Glass-Steagall: An Investigation of Easing Constraints
Research Methods in Economics
Phillip Reese
05/06/2011
Introduction
The Banking Act of 1933, more commonly known as Glass-Steagall, was passed
in response to the market crash in 1929. According to the Senate Committee on
Banking and Currency (1934) there were three reasons for Glass-Steagall. First, banks
invested their own assets which created risks to depositors. Second, unsound loans
were made to counter the risks taken on by the bank. Finally, banks pressured their
customers to invest in securities held by the bank. These three reasons express the
worries of risk, moral hazard, and conflicts of interest associated with the bank practices
before the crash and can be generally categorized as imperfect information. GlassSteagall was an attempt to rectify these problems. Over the course of its 66-year
history, the constraints set in place by the act had been whittled away until its official
repeal in 1999. William D. Jackson (1987) states the reasons in favor of these repeals.
First, securities firms and foreign firms were much less regulated by Glass-Steagall and
caused the banks to lose market share. Second, it was believed that conflicts of
interest could be handled by legislation and by separating the deposit taking arm from
the investment arm. Third, banks could offer more diverse options to their customers.
Finally, many other nations had more lenient regulations and were successful in both
areas (1987). The research is important because it provides another perspective to the
ongoing debate about financial regulation in light the most recent economic recession;
should Glass-Steagall be re-implemented or not, i.e. are the reasons for passing it in the
1930’s applicable today and why? And do these policies effect who can participate in
the market? This paper will observe the changes in savings and bank held securitized
assets during the periods in which repeals were made to Glass-Steagall in hopes to find
correlations among them and determine who is effected by them. This paper finds that
there appears to be correlations between repeals and movements in savings and bank
held securitized assets, the effects of which are debatable, and that the conditions
surrounding the 2008 recession are different from those of the Great Depression.
Literature
The stock market crash of 1929 is most commonly attributed to a bubble created
by the rapid economic growth of the 1920’s (Galbraith, 1954) and/or the
mismanagement of the nation’s money supply and interest rates (Friedman and
Schwartz, 1962). These two sources provide background on the conditions surrounding
the Great Depression and how the government responded, which will be compared to
the conditions and the response during the 2008 recession.
Kroszner and Rajan (1994) test the validity of the argument regarding conflicts of
interest. The hypothesis was that “bank securities affiliates could-and did-systematically
fool the (naive) public investor” (1994, p. 811). Their results show that the affiliates did
not fool the public into buying lower quality securities, and in fact “Not only did bank
affiliates underwrite higher quality issues, but also [they] find that the affiliateunderwritten issues performed better than comparable issues underwritten by
independent investment banks” (1994, p. 829). Since the affiliate issues performed
better and were of higher quality, it appears as though conflicts of interest were not
present. They sold higher quality securities to offset their lack of experience in the
industry and did not pressure customers to invest in securities held by the bank.
Eugene White (1986) investigated the risk associated with affiliates, another of
the three main issues addressed by the Glass-Steagall act. White’s results are, to say
the least, short and to the point. He had four questions about how affiliates may have
had a negative effect on the commercial banks. First, “Did a Securities Business
Increase the Probability of Bank Failure?” (1986, p. 40). His results decisively showed
that affiliates did not increase the probability of failure and they actually had the contrary
effect. Second, “Was Investment Banking Favored over Commercial Banking?” (1986,
p. 42). Again, the answer was no. He found that there was very little, if any, incentive
to favor one over the other, the “Divergence of ownership appears to have been the
exception rather than the rule” (1986, p. 42). Third, were there “Dangerous Swings in
Earnings or Safe Diversification?” (1986, p. 42). His results pointed out that there was
little correlation between a bank’s swing in earnings and an affiliate’s, they may have
moved together, but one was not reflective of the other. He also made note that the
additional risk involved, when a bank invested more money in securities, was small
compared to the gains from the returns. Essentially, there was no evidence to support
the fear of a dangerous swing. Finally, he asked “Was the Solvency or Liquidity of
Commercial Banks Endangered?” (1986, p. 45). Again, his results showed no support
for the fear, instead he noted that the size of the bank had a bigger impact on the banks
solvency and/or liquidity issues. All these factors together showed that a depositor’s
money was subject to little or no risk.
