Economic rationale for separation of conventional and merchant banking - I

Generically, conventional banking was evolved to make deposits and conducting lending to the customers with the aim to develop trade, commerce and industry in a country. Industrial development in the western society needed huge capital that was dominantly financed by the state, then by the banks and financial institutions and subsequently capital market equity financing.
Since the USA became the engine of capitalist development, financing through equity took lead compared to state and banking finance. Currently, financial systems of major industrial countries are dominated by equity financing.  For example, UK (55per cent+) and USA (65per cent+) and market economics more than 50 per cent of total financial system. Banking sector also involved itself in the stream of equity financing. The central objective of this paper is to question whether conventional banks should enter into merchant banking, which has been a long discussion point among economists, regulators, and politicians. Advocates supporting the proposition argue that commercial banks can exploit their information of the borrower in the merchant banking business and increase business opportunity by participating in equity financing, underwriting and IPO placement. An analysis of the effects associated with the commercial banks' expansion into the securities business, particularly the underwriting of corporate securities should consider why commercial banks exist in the first place. Traditional literature focused on banks' provision of payment and portfolio services. In contrast, contemporary theory of financial intermediation emphasises the banks' role as providers of liquidity, as well as delegated monitors in environments, characterised by asymmetries of information among participating agents. Within the framework adopted in the modern literature, it is usually conjectured that the commercial banks' mainly gain from expansion into the securities business from their information advantages and economies of scope.
INFORMATION ADVANTAGES: Firms generally have information regarding their clients' creditworthiness and about relevant features of their investment projects that is not readily available to outsiders. Some firms can reduce the information gap by contracting with an independent agent (a rating agency) that conveys the relevant information to outsiders and at the same time certifies its quality [(Holthausen and Leftwich (1986), Stickel (1986) and Hand, Holthausen and Leftwich (1992)]. Under these circumstances, important savings can be achieved by delegating certain functions to financial intermediaries. The cost of financial intermediation are reduced by avoiding  duplication of functions such as gathering relevant information about the borrower [Diam ond (1984) and Ramakrishnan and Thakor (1984), James (1987), Mikkelson and Partch (1986), Lummer and McConnell (1989), Slovin, Johnson and Glascock (1992), Best and Zhang (1993), Diamond (1991), Best and Zhang (1993)].
As a result, bank financing tends to be more expensive than public financing, thus explaining why firms tend to avoid the former type of funding. Moreover, some firms may also avoid bank funding to avert the additional scrutiny that usually comes with it. Because of this, firms with a higher reputation (usually larger firms) tend to raise funding directly in capital markets, while smaller and younger firms tend to rely on banks [Diamond (1991), Rajan (1992), Fulghieri (1994) Yosha (1995)]. This deepening of the bank-firm relationship may be a source of important gains to both parties. A "wider" bank-firm relationship may be a source of scope economies. It allows the bank to learn more about a firm by observing its behaviour with respect to more financial instruments, and it gives the bank the opportunity to use this information to monitor a firm's activity rather than just in lending decisions. Furthermore, by offering a larger number of services, a universal bank has more instruments to consider in the design of financing contracts. It also allows for more leverage over firms' managerial discretion, thus reducing agency costs. Empirical research on these scope economies is still very limited, but the results gathered so far already reflect consistency in the advantage of "widening" bank-firm relationship. Petersen and Rajan (1994), for example, find that the larger number of services provided by a bank leads to a greater availability of funding for its clients'.
ECONOMIES OF SCOPE: Economies of scope are pivotal to the efficiency of financial conglomerates in general and universal banks in particular. They may arise both from the production of financial services and from their consumption. Regarding production, economies of scope are said to exist when the cost of one organisation producing a given mix of products is less than the cost of several specialised firms producing the same bundle of products. Baumol, Panzar and Willig (1981) suggest that economies of scope in production arise when there are inputs that are shared or used jointly.
POTENTIAL COSTS OF UNIVERSAL BANKING: The most frequent arguments for maintaining the separation between commercial banking and the securities business is that combining the activities would create serious conflict of interest and would consequently threaten the safety and soundness of the banking system.
