Glass-Steagall Act: Commercial vs. Investment Banking

Order Code 1887061

G L A S S - S T E A G A L L ACT:

C O M M E R C I A L VS.

INVESTMENT BANKING

U p d a t e d J u n e 29, 1 9 8 7

GQYERNMENT D O C U M E ~

CBUECTION

by

W i l l i a m D.

Jackson

Economics Division

Congressional Research Service

CONTENTS

SUMMARY

ISSUE DEFINITION

BACKGROUND AND A N A L Y S I S

C O N G R E S S I O N A L H E A R I N G S , R E P O R T S , AND DOCUMENTS

FOR A D D I T I O N A L READING

GLASS-STEAGALL ACT:

COMMERCIAL VS. INVESTMENT BANKING

Debate o v e r reform of t h e N a t i o n ' s f i n a n c i a l s t r u c t u r e i n t h e 1 0 0 t h

Congress i n c l u d e s re-examination

of " t h e s e p a r a t i o n of b a n k i n g and

cormerce

T h i s s e p a r a t i o n was mandated by t h e G l a s s - S t e a g a l l Act ( p a r t

of t h e Banking Act o f 1 9 3 3 ) ; and was c a r r i e d f o r w a r d i n t o t h e Bank H o l d i n g

Company Act of 1956, a s amended i n 1970 and t h e r e a f t e r .

The r e s u l t i n g

i s o l a t i o n of b a n k i n g from s e c u r i t i e s was d e s i g n e d t o ( 1 ) m a i n t a i n t h e

i n t e g r i t y of t h e b a n k i n g s y s t e m ; ( 2 ) p r e v e n t s e l f - d e a l i n g and o t h e r

By h a l f a

f i n a n c i a l a b u s e s ; and ( 3 ) l i m i t s t o c k m a r k e t s p e c u l a t i o n .

c e n t u r y l a t e r , t h e "wall" i t c r e a t e d seemed t o b e c r u m b l i n g , a s b a n k e r s

c r e a t e d new f i n a n c i a l p r o d u c t s r e s e m b l i n g s e c u r i t i e s , and s e c u r i t i e s f i r m s

i n n o v a t e d new f i n a n c i a l p r o d u c t s r e s e m b l i n g l o a n s and d e p o s i t s .

The

o n g o i n g p r o c e s s o f " f i n a n c i a l d e r e g u l a t i o n w h a s evoked c a l l s f o r C o n g r e s s

t o g i v e d e p o s i t o r y i n s t i t u t i o n s new powers, e s p e c i a l l y i n t h e s e c u r i t i e s

field.

F i n a n c i a l d e r e g u l a t i o n i n t h e U n i t e d Kingdom, Canada, and J a p a n

h a s p u t a d d i t i o n a l p r e s s u r e on Congress t o re-examine t h i s Act.

Concerns

o v e r a s e e m i n g l y f r a g i l e s y s t e m of d e p o s i t a r y i n s t i t u t i o n s p e r s i s t ,

however, t e n d i n g t o p l a c e c o u n t e r - p r e s s u r e on Congress t o m a i n t a i n t h e

Act.

."

ISSUE DEFINITION

Should "banking"

be s e p a r a t e d from "corrunerce",

especially, the

investment banking ( s e c u r i t i e s ) b u s i n e s s ?

The 1 0 0 t h C o n g r e s s h a s been

a s k e d t o r e c o n s i d e r t h i s u n d e r l y i n g i n t e n t o f t h e G l a s s - S t e a g a l l Act i n

view o f : ( 1 ) t h e need t o m a i n t a i n c o m p e t i t i o n i n n a t i o n a l and world-wide

f i n a n c i a l m a r k e t s , and ( 2 ) t h e need t o m a i n t a i n c u s t o m e r c o n f i d e n c e i n t h e

s a f e t y o f d e p o s i t o r y i n s t i t u t i o n s . The A d m i n i s t r a t i o n and many d e p o s i t o r y

i n s t i t u t i o n s s e e k t o r e l a x t h i s Act somewhat; o t h e r p a r t i e s s e e k t o r e t a i n

i t s s e p a r a t i o n o f b a n k i n g and commerce.

BACKGROUND AND ANALY SI S

I n t h e n i n e t e e n t h and e a r l y t w e n t i e t h c e n t u r i e s , b a n k e r s and b r o k e r s

were sometimes i n d i s t i n g u i s h a b l e .

