Glass-Steagall Act (1933)

views updated May 14 2018

Glass-Steagall Act (1933)

Michael P. Malloy

Many economic and political factors led to the financial crisis that began in 1929, but the general breakdown of the U.S. banking system during the period from 1929 to 1932 certainly played a significant role in the crisis. It was this systemic failure that led Congress to review and reform the Federal Reserve System and the national banking system as well. In particular, the Banking Act of 1933, known as the Glass-Steagall Act (GSA) (48 Stat. 162), made several significant changes in the federal regulation of banks. Primary among these was the separation of commercial banking from investment banking.

Congress accomplished this separation through the application of several techniques. First, it applied direct prohibitions to the activities of certain commercial banks. Congress narrowly limited the types of investment activities in which national banks and state-chartered banks that were members of the Federal Reserve System (member banks) could engage. The law permitted the banks to act as agents for their customers in the purchase and sale of securities without recourse, but the law generally prohibited banks from dealing in (purchasing or selling) securities for their own accounts. The law also banned banking institutions from underwriting (distributing to the public) any issue of securities.

These prohibitions were not absolute, even as originally enacted. While the law prohibited the banks from purchasing any shares of stock of any corporation, they could purchase "investment securities" (high-quality debt securities) for their own account under certain limitations administered by the comptroller of the currency pursuant to GSA. The banks could also purchase, deal in, and underwrite obligations of the federal government and general obligations of states and their political subdivisions.

The second major regulatory technique GSA adopted was the elimination of legal affiliations between member banks (national and state) and investment banking firms. The GSA banned national banks and state member banks from maintaining affiliations with any organization engaged principally in the issuance, underwriting, or distribution of securities. Congress later repealed this prohibition, however, in the 1999 Gramm-Leach-Bliley Act (GLBA). Similarly, GSA prohibited corporations engaged in the issuance, underwriting, or distribution of securities from receiving deposits. Third, GSA prohibited interlocking directorates between member banks and any organizations engaged primarily in the securities business. (GLBA also repealed this provision in 1999.)

These provisions were intended to build a wall between commercial and investment banking. To understand why this position was taken, one must consider a number of factors, including: (1) the expansion of commercial bank involvement in the securities business during the 1920s; (2) the early legislative and regulatory responses to this development, ultimately unsuccessful; (3) the apparent effects of this extension of commercial banking into the securities field; and (4) the reaction of Congress when these effects became apparent during congressional hearings from 1931 to 1933.

EARLY BANKING REGULATION AND ACTIVITY

Two approaches to banking, broadly conceived, have been apparent throughout American banking history. The first is the English model, based on a sharp division between those institutions engaged in commercial banking and those engaged in investment banking. From this perspective, the law views investment banking as a risky, speculative venture and consequently as an inappropriate activity for an institution devoted to the care of deposits from the public.

In contrast, the German model views combining investment and commercial activities in a single enterprise as appropriate. Experts defend this approach on two grounds: efficiency and security. The efficiency of the German model is premised on the fact that the information sources and the business skills necessary for success in the investment banking business are similar to those needed in commercial banking as well. Further, the German model supposedly provides a more secure investment strategy because it provides a bank with a more diverse portfolio.

By 1865, Americans had accepted the English model of banking, and some commentators say that this is evidenced by the National Bank Act (NBA), which arguably required the separation of commercial and investment banking. The act defined the general powers of national banking associations to include "all such incidental powers as shall be necessary to carry on the business of banking," but did not explicitly allow banks to deal in securities. In California Bank v. Kennedy (1896), the U.S. Supreme Court held that national banks cannot exercise any powers except those the NBA expressly granted or that are incidental to carrying on a banking business. A national bank therefore did not possess the power to deal in equity securities, since that power was not granted by the act.

Despite the clear limitation found in the NBA, the U.S. banking system moved slowly toward the German model. Several factors explain this: increasing competition within the commercial banking industry; the development of the trust company after the Civil War (1861–1865); and the continuing competition between state and national banks. The typical trust company, authorized under state corporate law to engage in securities activities, soon became a full-service institution that could offer its customers both banking and investment services.

In response to the growing competition from trust companies, state-chartered commercial banks demanded additional powers from the state legislatures. By the early 1900s, legislatures granted most state banks many of the same powers to engage in investment activities already possessed by trust companies. National banks, however, were left out, and they sought justification for securities activities under the NBA. One of the first national banks to engage in underwriting activities was the First National Bank of New York. In 1908, in response to criticism from the comptroller concerning its securities dealings, the bank formed a securities affiliate, the First Security Company. The affiliate was incorporated under state law and was arguably free to conduct investment activities. In 1911 a second affiliate, National City Company, was organized, and by 1916 that affiliate was actively engaged in origination, underwriting, wholesaling, and retailing.

Eventually, a large number of securities affiliates of banks sprang up. By 1922, sixty-two commercial banks were actively engaged in investment banking, and ten others had formed securities affiliates. By 1932, there were approximately 300 securities affiliates of commercial banks in the United States. National banks owned two hundred of these affiliates, state-chartered member banks owned seventy, and nonmember banks owned thirty such affiliates.

