Out of the Shadows: Creating a 21st Century Glass-Steagall

The current financial crisis comes less than a decade after the culmination of a long, bipartisan effort to loosen US financial services regulation.  Those reforms included 1999's Gramm-Leach-Bliley Act ("GLBA"), which relaxed the post-Depression Glass-Steagall boundaries between commercial banking and investment banking.

This research note: summarizes the logical premises that supported loosening the Glass-Steagall framework; evaluates the accuracy of those premises, given the observed market realities of the credit bubble and crisis; and recommends a path forward.

The link between the financial crisis and the relaxation of Glass-Steagall's constraints is rather more complicated than typically understood.  GLBA largely relied on an internally consistent set of logical premises: (1) that widening the scope of banks' activities would allow them to reverse a long-term secular decline in competitiveness; (2) that non-depository "shadow banks" should continue to compete in the banking business, because free market discipline would force them to make sound credit risk-return decisions; and (3) that even if shadow banks failed to make good credit decisions, their resulting bankruptcies would not result in taxpayer harm.

To most policymakers at the time, those premises seemed sound.  But in hindsight, all three premises have proven disastrously false in the marketplace.

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Raj Date is Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former Wall Street managing director, bank senior executive, and McKinsey consultant.

Michael Konczal, a former financial engineer, is a fellow with the Roosevelt Institute.  His work has appeared at The Atlantic Monthly's Business Channel, NPR's Planet Money, The Baseline Scenario, Seeking Alpha, Huffington Post, and The Nation.