The Regional Economist -April 2000

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n March 11, 2000, the U.S. banking industry truly entered the new millen-

nium because, on that date, many provisions of the Gramm-Leach-Bliley

(GLB) Act went into effect. GLB repeals those sections of the Banking Act of

1933—commonly known as the Glass-Steagall Act—that separated commercial

and investment banking in the United States for nearly 70 years. Gramm-Leach-

Bliley also allows affiliations between commercial banks and insurance firms.

Under GLB, the U.S. banking system is now much closer to the universal system

common in many European and Asian countries than to the specialized system

most Americans have grown up with.1

A New Universein BankingAfter Financial Modernizationby Adam M. Zanetsky

The removal of the wall between commercial andinvestment banking has essentially created one-stopshopping for consumers' financial needs—banks cannow do it all, so to speak. Need a loan? Go to the bank.Want to buy securities? Go to the bank. Want life insur-ance? Go to the bank. Need batteries? Go to Wal-Mart.(Okay, banks can almost do it all.) This new system willincrease competition among the various types of finan-cial companies, which should result in better service,greater availability of all types of financial services and,perhaps, lower prices.2 The combination of commercialand investment banking is not new territory for theUnited States, however. Although most current genera-tions cannot remember when the two were combined,those alive in the 1920s and early 1930s (prior to Glass-Steagall) remember when commercial banks regularlyengaged in securities underwriting and transactions.

Why Divide in the First: Place?

Historians and economists have long studied theevents leading up to the passage of the Glass-SteagallAct in 1933. At the time—remember, this was during theGreat Depression—popular belief held that one of themajor causes of the Depression was banks'engagementin risky ventures through securities underwriting—thatis, guaranteeing a firm a specified price for its debt orequity issuance. After the 1929 stock market crash, andalong with the severe economic downturn of the era,

banks began to fail in record numbers. For example, thenumber of U.S. commercial banks declined 43 percentbetween December 1929 and December 1933, as reportedby economist David Wheelock in a 1993 article. Thesecurities affiliates of these commercial banks thenbecame the scapegoats for the failures. These failuresin turn became the ammunition that Sen. Carter Glass—who was already staunchly opposed to banks operatingsuch affiliates—needed to push through legislationseparating the two.3 The rest, as they say, is history.

Today, however, economists widely reject the notionthat commercial banks' engagement in forms of invest-ment banking led to their eventual failures. Rather,economists now point to poor Federal Reserve policy,which contracted the money supply in a time of greatneed, and strict branching restrictions as the primary rea-sons.4 Bank failures resulted more from illiquidity (or, inmany cases, insolvency) and undiversified portfolios thanfrom mismanagement and shady dealings. That said,these facts were not known or not understood in the1930s, leading Congress to separate the two activities onthe belief that doing so would prevent similar economicepisodes from occurring in the future.

The negative sentiment toward the commingling ofinvestment and commercial banking—and the potentialconflict of interest that such a commingling couldencourage—was not pervasive during the period,though. As economist Eugene White wrote in a 1986article, "[I]n the 1920s, some financial writers worried

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about the [conflict of interest] withina bank to [both] promote the securitiesof its business customers and...give pru-dent investment advice to its depositor-investors. Comments of this naturewere a minor dissonant note while thestock market was healthy (emphasisadded)." Still, the concerns about con-flicts of interest have resonated over time,even to the most recent debate about theseparation and its eventual repeal.

Unbiased FinancialAdvice?

The potential conflict of interest thatarises from the intertwining of commer-cial and investment banking has arguablybeen one of the most hotly debated

issues—in both academia andCongress—when lawmakerswere deciding whether tocombine the two practicesunder one roof. For exam-ple, commercial banks aresupposed to offer disinter-ested financial advice to

their customers.Investmentbanks, though,might also play

somewhat of a pro-motional role for their

clients, especially when underwrit-ing securities. When commercial

banks assume both roles, the questionis which will take precedence: promot-

ing securities or proffering disinterestedadvice? Although the two goals neednot necessarily be contradictory, they maymake the banking industry face criticismsimilar to what the Federal AviationAdministration, which has the dual roleof promoting air travel and regulating itssafety, recently had to fend off.

