A New Universe In Banking: After Financial Modernization


Adam M. Zaretsky

On March 11, 2000, the U.S. banking industry truly entered the new millennium because, on that date, many provisions of the Gramm-Leach-Bliley (GLB) Act went into effect. GLB repeals those sections of the Banking Act of 1933—commonly known as the Glass-Steagall Act—that separated commercial and investment banking in the United States for nearly 70 years. Gramm-Leach-Bliley also allows affiliations between commercial banks and insurance firms. Under GLB, the U.S. banking system is now much closer to the universal system common in many European and Asian countries than to the specialized system most Americans have grown up with.1

The removal of the wall between commercial and investment banking has essentially created one-stop shopping for consumers' financial needs—banks can now do it all, so to speak. Need a loan? Go to the bank. Want to buy securities? Go to the bank. Want life insurance? Go to the bank. Need batteries? Go to Wal-Mart. (Okay, banks can almost do it all.) This new system will increase competition among the various types of financial companies, which should result in better service, greater availability of all types of financial services and, perhaps, lower prices.2 The combination of commercial and investment banking is not new territory for the United States, however. Although most current generations cannot remember when the two were combined, those alive in the 1920s and early 1930s (prior to Glass-Steagall) remember when commercial banks regularly engaged in securities underwriting and transactions.

Why Divide in the First Place?

Historians and economists have long studied the events leading up to the passage of the Glass-Steagall Act in 1933. At the time—remember, this was during the Great Depression—popular belief held that one of the major causes of the Depression was banks' engagement in risky ventures through securities underwriting—that is, guaranteeing a firm a specified price for its debt or equity issuance. After the 1929 stock market crash, and along with the severe economic downturn of the era, banks began to fail in record numbers. For example, the number of U.S. commercial banks declined 43 percent between December 1929 and December 1933, as reported by economist David Wheelock in a 1993 article. The securities affiliates of these commercial banks then became the scapegoats for the failures. These failures in turn became the ammunition that Sen. Carter Glass—who was already staunchly opposed to banks operating such affiliates—needed to push through legislation separating the two.3 The rest, as they say, is history.

Today, however, economists widely reject the notion that commercial banks' engagement in forms of investment banking led to their eventual failures. Rather, economists now point to poor Federal Reserve policy, which contracted the money supply in a time of great need, and strict branching restrictions as the primary reasons.4 Bank failures resulted more from illiquidity (or, in many cases, insolvency) and undiversified portfolios than from mismanagement and shady dealings. That said, these facts were not known or not understood in the 1930s, leading Congress to separate the two activities on the belief that doing so would prevent similar economic episodes from occurring in the future.

The negative sentiment toward the commingling of investment and commercial banking—and the potential conflict of interest that such a commingling could encourage—was not pervasive during the period, though. As economist Eugene White wrote in a 1986 article, "[I]n the 1920s, some financial writers worried about the [conflict of interest] within a bank to [both] promote the securities of its business customers and...give prudent investment advice to its depositor-investors. Comments of this nature were a minor dissonant note while the stock market was healthy (emphasis added)." Still, the concerns about conflicts of interest have resonated over time, even to the most recent debate about the separation and its eventual repeal.

Unbiased Financial Advice?

The potential conflict of interest that arises from the intertwining of commercial and investment banking has arguably been one of the most hotly debated issues—in both academia and Congress—when lawmakers were deciding whether to combine the two practices under one roof. For example, commercial banks are supposed to offer disinterested financial advice to their customers. Investment banks, though, might also play somewhat of a promotional role for their clients, especially when underwriting securities. When commercial banks assume both roles, the question is which will take precedence: promoting securities or proffering disinterested advice? Although the two goals need not necessarily be contradictory, they may make the banking industry face criticism similar to what the Federal Aviation Administration, which has the dual role of promoting air travel and regulating its safety, recently had to fend off.

One difference from the FAA's situation is that, to stay in business, a bank must attract and keep customers. If, for example, a bank were to engage in dishonest dealings, and customers were to become aware of them, the bank would likely lose customers. This brings up a second difference in these situations: A bank has shareholders to worry about. If shareholders become unhappy with either a bank's performance or the value of its stock, they can replace the bank's management. But both of these differences exist whether banks underwrite securities or not.

The potential exists, though, for a bank that offers both loan and underwriting services to not give objective financial advice. One argument that has been made is that a bank might advise a business customer to issue new securities to repay its poorly performing bank loans. A bank could, however, make such a recommendation regardless of whether it has a securities affiliate or not. Another argument is that a bank, in an attempt to support the prices of securities it has underwritten, might offer imprudent loans to unsuspecting customers so that they would be able to buy these securities. This tactic would be foolhardy, though, since the bank would receive only a portion of the gain from underwriting, while incurring the entire amount of the loss from the defaulted loans.

