The Glass-Steagall Banking Act, more than any other piece of banking legislation, shaped the development of the current banking system in the United States. One of the numerous acts of economic reform passed in the first 100 days of Franklin Roosevelt’s administration, it sought to revive confidence in the banking system and reduce bank competition for depositors’ money.
In 1931 the position of banks in the United States caught the attention of the eminent economist John Maynard Keynes, who described it as the weakest element in the whole situation. Suspensions of deposit redemptions by banks had been averaging about 634 banks per year before the depression, already a high level. The banking crisis deepened with the onset of the economic crisis. Depositors pulled money out of banks, sometimes sending it abroad, sometimes hoarding it in homes. Gold reserves declined. From 1929 to 1933 over 5,000 banks suspended redemption of deposits. One-third of all U.S. banks failed during the depression. President Hoover saw the banks as a victim of a crisis in confidence. To prevent panic from spreading, President Roosevelt in March 1933 ordered all banks to close for a week.
On June 16 1933 the Glass-Steagall Banking Act became the law of the land. To help restore confidence in banks, the act banned deposit banks from engaging in investment banking. Investment banks buy newly issued stocks and securities from corporations and resell them to the public for a profit, playing a key role in marshaling capital corporations. After the stock market crashed, banks that had invested depositors’ money in stocks had no way to recover their investment and were forced into bankruptcy. The ban on investment banking remains in effect today, but has been weakened by innovations in the organization of the banking industry, and many people in Congress think it should be repealed. This divorce between deposit banking and investment banking does not exist in many countries, including Germany, France, Switzerland, and the United Kingdom.
The Act also gave the Federal Reserve System the power to regulate interest rates on savings and time deposits. This provision, known as Regulation Q, helped keep the cost of funds down for financial institutions. Another provision of the Glass-Steagall Banking Act prohibited interest-earning checking accounts. The payment of interest on checking accounts increased bank competition for deposits. This added competition might have driven some banks into bankruptcy. The deregulation of financial institutions in the 1980s phased out Regulation Q and removed the ban on checking accounts that pay interest.
The Federal Deposit Insurance Corporation (FDIC) owes its existence to the Glass-Steagall Banking Act. This corporation insures deposits from bank failure up to a maximum limit. All banks that are members of the Federal Reserve System must buy deposit insurance from the FDIC. Today virtually all commercial banks insure deposits with the FDIC. After the savings and loan crisis in the 1980s, the FDIC took over responsibility for furnishing deposit insurance to the thrift institutions. Deposit insurance helps maintain the public’s confidence in the banking system.
Large numbers of bank and thrift failures during the 1980s showed that financial institutions remained vulnerable to disinflation and recession. The Glass-Steagall Banking Act went a long way toward instilling resiliency and public confidence in the banking system.