One difference from the FAA's situa-tion is that, to stay in business, a bankmust attract and keep customers. If, forexample, a bank were to engage in dis-honest dealings, and customers were tobecome aware of them, the bank wouldlikely lose customers. This brings up asecond difference in these situations:A bank has shareholders to worry about.If shareholders become unhappy witheither a bank's performance or the valueof its stock, they can replace the bank'smanagement. But both of these differ-ences exist whether banks underwritesecurities or not.

The potential exists, though, for abank that offers both loan and under-writing services to not give objectivefinancial advice. One argument that hasbeen made is that a bank might advise abusiness customer to issue new securi-ties to repay its poorly performing bank

loans. A bank could, however, makesuch a recommendation regardless ofwhether it has a securities affiliate or not.Another argument is that a bank, in anattempt to support the prices of securi-ties it has underwritten, might offerimprudent loans to unsuspecting cus-tomers so that they would be able tobuy these securities. This tactic wouldbe foolhardy, though, since the bankwould receive only a portion of thegain from underwriting, while incurringthe entire amount of the loss fromthe defaulted loans.

Examples similar to these werealso heard by the Senate Banking andCurrency Committee when Glass-Steagall was first being considered in1933. Ferdinand Pecora, the committee'slegal consultant, summarized suchstories by stating:

A bank [is] supposed to occupy afiduciary relationship and to protectits clients, not lead them into dubiousventures; to offer sound, conservativefinancial advice, not a salesman'spuffing patter.... The introductionand growth of the investment affili-ate ha[s] corrupted the very heart ofthese old fashioned banking ethics.5

Some of these earlier claims werelater disputed in a 1994 article by econo-mists Randall Kroszner and RaghuramRajan, who investigated bank activitiesbefore the passage of Glass-Steagall.Kroszner and Rajan concluded thatallowing commercial and investmentbanking to occur under one roof didnot lead to widespread defrauding ofinvestors. Instead, their findings indicatethat, because markets and securitiesrating agencies were aware of the poten-tial for conflicts, banks shied away fromquestionable securities and primarilyunderwrote securities for older, largerand better-known firms than investmentbanks did.

A similar concern was voiced lastyear when the issue of an all-in-onebanking system arose. However, eco-nomic research into the subject, likethat conducted by Kroszner and Rajan,has overwhelmingly concluded thatGlass-Steagall was not justified.

All-in-One Banking vs.Separated Banking

Because all-in-one banking elimi-nates the distinctions between commer-cial banks, investment banks andinsurance companies, the all-in-onesystem allows banks to expand (ormerge) into areas previously off-limits.The U.S. financial market has already

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The Regional Economist -April 2000

witnessed the start of this processwith Citigroup, the company formedin 1998 from the merger of Citibankand Travelers Group. Others will likelyfollow, leading to the creation of whatsome might call banking behemoths.What will such a transformation do tothe American financial landscape?Will it be better or worse off? Willconsumer choices be limited?

Economist George Benston tackledthese very questions in a 1994 article—published five years before the passageof GLB. Benston's conclusions werethat, overall, all-in-one banking wouldoffer many benefits and few costs to U.S.consumers, despite worries that suchbanks might crowd out other financialinstitutions or that the possible collapseof one of these banks could wreak finan-cial chaos. While, at first glance, theseconcerns might seem reasonable, theliterature shows that, in fact, they arenot well founded.

Is There Still Room for

Specialized Firms?

In the new era, smaller, communitybanks will likely not offer the variety ofservices that their larger counterpartswill. Whether these community bankswill find their niche is discussed inTimothy Yeager's article in the October1999 issue of this publication. The ques-tion considered here is whether invest-ment banks will be able to survivealongside the banking behemoths.Evidence suggests that they will.Although banks might engage in activi-ties similar to traditional brokeragehouses, brokerage houses have devel-oped specialized skills that would bedifficult—short of a bank actually pur-chasing a brokerage firm—to duplicatequickly. For example, brokerage housesdevote substantial resources to research-ing and underwriting firms'equity anddebt offerings, whereas banks wouldgenerally rely on their establishedrelationships with firms to acquireinformation on them.

