The Gramm-Leach-Bliley Act of 1999: a bridge too far? Or not far enough?

• Author: White, Lawrence J.

1. INTRODUCTION

   The Gramm-Leach-Bliley Act (GLBA) of 1999, also termed the Financial Modernization Act of 1999, was signed into law on November 12, 1999. (1) At the time of its enactment it was hailed by supporters as an important step forward in the removal of the legal barriers between commercial banking and investment banking in the United States--a step that would strengthen both sectors. (2)

   A decade later, in the wake of the worst financial crisis since the early 1930s--followed by the worst economic recession since the early 1980s, possibly since even the 1930s--the GLBA has instead been flailed by critics as a major cause of the financial crisis of 2007-2009. These critics often call for a revival of the Glass-Steagall barriers that the GLBA eliminated. (3)

   A quite recent manifestation of this anti-GLBA sentiment is the so-called Volcker Rule, which would forbid deposit-taking financial institutions from engaging in proprietary trading for their own accounts or from operating hedge funds or private equity operations. (4)

   This Article argues that critics are mistaken in attributing a connection between the GLBA and the financial crisis. In fact, the GLBA had very little, if anything, to do with the financial crisis. Virtually all of the actions that can properly be identified as causes of the crisis could have occurred, and probably would have occurred, even if the GLBA had never been enacted--indeed, even if the original Glass-Steagall barriers had remained wholly intact. (5) Thus, a revival of the Glass-Steagall Act would achieve little, if anything, toward forestalling the kinds of actions that created the crisis or that might create a similar crisis in the future. The same argument applies to an application of the Volcker Rule.

   Further, a section of the GLBA erected new barriers to the ability of a nonfinancial firm to own a depository institution. This Article argues that this section is misguided. Thus, in an important sense, the GLBA did not go far enough in breaking down barriers.

   The remainder of this Article expands on these ideas. Part II provides some explanation and background on the GLBA. Part III discusses the causes of the financial crisis of 2007-2009 and shows that the GLBA had little, or nothing, to do with that crisis. Part IV addresses the issue of nonfinancial firms owning depository institutions. Section V concludes with forward-looking recommendations for public policy.

2. THE GLBA AND ITS CONTEXT

   At the heart of the GLBA was a partial repeal of the Glass-Steagall Act. (6) Thus, to understand the GLBA, it is necessary to understand the Glass-Steagall Act.

   1. Enacting Glass-Steagall

      In the wake of the stock market crash of 1929, the failure of thousands of commercial banks between 1929 and 1933, and the descent of the United States economy into the Great Depression, Congress saw the need for substantial reform of the banking system, initially embodied in the Banking Act of 1933. (7) Because the securities activities of commercial banks were thought to have contributed to the stock market crash and to the subsequent flood of bank failures, Congress included the Glass-Steagall provisions.8 In Section 16, commercial banks, and in

      Alternatively, the depository arm might ask the securities arm to underwrite a new securities issuance of a weak Sections 20 and 32, their holding companies and affiliates, were forbidden to undertake investment banking activities. Also, in Section 21, investment banking companies were forbidden from accepting deposits and thereby acting like commercial banks. In essence, commercial banks, which took in deposits and made business loans, and their holding companies could not underwrite or deal in securities; and investment banks, which underwrote and dealt in securities, could not offer deposits.

      The strength of Congress's feeling about the importance of this separation is indicated by the absence of any "grandfathering" of existing mixed arrangements. Those financial firms that embodied both functions were expected to divest (i.e., spinoff or sell) or shut down, one or the other. (9)

   2. Some Important Additions

      As discussed above, the Glass-Steagall Act restricted bank holding companies from engaging in investment banking. However, few other restrictions were placed on bank holding companies.

