FRBSF Economic Letter
98-21; July 3, 1998
The Separation of Banking and Commerce
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.
Conclusion
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
Economist
Reference
Cantillo, M. 1995. "The Rise and Fall of Bank Control in the United States:
1890-1920." Haas School of Business, Finance Working Paper #254.
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 or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
