Everything you would have wanted to know about the Glass Steagall Act, but didn't know that you needed to ask

Recently there's been a big mess on Wall Street. The federal government has rushed in to rescue financiers from their own massive bad judgment. An even bigger bailout plan is on its way to Congress

Supposedly, these bailouts are necessary to keep the larger economy from collapsing. When I listen to NPR or read news on the web, I hear and see frightened and baffled commentators comparing the situation to the Great Depression of the 1930s. No one seems to know what will happen next.

During the New Deal, it seemed obvious that the stock market crash and depression had been largely caused by the greed and stupidity of banks and financiers. The result was legislation regulating banks and stock traders.

During the right wing backlash of the past 30 years, many of those regulations have been abolished or undermined. Once again we seem poised on the brink of a catastrophe brought about by the worst excesses of unregulated capitalism. It seems clear that all this deregulation was less than a brilliant idea.

In a recent post, I linked to an article by Nomi Prins that called for re-regulation of financial institutions. Prins is no mere liberal ranter. According the biography on her web site, "Before becoming a journalist, Nomi worked on Wall Street as a managing director at Goldman Sachs, and running the international analytics group at Bear Stearns in London."

Prins has a particular piece of re-regulation in mind. As she explains in another post for Mother Jones, Prins wants to bring back something like the Glass Steagall Act.

Okay, here's where it gets just a little bit complicated. But bear with me, and I'm going to explain the Glass Steagall Act. The more of this stuff we ordinary people understand, the less chance the experts on Wall Street and in Washington have to take advantage of us.

First off, there were actually two Glass Steagall acts. According to Wikipedia, "Both bills were sponsored by Democratic Senator Carter Glass of Lynchburg, Virginia, a former Secretary of the Treasury, and Democratic Congressman Henry B. Steagall of Alabama, Chairman of the House Committee on Banking and Currency."

The first bill was passed in 1932, while Herbert Hoover was still president. It took the country off the gold standard and increased the ability of the Federal Reserve to influence the money supply.

The second bill, the Banking Act of 1933, is what most commentators are referring to when they talk about the Glass Steagall Act.

The act had a number of important provisions. It established the Federal Deposit Insurance Corporation on a temporary basis, and enabled it to regulate and insure bank deposits. It included something called Regulation Q, which allowed the Federal Reserve to regulate the interest rates that banks could pay. (We still have the FDIC. Regulation Q perished in 1980.)

But the heart of the Glass Steagall Act was its required separation of investment banking and commercial banking. Nomi Prins offers a good explanation:

Decisively, the Act forced institutions within the banking community to pick a side. You want to deal with the population at large, take their deposits, give them a safe place for their savings, and make reasonable loans for which you are as responsible as the borrowers? Terrific. As a commercial bank in 1933, the newly established Federal Deposit Insurance Corporation (FDIC) backed your depositors and the federal government regulated you.
Alternately, as an investment bank at the time you could raise capital through speculative investors at home or overseas. But you wouldn't get federal backing, and you couldn't use the citizenry's capital to fund your trading activities.
That simple Glass-Steagall separation not only kept consumer and speculative capital from intertwining within the same institution, it made it possible to understand the activities of all financial organizations. Transparency was not perfect, but it was more easily accomplished.

We lost this provision of Glass Steagall back during the Clinton Administration, through the passage of the Gramm-Leach-Bliley Act (GLBA).

Given the size of the current crisis, common sense seems to call for requiring more transparency from our financial institutions, and yes, subjecting them to stricter regulation.

A large part of the mess seems to have derived from the widespread sale of complicated, unregulated securities such as collaterialized debt obligations (CDOs) and credit default swaps.

And according to Wikipedia, the repeal of Glass Steagall

enabled commercial lenders such as Citigroup, the largest U.S. bank by assets, to underwrite and trade instruments such as mortgage-backed securities and collateralized debt obligations and establish so-called structured investment vehicles, or SIVs, that bought those securities. Citigroup played a major part in the repeal.

So you might think there would be universal support for bringing back Glass Steagall.

Not so.

For instance, NPR's Adam Davidson, insists that academic studies have proven that combined investment banks and commercial banks are actually more stable than banks that separate those two functions.

And Megan McArdle at atlantic.com insists that "Off [sic] all the most bizarre statements running around about this crisis, the most bizarre is the shockingly common belief on the left that this can somehow be traced back to the Gramm-Leach-Bliley act, which "repealed" Glass-Steagall."

I dunno. I think Nomi Prins's analysis in this AlterNet piece seems perfectly reasonable:

The Fed wants to avoid another huge failure in Merrill Lynch by pushing it under the rug of Bank of America. That is bad policy. Bank of America cannot possibly have a clue about the extent of Merrill's potential losses. This commercial bank taking over a speculative giant is much more dangerous than Lehman Brothers tanking. The Fed was within all of its rights and sanity to say no to Lehman's plea for a bailout. But it won't be able to do the same thing with Bank of America, which, unlike Lehman or Bear, is responsible for the accounts of millions of customers -- real people with real money on the line.
The speculative nature of the industry, in which commercial and investment banks can borrow beyond their abilities to repay, is a threat to national economic security. It requires a serious exit strategy.
There is no easy answer, but there is only one solution -- and it lies polar opposite to the Bank of America-Merrill Lynch merger logic. The only real way to stabilize the financial industry is to take it apart, quantify and separate its risks, and begin again. We can do this. FDR did it. The market is larger now, and more global. That is not an excuse for inaction; it belies a screaming need for useful action and meaningful regulation. Period.

Other commentators have suggested other approaches besides re-inventing Glass Steagall.

Writing for the New York Times, William R.Gruver suggests a consolidation of federal financial regulatory agencies--and a limit on which investors are allowed to buy the most complicated securities.

Dean Baker calls for a limit on executive compensation and a financial transactions tax.

Whatever combination of solutions we use, I think Prins is correct that we have a right to meaningful regulation of financial markets as a minimum price for these taxpayer bailouts.