Glass-Steagall and the Regulatory Dialectic - Economic Commentary - February 15, 1996

Sep 21, 2026

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An Economic Commentary explains how financial innovation and regulation in U.S. banking evolve through a “regulatory dialectic,” resembling a cat-and-mouse pattern between banks and regulators. It argues that constraints created by laws such as the Glass-Steagall Act and interstate banking rules generate incentives for banks to pursue alternative structures, products, and loopholes. The text reviews key examples, including circumvention of deposit-rate ceilings, interstate branching via holding companies, and new instruments targeting restricted activities. It also outlines proposed policy lessons from these interactions.

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Glass-Steagall and the Regulatory Dialectic

Regulatory dialectic and incentives

Financial innovation as regulatory circumvention

Interstate banking and the regulatory dialectic

# Glass-Steagall and theRegulatory Dialectic by Joao Cabral dos Santos CCongress,the Administration,and thebank regulatoryagencies are consideringvarious proposals to usher the U.S.banking system into the twenty-first cen-tury.The pace of financial innovation一spurred by advances in information tech-nology,globalization of the economy,and competition from other financialinstitutions—has made this reform seemlong overdue.However,any clear under-standing of the causes and consequencesof the reform movement must recognizethat some of the financial innovationsthat have sprung up over the last threedecades were specifically designed toavoid regulations that current reformefforts may repeal This interaction sometimes resembles acat-and-mouse game,or what ProfessorEdward Kane has termed the "regulatorydialectic."That is,prohibiting banksfrom adopting a specific path to achieveone of their objectives creates an incen-tive for them to find an alternative routeto the same goal. Financial innovations are generally in-troduced by larger and more aggressivebanks,and then are successively adoptedby other banks until regulators eventu-ally intervene.The nature and timing ofthis intervention are in turn influencedby interactions among the institutionsthat make up the bank regulatory systemand that are ultimately responsible toCongress,which makes the laws.² Like any other industry,banks are inbusiness to earm profits by supplying theproducts that their customers demand.Similarly,the factors that motivate inno-vation in the nonfinancial industry一changes in technology and in the marketenvironment—also motivate innovationin banking.But,because of their centralplace in creating money and credit,banks are considerably more regulatedthan are firms in the nonfinancial sector,and so have an extra incentive to inno-vate:Often,bankers aim to avoid regula-tions that prevent them from exploringprofitable opportunities as they arise. The last four decades have providedample evidence of how banks attempt tocircumvent regulations.In general,theyeither develop new financial products orchange their organizational structure.Banks avoided deposit-rate ceilings bymaking implicit interest payments(forexample,they offered gifts to depositorswhen market interest rates rose abovethe regulatory ceiling).They attemptedto overcome the prohibition on interstatebranching by creating bank holdingcompanies(BHCs)with banks in multi-ple states.And they circumvented theGlass-Steagall Act by developing newfinancial products,like MID(market-indexed deposit)accounts. Although some financial innovationseventually become accepted practices,others are blocked by new regulations.These regulations motivate banks todevelop other innovations,which in turnprompt further action by the regulators. The first half of this Economic Commen- tary presents a brief review of the inter- February 15,1996 The Glass-Steagall Act,passed a fewyears after the Great Depression,pro-hibited U.S.commercial banks fromengaging in investment banking activ-ities.This has led to the same costlycat-and-mouse game as did the prohi-bition against interstate banking.Bankers often develop financial inno-vations aimed at exploiting gray areasin the law,and regulators respond bysuccessively closing each loophole.Hence,in designing regulations,itseems sensible to take banks'incen-tives into account. actions among banks and regulators asbanks attempted to expand their activi-ties across state lines.The second halfdiscusses whether any lessons fromthose interactions can be applied to theongoing debate over reforming theGlass-Steagall Act. # ■ Interstate Banking andthe Regulatory Dialectic Banks'efforts to circumvent the regula-tions that prohibit interstate banking一and regulators'subsequent reactions一are a classic example of the regulatorydialectic.Since the 1950s,banks havetried to exploit the loopholes in theseregulations by changing their organiza-tional structure or by altering their port-fol

FAQs

What does the “regulatory dialectic” describe in this text?

It describes how banks respond to prohibitions by finding alternative routes to similar objectives, and how regulators later adjust rules in response to new innovations.

Why are banks portrayed as more motivated to innovate than nonfinancial firms?

Because banks occupy central roles in creating money and credit and therefore face heavier regulation, giving them stronger incentives to seek profitable opportunities within or around restrictions.

How did banks attempt to circumvent interstate banking restrictions?

They first used multibank holding companies and, after legislative responses like the Douglas Amendment, shifted toward one-bank holding companies with nonbank subsidiaries to expand activities across state lines.

Sep 21, 2026

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