This article is written by Kashish Khattar. Kashish is a fourth-year student at Amity Law School, Delhi with an avid interest in corporate and banking laws. The article is a discussion about the various banking law reforms that have taken place in the United States. He can be reached at https://www.linkedin.com/in/kashishkhattar).

Introduction

The Banking Act of 1933 or the Glass Steagall Act was mainly in response to the Great Depression of 1929 and the Black Tuesday. Just three years previous to this reform, the stock market had crashed on 29th October 1929 and came to be known as the Black Tuesday. This, in turn, led to the start of the Great Depression in the United States.

The Act is named after U.S. Senator Carter Glass who first introduced the legislation in Jan 1932, and Henry Steagall who co-sponsored the bill. On June 16, 1933, President Franklin D. Roosevelt signed the Glass-Steagall Act (“GSA”) into a law. The bill stated that it was made “to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent the undue diversion of funds into speculative operations, and for other purposes.” This law was part of the measures adopted during his first 100 days of the Presidency to restore the country’s economy and trust in the banking system. Its approach towards solving the banking system problem was to draw a line between commercial and investment banking activities through Section 20 of the GSA. Commercial banks would typically be allowed to accept deposits, make loans to businesses and the citizens but are not allowed to engage in speculation. However, the commercial banks would still be allowed to underwrite government bonds. Investment banks, on the other side, would be allowed to engage in speculation but will no longer be associated with commercial banks such as overlapping directorships or common ownership. After the passing of the GSA in 1933, banks were given a year to decide whether wanted to qualify as investment banks or commercial banks.

CREATION OF FDIC

The GSA basically sets up a firewall between commercial banks which can accept deposits and issue loans and investment banks who negotiate the sale of bonds and stocks. The Banking Act of 1933 which is mainly known for the Glass-Steagall reforms also created the Federal Deposit Insurance Corporation (“FDIC”) which protected bank deposits up to $2500 at the time which has changed to $25,000 in 2018. All the banks who were the member of the Federal Reserve were required to become stockholders of the FDIC on or before 1 July 1934. No state banks were eligible for membership in the Federal Reserve System until they had become a stockholder of the FDIC, and therefore become an insured institution with compulsory membership from national banks and voluntary membership from the state banks. The GSA had a large impact on the Federal Reserve also, the creation of Federal Open Market Committee under Sec 8 can be said to be one of them. Banking Act of 1933 did not talk about FOMC, which was included by the amended version in the Banking Act of 1935 and then again in 1942 which now closely resembles the modern FOMC. Prior to the implementation of the Act, there were no restrictions on the rights of a bank officer of a member bank to borrow from the bank. The GSA now prohibited the Fed Member banks to give loans to their executive officers and required the repayment of outstanding loans.

The GSA also introduced a Regulation Q which mandated that interest cannot be paid on checking accounts and gave the power to the Fed Reserve Authority to define ceilings on the interests that can be paid on all the other kinds of deposits. The argument behind this regulation was that payment of interest leads to excessive competition among the banks which can lead them to take part in the risky investments to pay the interests. The Dodd-Frank repealed the prohibition of the interest-bearing demand accounts. Beginning in the fall of 2011, the banks were allowed to offer interest-bearing demand accounts again.

Greenspan and the Bank Deregulation

Starting in the 1970s, large banks decided to push back on the GSA’s regulation arguing that they were seen to be less competitive in comparison to their foreign counterparts. The argument, supported by the Federal Reserve Chairman Alan Greenspan, that if banks were permitted to engage in the investment strategies, they would be able to increase the returns to their banking customers while avoiding the factor of risk because of their diversification of the business. Soon after this, several banks started to cross the line established by the GSA through loopholes in the GSA. For example, the GSA stipulated that while a Federal Reserve Member bank cannot deal in securities as such, the bank could be affiliated with a company that did not “engage principally” in these activities.

