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Do We Need to Reinstate the Glass-Steagall Act?

Posted By KnowYourBank.com

Posted on July 30, 2012, 9:23 p.m.

Tags: Opinion

Recently, JPMorgan Chase announced that it had lost more than $2 billion on risky trades. The news raised more questions about the need for tighter banking regulations; some insisted that more oversight is needed in order prevent the risk inherent in depository institutions proprietary trading. Others, though, believe that introducing new regulations won’t really solve the problem. Instead, there are suggestions that reinstating the Glass-Steagall act would be the most effective way to prevent these types of losses in the future.

What is the Glass-Steagall Act?

The Glass-Steagall Act is also known as the Banking Act of 1933. The passage of the Act was prompted by the bank failures during the Great Depression. The Banking Act was meant to help boost confidence in the financial system. While it included such measures as creating the FDIC and expanding the role of the Federal Reserve, the most important provision was in requiring banks to keep investment and commercial banking operations separate thus protecting deposits from capital market risk.

Glass-Steagall prohibited commercial banks from participating in investing. The idea was to reduce the risk to the banks that hold consumers’ money. During the early 1900s, commercial banks started floating bond issues and underwriting corporate stock issues. With banks so exposed to stocks, when the crash of 1929 came, it wasn’t much of a surprise when banks began to collapse.

In an attempt to shore up the system, Glass-Steagall insisted that different types of banks separate themselves. Commercial banks couldn’t engage in investing, and investment banks couldn’t accept deposits or make loans to consumers. There was a very clear line between the two. Glass-Steagall was the basis for a new normal in banking.

Dividing commercial banking and investment banking was the norm until the Gramm-Leach-Bilely Act of 1999. This Act pretty much amended the parts of Glass-Steagall that required commercial banks to stay away from investment banking. The idea was to modernize the financial system so that banks could offer more financial products. However, repealing the divisions between commercial and investment banking set the stage for financial institutions to take bigger risks.

Why Some Think We Need a Return to Glass-Steagall

Rather than make new regulations, some believe that a return to the Glass-Steagall rules would be ideal. The argument is that trying to regulate the ways that banks engage in investing behaviors will fall flat as the financial institutions remain a step ahead. The period that followed the introduction of the Glass-Steagall act was one of general stability in the banking system. If the Glass-Steagall act was reinstated depository institutions wouldn’t be able to take the kind of risks that JPMorgan Chase’s London office took(“The London Whale”), which resulted in massive losses with more possibly to come, that sort of risk would be restricted to investment banks – which would be expected to make investment bets and would not put deposits at risk. The most recent situation led JP Morgan's credit to be downgraded, and drove their market cap. value down by $15 billion.

The idea of completely re-instituting Glass-Steagall probably isn’t completely feasible, since so many investment brokers now offer at least some banking services, and many commercial banks offer investment products to consumers. However, some suggest that some aspects of Glass-Steagall could be put into practice, especially if it means insisting that commercial banks no longer use consumer deposits for risky investments.

What do you think? Do we need more regulation? Would a return to some of Glass-Steagall's provisions help or should things continue as they are? Do these kind of losses lead to self-regulation by financial institutions?

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