Obviously we don't want to have a repeat of the Great Financial Crash: therefore we need to work out exactly what the GFC was, what caused it and thus how we're going to stop it happening again. And the truth of the matter is, once we've worked through that, then we'll see that Glass Steagall wouldn't have prevented it happening and having a new Glass Steagall won't stop it happening again. That is, assuming that we actually examine what banks were allowed to do under Glass Steagall and don't just use it as a handy synonym for "stop banks doing things that crash the economy."
And here is what the crash was: it was a bank run. Sure, it was a wholesale bank run, not a retail one, but a bank run all the same. This is an inherent fragility of any system of fractional reserve banking. No bank has available to hand back to depositors all the money it has taken from said depositors. Because that's not what banks do: they lend out the money they have taken from depositors. And as Brad Delong has pointed out, you lend out long and borrow from the depositors short. If you lend long and borrow short you're a bank and if you don't then you're not a bank whatever the sign over the door says.
And that long short split is exactly what the fragility is in fractional reserve banking. Depositors can ask for their money bank immediately (mostly) and the people it's been lent to might have 12 months, maybe even 20 years, to pay it back. So, if all depositors turn up to ask for their money back at the same time the bank doesn't have it and goes bust. At least, in the absence of a central bank to provide liquidity they would.
So, our first approximation to the cause of the crash is that all the depositors did ask for their money back at the same time. Then we want to ask why: and that's because of those Mortgage Backed Securities (MBS), the bonds made up of securitised loans. Everyone knew that the banks had piles of these sitting in their vaults. No one knew, suddenly, what they were worth and no one really knew who had how many which were worth what? So, every depositor was interested in getting their money out of all such banks. And this is where the wholesale part comes in: most banks weren't living off lending out what we as individuals were depositing in the bank. Instead there was the overnight money market, the commercial paper market, the deposits of large companies and so on. And none of those deposits were insured by the FDIC. So, if a bank was to go bust it would be entirely possible that the depositor would lose millions, billions possibly.
And thus, of course, a bank run. And a very fast one too: because this was all very short term deposits, most of it either overnight or on demand.
So, a bank run brought on by depositors fearing for their money as a result of no one knowing who would go bust as the MBS market collapsed.
Do note something extremely important here. It was not because there were securitised loans in bonds that they went bust. If all of those bonds had gone off to final investors then the banks would have had no problems. Because there would not have been the runs. It also was not because the banks were creating these bonds, by securitising those mortgages. The process itself was just fine. The problem was that the banks were not selling all of those syndications.
That's where the problem was: the banks looked at the deals they were doing and decided to keep some of those bonds they had just created, or to buy some of those created across the street. And then when the price became entirely unknown everyone panicked and we got the wholesale bank run.
And that's the problem with thinking that Glass Steagall would have prevented it. Because it wouldn't: because a bank buying and or holding those bonds would have been just fine under Glass Steagall.
Again, note that it doesn't matter here that the banks were part of the system creating those bonds. It matters only, to cause the crash, that commercial nbanks working in a fractional reserve system had holdings of bonds that became unknown in price. Thus panicking depositors. And here's the relevant bits of Glass Steagall:
Together, they prevented commercial Federal Reserve member banks from:
dealing in non-governmental securities for customers
investing in non-investment grade securities for themselves
underwriting or distributing non-governmental securities
affiliating (or sharing employees) with companies involved in such activities
Note what they were still allowed to do: invest in investment grade securities for themselves. And that's exactly what they were doing and exactly the thing that caused the crash. The banks didn't buy the lower rated and graded junk or equity parts of those syndicated bonds. They bought the AAA rated tranches: AAA, by the way, indicating investment grade. Glass Steagall just wouldn't have stopped them doing that.
Now, it is possible to step back a bit and think that perhaps the investment bubble wouldn't have got quite so puffed up without the commercial banks underwriting bonds deals, and thus Glass Steagall would have made the problem smaller. And it's also possible to make other such adjustments to the argument around the fringes.
But this really is true: Glass Steagall would not have stopped the Great Financial Crash from happening because the things that allowed the GFC, fractional reserve banking and commercial bank investment in investment grade securities, were both allowable under Glass Steagall.
Thus re-enacting Glass Steagall won't be much influence on the chances of it happening again.