Financial Services Modernization Act 1999 or the Gramm-Leach-Bliley Act (“GLBA”)

The GSA had set up a wall between certain sectors of the financial services industry, they were a response to the perception that the mixing of a commercial with investment banking led to the Great Depression of 1929. Where the banks had taken up huge and highly risky investments with the depositors’ savings in the market and were even promoting the securities that they underwrote to their customers. This was a conflict of interest as the same banks were fulfilling the roles of both the types of banks allowed in the United States. GSA contained language mainly in Section 20 which separated commercial and investment banking. The law mainly prohibited bank’s affiliation with firms who were mainly engaged in underwriting and dealing securities. This made it possible for the bank holding companies to create subsidiaries or acquire firms to be involved in underwriting or dealing for as long as their “activities” were permissible. The subsidiaries were first approved by the Fed in 1987 and were fifty-one in number by the 2000s.

The main intention

The GLBA’s main intention was to promote the benefits of financial integration for customers and investors while at the same time protect the health of the banking and the financial systems of the nation. The GLBA or the Financial Services Modernization Act was signed into law by President Clinton in 1999, which repealed large parts of the GSA. The GLBA introduced the concept the of an FCH or a financial holding company. FCH was the extension of the concept of a bank holding company – an umbrella organization that can own subsidiaries involved in different financial activities. It was like a compromise, security and insurance underwriting and sales by depository institutions would be restricted. However, banks would be part of a larger corporation that would be involved in those activities. There were new regulations related to cross-marketing restrictions which prevented banks from promoting securities which have been underwritten by other subsidiaries to their customers. The restrictions regarding financial transactions between banks and non-bank subsidiaries also stayed. In addition to this, there was a size limitation on the banks’ financial subsidiaries. The total assets of a national bank have to be limited to a lesser of USD 50 billion or 45% of its total assets. It was necessary to appoint a regulator who would be able to enforce all these rules.

Regulations regarding FCH (Financial Holding Company)

To form an FHC, a company has to file a written declaration with the Federal Reserve Board that it has decided to be an FHC, and must also meet the requirements. The certification requirements basic purpose was to hold FCHs to a higher standard. The subsidiary depository institutions should be well capitalized and well managed in terms of the current banking regulations and they should have satisfactory ratings under the Community Reinvestment Act. If the subsidiaries have problems with their capitalisation or management, the FCH would face penalties and would be prohibited from undertaking new financial activities until the earlier problems are addressed. Otherwise, they can be forced by the Fed to divest their subsidiaries or stop engaging in other financial activities. When the FCH looks to start a financial authorized activity, it has the obligation to notify the Federal Reserve Board to inform them of its decision within thirty days.

The basic idea behind the kind of supervision of the FCH by the Fed is of functional regulation. The Fed supervises the consolidated organisation mainly relying its findings on the reports prepared by relevant state and federal authorities for the FCH subsidiaries. For example, the Securities and Exchange Commission has the job of regulating the registered stockbrokers, dealers and investment advisors etc. The state insurance department would look at the compliance being followed by insurance companies. The appropriate banking system, which can be federal or state would supervise the bank. The Fed mainly had the role of an umbrella supervisor in this particular law. It was deemed to be necessary because of the size of these institutions and their dealings being so complex, with risk being spread across all their subsidiaries but them being managed as just one big consolidated entity. Someone had to take the job of how all the dials are working inside the clock as a whole. Further, the main goal of this law was to protect the banks and its customers from the risks taken by the financial subsidiaries while at the same time ensuring that the protection given to banks were not extended to non-banking entities.

The typical way of selling insurance through banks was permissible under the state laws for standard chartered banks, but the national banks were mainly allowed to provide for credit-related insurance and operate insurance agencies in small towns where a bank office was situated. These laws had limited the bank’s insurance practice, but in 1998 the Citicorp which was said to be a large bank holding company at that time announced plans to merge with Travelers Insurance to make what we now know today as the Citigroup. However, this merger was not admissible under the current regulations of the United State but it was made in the anticipation of various changes expected in the law which was then under discussion in the Congress.

