Since the onset of the 2008 financial crisis there has been much debate over what led to the crisis and what could have or should have been done to avoid it. Opinions and solutions are numerous, but one of the most commonly stated and believed ones is that deregulation of the financial industry, especially the repeal of the Glass Steagall Act were a central cause of the crisis. For many media commentators and politicians it is a foregone and absolutely proven statement.

But having a healthy bit of scepticism of what politicians say should have led more people to actually look at the very basics of the premise, that if Glass Steagall had not been repealed then we would not have had the crisis. In this article I provide some background information to this act and analyse whether its repeal contributed to the crisis.

 

What Is The Glass Steagall Act?

The act was signed into law in 1933 during the Great Depression and covered many aspects of banking regulation. It also initiated the creation of the Federal Deposit Insurance Corporation (FDIC). Today, references to Glass Steagall usually refer to some sections of the act that were repealed in 1999.

To be more specific, it is the sections of the act that were designed to reduce speculation in the financial industry. This was achieved by restricting the affiliation of commercial retail banking organisations with investment and securities organisations.

In essence, you could no longer create an organisation that combined commercial banking and investment banking with the idea being that commercial client's money could not be used directly by the investment division of the same organisation.

 

Was There Deregulation?

While the Glass Steagall Act was by and large repealed in 1999, it is not correct to then simply conclude that there has been widespread deregulation in the financial industry. To put it into simple numbers, if there is deregulation in an industry and there originally were 20 regulations, then there now would have to be 19 or less regulations.

It is generally argued that from the Reagan 80s to the financial crisis of 2008 there was large scale deregulation reducing oversight over the financial industry. But how true is this statement?

Arnold Kling published an excellent research paper on this question with the title "Not What They Had In Mind" and I highly recommend reading it. What Kling essentially reveals is that between 1980 and 2009 there were four new regulatory policies for every one that was repealed. Bottom line is that it is a myth that there was actual deregulation of the financial industry.

Glass Steagall Act Repeal

Did This Cause The Crisis of 2008?

Proponents of this line of argument basically say that if Glass Steagall had been left in place there would have been much stricter regulation and oversight of financial organisations and therefore all the risky behaviour would have been kept at bay.

In order to verify this claim we have to first look at those organisations that would have been affected by Glass Steagall and see what caused them to find themselves in trouble. The three biggest organisations that had combined retail and investment banking, and ended up bankrupt or bought out were Wachovia, Washington Mutal and Bank of America. 

 

Wachovia:

Before the financial crisis, Wachovia was the fourth largest banking institution in the USA and it offered both retail and investment banking. Basically it is an organisation that Glass Steagall would not have allowed to exist. In December 2008 Wachovia was forced into a sale to Wells Fargo in order to avoid a total collapse of the holding company.

But in order to assess whether Wachovia as a pure retail bank would have stayed out of trouble we need to look at what led to its demise during the crisis. When you look at the losses that piled up during 2008 and eventually went out of control, they all centred on the company's loan book which was very heavily exposed to highly risky Adjustable Rate Mortgages (ARMs) which it had taken on when it bought Golden West Financial in 2005. As the interest rates on these ARMs went up, thousands of people could no longer afford their repayments and defaulted, leading to huge losses.

In other words, the problems that Wachovia faced were all on its traditional retail banking side. It was not in trouble because it had invested clients' money in dodgy mortgage backed securities through its investment division. Glass Steagall would have made absolutely no difference to Wachovia going bankrupt.

 

Washington Mutual:

Often abbreviated and referred to as WaMu, it was the largest savings and loan association before it collapsed in 2008. In 2008 the Office of Thrift Supervision seized control of the company and put it in receivership. After some of the assets had been stripped off and sold the company went into chapter 11 bankruptcy.

While the holding company was also involved in investment banking it was most heavily involved in the mortgage market. So, the same question has to be asked here, where did the losses stem from that caused the collapse.

Just like with Wachovia, WaMu was heavily exposed to ARMs and sub-prime mortgages. But it was not exposed to these through mortgage backed securities in its investment divisions. The company had essentially made too many high risk loans through its home loan offices. Again, Glass Steagall would not have made any difference to this happening.

 

Bank of America:

Being the second largest bank holding company in America it consists of both retail and investment banking, but the investment banking arm of the company only grew to its current size after the acquisition of Merrill Lynch during the financial crisis.

Just like with Wachovia and WaMu, Bank of America saw its losses increase to critical levels due to the fact that it was heavily exposed directly to the mortgage market. After the acquisition of Countrywide Financial in 2007, Bank of America became the leading mortgage originator with over 20% of all mortgages.

As with the already mentioned companies, Bank of America made huge amounts of home loans to highly risky lenders who were not able to service the loans when interest rates went up. Again, Glass Steagal would have done nothing to prevent this from happening.

Glass Steagall Act Repeal(112189)

What Were The Other Organisations At The Centre Of The Crisis?

First and foremost we have to look at the spectacular failures of Bear Stearns, Lehman Brothers and Merrill Lynch. All these companies collapsed because of too much exposure to mortgage backed securities and other complexly structured products where losses were in the billions.

But, Glass Steagall would not have had any effect on these organisations as they were pure investment banks. Essentially they were what Glass Steagall was designed to achieve, the separation of retail and investment banking.

Another big name during the financial crisis was AIG, which also suffered horrendous losses because of highly structured products. But AIG was an insurance company, so would never have come onto the radar of Glass Steagall.

Goldman Sachs is also a company that is often referred to as having been a major contributor to the financial crisis, and is one of the few very large companies that didn't go bankrupt. But again, this company is an investment bank with no commercial retail banking at all.

 

Conclusion

Using logic and some basic background information has essentially shown how wrong the argument at the centre of this article is. If Glass Steagall had been left in place then the very organisations that were at the heart of the financial crisis would not have been affected by it and would have done exactly what they did do, thus the crisis would still have happened.

Neither deregulation (which did not actually occur) nor the repeal of Glass Steagall (which did not affect the companies that went bankrupt) actually caused the crisis. All that is left now is that the actual regulations that were in place were either bad, ineffective or in and of themselves a contributing factor. It is beyond the scope of this article to look at whether more or less regulation would have avoided the crisis. As a concluding remark I want to point out that the reason it is so convenient for politicians to argue in this way is that it absolves them of any guilt; they can simply point the finger at other politicians rather than allow the finger of blame to point at them.

 

Image Credits: Scott Teresi, Paul Lowry