2. 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.

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

4. 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

5. 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

6. 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

7. 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

8. 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.

9. 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

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

11. 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

12. 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

13. 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

14. 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

15. 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.

16. 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

17. 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

18. 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.

19. 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.

20. Web Resources
Visit
Federal Reserve
OCC
FDIC
SEC

21. 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.

22. Pertinent Websites
Federal Reserve
Credit Suisse Group
FDIC
OCC
SEC