The two writers above have given empirical evidence refuting the reasons for
passing Glass-Steagall which leaves the question, why was it passed? Joseph Stiglitz
(2004) prefers to emphasize the departures from our economic models, such as those
mentioned in the Senate Committee and produce a much simpler argument in favor of
government regulation. Stiglitz states:
“Changes in technology, in laws, and in norms may all exacerbate
conflicts of interest, and, in doings so, may actually impair the overall efficiency of
the economy. The notion that change is necessarily welfare enhancing is
typically supported by the same simplistic notions, sometimes referred to as
market fundamentalism, that assert that markets necessarily lead to efficient
outcomes. If the economy is always efficient, then any change that increases the
output per unit input must enhance welfare” (Stiglitz 2004, p.22).
This idea asserts that changes in the market may intensify existing problems, such as
imperfect information, moral hazard, and conflicts of interest, all of which are the basis
for Glass-Steagall. This is to say that regardless of what the market fundamentals and
empirical evidence may show, regulation may produce a more efficient outcome. This
is because there are many variables which we cannot quantify accurately, so with
regard to White (1984) and Kroszner and Rajan (1994), although their evidence shows
that Glass-Steagall may not have been necessary, these factors are just bits of the
puzzle and do not completely rule out the need for Glass-Steagall, which seems
apparent by the depression. This notion is important because it gives a logical defense
for the policy perspective why Glass-Steagall was passed.
Intrusions and Repeals
Glass-Steagall remained largely unchanged until the 1960’s. James J. Saxon
opens the door to “expanding bank powers, and welcoming new banks and branches
into the national banking system” (OCC.gov). He believed the regulation of banks was
more restrictive of economic growth and welcomed a record number of new charters
into the national system, causing uproar among the commercial banks. He said:
“Where banking facilities are inadequate, the forces of economic growth will not
be fully realized. But, more important, banks can exert a positive influence in exploring,
fostering, supporting, and directing the economic development of a community or a
nation” (Saxon 1963, p.336).
Over the next 20 years banks would exploit loopholes in the regulation, such as creating
investment vehicles, like Money Market Accounts, that provided a work-around in order
to remain competitive with the banks that were less regulated. In 1980 The Depository
Institutions Deregulation and Monetary Control Act began phasing out Regulation Q,
allowing banks to pay interest on deposit accounts. Garn-St Germain Depository
Institutions Act of 1982 phased out Regulation Q completely. And finally, the official
repeal of Glass-Steagall, or what was left of it, was the Federal Services Modernization
Act of 1999, better known as Gramm-Leach-Bliley, which allowed commercial banks to
become affiliated with investment banks and the allowed the ability to merge.
Theory
Glass-Steagall implemented an entry barrier. It limited who could supply
investments by prohibiting commercial banks from being affiliated with investment
banks. Economic theory suggests that an entry barrier limits competition by reducing
the industry concentration and thereby limiting supply. By limiting supply, the regulation
increased the price for investments and forced out some potential investors.
Glass-
Steagall also implemented a price ceiling, Regulation Q. This regulated how much
interest commercial banks could pay on the deposit accounts of its customers, thereby
limiting their returns. Since the increased price is still affordable to upper class
investors and they are largely unaffected by commercial bank regulation, due to having
the means to earn returns through investment banks, it seems that the excluded
investors are therefore, middle class and/or lower class investors. These investors are
unable to benefit from the increased returns of these investments, however, by
excluding them, they are also protected from the risk of losing what they, potentially,
cannot afford.
By applying the theories involving a supply side constraint such as, supply and
demand and price movements, I can determine what effects the repeals to GlassSteagall had on personal savings and bank held assets, and whether or not the repeals
should be reversed. These methods should produce reliable results because it will
include evidence based in several theories of economics and it will compare these
effects to a highly examined topic, the Great Depression, and a currently debated topic,
the recession of 2008. It will use an intertemporal approach to study periods which are
regulated and periods which are unregulated, 1929-1933, 1976-1986, and 1995-2009,
and observe how the two variables change when the constraint is relaxed. These
variables should produce a sufficient number of observations and produce results
necessary to answer the questions above.
Analysis
Figure 1
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Personal Savings (left)
USD in Thousands
USD in Billions
1929-1937 Overlay
Member Banks Net Profit (right)
Notes: 1933, the Banking Act of 1933, Glass-Steagall, passed
Sources: Survey of Current Business, Table 4 (2010: p. 193)
Historical Statistics of the United States, 1789-1945, Table N 68-75 (1949: p. 268)
The chart in Figure 1 is the personal savings values for the years 1929 through
1937 overlaying the member bank net profits of the same years. These years were
chosen to illustrate the unregulated and regulated conditions before and after of the
passing of Glass-Steagall in 1933.
