The program merely had to be conducted in a “safe and sound manner” and be subject to the same controls as interest rate derivatives.30

The underlying argument for permitting these activities within the Glass‐​Steagall framework was the OCC’s wider concept of banking as “financial intermediation,” involving exchanges of payments between banks and their customers. The OCC developed this idea more fully after 1995. After being allowed to conduct commodity‐​based swaps, banks requested permission to engage in equity swaps and equity index swaps. These were allowed on the basis that all swaps were essentially “payments that (are) analogous to those made and received in connection with a national bank’s express powers to accept deposits and loan money.“31 The OCC argued, in conclusion, that “since national banks are exercising … statutory powers related to deposit taking, lending and funds intermediation when engaging in equity derivative swap activities, the prohibitions of Glass‐​Steagall are inapplicable.“32

In coming to this decision, the OCC focused on credit risk, but it is arguable that banks engaged in these activities would also be exposed to market risk, owing to market price fluctuations in the derivative and the underlying asset, since the banks in question would be acting as principals in both commodity‐ and equity‐​based derivatives contracts. That being said, market price fluctuations also affect bank loans, although the risks involved in derivatives may be more difficult to discern since the focus tends to be on the contract and not the underlying asset.33

Throughout the 1980s, the OCC gave its approval to banks and their operating subsidiaries to join security and commodity exchanges,34 act as discount brokers,35 offer investment advice,36 and manage individual retirement accounts.37 They were also permitted to undertake private offerings of securities,38 lend securities,39 and underwrite, deal in, and hold general obligation municipal bonds.40

Similarly, the Federal Reserve approved applications by banks to expand their activities when, in the Federal Reserve’s view, such an expansion would provide public benefits. In such cases, the Federal Reserve would add the activity or activities in question “to the list of activities that it has determined by regulation to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.“41 One example of this was the Federal Reserve’s acceptance of United Bancorp’s application to form United Bancorp Municipals de novo, in order to engage in underwriting and dealing in certain government securities.

At the request of BHCs, the Federal Reserve also provided guidance on when a company would be considered to be “engaged principally” in securities business under Section 20 of Glass‐​Steagall. BHCs were generally only allowed to engage in investment banking activities through separately capitalized subsidiaries, which became known as “Section 20 subsidiaries.” Their bank‐​ineligible securities could not exceed a certain percentage of the BHC’s gross revenue — a limit that the Federal Reserve initially set at between 5 and 10 percent of the revenue of the company.

In the spring of 1987, the Federal Reserve Board voted 3–2 in support of easing these regulations, despite opposition from Paul Volcker, the then‐​chairman. The Federal Reserve “concluded that subsidiaries would not be engaged substantially in bank ineligible activities if not more than 5–10 percent of their total gross revenues was derived from such activities over a two‐​year period, and if the activities in connection with each type of bank ineligible security did not constitute more than 5–10 percent of the market for that particular type of security.“42 By 1999 the Federal Reserve had approved applications allowing at least 41 Section 20 subsidiaries. The Federal Reserve authorized these companies to underwrite and deal in bank‐​ineligible securities,43 including municipal bonds, commercial paper, mortgage‐​backed securities, and other consumer‐​related securities, as well as corporate debt securities and corporate equity securities.44

Between 1996 and 1997, the sum of the Federal Reserve’s decisions effectively overruled Section 20 of Glass‐​Steagall. In December 1996, with the support of then‐​chairman Alan Greenspan, the Federal Reserve allowed the nonbank subsidiary of a BHC to obtain up to 25 percent of its revenue from underwriting and dealing in securities that a member bank may not underwrite or deal in, effective March 1997. The experience it had gained through the supervision of Section 20 subsidiaries over a period of nine years led the Federal Reserve to conclude that the 10 percent limit unduly restricted the underwriting and dealing activity of the Section 20 subsidiaries. The Federal Reserve decided that a “company earning 25% or less of its revenue from underwriting and dealing would not be engaged ‘principally’ in that activity for the purposes of Section 20.“45 In August 1997 the Federal Reserve further argued that the risks of underwriting had been proved to be manageable and that banks should have the right to acquire securities firms. In 1997 Bankers Trust (then owned by Deutsche Bank) bought the investment bank Alex Brown & Co., thus becoming the first U.S. bank to acquire a securities firm.

