Busting the Myth of Glass-Steagall

Before pining for the return of Glass-Steagall, let's reminisce a bit.

This famous piece of legislation, separating banking from investment banking, was born in the Depression era as a knee-jerk overreaction to the abuses of that era. Like Dodd-Frank in the current financial crisis, it was pandering to the popular perception, not necessarily the informed view. 

Returning to Glass-Steagall-like prohibitions may also be a knee-jerk reaction. Look at the history of changing needs and financial failures that led to innovations since Glass-Steagall was passed in 1933 and you can be your own judge of what we would be returning to if we would reestablish the old barriers.

The abuse of securities underwriting powers by banks was the populist theme that led to the passage of Glass-Steagall. However, such powers played little role in the financial disaster of 1929-33.

Martin Mayer, the historian and prolific writer of books and essays on the financial industry, says of that time that the banks' worst violation was manipulating the market prices of their own shares. This was a common unprincipled activity, legal at the time and practiced by nonfinancial corporations as well as financial institutions.

What has been accepted as the precipitating event of the start of the Depression was the stock market bubble that burst in October 1929, having risen fourfold during the decade. This rampant speculation was fueled by cheap loans from banks, where stock purchases were made with 10% margin. As banks saw the collateral underpinning their loans decline rapidly, they began to call in those loans made to speculators.

Many investors found it impossible to repay their debt and accelerated the rate of default which, in turn, eroded the confidence in the banking sector. Without bank deposit insurance, a bank failure meant depositors would lose all their money. As clients pulled their savings out, the speed at which banks collapsed accelerated.

Thereafter, as Milton Friedman and Anna J. Schwartz concluded in "A Monetary History of the United States, 1867–1960," the subsequent Depression was caused by the misguided reaction of the Federal Reserve in stepping back and allowing the money supply to dwindle. By 1933 the money supply fell to one-third of its peak in 1929.

The idea of investment banks being the bad actors of finance that should be separated from deposit-taking banks does not hold up well when we look at the actions of other actors – regulators, financial innovators and traditional bankers – over the ensuing years. Click below for a slideshow of numerous examples.

Returning to Glass-Steagall would require us all to deny the history of innovation and change, all the generations of regulatory and legal interpretations, all the good that had been done, and for what purpose?

Returning to the Glass Steagall prohibitions is to ask the uncomfortable question, what version of Glass-Steagall? Is returning to the prohibitions of Glass-Steagall a palliative just like the Volker rule, simple to say hard to do?

Are we out of ideas to modernize and adapt our financial system? Are we so attached to a lazy way, a safe way of solving our problems? Looking back rather than going forward?

Allan Grody is the President of Financial InterGroup Holdings Ltd. He is writing a book, Reengineering the Financial Corporation. This article is excerpted from the manuscript.