After the stock market crash of 1929 and subsequent bank run that led to the Great Depression, Congress wanted to eliminate the potential for another financial disaster. In order to mitigate future bank runs and crises, the Banking Act (known as the Glass-Steagall Act) was passed in 1933.
The Glass-Steagall Act had two main provisions; the creation of FDIC and the separation of commercial and investment banking. The Federal Deposit Insurance Corporation guaranteed bank deposits up to a certain amount. This alleviated the fear that depositors may feel during a banking crisis and potentially eliminate the catastrophic effects of a bank run. The separation of commercial and investment banking was notable because banks were no longer able to invest savings deposits into anything other than government bonds. Any investments in securities or other speculative holdings could not be made using savings deposits. This provision in the Glass-Steagall Act prevented banks from insolvency. Investing deposits into risky securities during a market crash could put a bank in a bind if the value of the securities can no longer cover withdrawals during a run on the bank.
While there were recessions and difficult economic periods after the Glass-Steagall Act was passed, one can argue that this legislation prevented another event like the Great Depression. Over time, certain parts of the Act and clever financial products gave banks more leniency when it came to using savings deposits as leverage for investments. Eventually, the Glass-Steagall Act was repealed during the Clinton Administration and replaced with the Gramm-Leach-Bliley Act, which allowed for the consolidation of investment banks, commercial banks and insurance companies.
One can argue that the financial recession of the late 2000’s occurred partially due to the repeal of the Glass-Steagall Act. The Gramm-Leach-Bliley Act led to the rise of comprehensive banks that utilized deposits as leverage for investing in mortgage-backed securities and other complex financial instruments. Once the housing bubble burst, the value of these securities was less than the amount of deposits in some banks, leading to insolvency and subsequent federal bail outs.
The late 2000’s recession was a complex event that was caused by many legislative events and a Federal push to make it easier to own a home. Had the Glass-Steagall Act been in place prior to the burst of the housing bubble, the effects of the recession may have been somewhat mitigated.
Please contact Mitlin Financial with any financial questions or if you would like more information regarding the Glass-Steagall Act.
Disclaimer: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.