The Quarterly Review of Economics and Finance 52 (2012) 104–113
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The Quarterly Review of Economics and Finance
journal homepage: www.elsevier.com/locate/qref
The Glass–Steagall Act in historical perspective
Larry Neal a,∗ , Eugene N. White b
a
b
University of Illinois at Urbana-Champaign, NBER, United States
Rutgers University, NBER, United States
a r t i c l e
i n f o
Article history:
Received 11 November 2011
Accepted 19 December 2011
Available online 3 January 2012
Keywords:
Commercial bank
Deposit insurance
Financial regulation
Glass–Steagall Act
Investment banks
Volcker rule
a b s t r a c t
Implementation of Volcker’s Rule requires a historical perspective on the original Glass–Steagall Act of
1933 that separated commercial banking from investment banks in the United States. Like the Dodd-Frank
legislation, the Banking Act of 1933 was passed before full analysis of the financial crisis was possible.
The intended consequences of Glass–Steagall made Federal deposit insurance feasible by limiting entry
of new banks while preserving unit banking. The unintended consequences, however, cut off access by
small- and medium-size enterprises to external finance and also reduced the capital base for investment
banks. Despite these harmful effects, the American economy did recover eventually.
© 2011 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.
Paul Volcker, while calling for the return of the Glass–Steagall
Act of 1933, which forbade commercial banks from dealing in securities and investment banks from taking deposits in the US, also said
that he has yet to see any evidence that financial market innovations have provided any benefit to the economy.1 These are fighting
words for financial historians, who have demonstrated to their
satisfaction that “financial revolutions” preceded most “industrial
revolutions”, wherever and whenever they have occurred. Further,
modern economic growth from the start of the eighteenth century
to the most recent examples at the close of the twentieth century has been driven and sustained by financial innovations (Neal,
1990, 2000; Rajan & Zingales, 2003; Rousseau, 2003; Rousseau &
Sylla, 2005). The history of finance, however, is also replete with
recurrent crises, which demonstrates that the long-run benefits of
financial innovations are often overlooked in the ensuing drama of
dealing with the losses sustained in the collapse of an economic
boom or financial bubble.
For a financial revolution to be successful in promoting the longrun growth of the economy, the distinct roles of financial intermediaries (banks), capital markets, and governments (regulators) have
to coordinate to achieve complementarity. In the face of an innovation by regulators, intermediaries, or markets, the other parts of the
financial system must adapt as well. System-wide adaptation turns
∗ Corresponding author.
E-mail address: lneal@illinois.edu (L. Neal).
1
For example, when speaking to the Wall Street Journal’s Future of Finance Initiative, held in West Sussex, United Kingdom, December 7–8, 2009.
out to be hard, mainly because the economic rationales for banks,
markets, and regulators are quite distinct and an innovation in one
leg of the financial triangle usually threatens the traditional operations in the other two legs. Atack (2009, Chap. 1) points out that
bank and market systems perform the same five basic functions
of (1) providing liquidity, (2) resolving denomination mismatches,
(3) reducing credit risk, (4) mediating maturity differences, and (5)
bearing interest rate and exchange rate risk, but that institutions
and markets do it in different ways. The distinction between banks
and markets may also be seen as the difference between personal
exchange, based on confidential information between the banker
and the client, whether the client is a depositor or a borrower, and
impersonal exchange, based on publicly available information accessible to all participants. When both banks and markets are operating effectively to perform the five financial functions listed above
the performance of each is enhanced and the economy prospers as a
result. Banks increase their ability to monitor the liquidity needs of
their clients when they can observe the fluctuations in the general
securities markets relative to the securities issued by their business
borrowers. The price discovery function of capital markets, on the
other hand, is improved by the operations of intermediaries who
use superior information to buy or sell any given security. To maintain the complementarity of the two legs of the financial system,
the regulatory authorities must also be well-informed and equally
competent in their oversight of both banks and markets.
Problems arise in general if there are sudden innovations in regulation, banking practices, or market opportunities, which helps to
explain why the rise of financial capitalism was struck by repeated
financial crises of one kind or another, as well as why the spread of
1062-9769/$ – see front matter © 2011 The Board of Trustees of the University of Illinois. Published by Elsevier B.V. All rights reserved.
doi:10.1016/j.qref.2011.12.005
L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
financial capitalism at the turn of both the twentieth and twentyfirst centuries created an increase in the number and severity of
financial crises. Here, we focus on the specific problem of a conflict
of interest within financial institutions. Conflicts of interest arise
if financial institutions that combine both banking and marketing
functions to provide better service for their clients also seize opportunities to increase their own profits ahead of the interests of their
depositors. If a bank exploits a conflict of interest to the detriment
of its customers, there are two problems from an economic point
of view in addition to the moral problem that the bank has violated
its fiduciary responsibility to its clients. First, there must be a loss of
information if the bank or any of its officers manages to exploit the
confidence of the bank’s customers. Second, there will likely be a
misallocation of resources for the society, as the implication is that
customers would have preferred an alternative allocation. These
are not easy problems to solve. Conflicts of interest may arise when
a bank has multiple functions that create incentives to misuse or
conceal information; the loss of information reduces the efficiency
of the financial system and the economy.
