Universal Banking

Commercial banks, investment banks, and insurance companies were originally created as distinct financial institutions that offered separate and distinct services. These institutions soon recognized, however, that combining these activities and services would provide economies of scope. In 1933, the Glass-Steagall Act halted the development of universal banking by banning the consolidation of these services under one organization. When the Glass-Steagall Act was repealed by Congress in 1999, universal banking reappeared. Given that the divisions within universal banks serve multiple clients, many potential conflicts of interest exist. If the potential for revenues in one department increases, employees in that department will have an incentive to distort information (or to pressure employees in another department to distort information) to the advantage of their clients and the profit of their department.

Several types of conflicts of interest can arise in universal banks:

• Securities issuers served by the underwriting department (and the underwriting department itself) will benefit from aggressive sales of the securities issue to customers of the bank, whereas the customers expect unbiased investment advice.

•A bank manager may push the issuing firm's securities to the disadvantage of the customer or may limit losses from a poor IPO by selling the firm's securities to the bank's managed trust accounts.

•A bank with an outstanding loan to a firm whose credit or bankruptcy risk has increased has private knowledge that may encourage the bank to use its underwriting department to sell bonds to the unsuspecting public, thereby paying off the loan and earning a fee.

•A bank may make loans to a firm on overly favorable terms to obtain fees from it for performing activities such as underwriting the firm's securities.

•To sell its insurance products, a bank may try to influence or coerce a borrowing or investing customer.

Conflicts of Interest. Banksters

Just as in the aftermath of the collapse of the tech bubble in 2000, the stock market crash of 1929 prompted many investors to question why they had been encouraged to purchase so many securities that declined in value so quickly. The public blamed the universal banks for hyping securities, and bankers were pejoratively referred to as "banksters." Public pressure led the Senate Banking and Currency Committee to hold hearings to investigate potential abuses by the universal banks. These hearings, which became known as the Pecora hearings after the chief counsel who led them, were as famous in their day as the Watergate hearings that led to President Nixon's resignation in 1974 or the hearings of the 9/11 Commission in 2004.

The Pecora hearings turned up several cases of apparently severe abuses of conflicts of interest in the banking industry. An affiliate of National City Bank (the precursor to Citibank) was accused of selling "unsound and speculative securities" to the bank's customers, particularly bonds from the Republic of Peru that went into default. Chase National Bank and National City Bank were accused of converting bad loans to companies such as General Theaters and Equipment and the General Sugar Company into securities that were sold to the public and investment trusts managed by these banks. The president of National City Bank, Charles E. Mitchell, and the head of Chase National Bank, Albert H. Wiggin, were accused of setting up pool operations, in which resources from the banks were used to prop up the bank's stock price for the benefit of these executives and their associates.

The resulting scandals led to passage of the Glass-Steagall Act in 1933, which eliminated the possibility of these conflicts of interest by mandating complete separation of commercial banking from investment banking activities. It was not until 1999 that this act was repealed by Congress to enable banks to be more competitive.

All of these conflicts of interest may decrease the amount of accurate information production by the universal bank, thereby hindering its ability to promote efficient credit allocation. Although there have not been any recent banking scandals involving conflicts of interest, they did surface in the aftermath of the stock market crash of 1929 (see the Conflicts of Interest box, "Banksters").

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