Glass-Steagall: An Investigation of Easing Constraints
Research Methods in Economics
Phillip Reese
05/06/2011
Introduction
The Banking Act of 1933, more commonly known as Glass-Steagall, was passed in response to the market crash in 1929. According to the Senate Committee on Banking and Currency (1934) there were three reasons for Glass-Steagall. First, banks invested their own assets which created risks to depositors. Second, unsound loans were made to counter the risks taken on by the bank. Finally, banks pressured their customers to invest in securities held by the bank. These three reasons express the worries of risk, moral hazard, and conflicts of interest associated with the bank practices before the crash and can be generally categorized as imperfect information. Glass-Steagall was an attempt to rectify these problems. Over the course of its 66-year history,the constraints set in place by the act had been whittled away until its official repeal in 1999. William D. Jackson (1987) states the reasons in favor of these repeals. First, securities firms and foreign firms were much less regulated by Glass-Steagall and caused the banks to lose market share. Second, it was believed that conflicts of interest could be handled by legislation and by separating the deposit taking arm from the investment arm. Third, banks could offer more diverse options to their customers. Finally, many other nations had more lenient regulations and were successful in both areas (1987). The research is important becauseit provides another perspective to the ongoing debate about financial regulation in light the most recent economic recession; should Glass-Steagall be re-implemented or not, i.e. are the reasons for passing it in the 1930’s applicable today and why? And do these policies effect who can participate in the market? This paper will observe the changes in savings and bank held securitized assets during the periods in which repeals were made to Glass-Steagall in hopes to find correlations among them and determine who is effected by them. This paper finds that there appears to be correlations between repeals and movements in savings and bank held securitized assets, the effects of which are debatable, and that the conditions surrounding the 2008 recession are different from those of the Great Depression.
Literature
The stock market crash of 1929 is most commonly attributed to a bubble created by the rapid economic growth of the 1920’s (Galbraith, 1954) and/or the mismanagement of the nation’s money supply and interest rates (Friedman and Schwartz, 1962). These two sources provide background on the conditions surrounding the Great Depression and how the government responded, which will be compared to the conditions and the response during the 2008 recession.
Kroszner and Rajan (1994) test the validity of the argument regarding conflicts of interest. The hypothesis was that “bank securities affiliates could-and did-systematically fool the (naive) public investor” (1994, p. 811). Their results show that the affiliates did not fool the public into buying lower quality securities, and in fact “Not only did bank affiliates underwrite higher quality issues, but also [they] find that the affiliate-underwritten issues performed better than comparable issues underwritten by independent investment banks” (1994, p. 829). Since the affiliate issues performed better and were of higher quality, it appears as though conflicts of interest were not present. They sold higher quality securities to offset their lack of experience in the industry and did not pressure customers to invest in securities held by the bank.
Eugene White (1986) investigated the risk associated with affiliates, another of the three main issues addressed by the Glass-Steagall act. White’s results are, to say the least, short and to the point. He had four questions about how affiliates may have had a negative effect on the commercial banks. First, “Did a Securities Business Increase the Probability of Bank Failure?” (1986, p. 40). His results decisively showed that affiliates did not increase the probability of failure and they actually had the contrary effect. Second, “Was Investment Banking Favored over Commercial Banking?” (1986, p. 42). Again, the answer was no. He found that there was very little, if any, incentive to favor one over the other, the “Divergence of ownership appears to have been the exception rather than the rule” (1986, p. 42). Third, were there “Dangerous Swings in Earnings or Safe Diversification?” (1986, p. 42). His results pointed out that there was little correlation between a bank’s swing in earnings and an affiliate’s, they may have moved together, but one was not reflective of the other. He also made note that the additional risk involved, when a bank invested more money in securities, was small compared to the gains from the returns. Essentially, there was no evidence to support the fear of a dangerous swing. Finally, he asked “Was the Solvency or Liquidity of Commercial Banks Endangered?” (1986, p. 45). Again, his results showed no support for the fear, instead he noted that the size of the bank had a bigger impact on the banks solvency and/or liquidity issues. All these factors together showed that a depositor’s money was subject to little or no risk.
The two writers above have given empirical evidence refuting the reasons for passing Glass-Steagall which leaves the question, why was it passed? Joseph Stiglitz(2004)prefers to emphasize the departures from our economic models, such as those mentioned in the Senate Committee and produce a much simpler argument in favor of government regulation. Stiglitz states:
“Changes in technology, in laws, and in norms may all exacerbate conflicts of interest, and, in doings so, may actually impair the overall efficiency of the economy. The notion that change is necessarily welfare enhancing is typically supported by the same simplistic notions, sometimes referred to as market fundamentalism, that assert that markets necessarily lead to efficient outcomes. If the economy is always efficient, then any change that increases the output per unit input must enhance welfare” (Stiglitz 2004, p.22).
