mance of banking firms around increased investment banking activity. This paper studies whether the commercial banking industry benefits from increased investment banking
powers or not, and which commercial banks benefit from increased investment banking powers and which do not.
III. Literature
Most prior research has focused on whether the Glass–Steagall Act is necessary due to conflicts of interest, or performance and diversification issues related to Glass–Steagall. In
this section, I discuss the conflicts of interest literature in three different areas: the theoretical papers that formalize the issue, papers examining long term performance of
commercial bank versus investment bank underwritten issues, and ex-ante pricing of commercial bank versus investment bank underwritten issues. I also review the literature
that studies performance of increased banking powers on commercial bank stock perfor- mance.
Theoretical Conflicts of Interest Literature
Several theoretical papers formalize the conflicts of interest inherent in commercial banks underwriting securities. Saunders 1985 identifies nine potential conflicts of interest such
as promotional role versus advisor, economic tie-ins, director interlocks, and using security proceeds to repay bank loans. In general, Saunders argues that maximization of
long-run profits implies preservation of reputation and, therefore, avoidance of exploita- tion of conflicts of interest by commercial banks engaged in investment banking activities.
He suggests outside mechanisms such as the market for corporate control, competitive market for financial services, default ratings of ratings agencies, and penalty power of
regulators provide a check on potentials for abuse.
Benston 1994 similarly reviews the potential for conflicts of interest by reviewing Germany’s example of universal banking. He discusses financial stability, economic
development, political power, consumer choice, and conflicts of interest. Benston finds that universal banking has potential for considerable benefits and poses few problems for
the economy. Benston suggests that Glass–Steagall should be repealed.
Kanatas and Qi 1998 present a theoretical model of firms seeking project funding with both combined and separate commercial and investment banking. They find that
economies of scope could enable combined entities to capture the borrowers’ underwriting business, which can reduce the firm’s investment. When modeled with firm’s incentive to
lower costly project development in anticipation of underwriting by lenders, the result is that combination of commercial and investment banking poses a social welfare cost.
However, if the combined commercial and investment bank has incentive for reputation building, the social costs of combination are mitigated without the need for regulation.
Puri 1999 compares and contrasts the underwriting behavior for banks with under- writing power versus investment houses and derives the implications for pricing. She also
models whether debt or equity held by the bank affects the certification of securities or prices. The model indicates that when information costs are high, prior financial claims
held by banks can cause banks to obtain better prices for underwritten securities than investment houses. Banks that hold equity in the firm have reduced certification ability.
The Erosion of the Glass Steagall Act 345
Puri’s model also suggests that banks and investment banks can coexist in the market and explains the rationale for the coexistence in the U.K. and France.
Overall, the theoretical literature suggests that conflicts of interest and other social costs associated with combining commercial and investment banking can be mitigated
through outside forces or reputation effects. Therefore, theory suggests that combining these activities is not likely to harm the industry or create a social cost as opponents
suggest. One exception is Rajan 1998 who shows that unrestricted competition does not necessarily lead to efficient institutions if the markets in which institutions compete are
not naturally competitive. Rajan suggests that for an integrated producer, ex-post rents are possible if an information advantage exists. Because commercial banks are intensive
information gatherers, Rajan suggests the ex-post rents could be greater than the ineffi- ciencies due to integration.
Commercial versus Investment Bank Underwritten Security Performance Literature
In general, long term performance studies of commercial versus investment bank under- written securities indicates no difference between the two underwriting groups, or that
bank underwritten securities perform better. For example, Kroszner and Rajan 1994 find the ex-post default performance of Section 20 affiliate underwritten securities is better
than comparable investment bank underwritten issues. The results were most evident for lower grade securities and more “information intensive” issues.
Ang and Richardson 1994 find no evidence that bonds underwritten by commercial banks underperformed those underwritten by investment banks. Bank affiliate issues had
lower default rates, higher ex-post prices, and no difference in yieldprice relationships when compared to investment bank issues. Ang and Richardson, as well as Puri 1994
find the two commercial banks that were the focus of the Pecora Committee had practically all categories of bonds fare worse than similar issues by other commercial bank
affiliates. National City Corp. and Chase Securities, the two banks in question, had higher default rates, but the market was not fooled by these underwriters because their securities
also had higher initial yields.
For the period from 1927 to 1929 before Glass–Steagall, Puri 1994 tests whether or not yields differ between securities underwritten by investment houses versus those
underwritten by commercial banks. Puri finds that commercial bank underwritten issues have lower yields ex-ante higher prices and, therefore, the certification effect of bank
inside information outweighs the conflicts of interest effect for corporate securities. Puri also finds that the certification effect is higher for bonds versus preferred stock, new
versus seasoned issues, and for non-investment grade versus investment grade securities. These results imply that corporate customers would benefit from the repeal of the
Glass–Steagall Act.
