Is the New Deal in banking a guide for today?

Eugene White 02 March 2010



As low interest rates and massive government spending have failed to spur a quick recovery, Washington is focusing more attention on reforming the institutions deemed responsible for the global financial crisis of 2008 and 2009. Many solutions, including new versions of the Glass-Steagall Act, hark back to the New Deal. The popular belief is that Congress successfully exposed the failures of the “banksters” and then imposed the strict regulations required to make the banking system tame and safe. Unfortunately, this picture is an historical mirage (Kroszner and Rajan 1994).

The new Financial Crisis Inquiry Commission has begun its hearings by hauling before it the bankers and officials presumed to have brought on the financial crisis. It has been called a “New Pecora Commission,” in conscious imitation of the dramatic Congressional inquest begun by the Senate Banking Committee in 1933. The Pecora hearings riveted the nation’s attention, dramatically investigating the misdeeds of the banks that until 1929 had been viewed as pillars of the economy.

A major part of the investigation focused on the innovation of commercial banks that had created securities affiliates. Unanticipated by existing regulation, this institutional development enabled commercial banks to enter the business of investment banking. When the stock market crashed in 1929 and the subsequent collapse of asset values wiped out many investors, the blame was placed on these aggressive new players who had grabbed a good share of the market from the stand-alone investment bankers. The hearings focused on securities affiliates’ sales of “exotic” assets like defaulted Peruvian bonds, manipulative trading practices, and the earnings of bank executives.

A dispassionate look at the evidence

For decades, this selective evidence has been repeated in the popular press and the web as a justification of the legislation. But, what did economists find when they took a dispassionate look at all of the evidence? In a series of articles, Randall Kroszner, Manju Puri, Raghuram Rajan and I discovered that that the securities issued by the affiliates actually performed better and were less likely to default those issued by stand-alone investment banks. The economies of sharing information by commercial and investment divisions of the same institution had trumped any temptation to exploit a conflict of interest. Furthermore, the commercial banks with affiliates were less likely to fail than stand-alone commercial banks – they were larger, more diversified, and hence safer.

So how did Congress craft legislation in response to this skewed evidence? The chairmen of the House and Senate banking committees, Henry Steagall and Carter Glass, had their own pet schemes to restructure the banking system. If the Roosevelt administration wanted any legislation, it had to kowtow to these mandarins who controlled the legislative agenda. Glass believed in the old and discredited “real bills” doctrine that banks would be completely safe if they could be restricted to very short-term commercial lending. He deemed any other banking activities, including investment banking, to be an inherent threat. While the administration and all experts argued that the securities affiliates should be brought under supervision of existing regulators to manage any problems, Glass insisted that there would be no legislation unless there was a radical and complete separation of commercial and investment banking.

Of course, the stand-alone investment banks were happy to advise him as to the wisdom of this course. A friend of the thousands of tiny banks that dominated the banking landscape of the time, Steagall pushed forward their agenda. These inefficient small and overwhelmingly single-office institutions were far from diversified and had suffered terribly in the banking crisis. They opposed branching and expansion of the large banks and sought legislation for deposit insurance, viewing it as a means to reassure their depositors who might otherwise flee to the safety of a bigger bank. The administration, the Federal Reserve, Glass, and many other Congressmen feared the moral hazard that insuring deposits would cause, but Steagall would accept no bill unless it had deposit insurance. So, a deal was done to forge the Glass-Steagall Act of 1933, producing deposit insurance and the separation of commercial and investment banking. The former started modestly but gradually grew to cover the banking system, creating huge incentives for risk-taking by bank executives, while the latter reduced competition and efficiency, raising the cost of capital to firms.

Some of the bankers who faced chief counsel Ferdinand Pecora had been guilty of certain crimes. But not all; and in fact, the true indictment was the whole industry had caused the Great Depression. The public and media have commonly assumed that they were convicted of this “crime” in the hearings. But again careful scholarship (including the work of Milton Friedman, Anna Schwartz, Ben Bernanke, and Christina Romer) has established that the primary cause of the Great Depression were the faulty policies of the Federal Reserve. The Fed, when faced with banking panics, failed to sufficiently expand liquidity, permitting the depression to deepen. Yet, while the bankers were subjected to the Glass-Steagall Act and a corset of regulations costing consumers and business billions of dollars, the Fed gained more power in the New Deal.

Where do the real causes of today’s crisis lie? We should be wary of rushing to conclusions, as a more careful examination of the causes is needed to enable us to properly reform the banking system. A mad dash for regulation where special interests can manipulate popular outrage is a recipe for cooking up the next financial disaster.


Bernanke, Ben (2000), Essays on the Great Depression, Princeton: Princeton University Press.

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

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

Puri, Manju (1996), “Commercial Banks in Investment Banking: Conflict of Interest or Certification Role?”, Journal of Financial Economics, 40:373-401.

Romer, Christina D (1993), “The Nation in Depression”, Journal of Economic Perspectives, 7(2):19-39, Spring.

White, Eugene N (1986), “Before the Glass-Steagall Act: An Analysis of the Investment Banking Activities of National Banks”, Explorations in Economic History 23(1):33-55, January.



Topics:  Global crisis

Tags:  Great Depression, global crisis, Glass-Steagall Act

Distinguished Professor of Economics, Rutgers University; Research Associate, NBER


CEPR Policy Research