Further changes occurred in 1996 when the Federal Reserve relaxed three firewalls between securities affiliates and their banks. Officers and directors could subsequently work for both the Section 20 subsidiary and the bank, provided that the directors of one did not exceed over 49 percent of the board of the other.46 The CEO of the bank was not allowed to be a director, officer, or employee of the securities affiliate, and vice versa. Restrictions on cross‐​marketing between the bank and its Section 20 subsidiary were repealed, and permissible intercompany transactions between a Section 20 and its affiliate were expanded to include any assets that have a readily identifiable and publicly available market quotation.

This outline of the most significant, incremental changes to the operation of Glass‐​Steagall has been provided to dispel the notion that the act was abruptly repealed without any thought being given to the safety and soundness of the banking sector. This brief history of Glass‐​Steagall in action also shows that the Act always allowed banks to underwrite and deal in certain classes of assets, while still preventing them from being affiliated with any organization engaged “principally” in underwriting and dealing in securities. The next section of this analysis will explore the extent to which the provisions of Glass‐​Steagall were actually repealed in 1999.

The Gramm‐​Leach‐​Bliley Act of 1999



The opening sections of the GLBA, also known as the Financial Services Modernization Act, make it clear that only Sections 20 and 32 of Glass‐​Steagall were being repealed. Section 20, remember, stated that national and state‐​chartered banks within the Federal Reserve System were not allowed to be affiliated with a business that was “engaged principally” in underwriting and dealing in securities. That section did not give a clear indication of the degree of integration that would be permissible under its terms. The section did, however, state clearly that a bank was not allowed to hold majority ownership or a controlling stake in a securities firm.47

Section 32 prohibited those same banks from having interlocking directorships with a firm principally engaged in underwriting, dealing in, or distributing securities. An officer, director, or manager of a bank could not also be a director, officer, or manager of a securities firm. In addition, a member bank could not provide correspondent banking services to a securities firm or accept deposits from such a company, unless the bank had received a permit from the Federal Reserve, which would only be issued if it was deemed to be in the public interest.48 Similarly, a securities firm was prohibited from holding on deposit funds from a member bank. These two sections of the Glass‐​Steagall Act were repealed.

As a result, the GLBA allowed for affiliations between commercial banks and firms engaged principally in securities underwriting, as well as interlocking management and employee relationships between banks and securities firms. Under the GLBA, banks are still not able to offer a full range of securities products, and securities firms still cannot take deposits. The GLBA authorized securities activities in two types of BHC affiliates: non‐​bank securities firms and financial subsidiaries of banks. Under the GLBA, wider activities could be carried out through a new form of BHC known as a financial holding company, which could include securities and insurance subsidiaries as well as bank subsidiaries and the various types of nonbanking firms that had already been permitted under the Bank Holding Company Act of 1956.49 The GLBA also authorized both national and state chartered banks to form financial subsidiaries to conduct a wide range of activities, including certain securities and insurance activities, without having to be part of a holding company structure. Nevertheless, a bank’s investment in a securities subsidiary cannot be recorded as an asset on its balance sheet. Such investments are effectively written off as soon as they are made.50

Crucially, Sections 16 and 21 of Glass‐​Steagall were not repealed. Section 16 prohibits banks from underwriting or dealing in securities or engaging in proprietary trading activities with regard to most debt and equity securities.51 Section 21 prohibits the acceptance of deposits by broker‐​dealers and other non‐​banks. These prohibitions also apply to banks affiliated with broker‐​dealers through a financial holding company structure, so that while a wide range of financial services can be offered through a single affiliated financial holding company, individual subsidiaries cannot offer universal banking services.52

