Lecture 1: Banking Models: What should banks be allowed to do?
Types of Banks
- Commercial banks: taking deposits, payment services, and lending
- Investment banks: activities on financial markets, including the underwriting of securities
- Universal banks combine commercial and investment banking activities
Universal Banks
- Universal banking is now available worldwide
- In the US not allowed between 1933 and 1999 (repeal of the 1933 Glass Steagall Act)
- In the EU possible since 1993 (based upon the 1989 Second Banking Directive)
Advantages of Universal Banking
- Economies of scale: economizing on fixed costs of raising capital and on other costs,
such as ICT systems
- Economies of scope: efficient use of information gained from one activity on other
activities; for instance, information gained on the lending client can be used to price
securities such as bonds properly
- Risk diversification: return to commercial and investment banking are not perfectly
correlated
Disadvantages of Universal Banking not related to policy:
- Potential conflict of interest: a bank could sell securities of a firm with low quality in
order to avoid taking losses on its own loan portfolio to this customer
- Complexity may make management more difficult resulting in a worse risk-return
trade-off
- Leaeven and Levine (2007) present evidence on a stock market discount for diversified
banks: the market value of a universal bank is smaller than the sum of the market values
of the commercial bank and the investment bank
Disadvantages of Universal Banking related to policy:
- An investment bank may use funding attracted by the commercial bank that is protected
by deposit insurance
- The universal bank may become “too-big-to fail” and the authorities may have to
undertake a costly bailout of a universal bank in distress
- The purpose of the bailout may be to safeguard the payments system that is facilitated by
the commercial bank, but in practice, the authorities need to bail out the commercial bank
as well as the investment bank
,Short history of Universal Banking in the US
- Before 1933, universal banking was allowed in the US
- Glass-Steagall Act of 1933: separation of commercial banking and investment banking
because of potential conflict of interest in case of issuance of securities for lending
customers
- One way to resolve the potential conflict of interest: banks may build a reputation for
only issuing good securities
- The risk of losing reputation is a check on conflict of interest because reputation is
valuable to the bank
Empirical Evidence on potential conflict of interest
- Kroszner and Rajan (1994) find that before 1933:
- Bonds issued by universal banks had relatively low defaults
- Universal banks with smaller investment banking affiliates underwrote more
senior bonds that are relatively transparent
- Hence, in the 1990s, economic research suggested reintroduction of universal banking in
the US would not be a problem
Gramm-Leach-Bliley Act of 1999
- Also in the 1990s, an increase in the optimal scale of investment banking due to the need
for large amounts of capital and the cost of computing
- Economies of scale can be realized by merging an investment bank with a commercial
bank
- The regulatory response came with the Gramm-Leach_Bliley Act of 1999, which
dismantled barriers to universal banking in the US
Universal Banking and Risk-return options
- Expansion in a bank’s ability to produce a wider set of products or enter new markets
expands the opportunity set
- If these activities are less than perfectly correlated with the existing set, this ability to
diversify risk allows lower risk without surrendering expected return
- Shift of the risk-return curve upwards (figure 9.1 in chapter 9)
- This upward shift of the risk-return curve needs to lead to lower risk-taking because the
actual outcome will depend on the preferences of bank owners and managers
- Bank owners that are more risk averse, having a relatively steep indifference curve, may
choose to increase expected returns and reduce risk
- Bank owners who are less risk averse may choose a combination of higher risk and
higher expected returns
,Endogeneity of Risk-taking
- Risk-taking is endogenous and diversification needs to lead to lower observed levels of
risk
- In empirical research, it is difficult to find a clear and stable link between measures of
diversification and measures of risk
- Saunders and Walter (1994) reviewed 18 studies that examined whether non-bank
activities reduced the risk of Bank Holding Companies and found no consensus
, Lecture 1: ADDITION
1. Banks can be categorized into different types based on their activities. Commercial banks
primarily focus on taking deposits, providing payment services, and lending. Investment
banks, on the other hand, engage in activities related to financial markets, including
underwriting securities. Universal banks combine both commercial and investment
banking activities.
2. Universal banking has become a widespread practice worldwide. In the United States, it
was prohibited between 1933 and 1999 under the Glass-Steagall Act of 1933, but it was
later repealed. In the European Union, universal banking has been possible since 1993,
following the Second Banking Directive of 1989.
3. Universal banking offers several advantages. Economies of scale can be achieved by
reducing fixed costs associated with capital raising and other expenses like information
and communication technology systems. Economies of scope come into play as
information gained from one activity can be efficiently utilized in other activities. For
example, information about a lending client can be used to accurately price securities
such as bonds. Risk diversification is another benefit as returns from commercial and
investment banking activities are not perfectly correlated.
4. However, universal banking also has its disadvantages. Not related to policy, there is a
potential conflict of interest where a bank may sell securities of low-quality firms to
avoid losses on its loan portfolio to those customers. Complexity can make management
more challenging, leading to a worse risk-return trade-off. Empirical evidence by Laeven
and Levine (2007) suggests that diversified banks may face a stock market discount,
where the market value of a universal bank is smaller than the sum of the market values
of its commercial bank and investment bank components.
5. Policy-related disadvantages of universal banking include the possibility of an investment
bank utilizing funding attracted by the commercial bank that is protected by deposit
insurance. Additionally, a universal bank may become "too big to fail," requiring costly
bailouts by authorities. The bailout may aim to safeguard the payments system facilitated
by the commercial bank, but in practice, both the commercial bank and investment bank
may require rescue.
6. In the history of universal banking in the United States, it was allowed before 1933.
However, the Glass-Steagall Act was implemented to separate commercial banking and
investment banking due to potential conflicts of interest when issuing securities for