Relying on information from estab-lished relationships enables banks toexploit economies of scope. Economies ofscope exist when it is cheaper for onefirm to offer a variety of services than itis for several different firms to offer thesesame services individually. For example,someone buying a house needs notonly a mortgage, but also homeowner'sinsurance. Since the repeal of Glass-Steagall, a bank can bundle the twotogether, perhaps offering both cheaperthan two separate firms could becausethe information needed for one is alsoneeded for the other. In this situation,

consumers would spend less time andmoney searching for these services; thatis, consumers' transaction costs would belower. Another conceivable conse-quence, though, is that the potentiallyfewer number of competitors in themarket might give these banks somemonopoly power, which could lead tohigher consumer costs overall.

Investment banks, on the other hand,would not be able to offer many of theservices all-in-one banks could unlessthey were willing to be supervised andregulated like banks. But this does notimply that investment banks could notsurvive alongside all-in-one banks.Other, similar types of special-ized financial companieshave been able tocoexist andsurvive along-side commer-cial banks foryears. For exam-ple, the current financiallandscape includes com-panies that specialize in mortgagelending, sales financing (such as GeneralMotors Acceptance Corp.), non-deposi-tory commercial lending (such asGeneral Electric Credit Corp.), andaccounts receivable (such as Walter G.Heller & Co.). The mere existence ofthese types of firms indicates that theyare providing their customers desired—though perhaps higher-priced—prod-ucts and services.

Too Big to Fail?

Because all-in-one banks tend to belarge, another concern is that the failureof even one of them could wreak havocon the nation's financial and paymentssystems. It does not take all-in-onebanks to raise this argument, however.Similar arguments have been made forexisting major commercial banks, any ofwhich could certainly disrupt markets ifthey fail.6 The concern since the repeal,though, is that the combination of com-mercial banks and securities and insur-ance firms would increase the chances ofa failure, and that that failure would rip-ple through the economy faster thanbefore. The evidence, however, showsthat larger, more diversified institutionsare actually more secure than less diver-sified institutions. In his 1986 article,Eugene White noted that:

While 26.3% of all national banksfailed [between 1930 and 1933], only6.5% of the 62 banks which had[securities] affiliates in 1929 and 7.6%of the 145 banks which conductedlarge operations through their bond

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The Nuts and Bolts of FinancialModernizationby W. Scott: McBride

he Gramm-Leach-BlileyAct (GLB), signed intolaw Nov. 12,1999, mod-ernizes the U.S. financial

services sector by tearing down thelegal barriers between commercialbanking, investment banking andinsurance. Before GLB, commercialbanks could only engage in the busi-ness of banking—for example, takingdeposits, making loans and offeringchecking accounts. Companies thatown banks, known as bank holdingcompanies, were similarly limitedto banking and businesses that areclosely related to banking, such asleasing, providing financial adviceand providing trust services. OnMarch 11, 2000, however, thesebarriers came rumbling down.New financial conglomerates canbe formed. Bank holding companiesare now able to acquire or mergewith securities firms or insurancecompanies, and securities firmsand insurance companies canacquire banks.

Furthermore, bank holding com-panies can now engage in any busi-ness that is "financial in nature."Most notably, they are permittedto sell and underwrite securities(known as investment banking),sell and underwrite insurance andengage in merchant banking. TheFed and the Treasury Departmenthave published a list of permissible

businesses that are financial innature, and in the future may includeadditional activities, such as realestate development or investment.Some of these businesses involverisks that are very different fromtraditional commercial bankingservices. In securities underwriting,for example, the underwriter buysthe securities from an issuing com-pany and resells them, taking on therisk of owning any of the securitiesthat it cannot sell. Insurance under-writing involves taking on the risk ofpaying the claims under insurancepolicies. Merchant banking involvesmaking stock investments in busi-nesses—usually, venture capitalinvestments in new businesses.Regulators believe these risks aremanageable and that the diversi-fication will prove healthy.

