Federal Reserve Bank of San Francisco

FRBSF Economic Letter

1998-21 | July 3, 1998

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The Separation of Banking and Commerce

John Krainer


On May 13, the House of Representatives passed H.R.10 and took the nation one step further towards financial service reform. If passed by the Senate and signed by the President, this bill would dismantle part of the Depression-era Glass-Steagall Act by bringing down the barriers preventing unions between banks, securities firms, and insurance firms.

But two features of the action on H.R. 10 show that the debate over the nature and scope of financial services reform is hardly over. The bill passed by the slimmest of margins–214-213. And, at the last minute, an amendment to the bill deleted the portion that would have allowed banks to engage in commercial activity. This amendment leaves in place restrictions on banks’ ability to take equity positions in firms as well as a prohibition against commercial firms owning banks.

This Economic Letter focuses on the banking and commerce debate and addresses two key questions: Why might banks and commercial firms want to affiliate, and why are lawmakers hesitant to allow these affiliations?

Banking and commerce, then and now

Banking and commerce have not always been separate in the U.S. Indeed, banks such as Chase Manhattan and Wells Fargo first emerged as the finance arms of commercial enterprises. Around the turn of the last century, banks routinely took equity positions in commercial firms and sat on company boards. Cantillo (1995) reports that in 1912 bankers sat on the boards (and, hence, may have exercised control) of companies accounting for 56% of GDP. These close relations did not go unnoticed. President Teddy Roosevelt and jurist Louis Brandeis argued that such relationships were dangerous because banks could use their positions on multiple corporate boards to encourage collusion. Eventually, the fear of a concentration of economic power in the hands of banks led to the Clayton Act, which prohibited interlocking directorships. Later, the 1929 stock market crash and subsequent bank failures drew attention to the fragility of the financial system. The Glass-Steagall Act and later the Bank Holding Company Act reduced the scope of operations for banks and created a separation between banking and commerce.

But this separation is not absolute. An individual can legally own controlling interests in both a bank and a commercial firm. In addition, bank holding companies can hold up to 5% of the voting stock and up to 25% of the voting and nonvoting stock in any firm. National banks can receive part or all of the interest payments on loans in the form of warrants or “equity kickers,” and can own a 5% stake in a venture capital firm that owns up to 50% of any firm. Finally, banks often take equity stakes in firms that have defaulted on their loans.

Unitary thrifts (thrift holding companies that own a single savings bank) have wide latitude to engage in commercial activities. Approximately one-quarter of the unitary thrifts currently use their commercial powers to operate in real estate development, as well as insurance sales and underwriting. Commercial firms can purchase thrifts. In the 1980s, firms such as Ford Motor Company and Sears Roebuck bought thrifts. The recent flood of applications for new thrift charters, however, has come mainly from nonbank financial firms.

Why would banks and commercial firms want to merge?

Firms in any industry choose to merge because they believe they will be more profitable together than they are apart. One compelling argument for efficiency benefits in mergers between banks and commercial firms is that a combination between two firms may result in the profitable delivery of new products. This enhanced profitability could emerge from operating synergies between the two firms. It could also be the case that the merged entity is able to reduce average costs by producing a wider array of complementary products. Because combinations between banking and commerce are not pervasive in the U.S., whether or not banks could exploit these scope economies by merging with commercial firms is mainly a speculative matter. There is reason to believe, however, that such unions might prove increasingly attractive in the future. As new technology has changed the way banks deliver their services, bank cost structures have come to look more like the cost structures of other nonbank information providers. Banks with excess data processing capacity, for example, would want to fill that capacity by offering services to other companies. Some national banks have leveraged their positions as providers of on-line banking to offer other internet services to their customers. It is even easier to imagine that established internet service providers would want to add banking services to their list of products.

Another benefit of linking banking and commerce relates to reducing information costs. One of the basic functions of a bank is to take in deposits and to provide finance to firms and other people in the economy. It is natural for banks to perform this service because they can gather information about borrowers more efficiently than individual depositors can. It is plausible, then, that banks would want to own firms (i.e., hold equity) in order to enhance their position as intermediaries. For example, by holding a large block of equity or by sitting on a company’s board, a bank could provide a source of discipline to the management that would reassure less-informed investors. Liability to other creditors in the case of bankruptcy would tend to discourage banks from exercising control at the riskiest companies. But for many companies, this risk would be outweighed by the benefit the bank could provide by reducing financial constraints.

