BANKING ACT OF 1933



Banking Act Of 1933 572
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The Banking Act of 1933, or the Glass-Steagall Act, was passed by Congress in June of that year in the face of vociferous opposition from the American banking community. More than six decades later, aspects of the act are still unpopular in banking and brokerage circles. Prohibiting commercial banks from using their own assets to invest in securities (such as stocks and bonds) is a principal provision of the Banking Act of 1933. This prohibition was included to abolish flawed investment practices, such as those followed by the largest commercial banks in the 1920s, and discourage uncontrolled speculation such as that contributing to the stock market crash of 1929. Another important provision of the Banking Act of 1933 was the establishment of the Federal Deposit Insurance Corporation (FDIC). The FDIC insures bank deposits up to a given amount; this not only restored public confidence in the nation's banks, but provided a life-giving flow of capital to the thousands of banks that had failed between 1929 and 1933. Six months after the inauguration of the FDIC in January 1934, the bank failures characteristic of the early years of the Great Depression came to a halt.

The depression had given rise to the severest crisis in banking history. Between 1930 and 1933 more than 9,000 banks closed their doors, and domestic investment decreased by 90 percent. Ninety percent of small community (i.e., "unit") banks failed because frightened customers withdrew all the money from their accounts, resulting in terminal losses of capital. By 1933 the banking system was a wreck. In large measure, the public blamed banks for the nation's economic problems. Congressional hearings in early 1933 revealed gross irresponsibility on the part of major banks, which had used billions of dollars of depositors' funds to acquire stocks and bonds, and had made unsound loans to inflate the prices of these securities. The public's venom against banks and stockbrokers was so great that many predicted imminent revolution.

In response to the national financial and economic crisis, one of the highest priorities of President Franklin D. Roosevelt's new administration was to resolve the banking dilemma. After congressional hearings took place in the spring, the Banking Act of 1933, the first of many major laws regulating the nation's finances, was passed on June 16. Even before FDR had taken his oath of office, the Glass-Steagall bill had been in the works. Representative Henry Steagall had proposed deposit insurance as a means of saving failed banks. This was not a new idea. Several states had initiated deposit insurance schemes in the 1920s, when bank failures were on the rise. During the depression, however, states lacked the capital resources to rescue their own state-chartered banks, to say nothing of the many smaller banks. Steagall realized that opposition to a federally insured deposit system would come from the large banks, which would resent parting with revenue for the sake of their weaker competitors. By the spring of 1933, however, even the major banks were willing to support this idea, rather than risk a more radical restructuring of the banking system.

Far more controversial was Senator Carter Glass's proposal, incorporated in the Banking Act of 1933, to separate investment from commercial banking. Only a handful of commercial banks had been guilty of financial transgressions during the 1920s, and these in most cases involved the misuse of depositors' funds to acquire and trade stocks and bonds. Additionally, there was evidence that these banks had made more than $8 billion in loans to brokers and dealers in the 1920s, fueling stock market speculation. Major banks had also compromised their integrity as they attempted to lure their own customers to invest in the banks' securities holdings. By using depositors' funds to invest in stocks and bonds, these banks imperiled savings and other deposits, given that these could be withdrawn on demand. Under Glass's proposal, commercial banks would be barred from trading securities.

The passage of the Glass-Steagall bill into law strengthened the regulatory power of the Federal Reserve. Member banks would have to report on all investment transactions and loans. Banks that were not members of the Federal Reserve had to be deemed in sound financial condition in order to join the FDIC (membership in FDIC became mandatory for banks belonging to the Federal Reserve), which condemned weak banks to oblivion, but strengthened sound ones. Henceforth banks were not only subject to greater public scrutiny and compliance, but were compelled to adhere to higher standards of practice. The result was that by mid-1934 bank failures had stopped, banks by the thousands had reopened after joining the FDIC, and banking stability has never again been so seriously jeopardized.

