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FRBSF
WEEKLY LETTER
December 29,1989
Do Banks Need Securities Powers?
In the United States, interactions between
commercial banks and U.S. businesses are
severely restricted. Banks can make loans to
businesses and purchase investment-grade corporate debt, but banks are not allowed to hold
either corporate equity or below-investmentgrade debt. The investment banking restrictions
imposed by the Glass-Steagall Act, moreover,
limit the ability of commercial banks to underwrite and market the securities of U.s. corporations, and limit the types of securities that banks
themselves may issue.
Comptroller of the Currency in the 1890s. They
began providing such services again through
affiliates, and by 1927, were the dominant
providers, performing over 60 percent of all
corporate bond underwriting. When the banking
affiliates were disbanded by law in 1933 and
replaced by independent investment houses,
total capital in the u.s. investment banking
business fell by two-thirds. This suggests that the
market believed that independent investment
banks were likely to be less effective than those
affiliated with banks.
These restrictions frequently are blamed for
the dramatic decline in the prominence of U.S.
commercial banks in world financial markets.
Whereas U.s. banks had over 30 percent of total
world banking assets in 1970, they have less than
10 percent today. Similarly, no U.s. bank currently is among the world's top 20 banks. Foreign
banks, in contrast, have broader powers, which,
some argue, have enabled them to grow through
profitable diversification of their holdings and
activities in the securities area. Many worry that
u.s. banks' ability to compete will deteriorate
further if the European banks adopt, as planned,
the universal banking model in 1992.
Indeed, in countries outside the u.s. where
integration has been permitted, banks are the
dominant investment bankers. In the "universal
banking" systems of Germany, Switzerland, and
Austria, for example, there is virtually no separation of commercial and investment banking, and
banks hold, underwrite, and broker corporate securities. The European Community has identified
the universal banking system as the model for the
EC when Community-wide banking is permitted
in 1992.
A number of issues must be resolved before bank
powers can be expanded, including concerns
over propagation of the banking safety net. This
Letter, however, argues that more is at stake in
the expansion of commercial banking into the
securities area than the simple diversification advantages often claimed for expansion of powers.
Without the ability to underwrite, hold, and
create a variety of securities, U.s. commercial
banks will become increasingly handicapped at
providing even their primary financial service,
loans to commercial enterprises. In addition,
contrary to the conventional view, expanded
powers actually may improve the self-discipline
of the banking system against risk taking.
A strong affinity
Historically, investment banking and commercial
banking have tended to be integrated. In the
United States, commercial banks were providing
investment banking services as early as 1812,
and continued to do so until prohibited by the
In japan, there is greater legal separation of
banking and securities powers than in the true,
universal banking countries; japanese banks may
not underwrite securities, for example. Crossshareholding among banks, insurance companies
and securities houses, however, creates a high
level of de facto integration of banking, investment banking, and commerce. Virtually all of the
top securities firms and insurance companies are
associated with a "main" bank in these so-called
"keiretsu" groupings.
In addition, banks may hold significant equity
interests in industrial firms. At present, banks
may hold directly up to five percent of their
assets in the equity of industrial corporations
(10 percent, before 1987), and more through their
affiliated insurance companies. Banks and their
affiliated insurance companies hold roughly 30
percent of all corporate equity in japan.
What do investment bankers do?
To understand why banks with broad securities
powers are dominant (where they are permitted),
it is necessary to understand the economic
FRBSF
purpose served by the underwriting process,
and the purpose served by bank ownership of
corporate equity.
The underwriting function is the major function
of an investment bank. When a corporation seeks
to sell securities to investors, it must overcome
certain "information asymmetries" that exist in
the marketplace. In particular, the corporation
seeking funds has better information regarding its
future prospects than do investors, and investors
may fear that the reported prospects are overstated. For this reason, without reliable, additional information to the contrary, the market
may value the corporation's securities at a level
below their true value, to the detriment of the
corporation's funding efforts.
Since investors generally cannot afford to develop
their own information channels, a third partyan investment bank-frequently is called upon
to help bring the sellers and buyers of the
securities together. To resolve the information
asymmetry, the investment banker must obtain
information of nearly the same quality as that
held by the corporation itself. It obtains this
information through independent research and
investigations of the financial condition of the
firm, and by exploiting the close relationship it
often has as the firm's prior underwriter and even
shareholder or director.
Once it has obtained the necessary information,
the investment banker must persuade investors
of the quality of this information if the information asymmetry is to be overcome. Investment
bankers gain investor confidence essentially by
developing a reputation for accurate representation. The investment banker's reputation thus is
extremely important in the underwriting process;
reputation even determines the order in which
the participating investment banks are named in
the newspaper "tombstone" announcements of
new underwritings. Since investment banks put
this valuable "reputational capital" at risk
whenever they underwrite a new security, the
incentive to misrepresent the issuing firm's prospects and thereby exploit investors is diminished.
Benefits of integration
Investment bankers' ability to resolve information
asymmetries is not perfect. Indeed, the most information-sensitive issues, initial public offerings,
.still sell when issued at prices significantly below
their ultimate market price. Nonetheless, resolution of information asymmetries is at the heart
of investment banking. It also provides possible
explanations for the apparent dominance of
universal banks over single-function commercial
and investment banks.