There are several remedies for conflicts of interest: (1) market
discipline, (2) mandated disclosure, (3) supervision, (4) separation
by function, (5) nationalization or direct government involvement
(Crockett, Harris, Mishkin, & White, 2004, p. 6). Relying on market
discipline alone implies that information available to the market
is sufficient to align incentives so that there is not temptation to
exploit conflicts of interest to the advantage of the bank or some
of its officers. If the market supply of information is inadequate,
then government may decide to mandate increased transparency
by specifying release of information regarding the condition of the
bank and the nature of the conflicts of interest. This action may be
coupled with increased supervision to ensure that the information
accurately reflects the condition of the bank and the many relationships of the bank. If these are deemed inadequate then a more
costly remedy may be required – that is, the functional separation
of the activities into separate subsidiaries or even separate institutions to ensure that the conflicts of interest are not exploited.
The loss of potential economies of scope from the combination of
activities that give rise to the conflicts of interest will be greater
in this case, although the regulatory costs of enforcing disclosure
and supervising activities will be reduced. Finally, the government
may itself take over some part of the provision of information or
even the operation of some part of the financial system if this last
remedy is believed to be insufficient.
Volcker’s rule to separate out proprietary trading from the other
activities of a bank falls into the fourth category, separation of
function, and reflects his concern that customers may never know
whether the bank is taking advantage of them. The Financial Stability Oversight Council issued “ten commandments” to guide the
several regulatory agencies as they implement the Volcker rule
starting April 1, 2011 (see Fig. 1, FSOC, 2011). The ten commandments of the FSOC are clearly consistent with the letter and intent
of the Glass–Steagall Act of 1933, with due allowance for the recent
financial innovations of hedge funds and private equity funds. The
bulk of the Glass–Steagall Act was devoted to spelling out the terms
under which such commercial banks, divested of their investment
banking departments, would be eligible for Federal deposit insurance. The Dodd-Frank bill enlarges the scope and extent of deposit
insurance for commercial banks, so the Volcker rule is intended to
prevent the moral hazard problem that deposit insurance creates
for bank managers trying to increase returns by taking increasingly
risky positions in the securities markets. Will it be successful, or will
further financial innovations undermine it, leading to unintended
consequences? To help answer these questions, we demonstrate
some of the possibilities that lie ahead by reviewing the policy concerns that led to the enactment of the Glass–Steagall Act originally,
105
the intended consequences that followed, and then examine a few
of the unintended consequences that emerged over time. Despite
our generally negative appraisal of the legislative intentions then
and the undesirable consequences that followed the Glass–Steagall
Act, we must note that it did persist for over 60 years. During this
time, the US economy maintained its preeminence as the world’s
most successful economy. We contend that among the unintended
consequences of the Glass–Steagall Act that impaired the efficiency
of the American economy, there also emerged a variety of financial
innovations that ameliorated many of the undesirable side effects.
1. Why take a historical perspective?
The set of regulatory initiatives taken by the US in the mid1930s had far-reaching effects on the strategy and structure of the
US banking sector as well as on the strategy and structure of the US
capital markets. The most obvious effects were certainly intended
by the legislators, but the unintended consequences led eventually
to a series of financial innovations in the US starting in the 1970s
with reactions by regulators that continue to the present. The critical breaking point that unraveled the financial structures put in
place after Glass–Steagall came in the early 1970s with the collapse
of the international financial arrangements known as the Bretton
Woods system. Until then, the financial system of the US functioned
largely as intended under the New Deal regulations of commercial
banking, investment banking, and the securities markets.