What we see in Figure 1 is decreasing savings and decreasing bank profits until
1933 and then increasing savings and increasing bank profits. This turn around seems
to coincide with the passing of Glass-Steagall. It appears that by restricting the supply,
prohibiting affiliation, the price of the investments increased. This seems to correlate
with the increasing profits seen following 1933. The increase in personal savings
seems to be a result of more perfect information, or rather the exclusion of those that
lack it. That is to say that preventing middle-class investors from having access to
these securities had a positive effect on the market; their lack of knowledge on how the
securities market worked lead to a panic, of losing assets they couldn’t afford to lose,
and contributed to the market’s sharp decline during the Great Depression.
Figure 2
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1976-1984 Overlay
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Personal Savings (left)
Insured Commercial Securites (right)
Notes: 1980, The Depository Institutions Deregulation and Monetary Control Act passed
Sources: Survey of Current Business, Table 4 (2010: p. 193)
The chart in Figure 2 is the personal savings values for 1976 through 1984
overlaying securities held as assets by insured commercial banks for the same years.
These years were chosen to illustrate the conditions before and after of the passing of
The Depository Institutions Deregulation and Monetary Control Act of 1980. This
allowed banks to set their own interest rates to compete for savings accounts
(Depository Institutions, 1980). This act relaxed the constraint known as Regulation Q,
or section 11 of Glass-Steagall, and allowed certain types of institutions to have
accounts that paid interest; many of the institutions had already exploited loopholes to
deliver the returns to investors through the use of NOW and Money Market Accounts.
Previously the regulation limited the returns on passbook savings accounts, largely held
by middle-class savers, and the NOW and Money Market Accounts offered a work
around.
What we see in Figure 2 appears to be nothing significant. The value of
securities held by commercial banks tapers off a bit, most likely due to a substitution
effect and decreased concentration in response to the eased constraint. This could be
caused by the entry of new firms from separate industries providing a similar product,
such as money market accounts. These substitutes can cause funds to be dispersed
among more firms and routed out of securities and into the new vehicles, thus
explaining the tapering. I would expect to see savings increase as a result of increased
competition. This is seen in the figure until 1982. Allowing the commercial banks to pay
interest on savings accounts did increase competition, in the form of high interest rates
paid, and showed that Regulation Q artificially held down the returns to these savers. It
also shows that the eased constraint had a positive effect on savers. The drop from
1982 to 1983 is more likely due to legislation passed in 1982, which will be covered in
the next section.
Figure 3
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USD in Billions
1978-1986 Overlay
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Personal Savings (left)
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Insured Commercial Securities (right)
Notes: 1982, Garn-St Germain Depository Institutions Act passed
Sources: Survey of Current Business, Table 4 (2010: p.193)
Statistical Abstract of the United States, No. 808 (1987: p.482)
Statistical Abstract of the United States, No. 778 (1988: p.473)
The chart in Figure 3 is the personal savings values for the years 1978 through
1986 overlaying securities held as assets by insured commercial banks for the same
years. These years were chosen to illustrate the conditions before and after of the
passing of the Garn-St Germain Depository Institutions Act of 1982. This act completely
repealed Regulation Q, in its Glass-Steagall form, and allowed S&Ls to sell ARMs, or
adjustable-rate mortgages (Garn-St. Germain, 1982). These mortgages helped banks
shore up their asset-liability mismatches and were an attempt to encourage people to
buy homes as they could get lower monthly payments by bearing the risk of higher
payments later.
What we see in Figure 3 is a bit more significant than the previous figure. We
see a drop in the personal savings rate the same year the bill is passed. This could be
the result of ARMs working as intended, encouraging people to buy homes increases
demand for homes and draws funds away from personal savings. Consumers spend
savings to buy houses, thereby lowering savings. The increase from 1983 to 1984 can
be explained by the return to saving as the demand for ARMs winds down and the drop
following could be the result of increased interest rates causing the payments on the
ARMs to increase, lowering savings again. The repeal of Regulation Q, as in figure 2,
should have an increasing effect on the savings rate by increasing competition for
deposits. This does not seem to be the case; perhaps because the earlier deregulation
already shifted the demand and left Regulation Q powerless over the market or perhaps
because the ARM loans are seen to be a better utilization of saver’s money, or both.