THE GROWTH OF SECURITIES AFFILIATES AND THE GSA

The growing involvement of commercial banks in investment banking drew criticism from legislative and regulatory quarters of the federal government. As early as 1913, a House Special Investigating Subcommittee known as the Pujo Committee (named after its chair, Representative Arsene Paulin Pujo, also the chair of the House Banking and Currency Committee), which investigated the institutional concentration of money and credit, denounced the extension of commercial banks into investment banking. The earliest extensive criticism from a regulatory authority came in a 1920 report of the comptroller of the currency, which questioned the legality of the securities affiliate system. It also noted functional problems with the use of affiliates, including conflicts of interest between management of the commercial bank and management of the affiliate, and the impropriety and risk of using bank deposits to fund speculative activities.

Despite these criticisms, Congress took no action to curtail the securities activities of commercial banks and their securities affiliates. During the 1920s even the comptroller's position eventually metamorphosed into a permissive one. Congress codified this position in the McFadden Act of 1927, amending the GSA by expressly extending the corporate powers of national banks to include the "buying and selling without recourse marketable obligations evidencing indebtedness ... in the form of bonds, notes and/or debentures commonly known as investment securities." The McFadden Act authorized the comptroller to determine what types of securities investments were sufficiently marketable to be appropriate. Thus, the only limiting principle was the "marketability" of these securities. The comptroller gave the term "marketable" a broad interpretation, so broad that virtually any public issue of bonds would qualify as a proper investment for a national bank.

From 1927 to 1929 commercial banks and their securities affiliates became even more significantly involved in the investment banking business. In 1929 J. W. Pole, then comptroller of the currency, proudly noted that the McFadden Act had added impetus to the movement to make commercial banks the distributors of the best type of investment securities. He stressed that the trust and securities fields were likely to be the area of greatest future expansion in commercial banking. The banks and the government discarded the English model. No doubt to Pole's embarrassment, soon after his statement the stock market panic of 1929 began, and by 1933 nearly 9,000 commercial banks in the United States had failed.

This series of disasters set the stage for definitive congressional action with respect to the securities activities of commercial banks. However, it took three years of contentious congressional investigation and debate (from the June 1930 introduction of Senator Carter Glass's first bill on the subject, until the enactment of the GSA in June 1933) before federal law decisively excluded banks and other financial institutions from the investment banking business.

A NEW ERA

The GSA and its prohibitions on banking activities remained stable until the 1960s, when banks began to seek regulatory and statutory justifications for competitive incursions into the securities business once again. As competitive pressures intensified on the banks' traditional, core businesses both from domestic nonbanking firms like mutual funds and from foreign banking and nonbanking competitors, the banks sought to widen their involvement in the securities business through favorable regulatory rulings and through litigation.

At the same time, federal courts began to limit the scope of GSA. In a 1971 case, Investment Company Institute v. Camp, the U.S. Supreme Court expressed skepticism of bank involvement in the securities business, particularly in light of the "subtle hazards" presented by such involvement, hazards the GSA had intended to eliminate in 1933. As late as 1984, in Securities Industry Association v. Board of Governors, the Supreme Court still emphasized the important prohibitions found in the GSA. However, as experts began to view the GSA as obsolete in light of the complex competition between banking and securities firms, the Supreme Court and the lower federal courts gradually began to interpret the scope of the act narrowly and technically, and to defer more to the judgment of the bank regulators. This narrowness was particularly evident in cases in which a holding company affiliate of a bank conducted the securities activities, rather than within the bank itself, as in Board of Governors v. Investment Company Institute (1981). In this case, the Supreme Court allowed a bank holding company to operate a closed-end investment company. And in Securities Industry Association v. Board of Governors (1984), the court allowed a bank holding company to operate a discount brokerage firm.

Nevertheless, it took Congress until 1999 to set new limits on GSA. Congress approved the GLBA, and President Bill Clinton signed it into law on November 12, 1999. This financial services reform legislation is one of the most significant pieces of federal banking legislation since the GSA itself. Among other things, it works a fundamental change in the scheme of regulation of securities activities of depository institutions. The GLBA eliminates prohibitions on affiliations between commercial and investment banking enterprises and on interlocking directorates between such enterprises, by repealing various GSA provisions. It also requires as a general rule that federal and state securities regulators, not bank regulators, supervise securities activities—whether undertaken by securities firms or banking enterprises. Whether this realignment of financial services regulation will prove to be effective awaits the judgment of future events.

See also: Federal Deposit Insurance Acts; Federal Reserve Act; securities Act of 1933; Securities Exchange Act of 1934.

BIBLIOGRAPHY

Kennedy, Susan. E. The Banking Crisis of 1933. Louisville: University of Kentucky Press, 1973.

Malloy, Michael P., ed. Banking and Financial Services Law: Cases, Materials, and Problems. Durham, NC: Carolina Academic Press, 1999 & 2002-2003 Supp.

Malloy, Michael P. Banking Law and Regulation, 3 Vols. New York: Aspen Law & Business, 1994 & Cum. Supps.