Commercial banking was stable and profitable thanks to the limitations on entry and the regulation of interest rates that could be
paid to depositors; investment banking found profitable niches in
placing government securities, especially for state and local governments in the US while a few investment banks established
footholds overseas; and regulators had little demand on their
expertise given the expanded role of deposit insurance. US stock
markets, under the watchful eye of the Securities Exchange Commission, established in 1934, broadened their customer base while
maintaining steady dividends and modest capital gains. All three
legs of the financial system seemed to be complementary and doing
well by the US economy, which maintained its global dominance
attained at the end of World War II. The Bretton Woods System
established by the US to sustain the international financial system
among the victorious allies after the war, however, collapsed over
the period from August 1971 to October 1973, as inflation surged
unevenly among the system’s members. The collapse of the fixed
exchange rate and capital control regime revealed the weaknesses
of the existing financial system, much as the collapse of the gold
exchange standard over the period 1929–1931 had revealed the
weaknesses of the US financial system of the 1920s.
After 1973, financial innovations emerged to cope with the challenges that appeared with the fresh opening of international capital
movements that had been sharply curtailed during the period
1945–1971. The consequences of the post-Bretton Woods financial innovations, first in the securities markets, then in commercial
banking, and finally in regulatory regimes seem to have led to more
frequent financial crises (Bordo & Eichengreen, 2002). We witness
now the political demands for further regulations by governments
around the world, but it is important to recognize the incentives
for further financial innovations and the way they will respond,
and have responded in the past, to changes in regulations. The
responses of the US financial sector to the regulatory reforms of
the New Deal, starting with the Banking Act of 1933 (a small section of which is best known as the Glass–Steagall Act), continuing
with the Securities Exchange Act of 1934 and the subsequent Banking Act of 1935 had both the intended consequences foreseen by
legislators but also unintended consequences (Chart 1).
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L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
Fig. 1. The FSOC implementing the Volcker rule.
Source: Financial Stability Oversight Council, Study and recommendations on prohibitions on proprietary trading and certain relationships with hedge funds and private equity
funds. January 2011.
2. Historical background for the Glass–Steagall Act
Chart 1. Commercial banks in the US, 1898–1998.
Source: Carter et al. (2005), Table Cj, pp. 289–297: Commercial banks – number and
assets, by Federal Reserve membership and type of bank.
A recurrent issue in the study of financial history is whether the
basic functions of financial intermediation are best carried out by
personal relationships between lenders and borrowers (banks) or
impersonal relationships through public markets (securities markets). For most financial functions, banks and stock exchanges can
serve as substitutes, and policy makers with short-run perspectives
will see them as such. But in the most successful economies historically, banks and securities markets have been complementary,
especially in the examples of Great Britain and the United States.
Capturing the complementarity of relationship banking with corporate clients and access to deep capital markets led to major
financial innovations in the United States at the end of the nineteenth century. In the first wave of innovation, investment banks
with access to foreign capital led the way – Morgan, Kuhn Loeb,
and Kidder Peabody – but imitators quickly followed, led by trust
companies who provided high interest payments to small-scale
depositors in urban America.
Trust companies provided the domestic customer base for more
aggressive investment banks who were willing to market new
L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
securities more broadly, such as Lehman Brothers and Goldman,
Sachs & Co. Between the two of them, they managed 114 offerings
for fifty-six firms over the period from 1906 to 1924, starting
with offering $10 millions of Sears, Roebuck & Co. preferred and
common stock. Clarence Dillon, the head of Dillon, Read & Co., one
of the old-line investment banks, commented later, “If you had
relied on houses like ourselves you probably would not have had
the automobile industry in this country. We would not have risked
it, and we would have taken it upon ourselves as a virtue” (Kroos
& Blyn, 1971, p. 133, cited by Davis & Gallman, 2001, p. 309).
After the panic of 1907, attributed to the “shadow banking”
industry that had developed led by trust companies in the central cities of the National Banking system, the government tried to
determine why banking failures and financial panics kept recurring
in the US. The Gold Standard Act of 1900, after all, was supposed
to have eliminated one cause of the repeated panics by removing uncertainty about exchange rate risk for foreign investors. The
work of the National Monetary Commission, created by Congress
as part of the Emergency Currency Act of 1908, better known as
the Aldrich-Vreeland Act, provided the empirical basis for regulatory reforms, which eventually culminated in the Federal Reserve
Act of 1913. The Commission examined both the US financial system and the structures of foreign financial systems in Europe and
issued 30 reports over the years 1909–1912. The 1908 legislation
merely gave the Secretary of the Treasury specific authority to allow
National Banks associations to increase their note issue in the event
of a “scramble for liquidity”, which was held to be the fundamental
cause of the panic of 1907. It was intended as a stopgap measure
until Congress enacted full-fledged reform of the financial system.
It was used just once, at the outbreak of World War I in 1914, and
was allowed to expire in 1915 when the Federal Reserve Act came
into force.
