It’s Complicated

by Elaine Schwartz    •    Jan 16, 2010    •    828 Views

Oversimplification concerns me.
Some people are saying we should resuscitate Glass-Steagall. Passed in 1933, the Glass-Steagall Act (Banking Act of 1933) prohibited commercial banks from engaging in investment banking activities and created the FDIC. Also a part of 1933 legislation, Regulation Q established a ceiling on savings account interest rates. Together, Glass-Steagall and Regulation Q created so safe a banking environment that bank failure was virtually impossible. It worked for close to 40 years.

Then though, during the late 1970s, dollars started fleeing the banks because interest rates were considerably higher elsewhere and FDIC insurance was an insufficient incentive for money to remain. Banks are a financial intermediary. When so much money leaves, the phenomenom is called “disintermediation”. Glass-Steagall and Regulation Q created banking restrictions that prevented commercial banks from vigorously competing against non-regulated financial firms. Glass-Steagall and Regulation Q led to disintermediation. Consequently, 1933 banking regulation was gradually phased out.
Soon a dilemma emerged.
With 1930s regulation we had no bank failures. But soon, we would have had few banks because their deposits were diminishing.
With deregulation, money flowed into banks. However, their risky behavior lead to many bank failures. The probable result? Again, many fewer banks.
As the heartbeat of our economy, banks pump our money from savers to borrowers. We need banks for our economy to function.
Figuring out a new regulatory environment is just not going to be simple.

Economic Ideas:
Financial Intermediary: An institution that connects savers with borrowers.
Disintermediation: When a financial institution is unable to connect savers and borrowers.

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