Examples similar to these were also heard by the Senate Banking and Currency Committee when Glass-Steagall was first being considered in 1933. Ferdinand Pecora, the committee's legal consultant, summarized such stories by stating:

A bank [is] supposed to occupy a fiduciary relationship and to protect its clients, not lead them into dubious ventures; to offer sound, conservative financial advice, not a salesman's puffing patter. . . . The introduction and growth of the investment affiliate ha[s] corrupted the very heart of these old fashioned banking ethics.5

Some of these earlier claims were later disputed in a 1994 article by economists Randall Kroszner and Raghuram Rajan, who investigated bank activities before the passage of Glass-Steagall. Kroszner and Rajan concluded that allowing commercial and investment banking to occur under one roof did not lead to widespread defrauding of investors. Instead, their findings indicate that, because markets and securities rating agencies were aware of the potential for conflicts, banks shied away from questionable securities and primarily underwrote securities for older, larger and better-known firms than investment banks did.

A similar concern was voiced last year when the issue of an all-in-one banking system arose. However, economic research into the subject, like that conducted by Kroszner and Rajan, has overwhelmingly concluded that Glass-Steagall was not justified.

All-In-One Banking vs. Separated Banking

Because all-in-one banking eliminates the distinctions between commercial banks, investment banks and insurance companies, the all-in-one system allows banks to expand (or merge) into areas previously off-limits. The U.S. financial market has already witnessed the start of this process with Citigroup, the company formed in 1998 from the merger of Citibank and Travelers Group. Others will likely follow, leading to the creation of what some might call banking behemoths. What will such a transformation do to the American financial landscape? Will it be better or worse off? Will consumer choices be limited?

Economist George Benston tackled these very questions in a 1994 article—published five years before the passage of GLB. Benston's conclusions were that, overall, all-in-one banking would offer many benefits and few costs to U.S. consumers, despite worries that such banks might crowd out other financial institutions or that the possible collapse of one of these banks could wreak financial chaos. While, at first glance, these concerns might seem reasonable, the literature shows that, in fact, they are not well founded.

Is There Still Room for Specialized Firms?

In the new era, smaller, community banks will likely not offer the variety of services that their larger counterparts will. Whether these community banks will find their niche is discussed in Timothy Yeager's article in the October 1999 issue of this publication. The question considered here is whether investment banks will be able to survive alongside the banking behemoths. Evidence suggests that they will. Although banks might engage in activities similar to traditional brokerage houses, brokerage houses have developed specialized skills that would be difficult—short of a bank actually purchasing a brokerage firm—to duplicate quickly. For example, brokerage houses devote substantial resources to researching and underwriting firms' equity and debt offerings, whereas banks would generally rely on their established relationships with firms to acquire information on them.

Relying on information from established relationships enables banks to exploit economies of scope. Economies of scope exist when it is cheaper for one firm to offer a variety of services than it is for several different firms to offer these same services individually. For example, someone buying a house needs not only a mortgage, but also homeowner's insurance. Since the repeal of Glass-Steagall, a bank can bundle the two together, perhaps offering both cheaper than two separate firms could because the information needed for one is also needed for the other. In this situation, consumers would spend less time and money searching for these services; that is, consumers' transaction costs would be lower. Another conceivable consequence, though, is that the potentially fewer number of competitors in the market might give these banks some monopoly power, which could lead to higher consumer costs overall.

Investment banks, on the other hand, would not be able to offer many of the services all-in-one banks could unless they were willing to be supervised and regulated like banks. But this does not imply that investment banks could not survive alongside all-in-one banks. Other, similar types of specialized financial companies have been able to coexist and survive alongside commercial banks for years. For example, the current financial landscape includes companies that specialize in mortgage lending, sales financing (such as General Motors Acceptance Corp.), non-depository commercial lending (such as General Electric Credit Corp.), and accounts receivable (such as Walter G. Heller & Co.). The mere existence of these types of firms indicates that they are providing their customers desired—though perhaps higher-priced—products and services.

Too Big to Fail?

Because all-in-one banks tend to be large, another concern is that the failure of even one of them could wreak havoc on the nation's financial and payments systems. It does not take all-in-one banks to raise this argument, however. Similar arguments have been made for existing major commercial banks, any of which could certainly disrupt markets if they fail.6 The concern since the repeal, though, is that the combination of commercial banks and securities and insurance firms would increase the chances of a failure, and that that failure would ripple through the economy faster than before. The evidence, however, shows that larger, more diversified institutions are actually more secure than less diversified institutions. In his 1986 article, Eugene White noted that:

While 26.3% of all national banks failed [between 1930 and 1933], only 6.5% of the 62 banks which had [securities] affiliates in 1929 and 7.6% of the 145 banks which conducted large operations through their bond departments closed their doors. This superior record may be partially explained by the fact that the typical commercial bank involved in investment banking was far larger than average while most of the failures were among smaller institutions.