      The Bank Holding Company Act (BHCA) of 1956 made major changes in this structure. (10) The BHCA was primarily designed to prevent multi-bank holding companies from extending their networks of separately chartered banks across state lines. (11) This prohibition reinforced the policies of the states, all of which at the time prohibited branching across state lines. As part of the BHCA, however, multi-bank bank holding companies were prevented from engaging in activities that were not financial services. In essence, banking was separated from "commerce." By preventing multi-bank bank holding companies from engaging in nonfinancial activities, the BHCA also prevented an industrial or commercial company from buying or merging with a multi-bank bank holding company, and the insurance business was explicitly prohibited from bank holding companies. In 1967, the Savings and Loan Holding Company Act established similar prohibitions for multi-thrift holding companies. (12)

      Overlooked by the BHCA of 1956 was a bank holding company that owned only one bank. This loophole was closed in the BHCA Amendments of 1970. (13)

   3. Erosion of Glass-Steagall

      The Glass-Steagall barriers remained intact until the 1970s when expansion initiatives by commercial banks and investment banks--often challenged in the courts or before regulatory agencies, but eventually approved--eroded those barriers. From the commercial banking side, commercial banks began to offer various kinds of securities services to household and business customers (e.g., assistance in stock purchases and sales) and began to offer corporate finance services (e.g., assistance in the private placement of securities issuances, and advice and assistance on mergers, acquisitions, divestitures, capital structures, and financial planning). (14) From the investment banking side, investment banks undertook activities that attracted business from both the assets side and the liabilities side of commercial banks' balance sheets. On the assets side, larger corporations were increasingly encouraged to borrow money through bond issuances in the securities markets rather than through loans from a commercial bank. Mortgage securitization, which began in 1970 with the Government National Mortgage Association (Ginnie Mae), meant that residential mortgages could be financed through the securities markets rather than through the deposits that were gathered by commercial banks and thrifts. On the liabilities side, money market mutual funds (MMMFs), which first came into existence in 1972, offered households a deposit-like instrument that was relatively safe and liquid, but that offered higher interest yields than could regulation-capped bank and thrift deposits.

      The 1980s and 1990s brought more incursions from both sides. The deregulation of stock brokerage commission rates in the early 1970s opened the door for discount brokerage services. Banks saw discount brokerage (involving only transactions services, without advice or research for customers) as a permitted product-differentiating strategy for entering the securities brokerage business. Then, in 1987, the Federal Reserve first allowed commercial banks to undertake a limited amount of underwriting of corporate securities, with those limits gradually loosened in the 1990s. (15)

      From the investment banking side, MMMFs grew sharply between 1978 and 1982 in response to double-digit interest rates combined with regulatory restrictions on the interest yields that commercial banks and thrifts could pay to depositors. (16) Even after these restrictions were removed in the early 1980s, the MMMF industry continued to grow. The short-term assets in which MMMFs could invest gradually expanded beyond treasury bills and large-bank certificates of deposit to encompass commercial paper--very short-term bonds that are issued by companies--which moved another lending product away from the assets side of banks' balance sheets and into the securities markets.

      Also, in the 1980s and early 1990s, the savings and loan debacle, and the consequent implosion of the thrift industry, opened opportunities for other routes of financing residential mortgages. (17) Partly, commercial banks expanded their mortgage activities. But, more importantly, securitization of residential mortgages by two government sponsored enterprises that focused on residential mortgage finance--the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac)--meant that mortgages were increasingly moving off the assets side of bank and thrifts' balance sheets and into the securities markets. (18) Further, the success of securitization for residential mortgages, and the continuing improvements in data processing and telecommunications technologies, led to securitization and the concomitant movement off banks' balance sheets of commercial real estate mortgages, credit card receivables, auto loans, and other consumer loans.

   4. The GLBA

      Beginning in the 1970s and continuing through the 1990s, the commercial banking industry--in addition to the incursions that were documented above--began lobbying efforts to repeal the Glass-Steagall Act, in whole or in part, so as to gain easier and more direct entry into the securities industry. For the most part, the investment banking industry resisted. (19) The investment banking industry had little interest in entering the commercial banking industry and primarily wanted to protect its turf from incursions. (20)

      By the end of the 1990s, however, the investment banking industry saw the handwriting on the wall and largely capitulated. (21) It may have helped...