Notwithstanding the successful global effort to strengthen the resiliency of the banking and financial system that was initiated after the 2008 financial crisis, a number of policymakers have proposed plans to “reinstate” the Glass-Steagall Act, which, until 1999, had prohibited commercial banks from affiliating with any company that engaged in securities underwriting or dealing.

Proponents of Glass-Steagall-style reforms claim that these changes would increase the safety and soundness of the banking system and reduce the risk of taxpayer exposure in the event of financial system distress.  Some proponents espouse the additional goal of forcing a reduction in the size or activities of the largest financial institutions.^[1]  While ensuring the safety and soundness of individual institutions and the financial system more broadly is a critically important objective, proposals to “reinstate” Glass-Steagall represent a misguided approach to achieving this goal, and, further, fail to account for the attendant risks that would be posed to our financial system if Glass-Steagall were to be “reinstated.” 

For all of the reasons discussed here, the question of “reinstating” Glass-Steagall was rightfully asked and rejected during the Dodd-Frank Act debate.

Proposals to “reinstate” Glass-Steagall would impose substantial costs on bank customers and the economy.

Glass-Steagall proposals are really a kind of industrial policy designed and intended to dramatically re-shape the existing banking industry to break apart commercial and investment banking operations and dictate the corporate structure of banks.  For example, and not acknowledged by proponents, a reinstatement of Glass-Steagall would entail the radical restructuring of the U.S. banking landscape, breaking apart, downsizing or otherwise restructuring the 75+ financial holding companies that currently engage in both types of banking activities to some extent.

Proponents of “reinstatement” also fail to acknowledge that there would be significant negative implications of dismantling and restructuring banking organizations, including the elimination of the economies of scale and scope provided by the affiliation of commercial banking and other financial institutions.  Rarely discussed by Glass-Steagall proponents are the collateral effects including substantial costs and inconveniences customers,^[2] who would be forced to discontinue long-standing relationships with existing financial institutions and establish new relationships with multiple financial institutions.

Large, diversified banks provide unique economic benefits to their customers and to the economy that would be diminished by proposals to “reinstate” Glass-Steagall.

“Reinstating” Glass-Steagall would involve legislative prohibitions on certain bank affiliations that would force financial institutions to change their size, structures, and activities, which would cause significant disruptions to the financial system and the real economy and eliminate the numerous benefits and efficiencies created by the affiliation between banks and other financial institutions. 

For example, as a result of their ability to mutualize significant yet fixed costs of technology and infrastructure costs, larger, diversified banking organizations are able to provide services to customers at lower prices.  In addition, as a result of their diverse business lines, vast geographic reach, and balance-sheet size, larger, diversified banks are able to offer products and services that are critical to the global financial system that smaller institutions are unable to offer.  “Reinstating” Glass-Steagall would significantly reduce the ability of larger, diversified institutions to offer critical services at lower costs.  

Moreover, the 2008 financial crisis clearly demonstrates the vulnerability of nondiversified institutions to distress, as several of the institutions that failed, such as Lehman Brothers, Bear Stearns, AIG, and Washington Mutual, operated on a relatively nondiversified basis.  Reinstatement would limit the ability of financial institutions to diversify their risk exposures, rendering them more vulnerable to threats.

Contrary to popular assertions, most of the core restrictions imposed by the Glass-Steagall Act remain in force and already provide robust protections against the kinds of risks that Glass-Steagall reinstatement proponents would purport to address.

The Glass-Steagall Act of 1933 originally included two fundamental prohibitions.  The first set of prohibitions generally forbade securities activities by banks and deposit-taking activities by securities firms – that is, they effectively banned the commingling of banking and securities activities within a corporate entity.^[3]  The second set of prohibitions restricted affiliations between depository institutions and securities firms, that is, they effectively banned the combination of commercial and investment banking activities within a single corporate structure.^[4]  Only this second set of prohibitions was repealed by the Gramm-Leach-Bliley Act.  The restrictions on the securities activities of banks and the deposit-taking activities of securities firms remain in effect today. This status quo has remained in place for over 80 years:  depository institutions with FDIC insurance and access to the Fed’s discount window cannot engage in investment banking, and broker-dealers and other securities companies cannot engage in banking.

In addition, the risks posed by banks’ affiliating with entities engaged in securities activities are squarely addressed by Sections 23A and 23B of the Federal Reserve Act, which impose strict quantitative limits, collateral requirements, market terms requirements, and other restrictions on transactions between a depository institution and its affiliates that effectively “ring-fences” every bank from any risk that its affiliates might pose to it.   These restrictions—which were in fact further strengthened by the Dodd-Frank Act—significantly circumscribe the types of affiliate transactions in which a depository institution may engage and protect the depository institution and the taxpayer from the risk of loss to the bank that may be posed by such affiliates.  The Dodd-Frank Act also imposes additional restrictions on the securities activities of entire banking organizations to enhance their safety and soundness, such as the restrictions set forth in the Volcker Rule, which prohibits banking organizations from engaging in proprietary trading activities.

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership.

[1] As is discussed below, many of the core restrictions imposed by the Glass-Steagall Act remain in force, and in the case of repealed provisions, other, robust protections are in place to address the risks that those provisions were designed to address.

[2] See Daniel Tarullo, Member, Board of Governors of the Federal Reserve System, Remarks at the Brookings Institution Conference on Structuring the Financial Industry to Enhance Economic Growth and Stability, Washington, D.C. (Dec. 4, 2012), available at http://www.federalreserve.gov/newsevents/speech/tarullo20121204a.pdf.  (“[A]n IO perspective suggests that [reinstating Glass-Steagall] could entail substantial costs. The reinstatement of Glass-Steagall would mean that bank clients could no longer retain one financial firm that would have the capacity to offer the whole range of financing options--from lines of credit to public equity offerings--depending on a client’s needs and market conditions. Moreover, many banks that are far too small ever to be considered TBTF do provide some capital market services to their clients--often smaller businesses--a convenience and possible cost savings that would be lost under Glass-Steagall prohibitions.”). See also The Clearing House, Understanding the Economics of Large Banks (Nov. 7, 2011), available at  https://www.theclearinghouse.org/~/media/files/association%20documents/20111107%20tch%20study%20understanding%20the%20economics%20of%20large%20banks.pdf?la=en (describing and estimating the unique economic benefits provided by large banks through economies of scale and scope and the spread of innovation).

[3] Sections 16, 5(c), and 21 of the Banking Act of 1933.

[4] Sections 20 and 32 of the Banking Act of 1933.