The Glass-Steagell Act During The Great Depression

The Great Depression of the 1930s changed the public policy perception regarding financial regulation. The regulatory framework under the Banking Act of 1933, popularly known as the Glass-Steagell Act, reformed the banking system in the United States. It was introduced to prevent the rate wars happening at exorbitant levels, as well as to curb conflicts of interest and excessive risk-taking financial activities. The first provision of the Glass-Steagell act was Regulation Q, which placed ceilings on depository interest rates. The second provision, Federal Deposit Insurance Corporation (FDIC) provided insurance against consumer deposits to prevent bank failures which were a common phenomenon during the Great Depression. The third provision,
Chinese Wall, drew a line between banking and non-banking activities, i.e. banks were not allowed to diversify from traditional banking activities of deposits and lending into securities, insurance etc. The fourth provision established entry barriers for banks to prevent excess amount of competition and also placed restrictions on interstate banking and the number of bank holding companies. The fifth provision included supervision of these financial institutions which involved regulation and periodic examination of solvency. Regulation Q placed ceilings of 5.25% interest rates on savings accounts, 5.75% to 7.75% on time deposits and 0% on checking accounts. It made an exception for the Savings and Loans Associations (S&Ls) specialized in mortgage financing, giving them a quarter per cent advantage over consumer deposits in order to encourage capital to flow into the housing industry. In 1932, the Federal Home Loan Bank Board (FHLBB) was established to regulate the S&Ls. In 1934, the Federal Savings and Loan Insurance Corporation (FSLIC) was established under the FHLBB as a deposit insurance fund for the thrift institutions. The federal regulations pertaining to the thrift industry were very different from that of commercial banks. The legislative framework was primarily driven by the public goal of encouraging residential ownership.

The regulation framework created under the Glass-Steagell Act was very effective in maintaining a stable environment and preventing bank failures throughout mid-twentieth century.
But in the four decades following Great Depression, few changes had been made to the regulatory framework. This was not a problem till the 1970s since there was little financial innovation in this period and the interest rate ceilings established by Regulation Q were not much of a constraint considering the prevailing market conditions. Before World War II, the Fed was pegging treasury rates below the Regulation Q ceilings. The Federal Reserve Treasury Accord of 1951 freed this pegging policy resulting in a rise in market interest rates and consequently cost-push inflation. Thus banks began lobbying against the Glass-Steagell act as it was becoming redundant with the emergence of new financial instruments that were combining both the deposit and securities markets. Along with that, foreign investment opportunities were seemingly more attractive in relation to the regulated domestic financial environment. The rapid growth of the European and Japanese banks in international financial markets proved hugely detrimental to the market position of American banks and its earnings. To top that, high inflation picked up in the 1970s leading to the disintermediation crisis. Monetarists incorrectly recognised the situation as demand-pull inflation where there was excessive money in the hands of the public and thus adopted tight monetary policy. In reality though, contrary to the conventional wisdom of the time, it was cost-push inflation with rise in marginal costs during a period of economic slowdown (Canova, 1995). This automatically led to a rise in market interest rates. This rise in interest rates ended up being a continuous process due to tighter money supply, making investment a costly activity and bringing down employment and aggregate
demand.

The high marker rates further decreased the already restricted profitability of the regulated financial institutions. Investors investing in the regulated institutions were basically facing negative real interest rates and thus looking for alternatives to invest in. This was the time when innovative financial instruments like commercial papers and money market mutual funds grew rapidly, with no intermediation or reserve requirements and higher rates of return, thus pushing funds out of these regulated institutions into them. In this scenario, the Fed had two ways to operate- it could’ve either brought these market instruments under the scope of the regulation or it could’ve removed the interest rate ceilings from the regulated institutions. It decided to take the latter path. State banking regulations were much more lax in comparison to federal banking regulations. Due to this regulatory arbitrage in the 1970s most of the financial innovation took place (Canova, 1995). Rather than controlling these instruments, the government further ratified them by raising the interest rate limits on close substitutes to these instruments which were offered by regulated banks and thrifts. With progressively higher market rates in the 1970s and 1980s, the interest rate ceilings under the Regulation Q were also adjusted and relaxed.

The steadily increasing offshore competition and accelerating domestic inflation combined led to a serious decline in the dollar value. Foreign investors as well as the central banks were willing to hold other currencies instead of dollar. In 1978, big commercial banks put huge pressure on the government to protect the dollar (Florida, 1986). Thus the government undertook a strict dollar defence programme with a hike in interest rates and credit controls. Though this put the US at a better footing in the international markets, it badly hit the domestic markets, bringing in recession. Along with this was the great divide between the regulated institutions themselves. Because the thrifts enjoyed a substantial spread between deposit and lending rates, it put the commercial banks at a comparative disadvantage. Thus the big banks which were losing their share in the savings deposit market to these thrifts pressurised the government to repeal the interest rate ceilings, pushing the financial system further down the path of deregulation.

The Glass-Steagell Act came into the picture at a time when the macroeconomic environment of the country was such that the financial system had to be ruled with an iron hand that would create b