Glass-Steagall Act 1933: Purpose, Provisions, Effects, And Repealing

Assignment Topic: Glass-Steagall 1933-its provision; its success or failures and its repeal in 1999.

Try to explain why the act was initiated, its development and why it was repealed.

Background of the initiation of the Act

The commercial banks have an important role to play in the economic operations of the country. The Glass Steagall Act, 1933 is derived from the names of the two congress senators who had introduced the bill in the wake of the stock market crash in the year 1929 in US. The main purpose of the act was to enable the distinction between the investment activities from the commercial banking activities of the banks. The rationale behind doing was to standardise and reform the practices of the banks and the securities affiliates that were regarded as one of the main culprits of the stock market crash in the year 1929. As a result, the act had barred the commercial banks and their affiliates from the dealing and underwriting the securities. However, sixty-six years after the introduction of the same, the act was repelled on the grounds of allowance of diversification to the banks in form of the investment banking, and the sales of the insurance. The assignment explores the various facets of the act, in terms of the events that led to the introduction, its purpose, and the reasons for the repealing of the same afterwards.

Initially the role of the commercial banks was confined towards providing liquidity, reduction of the credit risk, resolution of the issues with respect to the denomination, the investments in the short term and the self- liquidating loans to finance the transactions of the production or exchange, as was described by the National Banking Act of 1864. The definition also included the conduct of the incidental activities as were deemed necessary by the banks for the operations. Post the World War I needs of the financing, a wide number of banks had made a move towards the new methods of financing from the traditional ones, i.e. from the commercial loans to the stock and the bond issues. The inclusion of the term “incidental activities” led the banks to explore the opportunities to counter the competition. One such technique for countering competition was the conduct of the business through the affiliates, which enabled the banks to carry out various range of financial intermediation activities.

The decade of the 1920s was considered the boom period in terms of the economies. The period had witnessed growth of the securities business of the national banks. As the commercial banking is complementary to the investment banking, the same backed the banks’ entry into the said business, thereby leading to the competitive advantage. In addition, the commercial banks had a stronger base of the clients as compared to the other investment firms. The end of the decade led to a number of banks engaged into the activities of dealing, underwriting, and distributing a number of securities. The extent of the securities business sought after is very well depicted in the following table.

Thus, the above table shows a considerable increase in the number of state banks deriving a part of their incomes from the securities either by themselves or through the affiliates. In addition, the number of national banks engaged in the underwriting had also increased at a sharp pace in the span of short period of four years.

Provisions of the Act

The stock market crash of the year 1929, led to a long-term decline in the prices of the securities. The affiliates were considered one of the main reasons for the collapses of the stock prices leading to the disrupted banking activities. The contention behind the claim was the simultaneous investment in the securities by the affiliates and the boom in the stock market, depicting the conflicts of the interests in the conduct of the parties. In order to curb the defects in the banking system, and systematizing the abuse of the incidental practices of the banks through the affiliates, the Glass Steagall Act, 1933 was passed.

The Act was designed in four sections to separate the investment banking activities from the commercial banking activities. The first set of the four sections prohibited the national and the state member banks, including their affiliates from engaging into the underwriting the securities belonging to the corporates. The next section barred the financial institutions and the private banks from entering into the underwriting arrangements. The last part of the act has prohibited the officials and the other personnel of the member banks from entering into the acts like negotiation, purchase, or sale of the securities.

In addition, after the introduction of the act, the banks were given a year time to decide and choose the area of their respective specialization to be the commercial banking or the investment banking. In addition to this, the limit was set for the securities income of the banks, i.e. the 10 percent of the total income. The securities income arising out of the underwriting activity from the government issued bonds was regarded as an exception for the income allowable. The financial firms like the JP Morgan and Company that were the big players in the market, were asked to curb their income arising out of the securities.

The large financial institutions and the banks had consistently opposed the provisions of the act. The grounds for the said oppression were majorly focussed on the lines of the hindrance in the economic development and the versatility of the activities and the products of such institutions. Some of the contentions of the repealing of the Act were the lowering of the capital costs’ for such institutions, improvement of the international competitiveness, promotion of the innovations in the finance sector and the overall acceleration to the US economy and the financial services sector.

One of the major change that took place in the economy after the enactment of the act that posed the challenges to the regulators was the rising inflation and the volatility in the prices in the energy sector, in the year 1971. This resulted in the difficulties to sustain for the smaller institutions. One of the provisions of the act had imposed an upper limit on the interest offered on the deposits by the commercial banks. The rising inflation led to the increase in the market interest rates; however, the net returns were negative because of the upper limits imposed on the interest on the deposits offered.