Despite claims by Democratic legislators that the Federal
Reserve System was superior to the proposals of the National Monetary Commission, it closely followed the recommendations of the
Commission (Friedman & Schwartz, 1963, p. 171, fn. 59). But contrary to the wishes of Carter Glass, the Democratic Representative
in charge of the bill, National Banks as members of the Federal
Reserve System were allowed to affiliate with trust companies if
the trust companies had sufficient capital to qualify as National
Banks. Moreover, the securities affiliates of National Banks were
allowed to “act as trustees, executors, and administrators of stocks
and bonds, and to receive savings deposits subject to a 5 percent
reserve requirement”, effectively competing with state-chartered
trust companies (White, 1983, p. 129). For Carter Glass, this concession was only admissible in order to accomplish his goal of
bringing the state-chartered banks and large trust companies in
central reserve cities into the Federal Reserve System. But, it was
counter to his commitment to the “real bills” doctrine, namely that
bank loans backed by goods, whether in transit or in inventory,
were self-liquidating. Only such loans were the proper business of
commercial banks in Glass’s opinion. By contrast, loans provided
for the credit of reputable businesses but not based on specified
collateral laid the basis for uncontrolled speculation and eventual
financial disaster. It was the unforeseen rise of such loans by all
sorts of financial institutions in the 1920s that led Carter Glass
to insist on the separation of commercial banks from investment
banks when he took charge of the Senate Banking Committee as
Democratic Senator from Virginia.
To grasp the significance of the consequences of the
Glass–Steagall Act after the Great Depression in terms of possible consequences of the Volcker Rule after the “great recession”
of 2007–2009, it is useful to recall that both financial crises were
preceded by an extended period of robust growth of the international economy. The “roaring twenties” in the US coincided with the
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“five good years” of growth in the international economy from 1924
through 1928. Much as in the last decade, contemporary observers
of the 1920s were struck by the implications of new financial developments. The National Bureau of Economic Research, for example,
responded to President Hoover’s Conference on Unemployment in
1929 by commissioning a number of studies on The Recent Economic
Changes in the United States (1929). Oliver Sprague, who wrote the
History of Crises under the National Banking System for the National
Monetary Commission in 1910, and W. Randolph Burgess, who
interpreted Federal Reserve policy through the speeches and writings of Benjamin Strong, Governor of the New York Federal Reserve
Bank from 1914 to 1928, wrote the study on “Money and Credit and
their Effect on Business”.
Sprague and Burgess noted the rapid expansion of credit that
had occurred in the 1920s, at first in response to the huge imports
of gold during World War I and the rise in prices in response to
wartime demands in Europe, but then continuing in the 1920s
thanks to policies of the Federal Reserve and financial innovations.
The Federal Reserve Act reduced the reserve requirements of member banks against both demand and time deposits, increasing the
implicit money multiplier (p. 669). As France was then stabilizing its currency against gold, however, the further increase in gold
stocks could not be expected. The authors suggested “perhaps a
revision of the law is desirable to liberalize the provisions of the
Reserve Act concerning collateral for Federal Reserve notes”, if the
increase in credit was to be sustained (p. 671).
The financial innovations they described were mainly in the
form of investment trusts (also known as trust companies), which
had arisen at the turn of previous century but had increased greatly
in number and size after World War I. These new financial institutions paid interest on their deposits and invested their funds in
securities issued by new firms. Sprague and Burgess explained that:
The investment trust is not dissimilar in principle from the
savings bank, in that it gathers funds from many sources and
employs them in a diversified list of securities selected by a
management group. The principal differences are (1) that the
investment trust is not limited in its choice of securities by the
legal restrictions which surround savings banks, (2) that the
investment trust is not under such close governmental supervision, and (3) that the investment trust, unlike the savings bank,
usually makes no promise of a fixed rate of return, and indeed
has no set limit of return. (p. 689)
The effects of the investment trusts on the financial system
showed up in several ways. First was the sharp increase in personal savings that occurred in the period 1922–1927 compared to
the prewar period 1900–1913 (p. 674). Much of the increased savings by the public went into time deposits rather than demand
deposits, which led to an increase in stock market capitalization
as opposed to general price inflation, in the view of Sprague and
Burgess. For banks following traditional lines of business, however,
the competition from investment trusts meant that the interest
they could charge on commercial loans continued to decline. Such
banks responded by increasing their collateral loans (mainly call
loans to stock brokers) and security holdings (p. 683). The activity
of regional stock exchanges, especially in the East North Central region of the US (including Ohio, Michigan, Indiana, Illinois,
and Wisconsin), rose even faster than that in the New York Stock
Exchange. The fall in bond yields after World War I was matched by
an even sharper fall in industrial common stock yields (see Chart 2
from Sprague & Burgess, 1929, p. 658).