Then, i n t h e G r e a t D e p r e s s i o n a f t e r

1929, C o n g r e s s examined t h e mixing o f t h e "commercial" and " i n v e s t m e n t "

b a n k i n g i n d u s t r i e s t h a t o c c u r r e d i n t h e 1920s.

Hearings r e v e a l e d

c o n f l i c t s o f i n t e r e s t and f r a u d i n some b a n k i n g i n s t i t u t i o n s ' s e c u r i t i e s

A f o r m i d a b l e b a r r i e r t o t h e mixing of t h e s e a c t i v i t i e s was

activities.

t h e n s e t up by t h e G l a s s - S t e a g a l l Act. I t c o n s i s t s o f f o u r s e c t i o n s o f t h e

banker,

Banking Act of 1933. I t s l a n g u a g e makes i t a f e l o n y f o r anyone

broker, d e a l e r i n s e c u r i t i e s , o r savings i n s t i t u t i o n

t o engage i n t h e

d e p o s i t - t a k i n g and s e c u r i t i e s b u s i n e s s e s a t t h e same t i m e .

For Federal

R e s e r v e member b a n k s , i t i n c l u d e d r e i n f o r c i n g l a n g u a g e d e s i g n e d t o

s e p a r a t e t h e two a c t i v i t i e s d i r e c t l y and t h r o u g h c o r p o r a t e a f f i l i a t i o n o r

interlocking directorates.

As e x c e p t i o n s , banks c o u l d

underwrite and

d e a l i n o b l i g a t i o n s of t h e U n i t e d S t a t e s and many of i t s i n s t r u m e n t a l for

i t i e s , a l o n g w i t h o b l i g a t i o n s of S t a t e s and t h e i r s u b d i v i s i o n s

o n l y i f s u p p o r t e d by

example, c i t i e s , c o u n t r i e s , and s c h o o l d i s t r i c t s

t h e f u l l f a i t h and c r e d i t of t h e i s s u e ' r .

Banks were a l s o p e r m i t t e d t o

p r o v i d e s e c u r i t i e s b r o k e r a g e s e r v i c e s a t t h e r e q u e s t of c u s t o m e r s i n t h e

1933 A c t , a s amended i n 1935 t o a l l o w s t o c k p u r c h a s e s and s a l e s i n a n

1I

agency" c a p a c i t y a s w e l l .

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Much o f t h e i n t e n t o f t h i s Act was c a r r i e d f o r w a r d i n t o t h e

r e g u l a t i o n o f f i r m s c o n t r o l l i n g banks known a s bank h o l d i n g companies.

They became s u b j e c t t o F e d e r a l R e s e r v e c o n t r o l t h r o u g h t h e Bank H o l d i n g

Company Act of 1956, a s s t r e n g t h e n e d i n 1970.

Although Glass-Steagall

seemed t o m a i n t a i n t h e b a r r i e r s between

banking'' and "commerce"

f o r half a century, depository financial,

i n d u s t r i a l , and s e c u r i t i e s f i r m s have i n c r e a s i n g l y blended t h e b u s i n e s s e s

of b a n k i n g and b r o k e r a g e , u s i n g " l o o p h o l e s " i n t h e Act and o t h e r s t a t u t e s

(such a s t h o s e governing savings i n s t i t u t i o n s ) .

S i n c e 1982, a s a r e s u l t ,

b a n k s and t h e f i n a n c i a l arms of n o n - d e p o s i t o r y

f i r m s h a v e become

A c o n s p i c u o u s c a s e i s t h a t of d e p o s i t o r y

c o m p e t i t o r s t o some e x t e n t .

i n s t i t u t i o n s and t h e i r h o l d i n g companies e n t e r i n g t h e s e c u r i t i e s b u s i n e s s

a s "discount brokers."

By o n l y t a k i n g c u s t o m e r s ' o r d e r s , t h e y a v o i d

o f f e r i n g a d v i c e o r s p o n s o r i n g new s e c u r i t y i s s u e s , and t h u s ( a s c u s t o m e r s '

'1

a g e n t s 1 ' ) a p p e a r t o be o p e r a t i n g w i t h i n t h e l i t e r a l l a n g u a g e of t h e

G l a s s - S t e a g a l l Act.

I1

A n o t h e r way b a n k i n g i n s t i t u t i o n s have b l e n d e d t h e commercial and

i n v e s t m e n t b a n k i n g b u s i n e s s e s i s by e x p a n d i n g a b r o a d .