To help insulate bank deposi-tors—and taxpayers, who ultimatelypay for any losses to the federaldeposit insurance fund—from therisks of new financial businesses,banks will not be allowed to engagein these businesses directly. Instead,a bank can either set up a holdingcompany that could own the bankand non-bank financial companies,or it can purchase or set up financialsubsidiaries of its own. One big dif-ference between these two options isthat a bank holding company canconduct any financial activitythrough its non-bank subsidiaries,whereas a bank's subsidiaries cannottake part in insurance underwriting,merchant banking or real estateactivities. Whichever structure abank chooses, it is eligible to enterthe new financial businesses only ifit is well capitalized and well man-aged, and has a satisfactory recordof lending in low- to moderate-income areas.

Functional Regulation

Before Gramm-Leach-Bliley,banks were already subject to over-lapping regulation. The Fed regu-lates bank holding companies. TheOffice of the Comptroller of theCurrency, which is part of theTreasury Department, regulates

national banks and their sub-sidiaries. State banks and theirsubsidiaries are regulated by boththe state in which they are head-quartered and by the Fed (if theyelect to be members of the FederalReserve System) or the FDIC (ifthey are not members of the FederalReserve System).

As banks and bank holdingcompanies begin to engage in insur-ance and securities activities, theywill also become subject to regula-tion by state insurance regulatorsand the Securities and ExchangeCommission. To minimize overlap-ping regulatory burdens and poten-tially inconsistent requirements,GLB imposes a functional approachto regulating these diverse organiza-tions. GLB calls for each regulatorto largely defer to the regulator withexpertise over a particular function-banking, insurance or securities.For example, banking regulatorswill not normally be allowed toexamine or require reports froman insurance subsidiary.

That said, GLB also preserves theFed's central role as the umbrellaregulator of all companies that ownbanks. As these companies diversify,it is critical for a single regulator tobe responsible for the entire compa-ny to help ensure the safety andsoundness of the organization as awhole and to prevent losses in asecurities or insurance businessfrom jeopardizing the health ofan insured bank.

Tearing down the barriersbetween commercial banking,investment banking and insurancewas the main purpose of GLB, butit also has many other importantand wide-ranging provisions. It is ahistoric law that promises to funda-mentally alter the U.S. financialservices industry.

A summary of GLB can be foundon the Senate Banking Committee'sweb site, www.senate.gov/~banking/conf/index.htm.

W. Scott McBride is a lawyer and an officer atthe Federal Reserve Bank of St. Louis.

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departments closed their doors.This superior record may be partiallyexplained by the fact that the typicalcommercial bank involved in invest-ment banking was far larger thanaverage while most of the failureswere among smaller institutions.

The failure of the U.S. savings andloan industry in the 1980s provides agood, recent example of how a lack ofportfolio diversification can cripple suchinstitutions. This almost $200 billiondisaster occurred primarily becauseS&Ls specialized in providing fixed-rate,long-term mortgages that were fundedwith short-term savings. When interestrates rose sharply in the early 1980s,S&Ls found themselves in severe finan-cial trouble. These institutions were alsohamstrung by regulations that preventedthem from opening branches in differentstates—or, in some cases, even within astate—a factor that also doomed manyof the institutions during the GreatDepression. History has shown, though,that if even one of these anticipatedbehemoth institutions were to fail, orto become illiquid, the Federal Reservecould pump liquidity into the marketto maintain market stability—as itdid in October 1987 after the stockmarket crash.7

There also is no reason to believe thatlarger, all-in-one banks will engage inriskier ventures than their commercialbank counterparts, although engaging insuch ventures could make the behe-moths more likely to fail, according tosome. But even with Glass-Steagall andits restrictions in place, commercialbanks could not be prevented frommaking risky investment decisionsamong their limited investment choices.In fact, White argued that, although theintent of Glass-Steagall was to improvethe soundness of banks by separatingthe commercial and investment func-tions, this forced separation actuallyplaced a burden on the financial indus-try by disconnecting activities that, bytheir nature, are economic complements.Moreover, Kroszner and Rajan foundthat the securities that banks under-wrote before Glass-Steagall were ofhigher quality and performed betterthan comparable security issues fromindependent investment banks.

insured deposits for speculative activitycan cost taxpayers substantial sums ofmoney. Deposit insurance creates arisk—a moral hazard—in banking thatwould not exist otherwise. The moralhazard arises because the federal gov-ernment (a third party) guaranteesdepositors that their deposits will berepaid, up to a limit, if their bank fails.As such, bank managers—who wouldnot have to bear the cost of poorlyinvested deposits—might feel freer touse these deposits in risky ventures.

