Several US senators have introduced a bill bringing back elements of the Glass-Steagall Act “to reduce risks to the financial system by limiting banks’ ability to engage in certain risky activities and limiting conflicts of interest.” With some banks still struggling to swallow the Dodd-Frank Act, will the ‘21st Century Glass-Steagall Act’ serve to save the public or just support more lawyers’ pension funds.

What was the original Glass-Steagall Act?

As a response to the financial crisis and the Great Depression of 1929, the US Congress enacted the Banking Act of 1933, which was known as the ‘Glass-Steagall Act’ after its proposers. Very simply it was intended to stop to prohibit banks that held savings from engaging in other services, such as investment banking and insurance, which held different risk profiles to the deposit and loan business which savers had entrusted their money to.

What happened to it?

It was repealed under the ‘Gramm-Leach-Bliley Act’ signed by Bill Clinton in 1999. He said that Glass-Steagall had effectively been eroded by various legal compromises since the 1970s and decided that, rather than trying to reinforce it, the government should kill it.

So why bring it back?

The next ten years saw the development of the derivatives industry, in which the assets of retail banks were increasingly packaged as collateral for use by capital markets firms. Bear Stearns was heavily exposed to these products in 2007 which led to its collapse; Lehman Brothers shut its own ‘sub-prime’ retail mortgage operation that year and collapsed a year later, due to exposure against these assets. Inside Mortgage Finance recorded that the majority of the US$600 billion sub-prime mortgages issued in 2006 were securitised. The best that can be said about the situation is that the ability to generate large volumes of debt assets that could be used as collateral in highly profitable capital markets created a conflict of interest.

Surely this is what the Dodd-Frank Act was brought in to deal with?

It introduced a ban on proprietary trading for deposit-holding institutions and limited their ability to invest in firms that engage in ‘risky’ businesses, such as hedge funds, to 3%. However, the ability to identify proprietary trading relies entirely on the ability to determine the motivation behind a trade. Many financial institutions engage in behaviour that appears to be offsetting risk but actually generates alpha. Proving that the profit is generated by anything but an accident is nearly impossible.

What difference would the ‘21st Century Glass-Steagall Act of 2013’ make?

Under the new rules a deposit-taking firm cannot be or become “an affiliate of any insurance company, securities entity, or swaps entity”, be owned by them or an umbrella firm or trade like one. Existing affiliations would have to be broken and firms could not share executives or directors. Breaking up the banks would reduce the problem around ‘too-big-to-fail’ banks, although it would not remove it completely. Similar moves are currently being considered in Europe. Whether they can get enough support is another issue.