Glass-Steagall was a cornerstone of our regulatory structure which served to ensure the stability and safety of our financial system by separating depository banks from investment banks and brokers. The original law was put in place in 1933 as part of the overhaul of regulations that followed the Great Depression. This law functioned extremely well at preventing a repeat of that crisis until it was repealed in 1999 at the urging of Sanford Weil of Citicorp and others. Since this repeal we have experienced another financial crisis of a magnitude that rivals that of the Great Depression. Since the repeal Mr. Weil has said that repealing Glass-Steagall was a mistake and that it contributed to the current financial crisis.
Crucially, the law separated depository institutions which are insured by the Federal government, from investment banks which make speculative investments. Depository banks take deposits and make conservative loans against good collateral. The conservative nature of these loans is critical to the stability and safety of the system as these are origination loans, which means they create money in our economy. Money creation is a fundamental function of depository institutions. Indeed, more that 95% of the money supply is created by these loans. Loans of created money puts the entire financial system at risk if a large fraction of these loans are not repaid.
Investment banks often make use of leverage, or borrowed money, to make investments, thus putting the lender at the same risk as the investor. With the repeal of Glass-Steagall the investment banks were able to combine with depository institutions to create banking conglomerates like Citicorp. In principle, the depository bank side of the business should continue to make conservative loans against good collateral like real estate and factories, but internal forces in the combined banks have encouraged loans to the investment banking side to fund speculative investments. The investments undertaken by these banks are not simply funding new or expanding businesses, as is the primary purpose of such banks, but lately these investment have includes funding speculative purchases of securities which include exotic derivative securities.
These derivatives, as their name implies, are derived from other assets or securities, with the hope that the construction of the derivative has greater value than the components. This claim alone is suspect, but the real risk to the financial system comes from the great leverage applied in funding their purchases. Often, leverages of 10-1 or more are applied. In these cases the derivative security itself if put up as collateral for the loan to fund their purchase. Such high leverage and speculative valuations of these securities puts the loan from the depository institution at great risk and thus the deposits and the money supply at risk. Risk that the Federal government then insures, which passes those risks to the American people.
These risks have been realized in the current financial crisis with trillions of dollars lost by the big financial institutions and trillions more of bailouts and guarantees provided by the Federal Reserve and Federal government to these banks in hope of stabilizing the system. In the long run most of these losses will be born by the American taxpayer rather than the speculators and risk takers who fomented the crisis. Action must be taken to ensure that this kind of crisis does not happen again. We know that the Glass-Steagall law works, we should restore it immediately.