The i n t e r n a t i o n a l

o p e r a t i o n s of many l a r g e U n i t e d S t a t e s b a n k i n g o r g a n i z a t i o n s i n c l u d e t h e

u n d e r w r i t i n g , d i s t r i b u t i o n , and b r o k e r a g e of s e c u r i t i e s i n c o u n t r i e s s u c h

a s B r i t a i n , whose f i n a n c i a l m a r k e t s a r e more " d e r e g u l a t e d t ' t h a n o u r s . And

back i n t h e U n i t e d S t a t e s , t h e F e d e r a l R e s e r v e h a s j u s t l e t t h e g i g a n t i c

Sumitomo Bank of J a p a n ( w h i c h owns l a r g e U.S. b a n k i n g i n t e r e s t s ) buy i n t o

a l e a d i n g f u l l - s e r v i c e Wall S t r e e t

t h e p r o f i t s of Goldman, S a c h s

securities dealer.

U.S. banks c o n s e q u e n t l y view t h e i r U.S. o p e r a t i o n s a s

b e i n g a t a c o m p e t i t i v e d i s a d v a n t a g e , from an i n t e r n a t i o n a l p e r s p e c t i v e ,

d e s p i t e t h e p r e v e n t i o n o f f o r e i g n b a n k s ' m a i n t a i n i n g d e p o s i t o r y and

s e c u r i t y s e r v i c e s within our borders l e g i s l a t e d i n t h e I n t e r n a t i o n a l

Banking Act of 1978.

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U.S. banks and t h e i r h o l d i n g companies a r e t h u s s e e k i n g t o - o b t a i n

r e g u l a t o r y a n d / o r c o n g r e s s i o n a l a u t h o r i t y t o expand t h e i r f i n a n c i a l

s e r v i c e s i n t o new s e c u r i t i e s a r e a s .

I n t h e fixed-income a r e a , t h e y s e e k

t o u n d e r w r i t e and d e a l i n :

c o m n e r c i a l p a p e r , m u n i c i p a l r e v e n u e bonds, and

bonds backed by m o r t g a g e s and consumer l o a n s .

I n the equity area, they

s e e k t o s p o n s o r , r u n , a n d d i s t r i b u t e mutual funds ("investment

companies").

Such powers would l e a v e l e s s t h a n o n e - q u a r t e r of t h e

N a t i o n ' s d o l l a r volume o f f i n a n c i n g r e s t r i c t e d t o t r a d i t i o n a l s t o c k and

Many non-bank

bond d e a l e r s o n l y , a c c o r d i n g t o i n d u s t r y estimates.

providers of

financial services,

however,

q u e s t i o n whether t h e

i n s t i t u t i o n s can o p e r a t e i n t h e s e a r e a s w e l l , because t h e y have

e x p e r i e n c e d l a r g e l o a n l o s s e s i n t h e i r b a s i c b u s i n e s s of l e n d i n g .

The c a s e for p r e s e r v i n g t h e G l a s s - S t e a g a l l

arguments.

C o n f l i c t s of

Act i n c l u d e s t h e f o l l o w i n g

i n t e r e s t c h a r a c t e r i z e t h e g r a n t i n g of c r e d i t

-- l e n d i n g -- and t h e u s e of c r e d i t -- i n v e s t i n g -- by t h e

same e n t i t y , which l e d t o a b u s e s t h a t o r i g i n a l l y p r o d u c e d

t h e Act.

D e p o s i t o r y i n s t i t u t i o n s p o s s e s s enormous f i n a n c i a l power,

by v i r t u e of t h e i r c o n t r o l o f o t h e r p e o p l e ' s money; i t s

e x t e n t must be l i m i t e d t o e n s u r e s o u n d n e s s and c o m p e t i t i o n

i n t h e market f o r funds, whether l o a n s o r investments.

S e c u r i t i e s a c t i v i t i e s c a n be r i s k y , l e a d i n g t o enormous

losses.

Such l o s s e s c o u l d t h r e a t e n t h e i n t e g r i t y of

deposits.

I n t u r n , t h e Government i n s u r e s d e p o s i t s and

c o u l d b e r e q u i r e d t o pay l a r g e sums i f d e p o s i t o r y

i n s t i t u t i o n s were t o c o l l a p s e a s t h e r e s u l t o f s e c u r i t i e s

losses.

D e p o s i t o r y i n s t i t u t i o n s a r e supposed t o be managed t o l i m i t

risk.