CONFLICTS OF INTEREST:  Edwards (1979, p. 282) defines conflicts of interest as follows: "A conflict of interest exists whenever one is serving two or more interests and can put one person in a better position at the expense of another." Bröker (1989, p. 228) states that "a conflict of interest arises for a bank …dealing with a client if it has a choice between two solutions for a deal, one of which is preferable from its own interest point of view while the other represents a better deal for the client. A conflict of interest arises also for a bank … if it carries out activities involving two different groups of customers and if it has to strike a balance between the respective interests of the two customer groups." In light of these definitions, it becomes clear that even the existing specialised institutions face many situations where conflicts of interest may develop. Naturally, as financial institutions offer more products, and as the set of customers expand, so do the possibilities for conflicts to emerge. With respect to commercial banks' expansion into the securities business, conflicts of interest are said to arise because of the bank's advisory role to depositors (the bank may promote the securities it underwrites, even when better investments are available in the market) and because of its role as a trust fund manager (the bank may "dump" into the trust accounts it manages, the unsold part of the securities it underwrites).
Conflicts of interest may also develop because of the bank's opportunity to impose tie-in deals on customers (the bank may use its lending relationship with a firm to pressure the firm to buy its underwriting services under the threat of increased credit costs or non-renewable of credit lines). Moreover, bank has the ability to design deals aimed at transferring bankruptcy risk to outside investors (the bank may pressurise a borrower that is in financial difficulties to issue securities that the bank will underwrite and sell to the public with the understanding that the proceeds of the issue are to be used to repay the loan) [Rajan (1994), Puri (1995) and Kanatas and Qi (1995)]. Finally, conflicts of interest may also arise because of "inside information" (the bank may use the confidential information that it learns when it underwrites a firm's securities in a way that the firm did not contemplate, so as to disclose that information, directly or indirectly, to the firm's competitors)[Edwards (1979), Saunders (1985a), Kelly (1985b) and Benston (1990)].
BANK SAFETY AND SOUNDNESS: It is frequently argued that the failure of a bank, particularly of a big bank, may have a domino effect, forcing other banks (solvent and insolvent) into bankruptcy and creating a system failure (Calomiris and Gorton,1991). A bank may fail because of liquidity problems or because of other problems, such as a systemic shock (a deep recession, for example, may lead to a situation where the bank's losses exceed its capital) or fraud. In most countries, the desire to protect banks from runs on their deposits and to reduce the risk of a system failure, led to the development of governmental deposit insurance systems and discount window facilities (Diamond and Dybvig, 1983). However, these mechanisms create problems within themselves. Most notably, they reduce depositors' incentives to monitor banks and they give banks incentives to take excessive risk (Calomiris and Khan (1991), Diamond and Dybvig (1983), Kareken and Wallace (1978), Merton (1977, 1978) and Dothan and Williams (1980), Schwartz (1992).
PROFIT AND RISK IMPACT:  The deregulatory period with increased investment banking activities through Section 20 subsidiaries and the repeal of Glass-Steagall have increased the share of banks' non-interest income. This diversification and change in source of income has arguably had an impact on banks' profitability and risk. For example, Freixas et al. (2007) shows that financial conglomerates utilise excessive risk-taking due to their access to the safety net, and that this effect wipes out any diversification benefits. Moreover, a study from Yeager et al. (2007) failed to find significant diversification benefits within the financial service industry after the enactment of the GLBA. Yeager et al. (2007), however, argue that if synergies between commercial and investment banking arose, they were most likely captured in the 1990s due to the evolution of Section 20 subsidiaries.
 MARKET VALUE IMPACT: A study from Ramirez (2002) investigates whether security affiliates had any impact upon banks' market value during the 1920s. When combining commercial and investment banking, economies of scale and scope should eventually translate into a higher stock market value. Ramirez (2002) concludes that banks' security affiliates added 4 to 7 per cent to the market value of commercial banks in 1926 and 1927. This could explain the substantial increase in the share of American banks that became involved in securities underwriting during the 1920s, increasing from 277 banks in 1922 to 591 banks in 1929 (Peach, 1941). Additionally, Ramirez (2002) provides an estimate of the direct cost for banks when they are not allowed to combine commercial and investment banking. The direct cost per bank was about $8 million in 1927's dollar value, roughly equivalent, according to Ramirez, to approximately $61.5 million per bank in the dollar value of 1999. Although Ramirez (2002) estimates a cost for banks, he argues that one should be careful when interpreting these numbers; the private profits that seem to appear when combining commercial and investment banking do not necessarily translate into a loss for society in general. Consistent with Ramirez's (2002) Great Depression era study, Czyrnik and Klein (2004) find that the repeal of the GSA increased the market value of commercial and investment banks. Also Neale et al. (2010) find that the enactment of the GLBA was associated with an overall positive reaction in share prices for all kinds of financial service firms.

The writer, an FCA and a Ph.D, is Chairman, Emerging Credit Rating Ltd. The article is adapted from a paper he presented at a seminar jointly organised by the Bangladesh Young Economists' Association and Emerging Credit Rating Limited on October 17, 2014.
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