THE
BANKING ACT OF 1933: AN EXAMINATION OF THE PAST AND PRESENT

ABSTRACT

During the 2016 election,
one of the issues discussed by the candidates from Bernie Sanders to Hilary
Clinton and even Donald Trump was whether to reenact the Glass-Steagall Act.
The Glass-Steagall Act was four provisions within the
Banking Act of 1933. The Act was originally created after the fallout of the
Great Depression. It was later repealed in 1999 by President Bill Clinton under
the Financial Services Modernization Act of 1999. The objective of this paper
is to survey the Glass-Steagall Act from its inception, dissolution and
possible resurrection. It is the author’s aim to present a general historical
background and contemporary dialogue over this regulation. The paper strives to
assist both the business law and economics educators when instructing students
on the Great Recession of 2008-2010.

INTRODUCTION         

In an interview earlier this year, President Donald Trump raised the possibility of resurrecting the Banking Act of 1933. Colloquially termed as the Glass-Steagall Act, it was a law separating consumer lending and investment banking during the Great Depression. (Jacobs, 2017) While a month earlier, United States Senators Elizabeth Warren, John McCain, Maria Cantwell and Angus King introduced a modern version of the Banking Act of 1933 known as the 21^st Century Glass-Steagall Act to Congress. (Warren, 2017) All this political interest in an eighty-four year old regulation suggests an opportune moment to examine the creation of the Glass-Steagall Act in the 1930s and its eventual destruction in the 1990s.

The rest of this article will proceed
as follows. Part I offers the historical context for the establishment of
Glass-Steagall Act and its passage during the Great Depression. Part II then
offers an overview of the Glass-Steagall Act itself and the financial reform
components. Part III describes and examines the reasoning behind its abolishment
in the era of deregulation. Finally, Part IV concludes by examining the recent
deliberation within the context of financial reforms in the twenty-first
century.

Part I. A BRIEF HISTORY OF THE 1920S ECONOMY AND STOCK MARKET

The transition back to a peacetime economy
following the end of World War I was a difficult adjustment for the United
States. The post-World War I recession of 1919-20 even though extremely brief
was considered moderately severe. (NBER, 2012) The end of war time production
and returning troops contributed to high unemployment and decline in wages with
factories becoming idle. This was further exacerbated by resumption of normal
European agricultural production, which lower the demand for American
production. Farm prices fell at a catastrophic rate. The price of wheat, the
staple crop of the Great Plains, fell by almost half while cotton prices in the
South, fell by three-quarters. (Romer, 1988)

By the beginning of 1921, the United States had successfully transitioned to a peacetime economy especially in the metropolitan centers. (Miller, 2015) The period from 1921 to 1929 would come to be nicknamed “the Roaring Twenties,” a term coined by the famous author, F. Scott Fitzgerald. This capture the sense of prosperity and excitement as America gained dominance in world finance. (Soule, 1948) The United States would become the richest country in the world per capita and the largest total GDP. (Goldberg, 2003)The annual GNP grew at a rate of 4.7 percent from 1922 to 1929. (US DC, 1975)

The migration from rural America into major urban centers increased dramatically as farmers, many of whom had taken out loans to increase production, failed to make payments due to limited demand and excess supplies. With agricultural incomes remaining stagnant, farm foreclosures and rural bank failures increased at an alarming rate. While the major metropolitan cities was experiencing a renaissance with the growth of industries such as automotive, film, radio and chemical. New technological innovation like mass production and assembly-line accelerated demand for labor and real wages increase by around 20%. (Goldberg, 2003) Combining the rising wages with the falling cost of new mass produced goods allowed the middle-classes in urban centers to experience luxuries previously unattainable prior to World War I. The best example of this is the automobile. The Model T sold for $850 in 1908, now sold for $290 in 1924, the rate of automobile ownership increased from one car per fifteen Americans to one car per five Americans. (Allen, 1931)

The financial needs of these new industries altered the face of American capital markets. In the 1800s, commercial banks were severely limited in their ability to provide large long-term loans due to regulations. These restrictions prohibited National Banks from lending to one customer more than 10 percent of their capital and surplus. The effect of this regulation on banks’ lending capacity was amplified by strict state limits on branch banking that restricted banks’ ability to grow. Corporations turned to financing their capital investments out of retained earnings, bond and stock issues. The market for industrial securities, which first emerged in the nineteenth century, came of age in the 1920s, as both old and new firms issued equities to finance new plant and equipment. (Campbell, 1988)