First, there may be economies in the joint
provision of investment and commercial banking services. Specifically, the skills investment
banks require to underwrite and market corporate securities are analogous to those needed to
evaluate, monitor, and market bank assets and
liabilities. As a result, an organization that
combines both functions may be able to do
so more cheaply than can two stand-alone
organizations.
A second, and possibly more important, reason
for the dominance of the universal form of
banking is that such an arrangement may
enhance banks' ability to monitor and manage
the risks associated with their lending activity,
thereby improving the risk-adjusted return
enjoyed by banks. Conventionally, a commercial
bank's means of controlling adverse behavior are
limited to invoking loan covenants and withdrawing loan funding. The underwriting relationship available to a universal bank enhances this
channel of influence, since a corporation that
performs badly on its loans is at risk also of
losing access to reputable underwriting and,
hence, to other economical sources of funds.
Likewise, a universal bank's ability to own the
equity of the borrowing firm permits the lender
to participate in the firm's management, thereby
directly influencing the decisions to take on
risks. Inessence, holding some of the equity
helps resolve the incentive borrowers always
have to take advantage of lenders by taking on
riskier projects than the lender had anticipated.
Interestingly, this combined shareholder/lender
role played by universal banks is precisely analogous to the "stapled" debt and equity financing
("strip" financing) employed in some takeover
restructurings in the U.S. industrial sector.
Financial economist Michael Jensen has argued
that such combined positions in both debt and
equity improve corporate control and, thereby,
corporate efficiency. U.s. bank regulation, however, restricts such multi-security investments
by banks.
The evidence
Contrary to the views of some proponents of
expanded securities powers, therefore, the advantages of blending investment and commercial
banking may not come from enhanced opportunities for diversification. Indeed, evidence
suggests that diversification alone cannot explain
why universal banking dominates single-function
banking. Economists at the Federal Reserve Bank
of Minneapolis have looked for advantages
arising from diversification by studying the covariance of returns to banking and non-banking
activities. They found few benefits from diversification. In any event, the benefits of diversification should be available to investors simply by
owning equity in both commercial and investment banks; a physical joining of these
enterprises is not necessary.
There is, however, anecdotal evidence that equity
holdings and/or underwriting relationships offer
the advantages in information or incentives control hypothesized earlier. In both Germany and
Japan, for example, banks are permitted to hold
corporate equity and establish close working ties
to nonbank business. Businesses in both countries obtain more of their financing from banks
(and less from direct placement markets) than in
the United States. In Germany and Japan, about
75 and 80 percent, respectively, of corporate financing comes from banks, versus 40 percent in
the United States. Although this may be partly a
result of constraints on the primary securities
markets in Germany and Japan, the pattern also
is consistent with the argument that a more effective monitoring process stimulates bank lending.
In both Germany and Japan, economic historians
attribute the rapid pace of economic development partly to the close financial relationships
between industrial and financial firms. In Germany, these relationships took their current form
in the late 1800s and, it is believed, contributed
to the rapid economic development that subsequentlyoccurred.
In Japan, there is a similar association in time
between economic performance and broad
bank securities powers. Fifty years ago, Japanese
corporations obtained only about five percent of
their financing from bank loans, and as recently
as 1950, financial corporations owned less than
10 percent of corporate equity. Japan's rapid
economic development since that time has
coincided with increased bank participation
in finance.
The variations in finance patterns across Japanese
firms today also are consistent with the notion
that expanded financial powers facilitate bank
lending activity. The Japanese firms with the
strongest equity links (members of the "keiretsu"
industrial groups) rely on bank lending to a
greater degree than other firms. In fact, they
employ debt-finance overall to a greater degree;
keiretsu members have a debt-ta-equity ratia that
is 50 percent higher than non-member firms.
This suggests that bank relationship in Japan
may help to resolve the information-asymmetry
and incentive-control problems generally associated with debt finance.
More stability?
Broadening the securities powers of banks
also may enhance the stability of the economy.
Economists Hoshi, Kashyap, and Scharfstein,
for example, find that the firms associated with
keiretsu in Japan tend to alter their investment in
plant and equipment less abruptly in response to
changes in cash flow than do other firms. To the
extent that such effects result in less volatile
investment in the aggregate, the attendant
changes in business activity may be less
exaggerated.
We have not discussed the complex issues
of the bank safety net and deposit insurance
which, in the U.s., are important considerations
of bank powers reform. It is possible, however,
that integration of securities powers into
banking could actually reduce potential claims
on deposit insurance. One channel of such influence would be via the improved loan monitoring
that expanded securities powers would permit.
In addition, however, maintaining a high level
of reputational capital is critical to effective
investment banking. Such reputational capital
can be viewed as a goodwill "asset" of a universal bank that would be lost or diminished if
the banking firm were perceived to be engaging
in overly risky behavior. This may provide an
important, internal discipline against risk-taking.
Randallj.Pozdena
Vice President
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
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