The drop in the value of securities held by commercial banks from 1983 to 1984
can be explained by firms moving assets from securities into the funding of ARM loans.
Since the demand for homes seems to have increased, we would expect to see the
commercial banks increasing the supply of the loans, the trade-off being a decrease in
their assets. They begin to rise again after the flux of funds being moved into ARMs,
1984 on, due to savers moving money back into investment vehicles, thus increasing
the demand for securities. The movements in the chart seem to correlate with these
explanations, but are by no means definitive as new investment vehicles have been
created and they are not accounted for in these observations.
Figure 4
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1995-2003 Overlay
2003
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Personal Savings (left)
Insured Commercial Securities (right)
Notes: 1999, Financial Services Modernization Act passed
Sources: Survey of Current Business, Table 4 (2010: p. 193-194)
Statistical Abstract of the United States, No. 1174 (2003 p.745)
Statistical Abstract of the United States, No. 1169 (2004-2005 p.741)
The chart in Figure 4 is the personal savings values for the years 1995 through
2003 overlaying securities held as assets by insured commercial banks for the same
years. These years were chosen to illustrate the conditions before and after of the
passing of the Financial Services Modernization Act of 1999, or Gramm-Leach-Bliley as
it is more commonly known. This act officially repealed the barriers preventing
commercial banks from affiliating/merging with investment banks (Gramm-Leach-Bliley,
1999).
What we see here is commercial banks steadily increasing their security assets
and larger, more frequent movements in savings. The increase in security assets is
undoubtedly due to the deregulation and the combination of these banks has the
potential to impact the market in several ways. Commercial banks affiliating and
merging with investment banks, previously prohibited, may combine their assets and/or
be compelled to own more assets of an affiliated bank, increasing demand for securities
and explaining the increase in assets. It expands the supply to previously excluded
demand, such as middle and lower-class investors, by making accounts with little or no
minimum balance available, thus increasing demand.
The drop in savings could be explained by several scenarios. By selling to the
demand previously excluded, the securities vehicles may be sold to investors with less
than perfect information, so savings could fluctuate more frequently due to panicking
investors. The same, less knowledgeable investors may be losing money in these
investments they do not fully understand, also subtracting from savings. Another theory
is that investors began holding their money in real estate equity, their homes. The
housing boom during the 90’s and early 2000’s is well known and could explain the fall
in savings during that time. Defining a correlation in this figure is much more difficult in
this time period as more complex investment vehicles have been created and the
financial structure of the U.S. has changed dramatically since the Great Depression.
Figure 5
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Sources: Survey of Current Business, Table 4 (2010: p. 193-194)
Statistical Abstract of the United States, No. 1169 (2004-2005 p.741)
Statistical Abstract of the United States, Table 1176 (2011 p.736)
The chart in Figure 5 is the personal savings values for the years 2001 through
2009 overlaying securities held as assets by insured commercial banks for the same
years. This set was chosen to illustrate the continuing aftermath after the repeal of
Glass-Steagall. There is much debate about the impact repealing Glass-Steagall had
on the crisis of 07-08. Due to the large number of bank failures and record dollar
bailouts, it appears as though certain sections of Glass-Steagall were preventing
conditions conducive to such a catastrophe. The data above only adds a piece to that
ongoing debate.
What we see is commercial banks continuing to increase their securitized assets,
even during the recession, as well as more variation in the value of savings and
frequency of change. Without any legislative reference point, this data makes it difficult
to pinpoint any residual effects from the repeals. A couple things are apparent however.
The increase in the value of securities as assets is steadily rising. This could indicate
that, due to the constraints separating commercial banks from investment banks, there
was a portion of demand that was willing to buy securities, but they either did not have
access, due to these entry barriers, or the price was high enough to price them out of
the market, due to increased prices. So by repealing Glass-Steagall these buyers were
able to enter/re-enter the market. Perhaps it is these buyers that are responsible for the
frequency and depth of the fluctuations seen in personal savings. It could be the case
that some of these buyers simply, are under-informed, misinformed, lack experience, or
are speculating, when it comes to investing in securities, causing them to panic when
the market moves. In any case, there are a vast number of variables not accounted for
in the figure that could also be at work, so any correlation drawn here is a very loose
one at best.
