How is your bank using your money?
Passed June 16, 1933
Every two weeks, it is payday for Bob. Rather than spending his money carelessly, Bob always decides to deposit the majority of his paycheck into his bank account. Not having much knowledge of what the bank does with his money, Bob always assumes that they just keep it in their safes.
However, banks often lend out a portion of deposits to people asking the bank for a loan. Bob's bank, in particular, doesn't just give out loans; in fact, they actively participate in the speculation of the stock market. Using Bob's deposit money, his bank often buys stocks that they think will rise in value. But recently, the economy and stock market have not been doing well. Because of this, Bob's bank has lost all of Bob's money due to their risky investments. At the same time, Bob sees the downturn of the economy as a bonus for him. In his mind, he has been responsibly saving his paychecks, and now is a perfect time to buy himself a house as prices have fallen.
With plans to buy himself a house given the decline in home prices, Bob goes to the bank to withdraw his money (for the sake of this example, Bob is going to buy a house with cash rather than applying for a mortgage). However, when Bob goes to withdraw his money, the bank tells him that they are unable to give him his money back as the bank doesn't have it anymore. Devastated by this news, Bob loses all trust in the banking system.
This hypothetical situation is similar to what happened during the stock market crash of 1929 and the subsequent Great Depression. To prevent this from happening again, Congress passed the Glass-Steagall Act.
WHY THIS POLICY?
In the midst of the stock market crash of 1929 and the Great Depression, a wave of bank runs swept across the nation. People rushed to the banks to withdraw their money to prepare for the hard economic and financial times ahead. However, the banks did not have the people's money. As there was no clear distinction between investment and commercial banking, commercial banks often used depositors' money to speculate in equity markets. In the midst of the Great Depression, these speculative investments became highly volatile, and commercial banks began to lose their depositors' money.
To combat the issue of banks losing people's money, Congress passed the Banking Act of 1933, commonly referred to as the Glass-Steagall Act, named after its Congressional sponsors, Senator Carter Glass and Representative Henry B. Steagall. The Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC), which began insuring bank accounts up to $2,500, and separated commercial and investment banking. The goal was to make sure people's savings were protected by banks, but more importantly, the motive was to restore trust in the American banking system. With the mass failure of banks during the Great Depression, many people rushed to withdraw money from banks before they went bankrupt. However, these bank runs further hurt the banks, leading to a catastrophic cycle of bank runs and failures. To prevent this from happening again, Congress had to restore the public's faith in the banking system. By having a portion of their deposits insured by the full faith and credit of the government of the United States of America, people could have the confidence to deposit their money in banks.
In addition to the creation of the FDIC, the Glass-Steagall Act also separated commercial from investment banking. In the fallout of the stock market crash of 1929, many people pointed to banks' involvement in the securities market for their collapse. By restricting commercial banks, which took in deposits and made loans, from underwriting or dealing in securities, Congress created a regulatory firewall between commercial banks and investment banks and prevented commercial banks from using depositors' funds for risky investments. With the exception of commercial banks being able to underwrite government-issued bonds, the Glass-Steagall Act outlined that commercial banks could not have more than 10% of their income from securities. Additionally, it prevented investment banks from owning commercial banks or having close connections with them.
The Glass-Steagall Act passed the House of Representatives 262-19 on May 23, 1933. The Senate approved the bill on May 25, 1933, in a voice vote, and President Franklin D. Roosevelt signed the act into law on June 16. Given the context of the Great Depression and the stock market crash of 1929, there was no major opposition to the legislation. Most people agreed that banks played a big role in both the market crash and the downturn of the economy and should be more heavily regulated.
However, in the following years and decades, opposition grew against the Glass-Steagall Act, especially because of the separation of commercial from investment banking. Even Senator Glass, the person who advocated and spearheaded the legislation to separate commercial from investment banking, eventually tried to repeal this legislation. Ultimately, the provision of the Glass-Steagall Act that separated commercial from investment banking was repealed in 1999 through the Gramm-Leach-Bliley Act.
The Glass-Steagall Act was successful in restoring trust in the American banking system. With the establishment of the FDIC, which still exists and now insures deposits up to $250,000, people had the confidence to deposit their money in banks, knowing that they were insured by the United States Government. However, while the decision to separate commercial banking and investment banking was not initially seen as controversial, it faced major opposition throughout the 20th century. While the separation was initially seen as healthy for the financial system, opposition to this idea quickly grew in the years following the passing of the legislation. Some argued that by separating investment and commercial banking, it would increase risk in the banking industry as it prevented banks from diversifying their activities. Additionally, they argued that the separation would force commercial banks to compete with investment banks, which would promote riskier activity. In response to this, Congress eventually repealed certain provisions of the Glass-Steagall Act that separated commercial and investment banking in 1999 through the Gramm-Leach-Bliley Act (GLBA). Through the GLBA, investment banks, commercial banks, and insurance companies were able to consolidate into large investment bank holding companies in the early 2000s. In the fallout of the 2008 financial crisis, many cite the GLBA and the repeal of the Glass-Steagall Act for significantly contributing to the crisis.
Credit: Richard Jia
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