The Death of Glass-Steagall Was Carefully Planned and Highly Consequential

The death of the Glass-Steagall Act was the result of affirmative policy decisions by federal regulators and Congress. It was not the inevitable byproduct of market forces. Economic disruptions and financial innovations posed serious challenges to the viability of Glass-Steagall, beginning in the 1970s. The collapse of the Bretton Woods agreement, rising interest rates, and rapid growth in markets for deposit substitutes – including money market mutual funds, commercial paper, and securities repurchase agreements – created serious problems for banks during the 1970s and 1980s.

In my paper, ‘Was Glass-Steagall’s demise inevitable and unimportant?’, I argue that federal regulators and Congress could have defended Glass-Steagall and made adjustments to preserve its effectiveness.  For example, they could have enforced Glass-Steagall’s prohibition on the creation of deposit substitutes by nonbanks, and they could have relaxed the limits on deposit interest rates imposed by Regulation Q. Instead, regulators and Congress supported efforts by large financial institutions to break down Glass-Steagall’s structural barriers, which separated commercial banks from securities firms and insurance companies.

Federal agencies opened a number of loopholes in Glass-Steagall’s barriers during the 1980s and 1990s. Regulators allowed banks to securitize loans and deal in over-the-counter derivatives, which offered synthetic substitutes for securities and insurance products. However, the loopholes created by regulators were subject to many restrictions and did not allow banks to establish full-scale affiliations with securities firms and insurance companies.

The largest banks needed two major pieces of legislation to achieve their longstanding goal of becoming full-service universal banks. First, big banks and their trade associations persuaded Congress to pass the Gramm-Leach-Bliley Act of 1999 (GLBA). GLBA authorized the creation of financial holding companies that owned banking, securities, and insurance subsidiaries.  Second, the financial industry convinced Congress to adopt the Commodity Futures Modernization Act of 2000 (CFMA). CFMA insulated over-the-counter derivatives from substantive regulation under federal and state laws. The campaigns that led to the enactment of GLBA and CFMA lasted two decades and cost hundreds of millions of dollars. The largest financial institutions and their trade associations would not have pursued those campaigns unless they believed that both statutes would have great importance.

GLBA and CFMA proved to be highly consequential laws. They enabled banking organizations to become much larger and more complex and to offer a far broader range of financial products.  They transformed the U.S. financial system from a decentralized system of independent financial sectors into a highly consolidated industry dominated by a small group of giant financial conglomerates. GLBA and CFMA encouraged explosive growth in shadow banking, securitization, and over-the-counter derivatives between 2000 and 2007. All three markets played key roles in fueling the toxic credit boom and highly-leveraged financial bets that triggered the financial crisis of 2007-09.

The financial crisis has raised serious questions about the wisdom of removing Glass-Steagall’s structural barriers. Preserving those barriers would have reduced systemic risk by limiting contagion between the banking system and other sectors of the financial markets. For example, if large banks had not been exposed to heavy losses from the capital markets, they could have provided liquidity assistance and other support to leading securities firms as they did during the stock market crash in 1987 and the Russian debt default crisis in 1998.  In addition, maintaining and enforcing Glass-Steagall would have greatly reduced the size and potential risks of the shadow banking system by preventing securities firms and other nonbanks from funding their operations through run-prone deposit substitutes like short-term commercial paper and securities repurchase agreements.  

Arthur E. Wilmarth, Jr. is Professor of Law at George Washington University Law School