This entry contains information applicable to United States law only. Legislation passed by Congress in 1933 that prohibits commercial banks from engaging in the investment business.
The Glass-Steagall Act, also known as the Banking Act of 1933 (48 Stat. 162), was enacted as an emergency response to the failure of nearly five thousand banks during the Great Depression. The act was originally part of President Franklin D. Roosevelt's New Deal program and became a permanent measure in 1945. It gave tighter regulation of national banks to the Federal Reserve System; prohibited bank sales of securities; and created the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits with a pool of money appropriated from banks.
Beginning in the 1900s, commercial banks established security affiliates that floated bond issues and underwrote corporate stock issues. (In underwriting, a bank guarantees to furnish a definite sum of money by a definite date to a business or government entity in return for an issue of bonds or stock.) The expansion of commercial banks into securities underwriting was substantial until the 1929 stock market crash and the subsequent Depression. In 1930 the Bank of the United States failed, reportedly because of activities of its security affiliates that created artificial conditions in the market. In 1933 all the banks throughout the country were closed for a four-day period, and four thousand banks closed permanently.
As a result of the bank closings and already devastated economy, public confidence in the U.S. financial structure was low. To restore the confidence of the U.S. banking public that banks would follow reasonable banking practices, Congress created the Glass-Steagall Act. The act forced a separation of commercial and investment banks by preventing commercial banks from underwriting securities, with the exception of U.S. Treasury and federal agency securities, and municipal and state general obligation securities. More specifically, the act authorizes Federal Reserve banks to use government obligations and commercial paper as collateral for their note issues, in order to encourage expansion of the currency. Banks can also offer advisory services regarding investments for their customers, as well as buy and sell securities for their customers. However, information gained from providing such services cannot be used by a bank when it acts as a lender. Likewise, investment banks cannot engage in the business of receiving deposits.
A bank is defined as an institution organized under the laws of the United States, any state of the United States, the District of Columbia, any territory of the United States, Puerto Rico, Guam, American Samoa, or the Virgin Islands, that both accepts demand deposits (deposits that the depositor may withdraw by check or similar means for payment to third parties or others) and is engaged in the business of making commercial loans (12 U.S.C.A. § 1841 (c)(1) [1988]). Investment banking consists mostly of securities underwriting and related activities; making a market in securities; and setting up corporate mergers, acquisitions, and restructuring. Investment banking also includes services provided by brokers or dealers in transactions in the secondary market. A secondary market is one where securities are bought and sold subsequent to their original issuance.
Despite attempts to reform Glass-Steagall, the legislature has not passed any major changes — although it has passed bills that relax restrictions. Banks may now set up brokerage subsidiaries, and underwrite a limited number of issues such as asset-backed securities, corporate bonds, and commercial paper.
The Glass-Steagall Act restored public confidence in banking practices during the Great Depression. However, many historians believe that the commercial bank securities practices of the time had little actual effect on the already devastated economy and were not a major contributor to the Depression. Some legislators and bank reformers argue that the act was never necessary, or that it has become outdated and should be repealed.
See: Banks and Banking; Federal Reserve Board.