While Sprague and Burgess mentioned the possibility of speculative excess in the stock markets, signaled by a sharp rise in stock
prices and in call loan rates, on the whole they were sanguine
about the prospects of the financial sector. The Federal Reserve
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L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
Chart 2. Bond and industrial common stock yields, 1922–1928.
Source: Sprague and Burgess (1929, p. 658).
Chart 3. Movement of interest rates in the U.S., 1922–1928.
Source: Sprague and Burgess (1929, p. 658).
L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
seemed to be smoothing out cyclical fluctuations in commercial
paper rates, and by not sterilizing the huge inflows of gold since its
establishment had provided for a noteworthy expansion of credit
to business. The continued fall in yields on the most widely held and
traded securities, however, led savers to seek higher yields in the
newer and riskier securities that appeared in emerging markets in
South America and startup companies exploiting new technologies
appearing in radio, chemicals, electricity, and automotive. By 1928,
the stock market boom nationwide was creating upward pressures
on short-term interest rates, led by the call loans to stockbrokers
(Chart 3, Sprague & Burgess, 1929, p. 658).
The boom in the stock market was focused on companies boasting their applications of new technologies, the future of which
was uncertain – risky but potentially yielding high returns (White,
1990). Widespread participation in the stock market was mobilized
by the investment trusts and the security affiliates of commercial banks that had sprung up in the 1920s. Securities affiliates
then cooperated with their commercial bank, which could be a
state-chartered bank member or a National Bank that could take
advantage of the facilities offered by the Federal Reserve System
– access to discount facilities for eligible paper and par clearing
of checks with other member banks. Boom times with wartime
demands from Europe for US goods encouraged rapid expansion of
banks and stock exchanges throughout the country. Chart 1 above
showed the expansion of numbers of all three categories of banks
through World War I; Chart 4 below shows the rise of business on
regional stock exchanges, even as the New York Stock Exchange
remained the premiere exchange for the country. The two figures
are related as banks across the country decided to enter the securities business once the McFadden Act in 1927 allowed national
banks to have the same privileges accorded to state banks as far as
allowing branching or affiliation with a securities company.
The number of banks providing clients with securities services
from a department of the bank itself rose from 62 to 123 between
1922 and 1931, but the number of banks with separate securities affiliates rose from 10 in 1922 to 114 in 1931. Further, from
1927 to 1929, the share of all bond originations fell for investment banks (from 78 to 55%) while the share for commercial banks
rose (from 22 to 45%). Much of the new business was directed to
small and medium-sized businesses, the traditional clients of the
commercial banks who were now entering the securities business.
The older investment banks remained focused on the large-scale
corporations they had helped found in many cases (Peach, 1941).
The new, smaller firms increased the listing volumes on more than
30 exchanges around the country, with many of them more than
doubling during the 1920s (O’Sullivan, 2005, pp. 199–202).
An interesting sidelight on this phenomenon is the special
attraction of startup firms trying to exploit some aspect of the
new technologies of the time – residential electricity, radio, automobiles, and pharmaceuticals. Research by Lamoreaux, Sokoloff,
and Suttiphisal (2009) argues that patenting activity by small and
medium-sized enterprises was as important during the 1920s as
by large enterprises with their specialized research and development laboratories. These new enterprises, largely located in the
East North Central region of the US, relied on their local banks for
initial startup funding and then on their regional stock exchanges
for expanding their enterprise when an invention became profitable to market.
With the stock market crash of 1929 and the subsequent bank
crises of October 1930, March 1931, and culminating with the
September 1931 crisis, Senator Carter Glass certainly had enough
evidence to convince himself, and the rest of his Congressional
colleagues, that commercial banking had to be separated from
investment banking in whatever form it took. As Benston (1990)
demonstrates, however, all the testimony taken and evidence
109
submitted to the Congressional committees failed to make the
connection between the financial innovations that obviously had
occurred and the widespread failure of numerous banks. Most
failed banks, and there were thousands of them, were small rural
unit banks in agricultural regions where the continued fall of
commodity prices forced widespread mortgage foreclosures and
reduced land values. The affiliates abused by the largest state bank
to fail, the Bank of United States, were not security affiliates at
all, but instead were mortgage houses speculating on New York
City real estate, which had a brief bubble at the end of the 1920s
but then collapsed throughout the 1930s. Ironically, Senator Glass
was in favor of real estate lending by National Banks because it
encouraged state banks as well to join the system!