It is important to note, however, that the restrictions contained in Sections 16 and 21 did not and do not apply to U.S. government debt, the general obligations bonds of states and municipalities, or bonds issued by Fannie Mae and Freddie Mac. Glass‐​Steagall allowed banks to underwrite or deal in these securities. It also allowed banks to buy and sell whole loans; then, when securitization was developed, banks were also permitted, under Glass‐​Steagall, to buy and sell securities based on assets such as mortgages, which they could otherwise hold as whole loans. Banks were not allowed to underwrite or deal in MBS, but they could buy them as investments, and sell them when they required cash. None of these things were relaxations introduced by the GLBA. On the contrary, they had long been part of Glass‐​Steagall itself.

The GLBA also left intact Sections 23A and 23B of the Federal Reserve Act, which restrict and limit the transactions between affiliates in a single financial holding company conglomerate. Section 23A limits financial and other transactions between a bank and its holding company, or any of that BHC’s subsidiaries. It also specifically limits extensions, guarantees, or letters of credit from a bank to affiliates within the same holding company to 10 percent of the bank’s capital and surplus for any particular affiliate, and 20 percent of the bank’s capital and surplus for all affiliates in total. Any such lending to affiliates within the conglomerate has to be backed by U.S. government securities up to the value of the loan; if other types of marketable securities are used as collateral, the loan must be over‐​collateralized. All transactions between a bank and its subsidiaries must be on the same terms as the bank would offer to a third party. Banks cannot purchase low‐​quality assets from their affiliates, such as bonds with principal and interest payments past due for more than 30 days. All of these restrictions are applied by the Comptroller of the Currency to a national bank’s relationship with a securities subsidiary.

Section 23B of the Federal Reserve Act, meanwhile, requires that transactions between a bank and affiliates within the same BHC, including all secured transactions, must be on market terms and conditions. This applies to (a) any sales of assets by a bank to an affiliate; (b) any payment or provision of services by a bank to an affiliate; (c) any transaction in which an affiliate acts as agent or broker for a bank; (d) any transaction by a bank with a third party if an affiliate has a financial interest in that third party; and (e) instances in which an affiliate is a participant in the transaction in question. If there are no comparable transactions for identifying market terms, a bank must use terms, including credit standards, that are at least as favorable to them as those that would be offered in good faith to nonaffiliated companies.

These restrictions, as contained in Sections 23A and 23B of the Federal Reserve Act, serve to ensure that only banks can take advantage of the deposit insurance safety net and the Federal Reserve’s discount window; such financial support is not available to a bank’s holding company or its nonbanking affiliates.53 Once again, the GLBA had no impact on these provisions.

What’s more, all of the restrictions on the kind of securities in which banks could deal under Glass‐​Steagall remained in place after the GLBA. The OCC divides securities into five basic types. Banks can only underwrite, deal, or invest in Types I and II on their own account. These have to be “marketable debt obligations,” which are “not predominantly speculative in nature” or else are rated investment grade. Examples include government debt obligations, various federal agency bonds, county and municipal issues, special revenue bonds, industrial revenue bonds, and certain corporate debt securities. Permissible Type II securities include obligations issued by a state, or a political subdivision or agency of that state, which do not otherwise meet Type I requirements. The obligations of international and multilateral development banks and organizations are also permissible, subject to a limitation per obligor of 10 percent of the bank’s capital and surplus.54 The OCC places limits on the size of bank holdings in Type III, IV, and V securities, which include corporate bonds, municipal bonds, small business‐​related securities of investment grade, and securities related to residential and commercial mortgages. Banks can buy or sell securities in these categories, just as they can buy and sell whole loans; however, they cannot deal in or underwrite such securities.

