Overview This chapter analyzes the problems and risks arising as a result of the restrictions that force FIs to restrict activities to a narrowly defined financial services sector. It also explores the potential benefits to greater product expansion, the regulatory structure, barriers to FI expansion into real, or commercial sectors, and the potential effects of universal banking.

Introduction Universal FI structure in Germany, Switzerland and UK. Citicorp/Travelers merger clear indication of the rapidly eroding regulatory barriers separating FI types.

Risks of Product Segmentation lack of diversification makes optimization of asset mix more difficult and reduces flexibility Bank exposure to nonbank competition especially from Money Market Mutual Funds (MMMFs) Growth in commercial paper markets

Separation of commercial and investment banking via Glass-Steagall Segmentation in the U.S. Separation of commercial and investment banking via Glass-Steagall Exemptions for: Treasury Securities Municipal General Obligation bonds Private placements After various challenges, 1987 Fed allowed commercial BHCs to establish Section 20 affiliates as investment banks

Erosion of Glass-Steagall Permissible activities of BHCs expanded by Federal Reserve and OCC in 1997. Fed allowed direct acquisition of investment banks rather than establishing Section 20 subs. Resulted in number of M&As between commercial and investment banks in 1997 through 2000 UBS/Paine Webber CFSB/ Donaldson Lufkin Jenrette Deutsche Bank/Banker’s Trust preceded by Banker’s Trust acquisition of Alex Brown NationsBank/Montgomery Securities

Prior to Financial Services Modernization Act of 1999: Banking and Insurance Prior to Financial Services Modernization Act of 1999: Barriers to banks and insurance companies entering one another's lines of business Citigroup as a catalyst

Banking and Insurance 1986: banks began selling annuities but traditionally banks prevented from entering insurance. Restricted to agency activities, offering credit-related products in small towns. Garn-St. Germain Act specifies restrictions on BHCs establishing insurance affiliates.

Banking and Insurance (continued) Delaware: liberal laws allowing state-chartered banks to engage in P&C and life insurance. Nonbank banks as a route for insurance companies and commercial firms to engage in banking. Competitive Equality Banking Act 1987 Challenge to Bank Holding Company Act’s restrictions Citicorp and Travelers

Financial Services Modernization Act Financial Services Holding Companies eliminated restrictions in Texas and Rhode Island Functional Regulation Insurance functions regulated at state level

Commercial Banking and Commerce Banks can only engage in commercial activities “incidental to banking” Restrictions on BHCs are a more recent phenomenon. 1956 Bank Holding Company Act. Changes resulting from Financial Services Modernization Act regarding ownership limits

Nonbank Fin. Services Firms & Commerce Barriers generally weaker than for banking sector Financial Services Holding Company 85 percent of assets financial maximum of 15 percent in commercial or real assets Nonfinancial assets grandfathered

Issues in Expansion of Product Powers Overview Safety and soundness issues Economy of scale and scope issues Conflict of interest issues Deposit insurance issues Regulatory oversight issues Competition issues Universal banking Universal subsididiary model Barclay’s, Toronto Dominion Adopted by OCC

Risk of securities underwriting Safety and Soundness Risk of securities underwriting Firm Commitment British Petroleum Firewalls as protection from securities affiliate Risks from upstreaming or affiliate loans Downstreaming of funds Risks from contagious confidence problem Benefits from product diversification and geographic diversification

Economies of Scale and Scope Economies of scale opportunities for firms up to $25 billion in asset size. Revenue-based for largest FIs Economies of scope Pre-1997: limited by firewalls between banks and Section 20 subsidiaries. Greater gains possible with universal banking structure as in Germany.

Six potential conflicts Conflicts of Interest Six potential conflicts Salesperson’s stake NationsBank example. Stuffing fiduciary accounts Bankruptcy risk transference Third-party loans Tie-ins Information transfer

Reality of Conflicts of Interest Emphasize Potential conflicts of interest Chinese Walls limit information transfer Exploitation requires monopoly power imperfect or asymmetric information low value on reputation Nationsbank as counterexample

Deposit Insurance Deposit insurance may provide competitive advantage to banks over other FIs. Banks may also gain an advantage from being too big to fail.

Regulatory Oversight Large bank holding companies with extensive nonbank subsidiaries face a complex structure of regulators. If further integration of financial services then there may be argument for a single regulatory body. Downside is that the skill sets required to supervise one type of FI not necessarily fully transferable to regulating other FI types.

Web Resources Visit Federal Reserve www.federalreserve.gov OCC www.occ.treas.gov FDIC www.fdic.gov SEC www.sec.gov

Competition Procompetitive Anticompetitive Increased capital access for small firms Lower commissions and fees Reduce degree of underpricing of new issues Anticompetitive Long-run outcome could be oligopoly with higher prices for investment banking services.

Pertinent Websites Federal Reserve www.federalreserve.gov Credit Suisse Group www.credit-suisse.com FDIC www.fdic.gov OCC www.occ.treas.gov SEC www.sec.gov