THE BANKING ACT OF 1933
aka
THE GLASS-STEAGALL ACT
How it came to be?
Following the 1929 stock market crash and the Great Depression, there was need to restore confidence in the U.S. banking system and bring an end to bank runs. In addition, the "Pecora" investigations had demonstrated that the investment banking operations of commercial banks had been engaged in highly risky activities that were not in the best interest of their customers or their American public.
Senator Carter Glass (D-VA) sponsored the act, with the support of Congressman Henry Steagall (D-AL).
What did it do?
Though not often described as such, the Banking Act of 1933 (also known as Glass-Steagall) is actually a "two part" act.
PART ONE established the Federal Deposit Insurance Corporation (FDIC), guaranteeing bank deposits up to a certain amount. This began at $2,500 and over time has been raised to $250,000.
PART TWO separated commercial banking from investment banking. Commercial banks were prohibited from engaging in investment banking activities. It also restricted investment banks from funding their operations from bank deposits to engage in speculative and risky (i.e. volatile) securities trading activities. Banks were prohibited from underwriting and trading securities, apart from underwriting government-issued bonds, and general obligation (tax supported) bonds of state and local governments.
Learn more here from the Federal Reserve History.
What happened?
During the years since the Banking Act of 1933 was in effect, the country saw prosperity, stability and growth. Over the decades, bank regulators gradually gnawed away at Glass-Steagall, with a final repeal in by Congress in 1999.
IN THE 60's: Non-bank entities, such as General Motors and Sears began offering consumer credit, which competed with banks for loans. The Office of the Comptroller of the Currency (OCC) issued regulations, allowing banks to offer products similar to mutual funds and to underwrite (buy and sell) municipal bonds backed by project revenue in addition to those backed by the taxing power of the states or local governments. Inflation exceeded the interest rate cap on savings and other deposit accounts. Consumers began to seek other safe products with better returns and bonds, while prime customers began to bypass commercial banks and go directly to capital markets for borrowing or high yield savings. The Federal Reserve permitted the savings & loans associations (S&Ls) to pay higher interest rates on savings accounts than commercial banks and offer a product similar to a checking account, not subject to interest rate caps. S&Ls were not covered under Glass-Steagall.
IN THE 70's: Deposit account innovations were plentiful, including Merrill Lynch's “cash management account". Depositors could write checks against their funds in money management accounts and get better rates. Merrill could use deposits to trade securities (unregulated), unlike commercial banks. 1978 saw the first Mortgage-backed security (bundled mortgages sold to investors), offered by Bank of America.
IN THE 80's: The theme was commercial banks and investment banks acquiring each other and commercial banks began to trade in derivatives. The FDIC authorized state-chartered, non-Federal Reserve banks to partner with securities firms, even if they had FDIC insurance. The Fed permitted Bank of America to buy Charles Schwab and granted Citigroup, Bankers Trust and JPMorgan to trade mortgage-backed securities, municipal bonds and commercial paper. The OCC allowed Citibank to offer a collective investment trust - unregistered investment vehicles (like hedge funds) for pension and 401k plans.
IN THE 90's: The Gramm-Leach-Bliley Act put an end to PART TWO of Glass-Steagall in 1999, repealing the separation of commercial banks and investment banks. Commercial banks were now able to participate in the same speculative activities as investment banks.