Commercial banks did purchase more bonds, but they could not legally trade or acquire equities. To bypass these regulations, they developed the “affiliate system” which was a process of setting up independent but fully owned affiliates under state charters. This sanctioned them to penetrate all aspects of investment banking and the brokerage business. The number of affiliates grew rapidly from ten in 1922 to one hundred and fourteen by 1931. (White, 1986) These affiliates solicited many new customers and became a major distributors of stock and bonds, empowering them to become underwriters. By 1930, commercial banks’ security affiliates had obtained roughly half the bond originations. By moving into investment banking through their affiliates, commercial banks were thus able to continue servicing the requirements of their corporate customers (White, 1986)

While the securities affiliates catered to a broader clientele than most traditional brokerage houses, many small investors might still have shied away from buying securities, lacking sufficient capital to purchase a diversified portfolio of stocks. This obstacle was eliminated by the investment trusts, which served the same function as mutual funds do today. The investment trusts grew from about forty in 1921 to over seven hundred and fifty by 1929. Investment trusts were primarily institutions that sold securities to the public and used the proceeds to invest in stocks and bonds. There were two main types of investment trusts, management trusts and fixed trusts. The management trusts had managers overseeing the portfolio and making business decisions. The fixed trust, on the other hand, the portfolio could not be changed from its initial inception. (West, 1977)

The growth of the securities market, assisted by the establishment of investment trusts and securities affiliates, allowed firms to substitute stocks and bonds for commercial bank loans. This development began well before the stock market boom, but the pace of change accelerated in the 1920s with the rapid growth of modern industrial enterprise. During this decade, banks found their traditional role as intermediaries sharply reduced. Commercial loans as a percentage of total earning asset of national banks fell from fifty-eight percent in 1920 to thirty-seven percent in 1929. In response, they sought to increase their fee income by offering new financial services, including trusts and insurance. (West, 1977) Most importantly, they increased their role as brokers between the saving public and industry. Banks were familiar with their borrowers and conditioned to monitor their activities. However, the overall sophistication of investors was weakened by the influx of new people into the market. Even before the boom began, many people who had never bought stock before entered the market. One major group of new investors was women, whom brokers catered to with special programs and even their own rooms to watch the ticker tape. All these new investors lacked experience in buying stock and monitoring firms. , thus creating a favorable condition for the later crash in 1930. During 1921 the Dow Jones Industrial Average was at around 16 points, but by September 3, 1929, the Dow Jones Industrial Average swelled to a record high of 381.17, reaching the end of an eight year growth period during which its value ballooned by a factor of six. (US DC, 1975)

Another contributor to the economic
boom was easy credit. When an investor bought stock on margin, his broker
usually paid the difference by contracting a broker’s loan from a bank that was
collateralized by the stock. Call loans were the most important type of
brokers’ loans. These loans had a daily call option and floating interest rate.
Of lesser importance were time loans that had fixed maturity and fixed interest
rate. (Patterson, 1965) The stock market credit was key element in generating
irrational euphoria. This mania led individuals and institutions to believe
that all will be better, that they are meant to be richer and to dismiss as
intellectually deficient what is in conflict with that conviction. The ability
to purchase stock on margin was a great speculative lure. A buyer need only to
provide a fraction of the required funds, borrow the rest and enjoy the full
capital gain less the interest on the borrowed money. This only further fueled
unwise speculation for the public.

The Federal Reserve started to pursue a contractionary policy beginning in January 1928, with open market sales and a rise in the discount rate from three and half percent to five percent. In 1928 and 1929, the consumer price index fell and M1 grew only slightly. (Patterson, 1965)These policy was a consequence of its fears about the flow of credit to the stock market. The Federal Reserve had always been concerned about excessive credit for speculation. The Board wanted member banks making loans on securities to be denied access to the discount window in order to force credit away from speculation. By 1929, the brokers’ loan did not slow down but grew rapidly even though member banks’ loans to brokers was in sharp decline. The rapid growth occurred in loans from private investors, corporations and foreign banks in Europe and Japan, which quickly substituted for bank loans. (Patterson, 1965)

Brokers’ loans did not contribute to the stock market boom. Instead, the demand for credit to buy stock pulled funds into the market, forcing major reallocation of credit in the money and capital markets. The stock market boom also had a powerful effect on the demand for money due to the demand for transactions balances to buy stocks. This caused money markets to tighten further as the boom progressed, misleading the Federal Reserve as to the actual effect of its policies. As the call rate rose, there was a rapid decline in commercial paper. Commercial banks provided more loans and discounts to firms that had previously relied on the commercial paper market. (Patterson, 1965) The stock market demand for funds and new issues forced major changes in other financial markets. The growth in the new issues of domestic stock increased dramatically, while issues of domestic bonds and notes fell from $3.1 billion in 1927 to $2 billion in 1929 and foreign securities fell even more from $1.3 billion to $673 million. (Patterson, 1965)

