Glass-Steagall Act
Candlefocus EditorCommercial banks require customers to deposit their money in advance, and offer loans to customers based on the deposits. Investment banks, on the other hand, facilitate the buying and selling of securities, as well as the underwriting of them. The issue at hand was that the commercial banks were using the deposits to invest in speculative and risky investments, partaking in activities such as stock market speculation and involvement in the bond markets. The Glass-Steagall Act sought to remove the activities of banks and securities firms, forcing them to stick to one or the other.
Prior to the passing of the Glass-Steagall Act, banks could freely combine their commercial and investment banking activities, making profits off of investments as well as commercial loans. This was considered as particularly dangerous, as the two activities require completely different risks and return horizons. This created a conflict of interest, as the banks were more interested in speculative investments rather than customer deposits, leading to an influx of high-risk practices and rapid cycles of boom-and-bust.
Thus, the legislation – affectionately known as the Glass-Steagall Act – served to resolve this conflict of interest, separating traditional banking activities from the riskier speculative banking. The most significant element of the act was a ban on firms that had both commercial banking and investment services. Commercial banks were thus forced to choose between one of the two activities, while firms that chose the investment banking route could still partner with other institutions, provided they didn’t offer commercial banking services.
The Glass-Steagall Act thus served as a cornerstone of financial stability and customer protection until the 1990s, when the Gramm Leach Bliley Act eliminated the restrictions against affiliations in 1999. This set the ground for the 2008 financial crisis, as the segregation of services was no longer in place and banks were allowed to indulge in speculative investments.
The Glass-Stegall Act is one of the most important pieces of financial history, serving to regulate and protect traditional commercial banking activities from riskier investments. Having been in place from 1933 to 1999, the act brought financial stability and customer protection to a period of unparalleled economic turmoil, and in its absence, some argue that the crisis of 2008 could have been avoided. Although banks no longer have to stick to one activity and have been allowed to diversify their activities, the importance of the Glass-Steagall Act and its proven benefits cannot be disregarded.