Later research by White (1986), has shown that National Banks
with security affiliates actually were significantly less likely to fail
than National Banks without affiliates. Further analysis by Kroszner
and Rajan (1994), demonstrated that securities floated by security affiliates of commercial banks actually outperformed securities
underwritten by pure investment banks, even though they were
issued for smaller businesses with less history than the clientele
of the traditional investment banks. This result demonstrates that
the incentives for commercial banks to maintain the safety of the
securities issued by their affiliates for the benefit of their established client base overcame any incentives for moving bad loans
from their books by securitizing them and selling them off in distant
markets (Crockett et al., 2004, pp. 62–64).
Benston argues that it was Charles Mitchell’s testimony to the
Pecora Commission that swung popular opinion in favor of the separation of commercial banks from security affiliates. Mitchell was
the CEO of National City Bank, the largest commercial bank in the
world in 1929; CEO of National City Company, the security affiliate
of National City Bank; and CEO of City Bank Farmers Trust Company, a state-chartered institution that was one of the largest and
most aggressively expanding trust companies in the 1920s. Thus,
Mitchell was head of the largest, most diversified financial intermediary in the world (Cleveland & Huertas, 1985, pp. 154–158).
When the foreign bonds that National City Company had underwritten began to turn sour after 1929, the very size of National City
Bank and its affiliates brought Charles Mitchell to the special attention of the Senate committee chaired by Ferdinand Pecora (1936).
One egregious example of National City Company’s investment
advice gone sour was their role in promoting the sale of Peruvian
Bonds in 1927. Initially these 7% bonds rose in value and traded
above par as late as May 1930. But, when prices fell for Peru’s major
exports, the government’s revenues collapsed, the President was
deposed, and the government defaulted on the bonds, their price
dropped to 5–10% of par in 1931 and 1932. Mitchell was accused of
misleading investors, even though his security affiliate bore much
of the losses on these and other securities that the company had
underwritten. Under attack for this mishap and other losses that
the security affiliate had suffered, Mitchell resigned from all his
positions and the Glass–Steagall Act became part of the Banking
Act of 1933. The Securities Exchange Act of 1934 completed the
sweeping regulatory reforms of the New Deal.
3. Intended consequences
Removing the security affiliates from their commercial banking parent companies was the first object of the Glass–Steagall Act.
While this restriction applied only to member banks of the Federal
Reserve System, it had always been the objective of Senator Carter
Glass to induce the much more numerous state-chartered banks
and their “shadow banking” contemporaries, the trust companies
chartered by several states, to join the Federal Reserve System. It
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L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
Chart 4. The relative shares of the aggregate value of U.S. stock exchanges, 1927–1929.
Source: Davis, Neal, and White (2007, p. 713).
Fig. 2. Flow of outside funds to U.S. manufacturing firms (in scale).
Source: NBER Macrohistory Database, adapted from F. Lutz, Corporate cash balances, 1914–1943 (NBER, 1945), pp. 103–104, 116, 118, 120.
was Carter Glass, as a Democratic Representative from the state
of Virginia, who helped shepherd the original Federal Reserve Act
of 1913 through Congress. Twenty years later, as Democratic Senator from Virginia, Glass was a major author of the Banking Act
of 1933. As White (1983) demonstrated, Representative Glass was
frustrated by the regulatory response to the creation of the Federal
Reserve by individual states, who instead of encouraging their state
banks to join the Federal Reserve System made state charters even
more attractive than Federal Reserve membership. As a result, very
few state banks took up the option of joining the Federal Reserve
System and, indeed, increased in number until the banking crises
of the late 1920s and early 1930s.
The banking crises of the 1920s mainly hit the small state banks
committed to agricultural loans in unit banking states and put thousands of them out of business (Chart 1). Oliver Sprague, writing in
1929, was sanguine that “the decline will be at a far less rapid rate,
since the major cause of the disappearance of banks in recent years
– numerous bank failures – reflects conditions abnormally unfavorable to banking solvency in many localities, conditions unlikely
to reappear with any like severity in the near future” (Sprague &
Burgess, 1929, p. 690).
Chart 1 showed dramatically how earlier regulatory reforms
were rapidly overtaken by financial innovations in the US at the
beginning of the 20th century. The Gold Standard Act of 1900, for
L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
example, encouraged the formation of many new, smaller National
Banks by lowering the minimum capital required for a bank in
towns under 3000 population from $50,000 to $25,000. But the
response of states to this reform at the federal level completely
swamped the National Banking System with a variety of savings
institutions, Morris Plan banks, and trust companies (Neal, 1971;
White, 1983). The creation of the Federal Reserve System in 1913
did lead to some state banks becoming members, but many more
banks were formed under state charters to take advantage of boom
times during World War I, especially in agricultural states. The collapse of numerous banks after World War I was largely the effect
of falling agricultural prices combined with restrictions on branch
banking in most states (Alston, Grove, & Wheelock, 1994). The successive banking crises of 1929, 1930, 1931, and 1933 combined
with the change of political regime in 1933 with the election of
Franklin D. Roosevelt set the stage for the sweeping regulatory
reforms of the New Deal.