To summarize, then, banks could not under Glass‐​Steagall and cannot under the GLBA underwrite or deal in securities outside of certain carefully defined categories. Those who see a simple solution to our contemporary financial woes in repealing the GLBA and reimposing Glass‐​Steagall only betray their misunderstanding of both pieces of legislation.

The Financial Crisis and the Great Recession



If Glass‐​Steagall had remained in force in its entirety, would it have done anything to prevent the financial crisis and the subsequent recession? The simple answer is that it would not. Indeed, Glass‐​Steagall would have been irrelevant, since an examination of the causes of the crisis shows that the fault lay entirely elsewhere.

First, the investment banks that failed were stand‐​alone investment banks. The collapse of two Bear Stearns hedge funds in June 2007, after months of growing instability in the subprime market, exposed serious problems at that bank.55 A few months later, after the collapse of other hedge funds, Bear Stearns stock fell sharply following Moody’s downgrade of its mortgage bond holdings. In March, it was acquired by JP Morgan with the support of a $30 billion loan from the Federal Reserve. In September of that year, Lehman Brothers collapsed, as the overvaluation of its commercial and residential mortgages, its disregard of its own risk management policies, its excessive leverage, and its accounting irregularities were exposed. This time the Federal Reserve did not ride to the rescue. Lehman Brothers’ collapse was a shock to the financial system that rippled around the world, sparking a global credit crunch.56 But it was not links with commercial banks that caused these investment banks to fail. On the contrary, the immediate cause of the crisis can be seen more clearly by looking at why so many commercial banks failed themselves.

The number of failures of FDIC‐​insured banks increased as the financial crisis went on: 25 in 2008, 140 in 2009, 157 in 2010, 92 in 2011, and 51 in 2012 — a total of 465 altogether. Between January 2008 and December 2011, 75 percent of these failures (313 out of 414) were at small institutions with less than $1 billion in assets. The Government Accountability Office’s report shows that these small bank failures were largely driven by credit losses on commercial real estate loans, especially those secured on real estate to finance land development and construction.57 In addition, many of the failed banks had pursued aggressive growth strategies using nontraditional, riskier funding sources, such as brokered deposits — that is, large‐​denomination deposits that are sold by a bank to a middleman (broker), and then sold on by the broker to its customers; alternatively, the broker may first gather funds from various investors and then place them in insured deposit accounts. Failed banks had also shown weak underwriting and credit administrative practices.

It is worth focusing on the two largest bank failures and examining their causes. The first was IndyMac, with assets of $32 billion in July 2008, followed by Washington Mutual, with assets of $307 billion in September 2008. In each case, the analysis provided by the Office of the Inspector General provides useful and relevant insights, showing that it was primarily ill‐​considered lending that led to these banks’ failures.

IndyMac had metamorphosed from a real estate investment trust into a Savings and Loan Association in 2000, and from the start had pursued an aggressive growth strategy. From mid‐​2000 to the first quarter of 2008, its assets increased from nearly $5 billion to over $30 billion. The bank originated or bought loans, securitized them, and sold them to other banks, thrifts, or investment banks, but held the mortgage‐​servicing rights. The value of the business peaked at $90 billion in 2006. IndyMac concentrated on adjustable interest rate mortgages (ARMs), including ones in which the minimum payment did not cover the monthly interest payment; 75 percent of IndyMac’s borrowers were only making the minimum payment. IndyMac also specialized in Alt‐​A loans, which only required the minimum documentation verifying the borrower’s income — and sometimes not even that. These loans were very profitable for the company. With only 33 retail branches, IndyMac lacked deposits, and depended for its funding on secured loans from government‐​sponsored Federal Home Loan Banks (which provided 34 percent of the bank’s funding), as well as borrowing from the Federal Reserve and a German Bank. IndyMac’s loan reserves were inadequate, as was soon to be revealed. Crucially, IndyMac did not engage in any investment bank activity, and all of its activities would have been allowed under the original Glass‐​Steagall Act. Its failure was entirely due to poor business strategy.

As the Office of the Inspector General put it: