Universal Banking
Universal Banking
• Theoretical consideration • Banks have superior information about client firms and thus are qualified to serve as underwriters.
– Universal banking as a solution to agency problem
• Economy of Scope • Spillover • Banks exploit this informational advantage to unload the securities of low quality firms at a larger-than-fair price. • Are banks serving investors, client firms, or their shareholders? • How do self-interested (not naïve) investors react to the potential conflict of interests? • If they are systematically getting bad deals from commercial banks, they will punish commercial banks. • Market discipline should constrain commercial banks from behaving opportunistically!
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Evidence from pre-Glass-Steagall
• • • • • • • • The case of Fox Motion Picture General Theatres and Equipments acquired financially distressed Fox Motion Pictures by borrowing $15 million from Chase National Bank in 1929. In the following year, Chase Securities Company underwrote $23 million of common stocks and $30 million of debentures for GTE to repay the bank loans from Chase. In the following year, Chase again underwrote $30 million of debenture when GTE was in distress. Two years later, GTE was bankrupt. This is just one instance
– No way of making sound public policy.
Did commercial banks systematically fool naïve investors into buying low quality securities to benefit themselves and their client firms? If it was a systematic problem, we should observe poor performance of securities underwritten by commercial banks relative to those underwritten by independent investment banks.
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Evidence from Israel
• • • • • • Permits universal banking Data on the identity of underwriters, buyers of shares, debt holders, equity holders, and performance of firms. How do firms perform after IPO? The average post-issue accounting profitability of firms underwritten by a bank affiliated underwriter that were also borrowers from the same bank in the IPO year, is better than average These firms exhibit negative stock excess returns during the first year following the IPO, as well as negative first day returns which suggests that the negative one-year returns are partly driven by IPO overpricing. The post-IPO stock returns for the (small) sub-sample of firms whose equity was purchased by an investment fund affiliated with the bank underwriter lender exhibited extremely low stock returns both on the first day and during the first year. Banks underwrite good firms. Potential conflict of interests exists
– IPO over-pricing benefit their client firms at the expense of investors.
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Explanation
Fund managers keep buying overpriced shares. Investors are being screwed here. But they are not potted plants. How would you react to this situation? Move your money to investment banks that are free from conflict of interests. • Market discipline should work here! • Why not? • Commercial banks are involved in all the fund managements.
– Investors might not have any choice.
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• Collusion among a few banks.
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Regulatory Implication
• Conflict of interests is real in Israel. • Potentially important variable: competition among banks and independence of fund managers.
Glass-Steagall Act of 1933
• Separation of commercial banking from investment banking. • Concern about spillover • Concern about conflict of interests
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Spillover
• The failure rate of all national banks during the period was 26.3 percent. • Only 7.2 percent of national banks that dealt also in the securities business failed during the 1930 to 1933 period (White 1986).
Agency Problem
• Small dispersed investors do not have strong incentive to monitor and discipline corporate insiders. • Solution? • Dominant ownership and control of firms by wellinformed investors. • Banks are natural candidates. • “J.P. Morgan’s Men” • “Morganized” firms performed better than average.
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More Positive Evidence
• Evidence on the Morganized firms is “black boxy”. • We do not really know why these firms performed better. • If the theory is correct, we expect that bank-affiliated firms will enjoy better access to capital. • These firms faced tighter credit constraints after Glass-Steagall
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Empirical Strategy
• If firms are liquidity-constrained, they should invest less, ceteris paribus. • Investment opportunities are hard to control for. • Liquidity-constrained firms increase (reduce) investment when cash flow increase (decrease). • Liquidity-constraints should show up in the sensitivity of investment to cash flow.
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Recent Development
• • • • Econometric evidence that Glass-Steagal was unjustified. Universal banking has been working well in Europe. Gramm-Leach-Bliley Act (GLBA) of 1999 The formation of a new category of holding company, the financial holding company, which is allowed to own banks as subsidiaries and also own other subsidiaries that engage in all other financial activities.
– – – – – – Underwriting Dealing in securities Sponsoring and distributing all types of mutual funds Insurance underwriting and agency activities Merchant banking Holding insurance company portfolio investments.
• Issue • Extension of financial safety net
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