Effects of the Act

Another major change that took place after the enactment of the Glass Steagall Act was that a number of the statutory enactments had made additions to the bank eligible securities, by the inclusion of a number of the new classes of the securities. The changes like above formed the initial passage for the repealing of the Glass Steagall Act. In addition, one other major rationale that led to the reformation was that under the framework of the Glass Steagall Act, though the financial institutions were less likely to suffer the losses arising out of the securities market. Nevertheless, at the same time there were no other means to offset the losses arising out of the lending businesses of the banks and thus making it difficult for the profitable operations to occur.

Thus, it can be stated that a combination of the economic conditions and the judicial enactments led to the erosion of the strict provisions of the Glass Steagall Act.

The US economy was deeply hit by so many financial crisis during the wake of the year 1970. These were on the line of the failing of the saving bank accounts of the banks, eventually leading to the failure of a number of commercial banks. In addition, to the above the securities industry was underperforming. Thus, the government and the regulators of the financial sector were looking for a restructuring plan for the financial sector to get past the ongoing lows in the economy.

The year 1998 had witnessed a merger of the commercial bank holding company, namely the Citicorp and the insurance company, the Travelers Group. The merger was the violation of the provisions of the Glass Steagall Act, in terms of the one company being a commercial bank and the other outside the industry. The merger was regarded by the experts of the industry as the signal from the side of the regulators that such mergers would further be allowed if in interest of the industry as a whole. To regulate the merger the companies were given a two-year retainment period. Thus, though the forbearance was imposed on the merger, still the merger was an important step towards the reform of the financial sector and the economy of the US.

Consequently, the Gramm-Leach-Bliley Act repealed the part of the earlier enacted Glass Steagall Act in the year 1999. The act is also called as the Financial Services Modernization Act of 1999. The new act had repealed the part ranging from the section 20 to section 32. However, the part ranging from the sections 16 to section 21 of the Glass Steagall Act were not repealed by the act.

The new Act had provided the flexible framework to deal in the financial sector by allowing a smooth passage for the acquisitions and the mergers within and the beyond the industry members. The provision is popularly known as the cross industry mergers. In addition, the new act had dealt the uncertainty in terms of the regulatory framework, thereby sending a positive message and the positive wealth effect to the whole industry.

The provisions of the act were on the principle that the clients of the commercial banks are able to invest in the savings bank account, as well as the securities at the same time. The practice like above would provide the security of the investments made by the clients in the event of the economic changes in the nation.

The effect of the repealing of the act were that the market values of the bank holding companies had increased dramatically, with the inclusion of the insurance firms, subsidiaries and the securities firms in the business structure. This further led to the reduction of the risks in the operations and the reduction in the overall capital cost as well.

Conclusion

As per the discussions conducted in the previous parts, it can be states that the commercial banks and their activities are an important pillar of the functioning of the overall economy and the financial sector of any nation. Hence, the activities and the framework of the operations of the commercial banks and the related entities are widely regulated by the government in form of the enactment of the various acts that are in public interest, as well as the industry as a whole. The assignment explored one such reform that had taken place in the year 1933 in response of then ongoing economic crisis. However, the reforms so initialised in the form of the act had put strict conditions on the operations of the banks. Because of which scope for the power and growth of the banks and consequently the economy, had got limited. In response to the demand of the situation of the economy back then and the oppressions faced by the members of the industry, the Glass Steagall Act was later on repealed after almost 70 years of enactment. The introduction and the repealing of the said act are important milestones in the history of the US economy.

Alper, Carl E., St. John's Law Review | Journals | St. John's University School Of Law(2018) Scholarship.law.stjohns.edu <https://scholarship.law.stjohns.edu/lawreview?utm_source=scholarship.law.stjohns.edu%2Flawreview%2Fvol8%2Fiss1%2F38&utm_medium=PDF&utm_campaign=PDFCoverPages>

Carpenter, David H, Edward V Murphy and M. Maureen Murphy, The Glass-Steagall Act: A Legal And Policy Analysis (2016) Nationalaglawcenter.org https://nationalaglawcenter.org/wp-content/uploads/assets/crs/R44349.pdf

Ertu?rk, Ismail and Daniela Gabor, The Routledge Companion To Banking Regulation And Reform (2017)

Funk, Russell J. and Daniel Hirschman, "Derivatives And Deregulation" (2014) 59(4) Administrative Science Quarterly

Lucas, Robert E. and Juan Pablo Nicolini, "On The Stability Of Money Demand" (2015) 73 Journal of Monetary Economics

Nersisyan, Yeva, "The Repeal Of The Glass–Steagall Act And The Federal Reserve’S Extraordinary Intervention During The Global Financial Crisis" (2015) 37(4) Journal of Post Keynesian Economics

Van Slyke, Shanna, Michael L Benson and Francis T Cullen, The Oxford Handbook Of White-Collar Crime (1st ed, 2016)

White, Eugene Nelson, The Regulation And Reform Of The American Banking System, 1900-1929 (Princeton University Press, 2014)