Stanford Business School
Contact: Catherine Castillo; [email protected]
NEW ARGUMENT FOR FREEING BANKS
Stanford- After analyzing the reasons for instituting the Glass-Steagall
Banking Act, Stanford Business School researcher Manju Puri suggests that
barriers dividing commercial and investment banks be relaxed.
Whether commercial banks should be allowed to underwrite securities is one
of the oldest controversies in American banking. Regulators have long
feared that when commercial banks combine lending and securities
underwriting, they face a potential conflict of interest. The main concern
has been that banks could use the private balance sheet information they
obtain from lending to underwrite corporate securities that they know to be
bad. Banks would then be free to market the issue to the public and use
proceeds to repay bank loans.
It was these fears that prompted the Glass-Steagall Banking Act, which
built a wall between commercial banks and investment banks in 1933 during
the depths of the Great Depression. "It radically changed the financial
structure of the U.S. economy," says Manju Puri, assistant professor of
finance.
More than 60 years later, the debate still rages over this powerful U.S.
banking rule, even though many other countries have embraced universal
banking. Puri has examined both old records of bank practice before
Glass-Steagall and modern data from the underwriting industry. Her research
supports the notion that there is as little basis for concern now as there
was then.
While two isolated cases of abuse spurred congressional hearings that swept
Glass-Steagall into being, Puri found no evidence of systematic conflict of
interest among bank underwritings between 1927 and 1929. In fact, she
discovered that investors were willing to pay higher prices (which means a
lower yield for the investor) for securities underwritten by banks because
they perceived bank-underwritten issues to be of higher quality due to the
bank's superior knowledge of an issuer's financial condition. In a related
study, Puri examined more pre-1933 records showing that, as investors
expected, bank issues actually defaulted less than nonbank issues over a
seven-year period from their issue dates.
Attempts to do away with Glass-Steagall may have failed, but bank
regulators have chipped away at the statute. "They've reinterpreted it to
allow banks to have much broader powers than they did," says Puri. A key
reform in 1989 expanded bank powers under Glass-Steagall's Section 20,
which allowed banks to underwrite corporate securities through a subsidiary
on a case-by-case basis. Revenue restrictions prevent bank underwriting
from exceeding 10 percent of the subsidiary's revenue.
Contrary to the argument that greater universal banking powers will stunt
the availability of financing to smaller firms, a study of bank
underwritings in the 1990s shows that banks brought a larger proportion of
small firms to the market than did investment houses. Puri believes this
finding, based on 18 months of data, calls for more research to firmly
establish the trend, but it argues against assertions that universal
banking will result in banks catering only to larger, more lucrative
corporate customers.
As with underwritings before 1933, a review of recent securities showed
that issues with a lower credit rating are getting better prices through
bank underwritings because of commercial banks' lower costs of information.
By contrast, investment houses must engage in costly research, which can
raise the price of the security. "If you're not a company with Triple A
ratings, you might want to consider bank underwriting, particularly if you
have a lending relationship with the bank," says Puri.
Based on both historical and modern data, Puri concludes that although
banks were faced with conflicts of interest, they did not unduly exploit
private information available to them to underwrite bad issues. In fact,
the presence of banks as underwriters benefited firms in helping them
obtain better prices for their securities. This suggests that the basis for
restrictive regulations on bank activities is questionable, and, indeed,
the pressure for reform persists.
For more information contact: Janet Zich at 415.723-9193 or
[email protected]
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