Another information-related reason for banks to hold equity is to reduce their exposure to moral hazard. If it is difficult for a lender to monitor a borrower’s risks, limited liability borrowers will have incentives to increase the risk in their operations. Banks who anticipate this risk-shifting will either charge a higher price for the loan or demand more collateral. One way a firm can overcome this problem is to offer the bank an equity claim. The case of start-up ventures is a good illustration. By definition, start-ups have no track record on which to base an investment decision. Moreover, start-ups typically have little capital of their own and few tangible assets with which to collateralize a bank loan. If banks are to provide finance to these firms, they would need to take an equity claim.

It is important to note that these motives for banking and commerce affiliations produce very different predictions about ownership. If banks affiliate with commercial firms in order to reduce operating costs, then we should be equally likely to observe banks buying non-financial firms as we observe the reverse. If the affiliations are made for the sake of reducing information costs, then it is more likely that banks would be the buyers.

The risks surrounding banking and commerce

Policymakers should have no objections to mergers that lower operating costs or improve the flow of information between firms and their investors. But they are concerned about other potentially adverse outcomes associated with the union of banking and commerce. The Depression-era legislation that separates banking and commerce was originally designed to check banks from exercising undue influence over the commercial sector. The same fears of uncompetitive practices persist. But whether these fears are justified or not depends on how competitive markets are in the first place. For example, a bank could charge above-market rates to creditworthy competitors of its commercial affiliate, but only if there were no other lenders to step in and offer the market rate. Likewise, a bank could charge below-market rates to its own affiliate (or its affiliate’s suppliers or customers), but would only do so if the affiliate could recoup this loss by producing above-market returns in its own market.

The issue of whether a bank would provide cheap financing to an affiliate takes on an added dimension when one considers that bank deposits are insured. Deposit insurance is part of the federal safety net and can act as a form of subsidy to bank borrowing. Bankers and many academics argue that this subsidy is offset by regulatory burden. However, if the marginal value of the subsidy is positive, then a commercial affiliate will have an incentive to appropriate it. A related concern is that the value of deposit insurance is greatest (to a bank) when the bank holds risky assets. Given their current powers, banks, of course have plenty of risk-taking opportunities to exploit the deposit insurance option. The question, then, is whether there is something intrinsic about the relationship between banking and commerce that would encourage banks to take greater risks than they otherwise would. Surprisingly, little research exists on this question.

Another threat to the safety net depends on the extent to which depositors perceive that trouble in a bank’s affiliate could cause trouble in the bank itself. For example, a troubled commercial firm might have an incentive to shift bad assets to its banking affiliate (and exercise the deposit insurance option); or, a bank, in order to preserve its reputation, might have an incentive to bail out a struggling affiliate. In a worst case scenario, problems at a commercial affiliate could cause runs on the bank’s deposits.

International comparisons

We can shed some light on what the U.S. experience might be like by looking at the experiences of Germany and Japan. Germany has a universal banking system that places virtually no restrictions on bank investments or commercial firm investments in banks. Japanese law does place restrictions on bank equity holdings. However, banks are alleged to exert more control over corporations than their U.S. counterparts due to the interlocking directorships within the keiretsu system.

In Germany and Japan, banks exercise their right to hold equity in commercial firms, but it is unusual for commercial firms to own banks. This lopsided ownership pattern suggests that, in these two countries at least, operating synergies or cost reductions related to product mixes are not the primary motive for banking and commerce relationships. German and Japanese bank investments are often in large companies and appear to be made for the sake of enhancing the banks’ monitoring capabilities. Banks in these countries play a role in corporate governance that is filled in part by active shareholders in the U.S.


This Letter has attempted to lay out the incentives banks might have to engage in commercial activities and to explain why policymakers are hesitant to permit these relationships. Since the Glass-Steagall barriers are in place, it is difficult to say whether the gains to linking banking and commerce would be greater or less than the potential costs. Under the best of conditions, regulators need to be vigilant lest the safety net be exploited. Clearly, this task would be made more difficult if banks are allowed to affiliate with commercial firms. But one of the aims of this Letter has been to suggest that the potential benefits of linking banking and commerce are real and could grow in the future. If, someday, lawmakers choose to augment bank powers, they should proceed cautiously and with a mind to ensuring that the safety net does not extend beyond the banking sector.

John Krainer


Cantillo, M. 1995. “The Rise and Fall of Bank Control in the United States: 1890-1920.” Haas School of Business, Finance Working Paper #254.

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