Following the financial crisis of 2008-2009, much of the blame was directed at large financial institutions that took on high levels of risk in the years preceding the crash. From 1933 to 1999, investment and commercial banks were legally separated and could not be owned by the same holding company. This was originally seen as necessary because the Federal Reserve started insuring bank deposits in 1933, thereby protecting banks from risk. Allowing banks to merge added fuel to the fire of a previously existing moral hazard.
Progressives argued that the repeal of the Glass Steagall Act of 1933 sowed the seeds of the recession by allowing commercial and investment banks to merge. Two other schools of thought emerged. One argued that only one of the two main provisions of Glass Steagall was repealed (the other being FDIC Insurance), so banks after Gramm-Leach-Bliley faced extreme moral hazard from not deregulating enough. The last school contended that the facts don’t fit the popular blame repeal narrative and that merged institutions actually performed best in the crisis.
Glass Steagall
Before the Great Depression, banks in the United States were controlled by unit-banking laws that made it difficult to diversify their risk portfolios. Branching was illegal, so small and relatively vulnerable banks dominated the landscape. Even during the 1920s, more than 600 small banks failed each year in the U.S.
When the Great Depression struck, some 10,000 banks in the U.S. failed or suspended operations between 1930 and 1933. Canada, which had no such regulations on bank size or branching, experienced zero bank failures from 1930 to 1933. There were only 10 banks in Canada by 1929.
The U.S. Congress passed the Glass Steagall Act in 1933. Senator Carter Glass wanted to allow branch banking across the country but was opposed by Representative Henry Steagall and Senator Huey Long. They settled by allowing the states to decide if they wanted branch banking.
To protect smaller, non-branch banks from bank runs, the Act also created the Federal Deposit Insurance Corporation (FDIC). Now, bank deposits would be backed by the Federal Reserve.
However, Congress knew that this created a moral hazard for banks to potentially take too much risk; after all, the Fed could now bail them out. The last portion of Glass Steagall made it illegal for the same institution, or holding company, to act as both a commercial bank and a securities firm. This was designed to limit the use of deposit accounts to purchase risky investments.
Graham-Leach-Bliley and Moral Hazard
In 1999, Congress passed the Gramm-Leach-Bliley Act. This Act repealed the portion of Glass Steagall that separated commercial and investment banks. FDIC Insurance remained in place, however.
With FDIC Insurance – along with many other types of explicit or implicit government protections – banks could now assume very large, potentially risky investment portfolios. Many economists, including Mark Thornton, Frank Shostak, Robert Ekelund and Joseph Stiglitz, blame Gramm-Leach-Bliley for making these risky institutions too big to fail.
Others, including former President Bill Clinton, counter that Gramm-Leach-Bliley actually helped the economy through the crisis because commercial banks struggled much more than investment banks in the recession.
Either way, the ultimate risk appears to be the moral hazard of bank protection, not the merger of commercial and investment banks.