Separation of the commercial bank lending from investment
banking and insuring small investors from potential losses were
the central features of the New Deal banking regulations. Most of
the Banking Act of 1933 was taken up with defining the structure
and operating rules for the Federal Deposit Insurance Corporation,
which provided coverage for the depositors of all banks willing to
pay the nominal insurance premium, regardless of whether they
were state or federally chartered. Calomiris (2000) argues that the
combination of deposit insurance, the pet project of Representative
Steagall, with the separation of commercial from investment banking, the main object of Senator Glass, was a classic case of logrolling
to pass the combined legislation, as Glass was opposed to deposit
insurance in principle. Unpacking the two, especially when Regulation Q, the prohibition on paying interest on demand deposits
covered by Federal deposit insurance, was added, turned out to be
very difficult over the following decades.
The Banking Act of 1935 maintained the protected position
of commercial banks in unit-banking states further by forbidding investment banks from holding deposits. Henceforth, their
activities would have to be financed from own capital or shortterm borrowing. The Securities Exchange Act of 1934 required all
companies listed on any exchange to provide detailed accounts
similar to those that had been established earlier by the New
York Stock Exchange. Effectively, this reduced the competitiveness of the regional exchanges. Further protection for commercial
banks was provided throughout the Roosevelt Administration by
re-capitalizing numerous small banks through the purchase of preferred stock by the Reconstruction Finance Corporation (Mason,
1996).
Chart 1 also shows that the effect of these reforms in terms of the
numbers of commercial banks – National Banks, state bank members of the Federal Reserve System, and state bank non-members
– which remained quite stable until the financial innovations of
the 1970s began to emerge. In this sense only, the intended consequences of the New Deal reforms did occur – the structure of the
US banking sector remained stable in contrast to the rapid changes
in its previous history or the changes that have occurred since the
end of the Bretton Woods System and the onset of domestic financial deregulation. There were, however, unintended consequences,
which will be our focus for the remainder of the paper.
4. Unintended consequences
Access to finance for small and medium-sized businesses was
severely curtailed as a result of the combination of reforms to the
US financial system. Large businesses were able to resume investment programs by relying more on internal funds for financing
than earlier. Small businesses were cut off from external finance
111
in the newly restricted and regulated stock markets while their
bankers were concerned more with re-capitalizing or buying back
their preferred stock from the Reconstruction Finance Corporation for the rest of the 1930s. Fig. 2 contrasts the flow of external
funds to US manufacturing firms during the period, 1917–1942.
The immediate post-WWI years were exceptionally good for small
businesses, defined as firms with assets between $50,000 and $5
million, but their access to outside funds leveled off in the late
1920s and only picked up in 1940 with the onset of war demands.
Large businesses, defined as firms with assets over $5 million,
fell during the recession of 1920–1921 by contrast, but came out
of the depression much more rapidly than small businesses. The
impression given in Fig. 2 is confirmed by survey evidence collected by the National Industrial Conference Board asking firms
if they had problems obtaining external debt financing. In 1932,
41% of the very small firms (assets under $50,000) reported difficulties, as did 22% of small firms, but only 10% of the largest firms.
In 1938, a follow up survey was undertaken by Louis Kimmel on
behalf of the American Bankers Association to show how access to
bank credit had improved during the recovery from the depression.
True enough, the percentage of very small firms reporting difficulties had fallen to 30%, but the percentage falls for the small firms
were more substantial, down to 14%, and of the large firms only
3% then reported difficulty with obtaining bank credit (Bernanke,
2000, p. 63). Small businesses then as now accounted for most of
the changes in employment, and their continued financial difficulties help explain the continued high unemployment figures for the
1930s.
The Securities Exchange Act of 1933 also hurt access to external
finance, especially for smaller firms. The paperwork requirements
for listing even on the remaining seven regional exchanges, were
sufficient to exclude many of the firms that had taken advantage of
the financial innovations of the 1920s. Simon (1989) did an extensive analysis of the mean and variance of returns on new issues
listed on the New York Stock Exchange and regional exchanges
both before and after the SEC regulations. Her idea was that if the
SEC regulations were useful in providing superior information to
investors than the listing requirements followed by the various
stock exchanges, then even if the mean returns did not change,
as found by earlier studies by Stigler (1964) and Jarrell (1981), the
variance of returns on new issues would fall if better information
was provided initially to investors. However, she found that to be
the case only for the subset of new issues that were both unseasoned (had no previous history of trading on the exchanges) and
issued on regional exchanges. For those cases only, the SEC regulations apparently had the desired effect. Simon’s sample, however,
took only issues for firms with assets over $1.5 million, hardly the
case of small or even medium sized firms that would depend on
access to regional exchanges, as the minimum listing requirement
for the New York Stock Exchange was $1 million.