The 2008 Crisis

The financial crisis of 2007-08 made many critics come up and look at the GLBA effectively carrying out its end goals. The heart of the crisis involved USD 5 trillion worth of bad mortgage loans. It can be said to be a minor contributor but not the main factor that led to this crisis. The GSA mainly applied to banks, although the main mortgage-backed derivatives were created and sold by banks, the subprime mortgages were issued mainly by non-bank lenders. Further, the investment banks such as Lehman Brothers, Bear Stearns and Goldman Sachs- all the major players involved in the subprime mortgage meltdown never did venture into commercial banking. They were investment banks, as they had been even at the time of the repeal of the GSA. The root cause was the meltdown of the subprime mortgages which involved problems with the Housing and Urban Development (HUD) which required Fannie Mae and Freddie Mac to purchase just more of affordable mortgages to encourage lenders to make loans to low income and minority borrowers. A lot of factors as the Economists argued led to the recession of 2008, they were mainly a boom in subprime mortgage lending, inflated scores by credit rating agencies and an out of control securitization market. However, a partial blame can be given to the deregulation policies but the repeal of GSA played at most a minor role in the crisis.

DODD-FRANK WALL STREET REFORM (“DFA”)

The Dodd-Frank is supposed to have three pillars. They can be listed as:

1. Fixing the broken consumer finance system: This is achieved by making consumer protection, a primary requirement for the act and establishing a Consumer Financial Protection Bureau.
2. Fixing derivatives by having them traded on the exchange and making them clear through various central counterparties. This would limit the amount of risk attached to this kind of trading.
3. Fixing too big to fail institutions by building high-quality capital which in turn makes the large banks less likely to fail and having cross-border resolutions of systemically important financial institutions.

THE VOLCKER RULE or the Mini GSA 2.0

The part of the GSA i.e. Section 16, wasn’t repealed and used to limit the kind of investment that banks could make with the customer’s deposit funds. On the other hand, Section 20 which was repealed, limited what a bank could do even with their own money. The Volcker Rule enforced some of the prohibitions set out by Section 20.  The Volcker Rule mainly prohibits the banks from making risky short-term trading of securities, derivatives and commodity futures for their own benefit and it also prohibits banks from investing in private equity and hedge funds from their own accounts. Further, it also prohibits banks from converting their charter to avoid enforcement actions by the authorities.

Partial Roll Back of the DFA

On 24 May 2018, President Trump signed the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Act”) into law which reforms a lot of provisions of the DFA. As a result, only 10 biggest US banks have to now comply with the DFA. The changes executed through this Act mostly affect the small banks and not the large banking institutions of the country. The changes can be explained under the following heads:

1. Exemption of Small Banks from the Volcker Rule: Banks with less than $10 billion in assets that have total trading assets and trading liabilities accounting for 5% or less of the total assets and affiliates of such banks will be exempted from the Volcker Rule, which would help decrease the compliance requirement put upon these banks. Further, the Act removes a Volcker Rule limitation that prohibits a bank-affiliated investment advisor from using its name on hedge funds and private equity funds.
2. Reduction of Regulatory Burdens for all banking institutions: The Act rules out the need for banking companies with less than $250 billion in assets to comply with most aspects of “enhanced prudential standards” as defined in the DFA. The limit defined by the DFA was $50 billion in assets which was deemed to be too low by the standards of too big to fail institutions.
3. The other features of the Act include easing up mortgage loan data reporting requirements for the majority of banks, add safeguards for student loan borrowers and also include credit reporting companies to provide free credit monitoring services.

Conclusion

The GSA made commercial banks lower the risk and made it safer for the U.S. government to back those banks with deposit insurance, which in turn lead to safer banking in the United States. However, as we can see that trying to tear down barriers between commercial and investment banking which mainly aimed to prevent the loss of deposits in the event of investment failures show that regulatory attempts to safety can have huge adverse effects on the economy.

Less than 10 years following the repeal of the GSA led to the United States suffering the largest financial meltdown ever since the crash of the 1929 stock market which inspired the particular act. Only the time will tell, as to what to expect of President Trump’s dismantling of the Volcker Rule.