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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.
By Barbara Buell