This idea asserts that changes in the market may intensify existing problems, such as imperfect information, moral hazard, and conflicts of interest, all of which are the basis for Glass-Steagall. This is to say that regardless of what the market fundamentals and empirical evidence may show, regulation may produce a more efficient outcome. This is because there are many variables which we cannot quantify accurately, so with regard to White (1984) andKroszner and Rajan (1994), although their evidenceshows that Glass-Steagall may not have been necessary, these factors are just bits of the puzzle and do not completely rule out the need for Glass-Steagall, which seems apparent by the depression. This notion is important because it gives a logical defense for the policy perspective why Glass-Steagall was passed.
Intrusions and Repeals
Glass-Steagall remained largely unchanged until the 1960’s. James J. Saxon opens the door to “expanding bank powers, and welcoming new banks and branches into the national banking system” (OCC.gov). He believed the regulation of banks was more restrictive of economic growth and welcomed a record number of new charters into the national system, causing uproar among the commercial banks. He said:
“Where banking facilities are inadequate, the forces of economic growth will not be fully realized. But, more important, banks can exert a positive influence in exploring, fostering, supporting, and directing the economic development of a community or a nation” (Saxon 1963, p.336).
Over the next 20 years banks would exploit loopholes in the regulation, such as creating investment vehicles, like Money Market Accounts, that provided a work-aroundin order to remain competitive with the banks that were less regulated. In 1980 The Depository Institutions Deregulation and Monetary Control Actbegan phasing out Regulation Q, allowing banks to pay interest on deposit accounts. Garn-St Germain Depository Institutions Act of 1982 phased out Regulation Q completely. And finally, the official repeal of Glass-Steagall, or what was left of it, was the Federal Services Modernization Act of 1999, better known as Gramm-Leach-Bliley, which allowed commercial banks to become affiliated with investment banks and the allowed the ability to merge.
Theory
Glass-Steagall implemented an entry barrier. It limited who could supply investments by prohibiting commercial banks from being affiliated with investment banks. Economic theory suggests that an entry barrier limits competitionby reducing the industry concentration and thereby limiting supply. By limiting supply, the regulation increased the price for investmentsand forced out some potentialinvestors. Glass-Steagall also implemented a price ceiling, Regulation Q. This regulated how much interest commercial banks could pay on the deposit accounts of its customers, thereby limiting their returns. Since the increased price is still affordable to upper class investors and they are largely unaffected by commercial bank regulation, due to having the means to earn returns through investment banks, it seems that the excluded investors are therefore, middle class and/or lower class investors. These investors are unable to benefit from the increased returns of these investments, however, by excluding them, they are also protected from the risk of losing what they, potentially, cannot afford.
By applying the theories involving a supply side constraint such as, supply and demand and price movements,I can determine what effects the repeals to Glass-Steagall had on personal savings andbank held assets, and whether or not the repeals should be reversed. These methods shouldproduce reliable results because it will include evidence based in several theories of economics and it will compare these effects to a highly examined topic, the Great Depression, and a currently debated topic, the recession of 2008. It will use an intertemporal approach to study periods which are regulated and periods which are unregulated, 1929-1933, 1976-1986, and 1995-2009, and observe how the two variables change when the constraint is relaxed. These variables should produce a sufficient number of observations and produce results necessary to answer the questions above.
Analysis
Figure 1
Notes: 1933, the Banking Act of 1933, Glass-Steagall, passed
Sources: Survey of Current Business, Table 4 (2010: p. 193)
Historical Statistics of the United States, 1789-1945, Table N 68-75 (1949: p.268)
The chart in Figure 1 is the personal savings values for the years 1929 through 1937 overlaying the member bank net profits of the same years. These years were chosen to illustrate the unregulated and regulated conditionsbefore and after of the passing of Glass-Steagall in 1933.
What we see in Figure 1 is decreasing savings and decreasing bank profits until 1933 and then increasing savings and increasing bank profits. This turn around seems to coincide with the passing of Glass-Steagall. It appears that by restricting the supply, prohibiting affiliation, the price of the investments increased. This seems to correlate with the increasing profits seen following 1933. The increase in personal savings seems to be a result of more perfect information, or rather the exclusion of those that lack it. That is to say that preventing middle-class investors from having access to these securities had a positive effect on the market; their lack of knowledge on how the securities market worked lead to a panic, of losing assets they couldn’t afford to lose, and contributed to the market’s sharp decline during the Great Depression.
