Glass-Steagall Reform

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Glass-Steagall Reform

Previously, we briefly discussed that much has recently changed in the investment banking industry, driven primarily by the breakdown of the Glass-Steagall Act. This section will cover why the Act was originally put into place, why it was criticized, and how recent legislation will continue to impact the securities industry.

The history of Glass-Steagall

The famous Glass-Steagall Act, enacted in 1934, erected barriers between commercial banking and the securities industry. A piece of Depression-Era legislation, Glass-Steagall was created in the aftermath of the stock market crash of 1929 and the subsequent collapse of many commercial banks. At the time, many blamed the securities activities of commercial banks for their instability. Dealings in securities, critics claimed, upset the soundness of the banking community, caused banks to fail, and crippled the economy. Therefore, separating securities businesses and commercial banking seemed the best solution to provide solidity to the U.S. banking and securities’ system. In later years, a different truth seemed evident. The framers of Glass-Steagall argued that a conflict of interest existed between commercial and investment banks. The conflict of interest argument ran something like this:

1) A bank that made a bad loan to a corporation might try to reduce its risk of the company defaulting by underwriting a public offering and selling stock in that company. 2) The proceeds from the IPO would be used to pay off the bad loan.

3) Essentially, the bank would shift risk from its own balance sheet to new investors via the initial public offering. Academic research and common sense, however, has convinced mny that this conflict of interest isn’t valid. A bank that consistently sells ill-fated stock would quickly lose its reputation and ability to sell IPOs to new investors.…...

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