The stock market started to unravel on Wednesday October 23, 1929 to the close on Tuesday October 29, 1929, the New York Stock Exchange lost over twenty-five percent of its value. In that single week, the Dow Jones Industrial Average (Pierce, 1982) fell from 326.51 to 230.07, a drop of twenty-nine and half percent, while the Standard and Poor’s composite portfolio of ninety stocks (Schwert, 1990) fell from 28.27 to 20.43, a fall of twenty-seven and eight percent. As large as these drops were, they must be placed in the proper perspective. First, at the end of 1929, stock prices were less than twenty percent below their beginning of year level, and well above the level at the beginning of 1928. In addition, much of the October 1929 loss was regained by mid-April of 1930. But, nevertheless, it is important to keep in mind that the October 1929 crash was just one part of the sustained decline that began on September 3, 1929, when the Dow Jones Industrials closed at 381.17, and continued through the end of February of 1933, when Dow closed at 50.16 which was a cumulative decline of over eighty-five percent. While share prices certainly fell in late October 1929, and trading was disorderly in many respects, the market decline was more gradual and much longer than the term ‘crash’ implies. Finally, it is worth noting that the Dow Jones Industrial Average did not reach the nominal level of the September 1929 peak again until the mid-1950s.

In the immediate aftermath of the crash, President Herbert Hoover instructed Congress to investigate the prospect of separating commercial and investment banking. (Kelly, 1985) Senator Carter Glass spearheaded the effort in the Senate to devise new regulations, introducing early draft legislation in 1930, and holding hearings under the authority of the Senate Banking and Currency Committee in early 1931. (Kelly, 1985) In January 1932, Senator Glass introduced a revised bill that for the first time was specifically designed to separate securities affiliates from commercial banks. The financial sector was strongly opposed to the legislation fearing the pending legislation as unfairly restrictive of banking practices, and a threat to the prospects for economic recovery. On April 19, 1932 Senator Glass introduced the final version of this bill. The bill focused on securities affiliates as the key catalyst for the collapse of the financial sector, proposing the outright separation of commercial from investment banking. But President Hoover and much of Congress remained opposed to major financial regulatory reform, delaying further action on the bill.

As 1932 wore on, the prospects for Senate Glass’s bill seemed to improve. The public hearings into stock exchange practices revealed the excesses of Wall Street bonuses, income tax evasion, and highly profitable but misrepresented securities sales and other problematic business practices. The bill received a further boost when Senate Glass helped with the drafting of Franklin D. Roosevelt’s Democratic Party platform in 1932. He was able to insert a provision calling for the regulation and separation of commercial and investment banking. (Perkins, 1971) Throughout the spring and summer of 1932, banks and influential business groups continued to oppose the bill, meeting with members of Congress and criticizing the bill as harmful to credit, recovery and growth in the midst of the depression to the public. After Franklin D. Roosevelt’s electoral victory, even President Hoover came around to supporting a version of the bill realizing financial regulation of some kind was now inevitable. President Hoover with the help of a Republican Senate hoped to obtain passage of a more watered down version of the bill before Franklin D. Roosevelt and the newly elected Democratic Congress could be sworn in. (Perkins, 1971) They were unsuccessful in achieving passage in the Democratic House, where debate was already beginning on the prospect for deposit insurance called the Steagall’s deposit insurance bill. With the arrival of a new Congress and a new administration in March 1933, the Glass bill moved very quickly toward passage. Much of the “Hundred Days” session of Congress centered on bolstering the economy and staving off further financial collapse. Eventually, the Glass bill and Steagall’s deposit insurance bill would merge and secure bipartisan support for passage in the House. (Kelly, 1985)

Part II.  AN OVERVIEW OF THE GLASS-STEAGALL ACT

The Glass-Steagall Act consisted of four provisions:
sixteen, twenty, twenty-one, thirty-two, which taken together mandated the
separation of commercial and investment banking. Provisions sixteen and twenty
prevented any bank that accepts deposits from directly engaging in most
securities activities except for those involving municipal general obligation
bonds, United States government bonds, private placements of commercial paper
and real estate bonds. Provisions twenty-one and thirty-two address indirect
securities activities through bank subsidiaries or affiliates and apply to
banks that are members of the Federal Reserve System. Provision twenty
prohibits these banks from affiliating with any organization “engaged principally”
in underwriting securities, and Provision thirty-two prohibits director,
officer or employee interlocks between these banks and firms “primarily
engaged” in securities activities. The banking act also expanded permission for
national banks to engage in “branch banking” by opening subsidiary branches in
different localities and expanded the regulatory powers of the Federal Reserve.
It will also create a deposit insurance system by establishing what is now
known as the Federal Deposit Insurance Corporation. (12 U.S.C. §24)

As a substantive policy, the Glass-Steagall Act’s separation of commercial and investment banking was seen as crucial to preventing abuse by financial firms in selling securities. A commercial bank might promote the securities it underwrites and misrepresent the quality of these securities to its depositors instead of offering them disinterested investment advice. Or the bank might induce a troubled loan customer to issue new securities to repay the loan. If investors in these securities are naïve, they are penalized by purchasing poor quality securities believing they are good investments. If, however, investors are not naïve, they know such a conflict of interest might exist and will, therefore, adjust down the price they are willing to pay for such securities. In this case, the issuing firms that use commercial bank underwriters bear the cost by receiving less funding than they would like, so there is underinvestment. The economy is worse off, since some good investments go unfunded.