Figure 2
Notes:1980, The Depository Institutions Deregulation and Monetary Control Act passed
Sources: Survey of Current Business, Table 4 (2010: p. 193)
The chart in Figure 2 is the personal savings values for 1976 through 1984 overlaying securities held as assets by insured commercial banks for the same years. Theseyears were chosen to illustrate the conditions before and after of the passing of The Depository Institutions Deregulation and Monetary Control Act of 1980. This allowed banks to set their own interest rates to compete for savings accounts (Depository Institutions, 1980). This act relaxed the constraint known as Regulation Q,or section 11 of Glass-Steagall, and allowed certain types of institutions to have accounts that paid interest; many of the institutions had already exploited loopholes to deliver the returns to investors through the use of NOW and Money Market Accounts. Previously the regulation limited the returns on passbook savings accounts, largely held by middle-class savers, and the NOW and Money Market Accounts offered a work around.
What we see in Figure 2 appears to be nothing significant. The value of securities held by commercial banks tapers off a bit, most likely due to a substitution effect and decreased concentration in response to the eased constraint. This could becaused by the entry of new firms from separate industries providing a similar product, such as money market accounts. These substitutes can cause funds to be dispersed among more firmsand routed out of securities and into the new vehicles, thus explaining the tapering. I would expect to see savings increase as a result of increased competition. This is seen in the figure until 1982. Allowing the commercial banks to pay interest on savings accounts did increase competition, in the form of high interest rates paid, and showed that Regulation Q artificially held down the returns to these savers. It also shows that the eased constraint had a positive effect on savers. The dropfrom 1982 to 1983 is more likely due to legislation passed in 1982, which will be covered in the next section.
Figure 3
Notes: 1982, Garn-St Germain Depository Institutions Act passed
Sources: Survey of Current Business, Table 4 (2010: p.193)
Statistical Abstract of the United States, No. 808 (1987: p.482)
Statistical Abstract of the United States, No. 778 (1988: p.473)
The chart inFigure 3 is the personal savings values for the years 1978 through 1986 overlaying securities held as assets by insured commercial banks for the same years. Theseyears were chosen to illustrate the conditions before and after of the passing of the Garn-St Germain Depository Institutions Act of 1982. This act completely repealed Regulation Q, in its Glass-Steagall form, and allowed S&Ls to sell ARMs, or adjustable-rate mortgages (Garn-St. Germain, 1982). These mortgages helped banks shore up their asset-liability mismatches and were an attempt to encourage people to buy homes as they could get lower monthly payments by bearing the risk of higher payments later.
What we see in Figure 3 is a bit more significant than the previous figure. We see a drop in the personal savings rate the same year the bill is passed. This could be the result of ARMs working as intended, encouraging people to buy homes increases demand for homes and draws funds away from personal savings. Consumers spend savings to buy houses, thereby lowering savings. The increase from 1983 to 1984 can be explained by the return to saving as the demand for ARMs winds down and the drop following could be the result of increased interest rates causing the payments on the ARMs to increase, lowering savings again. The repeal of Regulation Q, as in figure 2, should have an increasing effect on the savings rate by increasing competition for deposits. This does not seem to be the case; perhaps because the earlier deregulation already shifted the demand and left Regulation Q powerless over the market or perhaps because the ARM loans are seen to be a better utilization of saver’s money, or both.
The drop in the value of securities held by commercial banks from 1983 to 1984 can be explained by firms moving assets from securities into the funding of ARM loans. Since the demand for homes seems to have increased, we would expect to see the commercial banks increasing the supply of the loans, the trade-off being a decrease in their assets. They begin to rise again after the flux of funds being moved into ARMs, 1984 on, due to savers moving money back into investment vehicles, thus increasing the demand for securities. The movements in the chart seem to correlate with these explanations, but are by no means definitive as new investment vehicles have been created and they are not accounted for in these observations.
Figure 4
Notes: 1999, Financial Services Modernization Act passed
Sources: Survey of Current Business, Table 4 (2010: p. 193-194)
Statistical Abstract of the United States, No. 1174 (2003 p.745)
Statistical Abstract of the United States, No. 1169 (2004-2005 p.741)
The chart in Figure 4 is the personal savings values for the years 1995 through 2003 overlaying securities held as assets by insured commercial banks for the same years. These years were chosen to illustrate the conditions before and after of the passing of the Financial Services Modernization Act of 1999, or Gramm-Leach-Bliley as it is more commonly known. This act officially repealed the barriers preventing commercial banks from affiliating/merging with investment banks (Gramm-Leach-Bliley, 1999).
What we see here is commercial banks steadily increasing their security assets and larger, more frequent movements in savings. The increase in security assets is undoubtedly due to the deregulation and the combination of these bankshas the potential to impact the market in several ways. Commercial banks affiliating and merging with investment banks, previously prohibited, may combine their assets and/or be compelled to own more assets of an affiliated bank, increasing demand for securities and explaining the increase in assets. It expands the supply to previously excluded demand, such as middle and lower-class investors, by making accounts with little or no minimum balance available, thus increasing demand.