What is a firewall?
A firewall is a legal barrier preventing the transfer of inside information and the performance of financial transactions between commercial and investment banks. The restrictions imposed on collaborations between banks and brokerage firms within the framework of the Glass–Steagall Act of 1933 acted as a form of firewall. One of the purposes of a firewall is to ensure that banks do not use the money of regular depositors to finance speculative activities which could put the bank and depositors at risk.
Key points to remember
- A firewall refers to the stipulations of the Glass-Steagall Act of 1933 which impose a strict separation of banking and brokerage activities in full-service banks and between depository and brokerage institutions.
- During the Great Depression, policymakers sought to eliminate the conflict of interest that arose when banks invested in securities with the assets of their account holders.
- In 1999, the Gramm-Leach-Bliley Act (GLBA) was introduced, allowing commercial banks to re-engage in investment banking and securities trading.
- A handful of politicians and economists claim that this deregulation contributed to the 2008 financial crisis and have since called for the Glass-Steagall Act to be re-enacted.
Understanding Firewalls
A firewall refers to the strict separation of banking and brokerage activities within universal banks and between deposit and brokerage institutions. Under the Glass-Steagall Act of 1933, a separate line was drawn between the banking industry and the investment industry, prohibiting a Financial institution (FI) to operate as both a bank and a brokerage firm.
In the early 1930s, nearly 8,000 American banks failed or suspended operations.To restore public confidence in the system, it was deemed necessary to sever the links between banking and investment activities, which were believed to have played an important role in the stock market crash of 1929 and the ensuing depression.
Policy makers have recognized the need to eliminate conflict of interest that happened when the banks invested in securities with the assets of their account holders. Proponents of the bill argued that banks should protect their customers’ savings and checking accounts, not use them to engage in excessive speculative activity.
Based on these findings, a firewall, named after the resistant walls used in construction to prevent the spread of a fire in a building, was put in place to separate banking and investment activities. The aim was to prevent banks from issuing loans which served to drive up the prices of the securities in which they held an interest and from using depositors’ funds to subscribe Stock offerings.
Example of a firewall
Before the Great Depressioninvestors borrowed from margin commercial banks to buy shares. After two decades of rapid growth, people believed that stock prices would continue to rise and that capital appreciation would enable them to repay the loan.
Indeed, the banks used the money of regular depositors to finance the loans, exposing them to high levels of risk. When the Great Depression hit in late 1929 and stocks were bludgeoned, this accepted practice came under intense scrutiny. The government was compelled to act by introducing new reforms in the financial sector which effectively put an end to brokerage activities that put depositors’ money at risk.
Firewall history
Despite some opposition, the Glass-Steagall Act and its firewall went virtually unchallenged for several decades. However, by the 1980s many of its provisions began to be ignored, amid a rise of giant financial services companies, a roar stock Exchangeand an anti-regulatory position within the Federal Reserve and the White House.
Finally, in 1999, the Gramm-Leach-Bliley law (GLBA) was introduced, allowing commercial banks to re-engage in investment banking and securities trading. Section 16 of the Glass-Steagall Act remained in effect, restricting the types of assets in which banks could invest depositors’ funds, although by then many other parts of the law had been repealed, essentially allowing banks to act as securities dealers, and vice versa.
It took 12 repeal attempts before Congress passed the Gramm-Leach-Bliley Act in 1999 to repeal key provisions of the Glass-Steagall Act.
Some politicians and economists claim so deregulation contributed to the 2008 edition financial crisispointing out that the absence of firewalls has led American financial institutions to become too big to fail and too reckless with client funds.Amid this debate, politicians regularly began to call for the reinstatement of the Glass-Steagall Act.
In 2015, a group of senators – John McCain (R-Arizona), Elizabeth Warren (D-Mass.), Maria Cantwell (D-Wash.) and Angus King (I-Maine) – launched a bill for the 21 Century Glass-Steagall Act, calling for a separation of traditional banks from investment banks, hedge fundsinsurance and capital investment activities over a five-year transition period.The bill was read into the Congressional docket and referred to the Banking, Housing, and Urban Affairs Committee, but no further action was recorded. In April 2017, the same senators reintroduced the bill, this time with additional bipartisan support from policymakers, including former President Donald Trump, then Treasury Secretary Steve Mnuchin and former National Economic Council Director Gary Cohn.The bill, however, failed to pass through Congress.