Conclusion
This paper has looked at several snap-shots of American economic history,
some not yet examined, in hopes to gain insight into what effects can be seen when a
Glass-Steagall was repealed. The goal of this insight is to apply it to two peculiar
cases, the Great Depression and the recession in 2008, in hopes to determine if the
conditions surrounding the markets were similar. When comparing the data of the
depression era to that of the 2008 crisis, they are expressly different. According to the
data, there are strong correlations between the passing of Glass-Steagall and the turnaround following, but very weak correlations between its repeal and the ensuing
instability. This could be due to the fact that economy was weaned off of Glass-Steagall
over the course of 20 years, allowing markets time to adjust, many of the loopholes in
Glass-Steagall were exploited and undermined its intended effects, the two cases
simply have different conditions, or any combination thereof.
The effects observed when repeals were made to Regulation Q seemed to be
positive. The market showed signs of increased competition and consumers saw the
benefits of this in the form of increased returns on their deposits. The effects observed
when repeals were made to the sections separating commercial banks from investment
banks seemed to be positive for the banking industry as they saw steady increases in
the amount of securities they held yet they seemed to have no discernable effect on
personal savings and only lessened overall competition in the market. The steady
increases the banks saw could be a necessity due to the new vehicles, such as hedge
funds, having and increased dependence on securities and/or the banks are diversifying
against risk in an attempt to strengthen themselves. Relaxing this constraint also
seemed to have the effect of creating firms that were too big to fail and required
bailouts, so to answer the question whether or not Glass-Steagall should be re-instated,
I would say it depends. I would be in favor of, as my findings seem to support, reinstating regulations separating the banks; they would need to be updated to current
market conditions however.
Many potential investors were affected by this legislation. Regulation Q
artificially held down returns and the separation of commercial and investment banks
prevented middle and lower-class investors from having the opportunity to increase their
returns. So we can say definitively that Glass-Steagall did affect demand through the
excise of its constraints on supply.
Another observation of note is, there appears to be, according to the data, some
correlation between repeals to Glass-Steagall and the tracking of the two variables. In
the earlier charts, the two variables seem to track closely similar, and as the years
progress there are repeals to Glass-Steagall and the two variables seem to track further
and further apart and dissimilarly.
There are many areas in which this research may be faulted. For example, the
variables only allow for a very narrow scope; Glass-Steagall affected more than just
securities, it affected bonds, loans, new banks, etc., and there are many more variables
affecting the two variables chosen other than Glass-Steagall. They assume that
securities are held by investors as a means to save, and that they are purchased
through a commercial banking entity. The research does not empirically test the
strength of the correlations that have been observed. The research, also, does not take
into account any effect the creation of the FDIC may have had and this is another
aspect of Glass-Steagall.
Some ideas to further the research arose while running my observations. A test
to see how the market would react to re-instating Regulation Q would confirm whether
or not the observed effects are correct. A More in depth analysis of Gramm-LeachBliley’s consequences and implications of too big to fail seems appropriate as this act
was observed to be the only repeal with indiscernible effects on personal savings. This
could be used to support a case for bringing back portions of Glass-Steagall or at least
strengthening the Volcker Rule. A test to see how nonmember commercial banks faired
against those regulated by Glass-Steagall would create a baseline of comparison which
could be used to compare the two types of banks and see how closely they track during
the given periods. I would also be interested to see what role the FDIC backstop played
in these fluctuations. And finally any research expanding on the faults noted previously
would further explain the conditions present during the time periods observed.
References
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Bureau of Economic Analysis, Survey of Current Business, (2010).
Comptroller of the Currency, Annual Report (1963), pp.336. Remarks of James J.
Saxon, Comptroller of the Currency, 1963.
Depository Institutions Deregulation and Monetary Control Act of 1980, Pub. L. 96-221,
94 Stat.132 (1980).
Financial Services Modernization Act of 1999, Pub. L. 106-102, 113 Stat. 1338 (1999).
Friedman, Milton and Schwartz, Anna J. (1963). A Monetary History of the United
States, 1867-1960. Princeton: Princeton University Press.
Galbraith, John K (1954). The Great Crash of 1929. Mariner Books. New York.
Garn-St. Germain Depository Institutions Act of 1982, Pub. L. 97-320, H.R. 6267 (1982).
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Retrieved from: http://digital.library.unt.edu/ark:/67531/metacrs9065/
James Saxon (n.d.) OOC. Retrieved from: http://www.occ.gov/about/leadership/pastcomptrollers/comptroller-james-saxon.html
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White, Eugene Nelson (1986). “Before the Glass-Steagall Act: An Analysis of the
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