A later study by Ramirez (1999), however, showed that the
Glass–Steagall Act did have the effect of eliminating the financial
advantages that firms with close affiliations with an investment
bank or a commercial bank’s security affiliate enjoyed before
Glass–Steagall. He studied the sensitivity of investment expenditures by firms to the availability of their internal funds both before
and after Glass–Steagall, distinguishing firms by whether they had
affiliations with financial institutions. Before Glass–Steagall, such
an affiliation reduced the dependence of investment spending on
internal funds, at least compared to a control group of firms that
had no affiliations with any type of financial institutions. After
Glass–Steagall, however, there was no difference in dependence
on internal funds for driving investment expenditures. The effect
on investment would be most marked for smaller firms, who also
suffered from limited access to bank finance.
112
L. Neal, E.N. White / The Quarterly Review of Economics and Finance 52 (2012) 104–113
Meanwhile, securities affiliates either disappeared or were separated from their mother bank, while that investment bankers
remained in business simply by re-organizing into new partnerships (Carosso, 1970). But the further requirement of Glass–Steagall
that investment banks give up taking deposits in competition
with commercial banks meant that the new firms were dependent strictly on their capital or on short-term loans. The sudden
reduction in the capital of US investment banks had obvious consequences for their role in financing new issues, whether for
corporations or governments.
To provide government protection for investors in the international securities that had gone into default, such as the Peruvian
bonds underwritten by National City, the Roosevelt administration created the Foreign Bondholders Protective Council in 1933.
After numerous conflicts with the diplomatic goals of the State
Department, which eschewed gunboat diplomacy, the FBPC was
eventually disbanded in 1940 having failed to recover even partial
repayments of the defaulted government bonds (Adamson, 2002).
It remained up to the various rating agencies that had been assessing the value of the securities held by commercial banks during
the 1930s to rate the bonds issued by foreign governments, as well
as by corporations. Flandreau (2011) has demonstrated that the
leadership role of the largest investment banks – Rothschild’s in
London and Morgan in New York – that had given the equivalent
of Good Housekeeping Seals of Approval to the foreign government bonds they promoted in the nineteenth century disappeared
after the regulatory reforms of the 1930s. It no longer mattered
which investment bank took the lead in an underwriting syndicate
to determine the likelihood of future default. For businesses, only
the largest, most conservative firms were considered feasible for
the smaller, more constrained investment banks that remained.
Patenting activity thereafter shifted towards large corporations
with in house research facilities, until venture capital firms came
of age in the 1980s (Lamoreaux et al., 2009; O’Sullivan, 2005).
5. Conclusion
The accumulated evidence yields the conclusion that the combined effects of the regulatory reforms of the New Deal were
deleterious to financing economic growth for the US. However, in
spite of the higher costs of finance, the economy recovered from
the depression and resumed significant rates of growth after World
War II, reducing incentives to repeal even the most harmful of the
regulations. Part of the reason for the persistence of the regulations
must also have been the difficulty of unpacking the complex mix
of regulations, many of which had developed powerful constituencies, such as savings and loan associations and unit banks. Further,
financial innovations eventually diminished the worst effects of
the reforms. Institutional investors, representing pension funds or
mutual insurance companies, became the new customer base for
securities markets. Venture capital firms, initially created to bring
government-financed technology to the civilian market, arose to
take the place of local commercial banks that provided seed money
for new inventions before the Great Depression. The collapse of the
Bretton Woods system in 1971–1973, induced a new set of financial innovations, which set the stage for the deregulations of the
1980s and 1990s.
The current set of regulatory reforms in the US, we suspect,
largely overlook the long-run challenge of achieving the beneficial
coordination of banks, markets, and regulations that can sustain
long-run economic growth, both for the US and the rest of the
world. Like the regulations put in place in the 1930s, they focus
on preconceptions long held by policy leaders such as Carter Glass,
or Paul Volcker, rather than in-depth analysis of the coordination
problems that arise in the absence of full disclosure of relevant
information to potential investors. No doubt, financial innovations
will arise to cope with the difficulties posed by new regulations as
they take effect – but in the globalized finance of the twenty-first
century, they are just as likely to take place someplace else in the
world as in the United States.
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