The Gramm-Leach-Bliley Financial Services Modernization Act
Among the reasons for the GFC, the Gramm-Leach-Bliley Financial Services Modernization Act plays a significant role. The law repealed the Glass-Steagall Act, which had regulated the relationship of commercial banks regarding investment activities since 1933 (Carpenter, Murphy, E., Murphy, M., 2016). The law greatly influenced the period of stability in the U.S. by ensuring banks’ safety and cooperation with the state apparatus. The repeal of the Glass-Steagall legislation had a significant impact on banking operations and was one of the global causes of the crisis.
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Prerequisites of the Law, Its Implementation, and Effect
The primary purpose of the law was to separate commercial and innovative banks, as it secured the U.S. from another crisis, as the state suffered significant losses in the fall of 1929. The Glass-Steagall Act was initially an initiative of Senator Carter Glass alone, who proposed several bills between 1930 and 1932 (McDonald, 2016). First, there was an emphasis on regulating a combination of commercial and investment banks directly. Second, Glass raised the question of bringing banking operations under the supervision of the Federal Reserve System. As a result, in 1932, Senator Glass provided a bill in which the critical point was the requirement that commercial banks liquidate their securities branches.
At first, there were remarks about the over-regulation of national banks and a significant restriction of competition. On this basis, there was a risk of the rejection, but it was approved thanks to suggestions from Chairman Henry B. Steagall. In May 1933, Stegall proposed that state banks be allowed to receive federal deposit insurance. On June 16, 1933, the Stegall-Glass Act was passed and separated commercial and investment banks.
Among other positive consequences is the prohibition of commercial banks members of the Federal Reserve System from dealing in non-government securities. In addition, there was a prohibition on the distribution of non-government securities (McBride, Evans, Plehwe, 2021). The law essentially combined two projects of Congress: the federal system of bank deposit insurance and the regulation of combinations of banks of two types at once. Thus, the law did bring economic stability to the U.S. banking system.
The law has benefited the U.S. economy by creating a sense of responsibility among investors. In addition, the law provided strong protection through full deposit insurance by the FDIC of 1.07.1934. The imposition of a prohibition on exceeding a certain amount of the interest rate on current accounts (Regulation Q) reduced the rate of speculation and improved the customer-friendliness of banks (Carpenter, Murphy, E., Murphy, M., 2016). The regulation of banks with strict supervision and control in the form of regular reports maintained economic stability almost until the law’s repeal.
The Repeal of the Law and Its Role in the GFC
Despite the effectiveness of the Glass-Steagall Act, by the mid-1980s, the law had little impact on banking systems. This was due to the growing number of loopholes for both investment and commercial activities (Wilmarth, 2017). In addition, the Office of the Controller of the Currency interpreted the law in such a way that legal entities could find ways to combine activities, including regarding securities.
Thanks to the passage of the Financial Modernization Act (or Gramm-Leach-Bliley Act) in 1999, holders of securities had pre- and post-transformation rights (Mishkin, 2018). In addition, in a reversal of the traditional approach to market separation, the phenomenon of lobbying further stimulated Congress to abolish: in particular, the merger of the Travelers Group with Citicorp. This directly contradicted the Glass-Steagall Act, so it is believed that the status of the companies influenced the repeal.
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The repeal of the Glass-Steagall Act changed the rules of U.S. banking and empowered financial conglomerates. It is now believed to have been one of the causes of the 2008 crisis (Wilmarth, 2017). During the GFC, the risks of financial institutions increased significantly, and cases of predatory lending and theft of financial products in general increased. In addition, the mortgage crisis led to a ban on foreclosures. As a result, the banking system was stressed and underwent a significant decline. Among the consequences of the repeal were: depreciation of securities (MBS), embezzlement, and the formation of a housing bubble.
Mortgage-backed securities (MBS) are debt securities that receive financing based on loan commitments. Low-quality securities issued on the basis of subsidized lending have led to a crisis in the marketplace (Choudhry, 2018). Collateralized debt obligations (CDOs) are a category of securities that carry the credit risk of the borrower and are subject to debt covenants. CDOs were relevant security in a robust real estate market, but during the GFC, they acted as a “toxic” category. This was due to the default of high-interest rate holders relative to corporate bonds (Ouliaris and Rochon, 2020). As a result of market overheating and reduced economic immunity, the market was flooded with CODs issued to all depositors, even in the absence of home loan repayment.
The increase in the number of securities backed by debt or subsidized credit has led to excessive hoarding. As a consequence, investing in the U.S. housing market led to a housing bubble. By 2008, the price of housing had fallen substantially, making it impossible to pay the high mortgage rates that led to the default on debt (Stanford, 2021). In addition, the repeal of the Glass-Steagall Act had an impact, which manifested itself in an increase in speculation by deposit banks (McDonald, 2016). This means that virtually all the systems for protecting citizens and for insuring deposits were lost, so the stimulation of the crisis came from within the banking system.
The Glass-Steagall Act allowed the risky activities of legal entities to be kept in check by imposing additional restrictions on financial transactions. Its adoption bore considerable fruit, becoming the mainstay of a stable, strong economy. However, the exhaustion of restrictions and oversight led to the abolition of the law and, as a consequence, the formation of a financial pit (Magas, 2021). Abolition contributed to the accumulation of bubbles in the financial market and real estate. The depreciation of securities and the growth of speculation and embezzlement were the causes of the GFC.
Carpenter, D. H., Murphy, E. V., Murphy, M. M. (2016). The Glass-Steagall Act: A legal and policy analysis. Congressional Research Service.
Choudhry, M. (2018). An introduction to banking: principles, strategy and risk management (securities institute). 2nd edn. Hoboken: Wiley.
Magas, A. (2021). Post GFC-crisis lessons: USA – and the advanced economies. Society and Economy, pp. 15-56.
McBride, S., Evans, B. and Plehwe, D. (2021). The changing politics and policy of austerity. 1st edn. Bristol: Bristol University Press.
McDonald, O. (2016). The repeal of the Glass‐Steagall Act: myth and reality. Policy Analysis, 804, pp. 1-24.
Mishkin, F. (2018). Economics of money, banking and financial markets (What’s new in economics). 12th edn. London: Pearson.
Ouliaris, S. and Rochon, C. (2020). Pre- and post-GFC policy multipliers. IMF Working Papers, 20. Web.
Stanford, J. (2021). ‘The crisis next time: the GFC and the continuing fragility of capitalism’, The Changing Politics and Policy of Austerity. Bristol: Policy Press, pp.248-271.
Wilmarth, A. E. (2017). The road to repeal of the Glass-Steagall Act. GWU Law School Public Law Research Paper, 61.