Kroszner and Rajan 1997 study yields on bank underwritten securities by bank affiliates versus bank departments before the Glass–Steagall Act. They find that bank
departments “cherry picked” the higher quality firms as compared to affiliates, however, the departments obtained lower prices. Department issues had risk premia higher than
affiliate underwritten securities, and particularly so when the issuance was announced to repay debt. Their findings suggest that market participants could properly account for
conflicts of interest and using issuance proceeds to repay debt is incorporated into the security price.
346 K. B. Cyree
In related research conflicts of interest research, Hamao, Packer, and Ritter 1998 find that Japanese firms with venture capital backing from securities company subsidiaries
perform significantly worse over a 3-year time horizon than other IPOs. Results suggest that conflicts of interest influence the pricing and long-run performance of initial public
offerings in Japan. Gompers and Lerner 1999 review underwriting of IPOs by invest- ment banks that hold equity through a venture capital subsidiary. Gompers and Lerner find
that affiliated issues perform as well or better than those where the investment bank did not hold an equity position. They suggest their findings offer no support for prohibitions
on universal banking instituted by Glass–Steagall.
Ex-ante Pricing Literature
Ex-ante pricing of commercial versus investment bank underwritten securities is well studied. Ang and Richardson 1994 and Puri 1996 find that securities underwritten by
commercial banks before Glass–Steagall had higher ex-ante prices than investment bank issues, and this effect is stronger for junior and information intensive issues. Gande, Puri,
Saunders, and Walter 1997 also find bank underwritten issues higher priced than investment bank issues, particularly for small and non-investment grade securities. Gande,
Puri, and Saunders 1999 find a reduction in underwriter spreads among lower rated and small size debt issues from 1985 to 1996 after the weakening of Glass–Steagall. Bank
entry into the underwriting market reduced spreads initially, but did not persist through time as investment banks apparently matched spreads on an immediate basis.
Hamao and Hoshi 1997 study bond underwriting by bank subsidiary securities firms in Japan and find neither certification effects or conflicts of interest dominates the bank
underwriting of corporate bonds. Japanese bank subsidiaries do, however, bring smaller issues to the market than do existing securities firms suggesting increased access to capital
markets for smaller firms.
Bank Risk and Performance around increased Investment Banking Activity
Several studies review performance or changes in risk of the banking firm around increased underwriting powers. Kwast 1989 reviews the potential for diversification
gains by banks expanding into underwriting securities. The return on assets and standard deviation for securities activities are higher than the return on assets and standard
deviation for commercial banks. Boyd, Graham, and Hewitt 1993 use accounting values and market data to simulate mergers between commercial banks and financial service
firms. The simulations using accounting data suggest that BHC’s that merge with firms in any of the four non-banking industries securities, real-estate, real-estate development, and
insurance agentbroker increase the risk of failure at virtually any portfolio weight.
Saunders and Smirlock 1987 study performance around the initial increase in invest- ment banking powers for commercial banks. They found that banks expanding into
discount brokerage insignificantly affected bank share price reaction and risk. However, Saunders and Smirlock find that securities firms experience a significant decline in market
value.
Apilado, Gallo, and Lockwood 1993 review the market reaction among groups of banks for increased underwriting powers in 1987. Most of the positive excess returns are
found to be earned by the Money Center bank group. Cumulative excess returns for
The Erosion of the Glass Steagall Act 347
investment banks were negative and insignificant. They also find that risk did not decline significantly for any of the groups around the initial increase in underwriting power for
commercial banks. Bhargava and Fraser 1998 use a multivariate regression model to study prior effects
of four Federal Reserve Board decisions that allowed commercial banks to participate in investment banking through Section 20 subsidiaries. When the less expansive powers to
underwrite mortgage securities and municipal revenue bonds were initially proposed in April 1987, banks that participated experienced positive and significant abnormal returns.
When these powers were expanded in January 1989 to include corporate debt and equity, as well as the subsequent decision to double the amount allowed in September 1989, banks
experienced negative abnormal returns and increases in risk. They also study the 1996 proposal by the Federal Reserve Board to increase the allowable Section 20 revenue to
increase to 25 and find no wealth effects for commercial banks or investment banks. Bhargava and Fraser do not study the wealth effects of large banks expanding underwrit-
ing power on smaller banks and only look at the initial proposal to increase the section 20 loophole.
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IV. Methodology and Data