Malloy, Michael P. Bank Regulation Hornbook. 2d ed. St. Paul, MN: West Group, 2003.

McCoy, Patricia A., ed. Financial Modernization after Gramm-Leach-Bliley. Newark, NJ: LexisNexis, 2002.

Perkins, Edwin J. "The Divorce of Commercial and Investment Banking: A History." 88 Banking Law Journal 483 (1971).

Major Acts of Congress Malloy, Michael P.

Glass-Steagall Act

views updated May 23 2018

GLASS-STEAGALL ACT

The Glass-Steagall Act, also known as the Banking Act of 1933 (48 Stat. 162), was passed by

Congress in 1933 and prohibits commercial banks from engaging in the investment business.

It was enacted as an emergency response to the failure of nearly 5,000 banks during the Great Depression. The act was originally part of President franklin d. roosevelt's new deal program and became a permanent measure in 1945. It gave tighter regulation of national banks to the Federal Reserve System; prohibited bank sales of securities; and created the federal deposit insurance corporation (FDIC), which insures bank deposits with a pool of money appropriated from banks.

Beginning in the 1900s, commercial banks established security affiliates that floated bond issues and underwrote corporate stock issues. (In underwriting, a bank guarantees to furnish a definite sum of money by a definite date to a business or government entity in return for an issue of bonds or stock.) The expansion of commercial banks into securities underwriting was substantial until the 1929 stock market crash and the subsequent Depression. In 1930, the bank of the united states failed, reportedly because of activities of its security affiliates that created artificial conditions in the market. In 1933, all of the banks throughout the country were closed for a four-day period, and 4,000 banks closed permanently.

As a result of the bank closings and the already devastated economy, public confidence in the U.S. financial structure was low. In order to restore the banking public's confidence that banks would follow reasonable banking practices, Congress created the Glass-Steagall Act. The act forced a separation of commercial and investment banks by preventing commercial banks from underwriting securities, with the exception of U.S. Treasury and federal agency securities, and municipal and state general-obligation securities. More specifically, the act authorizes Federal Reserve banks to use government obligations and commercial paper as collateral for their note issues, in order to encourage expansion of the currency. Banks also may offer advisory services regarding investments for their customers, as well as buy and sell securities for their customers. However, information gained from providing such services may not be used by a bank when it acts as a lender. Likewise, investment banks may not engage in the business of receiving deposits.

A bank is defined as an institution organized under the laws of the United States, any state of the United States, the District of Columbia, any territory of the United States, Puerto Rico, Guam, American Samoa, or the Virgin Islands, that both accepts demand deposits (deposits that the depositor may withdraw by check or similar means for payment to third parties or others) and is engaged in the business of making commercial loans (12 U.S.C.A. § 1841 (c)(1) [1988]). Investment banking consists mostly of securities underwriting and related activities; making a market in securities; and setting up corporate mergers, acquisitions, and restructuring. Investment banking also includes services provided by brokers or dealers in transactions in the secondary market. A secondary market is one where securities are bought and sold subsequent to their original issuance.

Despite attempts to reform Glass-Steagall, the legislature has not passed any major changes—although it has passed bills that relax restrictions. Banks may now set up brokerage subsidiaries, and underwrite a limited number of issues such as asset-backed securities, corporate bonds, and commercial paper.

The Glass-Steagall Act restored public confidence in banking practices during the Great Depression. However, many historians believe that the commercial bank securities practices of the time had little actual effect on the already devastated economy and were not a major contributor to the Depression. Some legislators and bank reformers argued that the act was never necessary, or that it had become outdated and should be repealed.

Congress responded to these criticisms in passing the Gramm-Leach-Bilely Act of 1999, which made significant changes to Glass-Steagall. The 1999 law did not make sweeping changes in the types of business that may be conducted by an individual bank, broker-dealer or insurance company. Instead, the act repealed the Glass-Steagall Act's restrictions on bank and securities-firm affiliations. It also amended the Bank Holding Company Act to permit affiliations among financial services companies, including banks, securities firms and insurance companies. The new law sought financial modernization by removing the very barriers that Glass-Steagall had erected.

cross-references

Banks and Banking; Federal Reserve Board; Glass, Carter.

West's Encyclopedia of American Law

Glass-Steagall Act

views updated May 23 2018

GLASS-STEAGALL ACT

GLASS-STEAGALL ACT, an emergency banking measure passed by Congress in 1932. Its first two provisions permitted particular member banks to use collateral normally ineligible for rediscount to borrow from Federal Reserve banks at one percent above the rate on normally eligible paper. The act authorized the Federal Reserve Board to permit Federal Reserve banks to use U.S. government obligations, gold, and eligible paper to secure Federal Reserve notes. This act stabilized the banking system only temporarily.

The following year, Congress passed the Glass-Steagall Act of 1933, also called the Banking Act of 1933, which created the Federal Deposit Insurance Corporation and separated investment and commercial banking. Congress repealed the Glass-Steagall Act of 1933 in 1999, with the passing of the Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act), thus removing the regulations barring mergers among banking, securities, and insurance businesses.