Product Product DiversificationDiversification

Chapter 21

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K. R. Stanton

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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.

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Introduction

Universal FI structure in Germany, Switzerland and UK.

Citicorp/Travelers merger clear indication of the rapidly eroding regulatory barriers separating FI types.

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Risks of Product Segmentation

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

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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

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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

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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

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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.

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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

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Financial Services Modernization Act

Financial Services Holding Companies eliminated restrictions in Texas and Rhode

Island Functional Regulation

Insurance functions regulated at state level

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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

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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

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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

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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

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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.

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Conflicts of Interest

Six potential conflicts Salesperson’s stake

NationsBank example. Stuffing fiduciary accounts Bankruptcy risk transference Third-party loans Tie-ins Information transfer

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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

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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.

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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.

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Web Resources

Visit

Federal Reserve www.federalreserve.gov

OCC www.occ.treas.gov

FDIC www.fdic.gov

SEC www.sec.gov

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Competition

Procompetitive 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.

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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