If a bank used insured deposits tofund risky securities, or to cover insur-ance policies, a market aberration ornatural disaster could severely strain thebank's financial position. Because thefederal government guarantees deposi-tors' funds, however, taxpayers—notbank managers—could end up footingthe bill for the loss. Thus, some haveargued that all-in-one banking opensthe door to more opportunities for suchabuses, creating the potential for aneven bigger debacle. Gramm-Leach-Bliley addresses this issue by requiringthe Federal Reserve, the Comptrollerof the Currency and the Federal DepositInsurance Corp. to restrict transactionsbetween insured depository institutionsand their subsidiaries and affiliates.

Exploring theRechartered Territory

The Gramm-Leach-Bliley Act of 1999allows banks to explore the recharteredterritory in the new millennium. Despitewhat were believed to be good inten-tions when the Glass-Steagall Act of1933 was passed, more-critical examina-tions of that period have demonstratedthat the good intentions were misplaced.With the wall between the two bankingpractices torn down, U.S. banks will bebetter able to compete with otherdomestic financial institutions. As com-panies and customers adjust to the newlandscape, most will no doubt come tobelieve that the change shouldn't havetaken so long to make.

Adam M. Znretsky is an economist in the ResearchDivision of the Federal Rescroe Bank of St. Louis.Paige M. Skiba provided research assistance.

The Regional Economist • April 2000

ENDNOTES

1 True universal banking, as typifiedby the German or Swiss bankingsystems, still does not exist in theUnited States because banks herecannot hold equity positions incommercial companies.

2 Increased competition does notnecessarily imply lower prices, asimproved or new services mightbe offered that customers wouldbe willing to pay for.

3 Sen. Glass chaired the subcommitteethat heard testimony about thealleged abuses of commercial banksand their securities affiliates.

4 See Friedman and Schwartz (1963),Chapter 7.

5 Pecora, quoted in White (1986).

6 See Goodhart (1995) for suchan argument.

7 See Zaretsky (1996) for a descriptionof this episode and the Fed's respon-sibility as the lender of last resort.

8 Deposit insurance was also createdin 1933.

REFERENCES

Benston, George J. "UniversalBanking," Journal of EconomicPerspectives (Summer 1994),pp. 121-43.

Friedman, Milton, and Anna J. Schwartz.A Monetary History of the UnitedStates 1867-1960, PrincetonUniversity Press (1963).

Goodhart, C. A. E. The Central Bankand the Financial System, The MITPress (1995).

Kroszner, Randall S., and Raghuram G.Rajan. "Is the Glass-Steagall ActJustified? A Study of the U.S.Experience with Universal BankingBefore 1933," The American EconomicReview (September 1994), pp. 810-32.

Wheelock, David C. "Is the BankingIndustry in Decline? Recent Trendsand Future Prospects from aHistorical Perspective,"Review,Federal Reserve Bank of St. Louis(September/October 1993), pp. 3-22.

White, Eugene Nelson. "Before theGlass-Steagall Act: An Analysis ofthe Investment Banking Activitiesof National Banks,"Explorations inEconomic History (January 1986),pp. 33-55.

Yeager, Timothy J. "Down, But NotOut: The Future of CommunityBanks," The Regional Economist,Federal Reserve Bank of St. Louis(October 1999), pp. 5-9.

Zaretsky, Adam M. "Learning theLessons of History: The FederalReserve and the Payments System,"The Regional Economist, FederalReserve Bank of St. Louis(July 1996), pp. 10-11.

Who Pays for Failure?

Deposit insurance has added a newdimension to the discussion, especiallysince it did not exist prior to 1933.* Asthe United States experienced duringthe 1980s S&L debacle, the use of

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