United States’ Banking Law has had a long and troubling history, marked by the worst financial disasters in history. These have subsequently shaped Financial Law into its present form. Most notably, the legislative revolution in American financial regulation occurred after the 1929 stock market crash and during the Great Depression which created the 1930s Securities Acts and the Glass-Steagall Act.
In his first term as President, Franklin D. Roosevelt signed into law the United States Banking Act of 1933, or what is more commonly known as the Glass-Steagall Act (GSA). As the most important piece of banking legislation in the 20th Century, Glass-Steagall was enacted with the aim of separating commercial and investment banks in order to prevent commercial banks from speculating heavily in securities and to address the abuses that arose from the close relationship between commercial and investment banks.
In light of the results of the United States Presidential Election, there have been calls for Joe Biden and a Democrat-majority Congress to enact a modern version of the Glass-Steagall Act in order to reign in the banking industry and prevent credit crises such as that of 2007 to 2008.
To argue for such a policy change, however, requires acknowledging that a Glass-Steagall-like law would in fact prevent another financial crisis from happening. The question then becomes, did the repeal of the Glass-Steagall Act contribute to a crisis in subprime markets and debt securities?
Some argue that the repeals of Sections 20 and 32 led to riskier banking practices in securities underwriting and the dealing of securities, including securitised loans. Section 20 specifically prohibited a commercial bank from engaging in “the issue, flotation, underwriting, public sale, or distribution” of securities unless it was specifically an investment bank under the GSA. Section 32 also prohibited any officer or director from “purchasing, selling, or negotiating securities”. The reimplementation of these two laws would “separate” investment and commercial banks such that commercial banks could not participate in securitisation.
This included the forms of asset-backed securities (ABSs), collateralised debt obligations (CDOs), and mortgage-backed securities (MBSs). These forms of securitised debt carried significant exposure, given the unsustainable rise in subprime lending in the US housing market such that the rise in mortgage defaults (among subprime borrowers) contributed to debt securities losing their value, and creating a loss for the financial institution which created them.
Some, therefore, claim that the partial repeal of the GSA by the Gramm-Leach-Bliley Act (GLBA) in 1999 allowed commercial banks to affiliate with investment banks in their securities underwriting and dealing, and, as a consequence, promoted risky business models in securities dealing. This “business” model is claimed to have been permitted by the GLBA, which failed to divest commercial banks from their securities affiliates.
This was the case for the Citicorp and Travelers merger that created Citigroup, which became one of the major banks with significant ABS exposure in its books. However, many banks involved in the origins of the financial crisis were not commercial banks with affiliated securities firms. Rather, they were investment banks with significant ABS and CDO portfolios such as Lehman Brothers, Bear Stearns, and Merrill Lynch. In this case, the GSA would not have prevented these banks from making large investments in subprime assets.
There is further evidence to suggest that the enactment of the GLBA did not affect securities holdings by commercial banks after the repeal of Sections 20 and 32 of the GSA. In fact, securities holdings of commercial banks continued to fluctuate without regard for the passing of the GLBA, indicating that the law did not have the effect some commentators attribute to it.
Such analysis fails to account for data indicating that securities holdings are a matter of business strategy rather than the result of the GLBA explicitly enabling banks to pursue risky financial activities. Given that Section 16 of the GSA was not repealed in 1999, it still remained illegal for commercial and investment banks to purchase, sell, underwrite, or distribute securities, highlighting that the GSA was in itself ineffective in preventing securitisation by banks.
Instead of arguing that a reintroduction of the GSA will benefit the United States economy and banking industry, perhaps legislators should concern themselves with banning certain securities investments that can, in certain market conditions, lead to a financial meltdown for the bank or securities firm making that specific investment, as was the case with securitised financial instruments. As has been noted, the failure of the GSA to prevent types of securitisation largely falls into the narrow legal definitions of what constitutes a “security”.
This was partly solved by the Dodd-Frank Reform Act of 2010, which attempted to rein in financial companies and their activities. Dodd-Frank and Basel III encouraged lowering the risk caused by investing in volatile assets by mandating that banks should have minimum capital requirements in relation to “risk-weighted assets”. Dodd-Frank added further restrictions on banks and financial institutions with regards to OTC (over-the-counter) derivatives and swaps that were perceived to be responsible for worsening the crisis.
These had previously been undefined and unregulated with the exception of prudential banking regulators. Most importantly, Dodd-Frank included the “Volcker Rule”, which banned banks from committing to proprietary trading and prevented ownership of hedge funds or private equity funds. Regulations created by legislation such as Dodd-Frank that restrict trading in specific securities are able to limit specific financial risks that have the potential to spread risk to other assets. This is more effective than the broad approach of the GSA that eventually became vulnerable to a number of loopholes and exemptions.
While US financial regulation required a major overhaul following the 2007-2008 crisis, it is necessary to remark that the “deregulation” narrative only serves to hinder the progress of financial law in encouraging the objectives of capital formation and minimising the risks and costs of economic crises. Regardless of one’s opinion as to whether the Dodd-Frank Act pursues these goals, we must not reintroduce a “quick fix” that fails to serve both the interests of the financial sector and the wider economy.