The Long and Bumpy Road to Glass-Steagall Reform: A Historical and Evolutionary Analysis of Banking Legislation - Other Articles - Glass-Steagall Banking Act of 1933

American Journal of Economics and Sociology, The,  Oct, 2001  by Jill M. Hendrickson

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III

History of the Relationship Between Commercial and Investment Banking

PRIVATE BANKS (unincorporated) generally conducted two types of business: investment and/or general banking. During the first decade of the 20th century the majority of private bankers involved in securities catered to large institutions and businesses only. These large institutions, such as J. P. Morgan, engaged in underwriting, buying, and distributing new issues and usually did not accept deposits from the general public, only from corporate clients, friends, and employees (Carosso 1970:89). Consequently, the financial needs of the smaller retail companies and other small enterprises seeking to go public were unmet. This provided an opportunity for another small group of private banking and brokerage houses to become underwriters. Those accepting this opportunity were private bankers such as Goldman, Sachs and Co. and Lehman Brothers.

An informal code of ethics regarding competition among and between private bankers ruled securities dealings, including mutual respect for their respective client bases. More formally, often original purchase or underwriting contracts included a clause requiring the corporation to offer all additional securities over a specified period through the originator's firm. In this way competition was kept to a minimum between large private banking and investment institutions.

At the turn of the century, state commercial banks began deviating significantly from their orthodox role as lenders of short-term industrial credit by becoming important suppliers of credit in the securities field. State commercial banks became involved in securities partly through direct purchases of securities for the banks' own asset portfolios and partly through the granting of call loans. Moreover, their bank credit was primarily secured by stocks and bonds as collateral. Though it is not known exactly how much commercial bank credit was allocated to investment purposes during this time, it has been estimated that one-half of their credit in 1909 went for loans or purchases of securities (Krooss and Blyn 1971). State commercial banks usually conducted their securities business through bond departments established to handle the bank's own investments.

Following the Civil War there had been an explosion of new securities issued to finance railroads leading to the western United States and the expansion in public utility fields. Many state chartered banks had taken advantage of this opportunity by furthering their involvement in securities underwriting. Historically, national banks were barred from underwriting or dealing in corporate stocks by the absence of any legal power to do so in the National Bank Act (Nichols 1984). Thus, while the boundaries for national banks' involvement with corporate securities were not expressly stated, the National Bank Act was interpreted and implemented such that corporate security dealings were banned. Eventually, several steps were taken to explicitly keep national banks from underwriting corporate stocks. By a 1902 ruling of the Comptroller of the Currency, national banks had no legal authority to underwrite corporate securities (Litan 1987). In addition, several court hearings during the turn of the century prohibited national banks from engaging in commercial securities activity. Beginning with the First National Bank of New York in 1908, national banks responded to these restrictions by creating holding companies under state chartered affiliates that could then underwrite corporate securities and engage in securities dealings (Nichols 1984).