What is a Firewall?
Firewall refers to the strict separation between banking and brokerage activities within full-service banks, and between depository and brokerage institutions as stipulated by the Glass-Steagall Act of 1933.
How Does a Firewall Work?
Prior to the Great Depression, investors would borrow on margin from commercial banks and use the money to purchase stocks. Following the logic that capital appreciation in the purchased stocks would offset and be used to repay the loan amount, this practice was legal and considered acceptable, particularly during the period of rapid growth experienced in the two decades prior. This practice, however, exposed ordinary depositors to high levels of risk because the banks were using their money to finance these loans.
The advent of the Great Depression in late 1929 led to numerous government-mandated reforms in the financial industry. The legislation comprised in the Glass-Steagall Act of 1933 put an end to brokerage activities that compromised depositors' accounts.
Why Does a Firewall Matter?
Named for the construction element that keeps a fire from spreading from one area of a building to another, the firewall provision comprised in the Glass-Steagall Act protects depositors from the high-risk environment of investment banking.