When the 2008 financial crisis hit, many economists pointed to Glass-Steagall’s repeal as a cause. The theory was that banks, now able to combine commercial and investment operations, had taken excessive risks and that when the securities market crashed, the commercial banks fell with it. Critics argued that repealing Glass-Steagall was a mistake.

However, others noted that banks did not fail directly due to securities trading losses; they failed due to mortgage-backed securities implosion and derivatives exposure. Investment banks (which were not covered by deposit insurance) failed immediately (Bear Stearns, Lehman Brothers). Commercial banks, which held mortgages, failed over time (IndyMac, Washington Mutual). The causation was not clear-cut.

Modern calls to reinstate Glass-Steagall

Some progressives (notably Elizabeth Warren) have called for re-enacting Glass-Steagall. The argument is that modern universal banks are too big and too risky, and that separating commercial from investment banking would reduce systemic risk. Conservatives and banks oppose it, arguing it would reduce scale and competitiveness. The Volcker Rule (2010) can be seen as a partial re-implementation of Glass-Steagall principles — it prohibits proprietary trading but allows investment banking.

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