The United States has remained unique in the developed world in its separation of commercial from investment banking, although with the passage of time many of the provisions of the Glass-Steagall Act have been diluted or bypassed, and many members of the banking community continue to call for the act's revision or repeal.

Responding to perceived changes in the economy and investment activities, the Federal Reserve ruled in 1987 that bank holding companies could establish affiliate corporations to engage in the trading of selected securities—including municipal bonds, commercial paper, and mortgage backed securities —as long as such activities did not account for more than 5 percent of the holding company's revenues. In 1989 these restrictions were further relaxed, enabling bank holding companies to engage in corporate debt and equity underwriting, and raising the "revenue cap" to 10 percent. The revenue cap was raised to 25 percent in December 1996. Despite such modification of the provisions of Glass-Steagall, by the mid-1990s Congress was compelled to consider the fundamental revision or total abrogation of the act.

As the stock market gained value with unprecedented rapidity between 1995 and 1998, the financial community pressed Congress to allow banks to affiliate with insurance companies and engage in the provision of mutual funds to their investors. To allow such activities on the part of banks would entail the virtual abolishment of the Glass Steagall Act, and by spring 1996 legislative stalemate had ensued. Debate over the future of Glass-Steagall took an ironic turn in the late 1990s as brokerage firms became incredibly profitable with the rise of mutual fund investment and a stock market whose value reached previously unheard of levels. Suddenly, some larger brokerage firms were in a position to acquire banks, and banks found themselves in the position of supporting Glass-Steagall, which barred takeovers of banks by securities companies!

Regulatory agencies also wavered in their positions regarding Glass Steagall and its amendment or repeal. The U.S. Department of the Treasury announced in December 1997 that it supported reform of the act, but reversed course in March 1998 by announcing that it opposed House Resolution 10 (HR 10, the Financial Services Competition Act), a measure that would virtually remove the Glass-Steagall Act's separation of banking and securities operations. With the support of Federal Reserve Board chairman Alan Greenspan, HR 10 passed by a razor-thin margin of 214-213 in May 1998, and was passed on for approval in its Senate form by a 16-2 vote of the Senate Banking Committee in September 1998. Congressional observers believed that the Financial Services Competition Act would pass in some form and have an effect on the national banking and insurance industries by the early 21st century.

[ Sina Dubovoy ,

updated by Grant Eldridge ]

FURTHER READING:

"Another Bang." Banker, August 1995, 9.

Benston, George J. The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revisited and Reconsidered. New York: Oxford University Press, 1990.

Brostoff, Steven. "Bank Bill May Limit Comptroller Power." National Underwriter Property and Casualty Risk and Benefits Management, 12 June 1995.

——. "Treasury Report: Time is Right to Break with Past in Financial Services." National Underwriter Life and Health Financial Services Edition, 15 December 1997.

Bruchey, Stuart. The Wealth of the Nation: An Economic History of the United States. New York: Harper & Row, 1988.

Connolly, Jim. "Regulators Will Write to Congress on H.R. 10." National Underwriter Life and Health Financial Services Edition, 21 September 1998.

"Down with Glass-Steagall." Economist, 28 March 1998.

Fearon, Peter. War, Prosperity, and Depression: The U.S. Economy, 1917-45. University Press of Kansas, 1987.

"Financial Services Fix." Nation's Cities Weekly, 18 May 1998.

"Greenspan's View of Glass Steagall Bill: 'Urgently Needed' and Well Designed." American Banker, 16 May 1996.

Hensley, Scott. "Bank Fund Executives Get Grim View of Life after Regulatory Reform." American Banker, 3 October 1995.

Osterland, Andrew. "Shatterproof Glass: How Bank Bureaucrats Are Shaping Financial Services Deregulation." Financial World, 17 June 1997.

Serwer, Andrew. "Fresh Act for Banks." Fortune, 10 November 1997.

"With Whimper: American Banking." Economist, 2 November 1996.



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