The Pros And Cons Of The Glass Steagall Act

As a student of economics, I believe that the repeal of the Glass-Steagall Act via the Gramm-Leach-Bliley Act was not a primary reason behind the Global Financial Crisis 2008; however it did however worsen the situation.

The Glass Steagall Act

The Glass Steagall Act was initially signed into law in 1933 after the famous stock market crash of 1929. Commercial banks had invested heavily in the stock market and after the crash, a hefty part of the population lost their savings.

To prevent something similar from happening again, the Glass Steagall Act was passed. The essence of this act was a complete separation of commercial and investment banking activities.

Commercial banks could only accept deposits and make loans; they could not involve themselves

However, I do not believe this was the cause for the financial crisis.

As mentioned, the Glass Steagall Act prevented investment banks from interacting with commercial banks, therefore there would be no possibility that investment banks would buy loans from the commercial banks and issue securities such as CDOs (which would later turn toxic due to mortgage payment defaults) against that pool of loans.

However this was not true. Even if the Glass Steagall Act was not repealed, this lethal financial securitization would yet be possible because of a loophole present in the Act. Even though the act prohibited integrations between investment and commercial banks, the term 'commercial bank' was very tightly defined and included only the large member banks of the Federal Reserve. This meant that the investment banks could own smaller non member banks (as subsidiaries) such as savings and loan associations who would be made to aggressively give out subprime mortgages and these mortgages later being bought by the parent investment banks to issue CDOs against.

Lehman Brothers had BNC Mortgage, Merrill Lynch had First Financial

Actual causes of the Global Financial Crisis

There were a variety of factors (that had nothing to do with the act) to blame for this crisis. One important factor was low interest rates, which was promoted by George Bush during his presidential campaign for each American to have his own home. Low interest rates increased home loans drastically which start creating a price bubble.

Further, the quality of home loans given declined over time; credit of the person was not scrutinized. Because of such high amount of subprime loans, home owners began to default on their payments impacting the rest of the economy through CDOs.

Faulty rating given by agencies such as S & P to these toxic CDOs also contributed. The AAA rating induced a wide variety of investors to invest in these CDOs which multiplied the impact when loan defaults took place.

Commodity Futures Modernization Act (2000) was also party responsible as it allowed derivatives (such as CDOs) to be unregulated. SEC raised the leverage limit for investment banks from 12:1 to 30:1 increasing the investment banks'