Introduction
To quote Sheila Bair, who was head of the US Federal Deposit Insurance Corporation from 2006 to 2011, 'I feel for the regulators. You're damned if you do and you're damned if you don't' (Bair, 2022). In other words, assessing the extent to which the Glass-Steagall Act contributed to the financial crisis is not a direct criticism of the act or its removal. Instead, it demonstrates the endless cycle of opposition to both financial regulation and deregulation. The Glass-Steagall Act was introduced during a time of economic turmoil, repealed during a time of economic prosperity when it had grown outdated, and then less than ten years later, in yet another period of economic turmoil, arguments arose suggesting its repeal should never have happened.
The answer to what regulators could have done differently always seems so simple after a crisis, but never before, with Alan Greenspan, who was the Federal Reserve Board chairman for twenty years prior to the financial crisis, providing a possible answer, 'History tells us [regulators] cannot identify the timing of a crisis or anticipate exactly where it will be located or how large the losses and spillovers will be' (The Financial Crisis Inquiry Commission, 2011, p. 3). Whilst there is no clear right or wrong answer to financial regulation, the repeal of the Glass-Steagall Act undoubtedly created a level of systemic risk by removing a barrier allowing the merging of investment and commercial banks to form institutions that were deemed 'too big to fail', ultimately contributing to the financial crisis of 2008. However, whilst the repeal was a contributing factor in the build-up to the financial crisis, it was merely one of many institutional failures of the financial system responsible for the crisis and, therefore, the repeal was a necessary modernisation of financial regulation.
The Lifespan of the Glass-Steagall Act
This story begins with a financial crisis - not the 2008 financial crisis, but the Wall Street Crash of 1929. Following the prosperous years of the 'roaring twenties', by the end of the decade the stock market was strongly overvalued, and it came crashing down towards the end of October 1929 (Bierman, 2013). What followed was the Great Depression, a period of economic inactivity which was arguably not caused directly by the crash of the stock market itself, but by 'monetary forces, problems in the banking system and missteps of the Federal Reserve' (Bierman, 2013, p. 125). The Banking Act of 1933, commonly referred to as the Glass-Steagall Act, introduced drastic measures to restore faith in the banking system. Following the signature of President Franklin D. Roosevelt on June 16, 1933, the act introduced provisions including the creation of the Federal Deposit Insurance Corporation, restrictions on speculative use of credit, and most importantly, the separation of commercial banking and investment banking (Preston, 1933).
The provisions laid out in the Glass-Steagall Act lasted for more than six decades before its repeal in 1999 (Barth, et al., 2000). The regulations had proved effective until the 1970s when commercial and investment banks saw the profitability in expansion and began challenging the act through the courts and regulatory bodies (White, 2010). Alongside frequent lobbying, the decision to repeal was supported by empirical evidence from academics that the securities activities of commercial banks were not to blame for the Great Depression (Barth, et al., 2000). The political economy at the time also favoured deregulation. President Bill Clinton was well into his second term following re-election in November 1996, which was predominantly a result of the prosperous American economy during his first administration (Bailey, 1999). Additionally, influential figures like Alan Greenspan and Robert Rubin encouraged a laissez-faire attitude towards regulation, enabling Wall Street's desire for bigger profits (Whalen, 2008). When the Gramm-Leach-Bliley Act was enacted on 12th November 1999, the arguably most important provision of the Glass-Steagall Act disappeared, allowing companies to offer banking, securities, and insurance financial services simultaneously (Barth, et al., 2000).
The Repeal's Role in the Financial Crisis
At the turn of the twenty-first century, the first warning signs appeared with the bursting of the dot-com bubble and the collapse of Enron (Wilmarth Jr., 2009). With Glass-Steagall's provisions removed, commercial banks challenged the investment banking business, sparking strong competition leading to a surge in issuing corporate securities, with Initial Public Offerings rising from $28 billion in 1994 to $76 billion in 2000 (Wilmarth Jr., 2009). Between 2000 and 2002, the value of all publicly traded U.S. stocks dropped by a staggering 45%, the largest collapse of the stock market since the 1929 crash (Wilmarth Jr., 2009). This decline can be attributed to wide-scale accounting fraud where universal banks pressured in-house auditors to provide falsified reports to please clients and attract new investment (Wilmarth Jr., 2009).
The repeal also created serious conflicts of interest. After Robert Rubin lobbied for the repeal, he joined Citigroup in a senior position merely months after resigning from his treasury position (Ferguson & Johnson, 2009). Citigroup was in the process of merging with Travelers Insurance, with the merger relying on the GLBA to remove Glass-Steagall's provisions (Ferguson & Johnson, 2009). In total, from 1999 to 2008, the financial sector spent $2.7 billion in lobbying (The Financial Crisis Inquiry Commission, 2011). Financial institutions saw profitability in the repeal, allowing them to diversify investments. Eight of the top fifteen subprime firms in the U.S. were owned by banks (Ferguson & Johnson, 2009) - a worrying statistic considering the role the subprime mortgage crisis played in the financial crisis.