Part III. The ABOLISHMENT OF THE GLASS-STEAGALL ACT

During the 1980s and 1990s, federal banking
agencies and courts adopted creative statutory interpretations that enabled
banks to engage in stock markets activities and allowed nonbank financial
institutions to offer substitutes for deposits. The collective impact of those
rulings eroded Glass-Steagall barriers by permitting commercial banks to behave
more like securities firms and allowing nonbanking financial institutions to
behave more like banks. (Markham, 2000)

Federal agencies and courts was able
to undercut Glass-Steagall in three significant ways. First, nonbank financial
institutions were allowed to fund their operations by offering short-term
financial instruments that were redeemable at par and served as functional
substitutes for deposits. Those instruments included money market mutual funds,
commercial paper, and securities repurchase agreements. The largest commercial
banks also began to rely significantly on these type of instruments after they
were allowed to reestablish securities affiliates beginning in 1987. (Markham,
2000)

Second, banks received permission to
convert their consumer and commercial loans into asset-backed securities
through the process of securitization. Third, banks gained authority to become
dealers in over-the-counter derivatives, which provided synthetic substitutes
for securities, exchange-traded options and futures. (Whitehead, 2010)

The National banks were not satisfied
with the limited victories they achieved by opening loopholes in
Glass-Steagall. They lobbied and launched a prolonged campaign in the 1980s and
1990s to repeal Glass-Steagall’s provisions. In 1991, the U.S. Treasury
Department issued a landmark report, which called for the removal of state
banking restrictions on interstate banking as well as the repeal of
Glass-Steagall. Congress adopted Treasury’s plan by enacting the Riegle-Neal
Interstate Banking and Branching Efficiency Act, which allow nationwide banking
and branching. In 1998, with the merger between Travelers, a large insurance
and securities conglomerate, and Citicorp, the largest U.S. bank to create
Citigroup created the first “universal bank” to operate in United States since
1930s. (Whitehead, 2010) Thus exerting extreme pressure on Congress to repeal
the Glass-Steagall’s anti-affiliation rule.

Citigroup and other large financial
institutions began a massive lobbying campaign that finally persuaded Congress
and President Bill Clinton to adopt the Gramm-Leach-Bliley Act in 1999. This
act authorized the creation of financial holding companies that could own
banks, securities firms and insurance companies and finally repealed
Glass-Steagall Act. (Sissoko, 2017)

Part IV.  GLASS-STEAGALL ACT IN THE TWENTY-FIRST CENTURY

In the fall of 2008, the United States
experienced a sudden financial crisis that plunged the financial sector into
the worst economic downturn since the Great Depression. The large banks
originated subprime mortgage and sold them to their depositors as securities. As
home prices declined, mortgage delinquencies and foreclosures increased causing
a devaluation of subprime mortgaged securities. (Taub, 2014)

In the aftermath, President Barack Obama introduced a series of regulatory proposals to address the Great Recession of 2008-2010. Discussion about Glass-Steagall started to take shape both in public and private sectors. (Wack, 2012) This crystalized into reality during the 2016 Presidential election with both the Democrat and Republican platforms signaling possible reinstatement of Glass-Steagall.

In 2013, Democratic Senator Elizabeth Warren and Republican Senator John McCain proposed a bipartisan bill, the 21^st Century Glass-Steagall Act, which would reinstate the Glass-Steagall Act. (Warren, 2017) After winning the 2016 election, the Trump administration is open to implementing legislation that would function to reinstate the provisions of Glass-Steagall. But in a hearing before the Senate Banking Committee on May 18, 2017, Treasury Secretary Mnuchin clashed with Senator Warren, saying that the Trump administration does not support a full separation of banks and investment banks. (Bryan, 2017)

In conclusion, in light of the lively debate in Washington and further developments in this area are likely to continue. The financial services industry faces the real possibility of a bipartisan effort to pursue a number of possible approaches to reinstating the potions of the Glass-Steagall Act that separated commercial and investment banking. Such legislation could have a profound impact not only on banks but potentially on many other types of business within the financial industry.

* Weindorf & Company CPAs LLP, 6080
Jericho Tpke, Ste 306, Commack, New York, 11725

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