The failure of the U.S. savings and loan industry in the 1980s provides a good, recent example of how a lack of portfolio diversification can cripple such institutions. This almost $200 billion disaster occurred primarily because S&Ls specialized in providing fixed-rate, long-term mortgages that were funded with short-term savings. When interest rates rose sharply in the early 1980s, S&Ls found themselves in severe financial trouble. These institutions were also hamstrung by regulations that prevented them from opening branches in different states—or, in some cases, even within a state—a factor that also doomed many of the institutions during the Great Depression. History has shown, though, that if even one of these anticipated behemoth institutions were to fail, or to become illiquid, the Federal Reserve could pump liquidity into the market to maintain market stability—as it did in October 1987 after the stock market crash.7

There also is no reason to believe that larger, all-in-one banks will engage in riskier ventures than their commercial bank counterparts, although engaging in such ventures could make the behemoths more likely to fail, according to some. But even with Glass-Steagall and its restrictions in place, commercial banks could not be prevented from making risky investment decisions among their limited investment choices. In fact, White argued that, although the intent of Glass-Steagall was to improve the soundness of banks by separating the commercial and investment functions, this forced separation actually placed a burden on the financial industry by disconnecting activities that, by their nature, are economic complements. Moreover, Kroszner and Rajan found that the securities that banks underwrote before Glass-Steagall were of higher quality and performed better than comparable security issues from independent investment banks.

Who Pays for Failure?

Deposit insurance has added a new dimension to the discussion, especially since it did not exist prior to 1933.8 As the United States experienced during the 1980s S&L debacle, the use of insured deposits for speculative activity can cost taxpayers substantial sums of money. Deposit insurance creates a risk—a moral hazard—in banking that would not exist otherwise. The moral hazard arises because the federal government (a third party) guarantees depositors that their deposits will be repaid, up to a limit, if their bank fails. As such, bank managers—who would not have to bear the cost of poorly invested deposits—might feel freer to use these deposits in risky ventures.

If a bank used insured deposits to fund risky securities, or to cover insurance policies, a market aberration or natural disaster could severely strain the bank's financial position. Because the federal government guarantees depositors' funds, however, taxpayers—not bank managers—could end up footing the bill for the loss. Thus, some have argued that all-in-one banking opens the door to more opportunities for such abuses, creating the potential for an even bigger debacle. Gramm-Leach-Bliley addresses this issue by requiring the Federal Reserve, the Comptroller of Currency and the Federal Deposit Insurance Corp. to restrict transactions between insured depository institutions and their subsidiaries and affiliates.

Exploring the Rechartered Territory

The Gramm-Leach-Bliley Act of 1999 allows banks to explore the rechartered territory in the new millennium. Despite what were believed to be good intentions when the Glass-Steagall Act of 1933 was passed, more-critical examinations of that period have demonstrated that the good intentions were misplaced. With the wall between the two banking practices torn down, U.S. banks will be better able to compete with other domestic financial institutions. As companies and customers adjust to the new landscape, most will no doubt come to believe that the change shouldn't have taken so long to make.


Adam Zaretsky wrote the article. W. Scott McBride wrote the sidebar. Paige M. Skiba provided research assistance. W. Scott McBride was a lawyer and an officer at the Federal Reserve Bank of St. Louis.


  1. True universal banking, as typified by the German or Swiss banking systems, still does not exist in the United States because banks here cannot hold equity positions in commercial companies. [back to text]
  2. Increased competition does not necessarily imply lower prices, as improved or new services might be offered that customers would be willing to pay for. [back to text]
  3. Sen. Glass chaired the subcommittee that heard testimony about the alleged abuses of commercial banks and their securities affiliates. [back to text]
  4. See Friedman and Schwartz (1963), Chapter 7. [back to text]
  5. Pecora, quoted in White (1986). [back to text]
  6. See Goodhart (1995) for such an argument. [back to text]
  7. See Zaretsky (1996) for a description of this episode and the Fed's responsibility as the lender of last resort. [back to text]
  8. Deposit insurance was also created in 1933. [back to text]


Benston, George J. "Universal Banking," Journal of Economic Perspectives (Summer 1994), pp. 121-43.

Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States 1867-1960, Princeton University Press (1963).

Goodhart, C. A. E. The Central Bank and the Financial System, The MIT Press (1995).

Kroszner, Randall S., and Raghuram G. Rajan. "Is the Glass-Steagall Act Justified? A Study of the U.S. Experience with Universal Banking Before 1933," The American Economic Review (September 1994), pp. 810-32.

Wheelock, David C. "Is the Banking Industry in Decline? Recent Trends and Future Prospects from a Historical Perspective," Review, Federal Reserve Bank of St. Louis (September/October 1993), pp. 3-22.

White, Eugene Nelson. "Before the Glass-Steagall Act: An Analysis of the Investment Banking Activities of National Banks," Explorations in Economic History (January 1986), pp. 33-55.

Yeager, Timothy J. "Down, But Not Out: The Future of Community Banks," The Regional Economist, Federal Reserve Bank of St. Louis (October 1999), pp. 5-9.

Zaretsky, Adam M. "Learning the Lessons of History: The Federal Reserve and the Payments System," The Regional Economist, Federal Reserve Bank of St. Louis (July 1996), pp. 10-11.

Adam M. Zaretsky 
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