May 3, 2017    4 minute read

Why Does Trump Want to Bring Back the Glass-Steagall Act?

Wall Street On the Rocks    May 3, 2017    4 minute read

Why Does Trump Want to Bring Back the Glass-Steagall Act?

On May 1st it was reported that the 45th President of the United States Donald J Trump is actively considering a breakup of giant Wall Street banks.

“I’m looking at that right now. There are some people that want to go back to the old system, right? So we’re going to look at that.”

The Law

The Banking Act of 1933, known as the Glass-Steagall Act (named after its proponents, Senator Carter Glass and Congressman Henry B Steagall), was one of the responses to the great depression: it established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms to control speculation.

The principal among these were the introduction of a clear separation between traditional banking and investment banking. The two activities could not be exercised by the same intermediary, having thus the separation between commercial banks and investment banks. The purpose of the measure was to prevent cases where the failure of an intermediary would also entail the failure of the traditional bank: this would avoid the real economy being exposed to the danger of purely speculative financial and adverse events.

Commercial banks and investment banks differ in nature and purpose. The first ones offer deposit and lending services to businesses and companies, thus providing liquidity to the productive sector. The latter are financial institutions that provide assistance to corporations in raising capital and posed as middlemen in mergers and acquisitions and the buying and selling of derivatives and equities.

In particular, the law forbade commercial banks from underwriting the purchase of any title, with the exception of bonds, unless it was explicitly requested by the customer. They were also not allowed to affiliate with companies involved in investment banking. Similarly, if a financial institution decided to participate in the buying and selling of securities, it could not offer deposit services. The part of the law regarding the separation of traditional and investment banks was cleared by Bill Clinton in 1999.

‘History is Life’s Teacher’

With the crisis of 2007, the scenario that the Glass-Steagall Act aimed to prevent came true: insolvency in the subprime market, which began in 2006, triggered a liquidity crisis which was transmitted immediately to traditional banking, given the latter’s mingling with investment activity (in this case, real estate).

When the global financial crisis exploded in September 2008, it blew $10trn from global equity and saw the end of Lehman Brothers and their 25,000 employees’ jobs.

Without distinction between types of banks but with the FDIC intact, it is clear that the banks felt free to make investments with less caution because of the deposit insurance guaranteed by the Government. This was the case for particularly large banks (the famous “Too Big To Fail”), that governments would let fail only in very remote cases to avoid the huge disruption that their failure would create.

An Economic Revolution

As reported, Trump is considering whether or not to, in a sense, dismantle big banks on Wall Street. This hypothesis did immediately strain the share prices of financial groups such as JP Morgan, Goldman Sachs and Bank of America Corp.

This proposal is not exactly surprising news, though, since Trump spoke of introducing a 21st century Glass-Steagall Act during his campaign. Treasury Secretary Steven Mnuchin and Chief White House Economic Council Gary Cohn – both former employees of Goldman Sachs – appear to favour some sort of Glass-Steagall Act, which is good news for Trump since he can not unilaterally restore the law and Congress has to pass the new version of it.

The re-introduction of the Glass-Steagall Act or something similar to it would probably be the biggest economic revolution of the last fifty years, which could put an end to that fictitious world that is finance too often governed by greedy speculators and “players” who have no interest for the common good.

Is Trump learning from history? It could be that, in order to avoid future crises like that of 2008, the reintroduction of the Glass-Steagall Act could be the right move. The finance world has too many times failed to learn from the past. As Cicero put it, “historia magistra vitae” (history is life’s teacher).

 

Get articles like this straight to your inbox each morning with our Breakfast Briefing. Sign up by clicking here!

Log in with your details

or    

Forgot your details?

Create Account

Send this to a friend