Out of the Shadows: Creating a 21st Century Glass-Steagall
The current financial crisis comes less than a decade after the culmination of a long, bipartisan effort to loosen US financial services regulation. Those reforms included 1999’s Gramm-Leach-Bliley Act (“GLBA”), which relaxed the post-Depression Glass-Steagall boundaries between commercial banking and investment banking.
This research note: summarizes the logical premises that supported loosening the Glass-Steagall framework; evaluates the accuracy of those premises, given the observed market realities of the credit bubble and crisis; and recommends a path forward.
The link between the financial crisis and the relaxation of Glass-Steagall’s constraints is rather more complicated than typically understood. GLBA largely relied on an internally consistent set of logical premises: (1) that widening the scope of banks’ activities would allow them to reverse a long-term secular decline in competitiveness; (2) that non-depository “shadow banks” should continue to compete in the banking business, because free market discipline would force them to make sound credit risk-return decisions; and (3) that even if shadow banks failed to make good credit decisions, their resulting bankruptcies would not result in taxpayer harm.
To most policymakers at the time, those premises seemed sound. But in hindsight, all three premises have proven disastrously false in the marketplace.
On the systemic misunderstanding of GLBA in the Endnotes:
It is not wholly accurate to claim, as is commonly the shorthand, that GLBA repealed Glass-Steagall. Rather, GLBA allowed commercial banks and securities firms to become affiliated with each other, but kept other prohibitions in place. See Peter Wallison, ‘De- regulation and the Financial Crisis: Another Urban Myth’, American Enterprise Institute Outlook Series, text accompanying notes 6-9 (October 2009). Of course, even GLBA’s sponsors appeared to believe that they were repealing Glass-Steagall, so the confusion today, more than 10 years later, is not especially surprising. Senate Banking Committee, Press Release: ‘Gramm Closing Floor Statement on Gramm-Leach-Bliley Act of 1999’ (November 4, 1999) (‘Ultimately, the final judge of the bill is history. Ultimately, as you look at the bill, you have to ask yourself, ‘Will people in the future be trying to repeal it, as we are here today trying to repeal — and hopefully repealing — Glass-Steagall?’ I think the answer will be no’).