T h e i r managers t h u s may n o t b e c o n d i t i o n e d t o

o p e r a t e prudently

i n more s p e c u l a t i v e s e c u r i t i e s

businesses.

An example i s t h e c r a s h o f r e a l e s t a t e

i n v e s t m e n t t r u s t s s p o n s o r e d by bank h o l d i n g companies a

d e c a d e ago.

The case against preserving the Act -- that is, for relaxing its

restrictions -- includes the following counter-arguments.

(1)

Depository institutions now operate in "deregulated"

financial markets in which distinctions between loans,

securities, and deposits are not well drawn.

They are

losing market shares to securities firms that are not so

strictly regulated, and to foreign financial institutions

operating without much restriction from the Act.

(2)

Conflicts of interest can be prevented by enforcing

legislation against them, and by separating the lending and

credit functions through forming distinctly separate

subsidiaries of financial firms.

(3)

The securities activities that depository institutions are

seeking are both low-risk by their very nature, and would

reduce the total risk of organizations offering them -- by

diversification.

(4) In much of the rest of the world, depository institutions

operate simultaneously and successfully in both banking and

securities markets. Lessons learned from their experience

can be applied to our national financial structure and

regulation.

CONGRESSIONAL HEARINGS, REPORTS, AND DOCUMENTS

U.S.

Congress. House. Committee on Banking, Finance and Urban Affairs.

Subcommittee on Financial 1nstitut.ions Supervision, Regulation, and

Insurance. Financial condition of the bank and thrift industries.

Washington, U.S. Govt. Print. Off., 1986. Part 1, 827 p.; Part 2,

1628 p.; Part 3, 832 p.

U.S.

Congress. House. Committee on Energy and Commerce. Subcommittee

on Telecomnunications, Consumer Protection and Finance.

Financial

restructuring. Washington, U.S. Govt. Print. Off., 1985. 466 p.

----- Restructuring financial markets:

the major policy issues.

from the Subcomnittee Chairman.

99th Congress, 2nd

Washington, U.S. Govt. Print. Off., 1986. 399 p.

(Committee Print no. 99-DD)

report

session.

A

U.S.

Congress. House. Committee on Government Operations. Subcommittee

on Commerce, Consumer, and Monetary Affairs.

Hearings on the

structure and regulation of financial firms and holding companies.

Hearings held Apt. 22; June 11; Sept. 12, 18, and 24; and Dec. 17 and

18, 1986.

U.S.

Congress. Senate. Comrnittee on Banking, Housing and Urban Affairs.

Comprehensive reform in the financial services industry. Washington,

U.S. Govt. Print. Off., 1985. Part 1, 992 p.; Part 2, 1341 p.; Part

3, 38 p.

----.. The Competitive Equality Banking Act of 1987; report to accompany S.

790. Washington, U.S. Govt. Print. Off., 1987. (100th Congress, 1st

session. Senate. Report no. 100-29) (forthcoming)

U.S.

Congress. Senate. Committee on Banking, Housing and Urban Affairs.

Subcornmi t tee on Financial Institutions and Consumer Affairs.

Consumer benefits associated with the changing financial services

environment. Washington, U.S. Govt. Print. Off., 1986. 84 p.

FOR A D D I T I O N A L READING

U.S.

Library of Congress.

Congressional Research Service.

The Bank

Holding Company Act: background, summary, and analysis, by William

Jackson and Henry Cohen. [Washington] 1986. 18 p.

CRS Report 86-26 E

----- Banking and securities regulation:

exploring alternatives, by Bruce

K. Mulock, F. Jean Wells, and Kevin F. Winch.

[Washington] 1985.

27 p.

CRS Report 86-500 E

----- Commercial banking competition and regulation:

considerations, by William Jackson.

CRS Report 85-104 E

----- The Glass-Steagall Act:

A

public policy

[Washington] 1985. 56 p.

legal

overview,

by

Henry

Cohen.

(Washington] 1982.

CRS Report 82-189 A

----- Legal analysis of major statutory and regulatory powers of the

Securities and Exchange Commission and the four banking agencies to

regulate securities and securities-related activities of financial

institutions by Michael V. Seitzinger and Henry Cohen. [Washington]

1985. 27 p.

CRS Report 85-742 A

----- The

legality of securities brokerage activities of

institutions, by Henry Cohen. [Washington] 1985. 17 p.

CRS Report 85-688 A

----- The

separation of banking

[Washington] 1987. 15 p.

CRS Report 87-352 E

and

commerce,

by

William

financial

Jackson.