A Crisis of Many Causes
Despite the repeal's contributions, economist Lawrence J. White argued that the causes of the financial crisis would have occurred even without the repeal of Glass-Steagall, with the GLBA having little responsibility in the crisis (White, 2010). There were indeed greater causes and contributors. Credit rating agency failures played a critical role. At the time of the crisis, there were over 150 credit rating agencies worldwide, with the market dominated by Moody's, Fitch, and Standard & Poor's (White, 2010). The scale adopted by these agencies was internationally recognised and a feature of federal financial regulation, giving the impression that financial institutions could trust the ratings without conducting their own risk evaluations (White, 2010). Warning signs appeared when during Enron's collapse in November 2001, all three agencies considered Enron's bonds to be 'investment grade' just five days before bankruptcy (White, 2010). Similarly, Lehman Brothers had 'investment grade' ratings on the morning it declared bankruptcy in September 2008 (White, 2010). The failures of these agencies were demonstrated by the statistic that 90% of collateralised debt obligation tranches originally rated AAA by S&P had been downgraded, with 80% falling below investment grade (White, 2010).
The collapse of Lehman Brothers in 2008 represented the catastrophic peak of the financial crisis. While the company's aggressive investments were partly influenced by the expansion of financial service institutions following Glass-Steagall's repeal, its ultimate downfall was primarily due to its exposure to the housing bubble and subprime mortgages, combined with excessive leverage and the firm's inherent fragility (Wiggins, et al., 2019). Excessive borrowing by banks left them vulnerable to financial ruin. By 2007, the leverage ratios of the five main investment banks were 40 to 1, with Bear Stearns having $11.8 billion in equity but $383.6 billion in liabilities (The Financial Crisis Inquiry Commission, 2011). The danger of this debt was obscured by lack of transparency, with leverage hidden using off-balance sheet entities (The Financial Crisis Inquiry Commission, 2011). From 2001 to 2007, the national mortgage debt almost doubled despite wages remaining static, creating what The Financial Crisis Inquiry Report described as a '21st century financial system with 19th century safeguards' (The Financial Crisis Inquiry Commission, 2011, p. xx).
A Necessary Modernisation
Despite its flaws, the repeal of Glass-Steagall was a significant and necessary modernisation of financial regulation. Commercial banks had already found ways around the act's provisions and were selling stocks, bonds and offering consultation on mergers and acquisitions (Markham, 2010). This demonstrates that the GLBA did not suddenly allow a merger between investment banks and commercial banks; it merely removed provisions that banks were already avoiding through legal loopholes. Globalisation had also undermined the division between commercial and investment banking. In May 2010, 47 out of 526 financial holding companies registered in the United States were formed by foreign banks, exempting them from Glass-Steagall's provisions (White, 2010). Without the GLBA, domestic banks would have been negatively impacted and unable to compete with foreign counterparts.
The reforms introduced after the crisis demonstrate the proper balance that should have been struck. In July 2010, President Obama enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act as a reformative response (Barr, 2012). The act provided safeguards and regulations that should have been implemented within the GLBA. One particular section, the Volcker Rule, prohibits banks from engaging in proprietary trading and reinstates a partial divide between commercial and investment banks (Whitehead, 2011). The Turner review, conducted by Adair Turner, suggested introducing a maximum gross leverage ratio to prevent excessive, unstable growth of financial corporations (Turner, 2009). It also recommended ensuring credit ratings are only applied to securities where the rating can be consistent and that agencies should clarify their ratings only demonstrate credit risk, not liquidity or share value (Turner, 2009).
Conclusion
There is not a categorically right or wrong answer as to how much the repeal of the Glass-Steagall Act contributed to the 2008 financial crisis, merely a scale of different views and opinions. The repeal contributed to the crisis by enabling conflicts of interest and unregulated profit-driven growth. However, these issues were not solely responsible for the crisis, nor were they on the same scale as the failures of credit rating agencies or the extreme leverage that caused the collapse of major investment banks.
The reforms suggested by Adair Turner and introduced in the Dodd-Frank Act demonstrate what the GLBA should have been - a fair balance of financial regulation that encourages modernisation but prevents corporate greed from flourishing. Whilst the repeal of the Glass-Steagall Act was a contributing factor in the build-up to the financial crisis, it was merely one of many institutional failures of the financial system. Therefore, the repeal was a necessary modernisation of financial regulation that unfortunately lacked adequate safeguards against the profit-driven incentives of Wall Street.
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