Commercial & Investment Banking: Should This Divorce Be Saved?

April 01, 1995

By Michelle Clark Neely

The separation between commercial and investment banking has been one of the primary features of the U.S. financial system since the 1930s. Congress is responsible for this separation, having decided that the investment banking activities of the nation's large commercial banks contributed to the widespread bank failures of the Depression. To prevent further failures, it passed legislation in 1933 that created a wall between commercial and investment banking activities and authorized a federal deposit insurance system.

Since the Depression, a number of academic studies have suggested that such investment banking activities did not significantly contribute to massive bank failures. In addition, many now argue that the U.S. commercial banking system would actually be stronger if banking organizations were permitted to affiliate directly with investment banking concerns, a system usually referred to as universal banking. Some even advocate affiliations between banks and commercial or insurance firms. Should the divorce between commercial and investment banking be saved, or is there a good case for reconciliation?

A Common-Law Marriage

Commercial and investment banking have been kept apart for most of America's history. According to Perkins (1971) and others, our post-Civil War banking system was modeled more or less on English banking practices, which featured a sharp division between commercial and investment banking. Investment banking, which involves dealings in stocks and bonds, was considered both risky and unsound for commercial banks that collected savings from the public.

The concurrent development of trust companies, however, blurred this neat distinction. Because of relatively liberal state incorporation laws, many trust companies evolved from administering estates and wills, to soliciting customer deposits and financial planning, and later to distributing, marketing and purchasing corporate equity securities. While some financial analysts of the time noted the potential conflict of interest, others praised the convenience of being able to get all types of banking and investment services under one roof.

Recognizing the advantages that trust companies enjoyed, state-chartered banks lobbied for and won comparable powers. Nationally chartered banks, which were not granted these powers under the National Bank Act of 1864, gained them anyway by setting up separate state-incorporated securities affiliates. On the eve of World World I, state and national banks' move into investment banking was not a major or even a minor public policy issue. That would change in the inter-war period.

The massive sale of bonds to finance WWI brought scores of new players into the securities markets. Banks were expected to help the war effort by lending investors the funds to purchase war bonds on favorable terms; they did so in large numbers by expanding their bond departments or forming new securities affiliates. By 1922, 62 commercial banks were directly engaged in investment banking, and another 10 had launched securities affiliates.

Commercial bank involvement in investment banking continued to grow in the 1920s. A reduction in corporate loan demand, caused by the issuance of long-term corporate debt and equity and large cash flows that eliminated the need for borrowing by many companies, led commercial banks to look elsewhere for profits. Many large urban banks, buoyed by a rising stock market and other factors, chose investment banking to fill that profit void. Between 1927 and 1930, commercial banks' share of the new bond issuance participation market rose from 37 percent to 61 percent. By 1930, commercial banks and their securities affiliates were the principal players in investment banking. Commercial and investment banking had more or less merged into a common-law marriage, without any fanfare but also without a complete official blessing.

1929: Marriage on the Rocks

The stock market crash of 1929, some spectacular bank failures and the advent of the Great Depression cast a bright light on this union. Because many blamed the crash on excessive speculation in the stock market, institutions associated with securities markets, including the securities affiliates of large commercial banks, were deemed guilty by association. Leading the charge against the bank securities affiliates was Senator Carter Glass of Virginia.

Glass was never comfortable with the unofficial union of commercial and investment banking. During the course of several hearings he convened in the early 1930s, bankers were accused, among other things, of making bad loans to their corporate borrowers, then duping other customers into buying securities issued by these firms, with the proceeds going to pay off the loans. Glass became convinced that the mixing of commercial and investment banking caused the catastrophic events of the late 1920s and early 1930s. His solution: split them apart.

Glass' opponents argued that the affiliate system had been instrumental in the strong economic growth of the 1920s and that bank customers had become accustomed to one-stop banking; such arguments, however, largely fell on deaf ears as stock market scandals and bank failures increased. In May of 1933, Glass' bill mandating the legal separation between commercial and investment banking was merged with Representative Henry Steagall's deposit insurance bill, and in June, President Roosevelt signed the Banking Act of 1933 into law, severing most of the ties between commercial and investment banking.

The Divorce Decree

Under the Banking Act of 1933 (or the Glass-Steagall Act, as it is commonly referred to) banks were forbidden from:

purchasing securities for their own accounts (Section 16);
issuing, underwriting, selling or distributing, at wholesale or retail, or through syndicate participation, stocks, bonds, debentures, notes or other securities, with the exception of certain U.S. and municipal government securities (Section 21);
affiliating with a company principally engaged in the activities listed above (Section 20);
having interlocking directorships or close employee relationships with a firm principally engaged in securities underwriting or distribution, even if there is no common ownership or corporate affiliation between the commercial bank and the investment company (Section 32).

Over time, federal bank regulators and the courts have eroded some of the official separation by permitting banks to engage, mostly indirectly, in many securities-related activities.1 For example, both the Federal Reserve and the Office of the Comptroller of the Currency (OCC) permit the banks they regulate to engage in many mutual fund-related activities, including the provision of full service and discount brokerage services and investment advisory services for a fund.

Regarding underwriting, the Federal Reserve has allowed member banks to affiliate (through the bank holding company structure) with securities companies that underwrite commercial paper, mortgage-backed securities and corporate debt and equity securities, among other instruments, so long as these activities contribute less than a small, fixed percentage of the affiliate's revenue. About 36 banking organizations operating in the United States currently have active securities affiliates, dubbed "Section 20 subsidiaries" after the Glass-Steagall provision that proscribes full affiliate relationships (see table).2

Table 1

The Erosion of Glass-Steagall: U.S.-Based Banking Organizations with Section 20 Subsidiaries (as of 1/5/95)¹

Parent Organization	Parent Location	Section 20 Subsidiary
BankAmerica Corp.	San Francisco, CA	BA Securities, Inc.
Bankers Trust N.Y. Corp.	New York, NY	BT Securities Corp.
Banc One Corp.	Columbus, OH	Banc One Capital Corp.
Bank South Corp.	Atlanta, GA	Bank South Securities Corp.
Barnett Banks Inc.	Jacksonville, FL	Barnett Securities, Inc.
Chase Manhattan Corp.	New York, NY	Chase Securities, Inc.
Chemical Banking Corp.	New York, NY	Chemical Securities, Inc.
Citicorp	New York, NY	Citicorp Securities, Inc.
Dauphin Deposit Corp.	Harrisburg, PA	Hopper Soliday & Co., Inc.
First Chicago Corp.	Chicago, IL	First Chicago Capital Markets, Inc.
First of America Bank Corp.	Kalamazoo, Ml	First of America Securities, Inc.
First Union Corp.	Charlotte, NC	First Union Capital Markets Corp.
Fleet Financial Group, Inc.	Providence, Rl	Fleet Securities, Inc.
Huntington Bancshares, Inc.	Columbus, OH	Huntington Capital Corp.
J.P. Morgan & Co., Inc.	New York, NY	J.P. Morgan Securities Inc.
National City Corp.	Cleveland, OH	National City Investments Capital, Inc.
NationsBank Corp.	Charlotte, NC	NationsBanc Capital Markets, Inc.
Norwest Corp.	Minneapolis, MN	Norwest Investment Services
PNC Bank Corp.	Pittsburgh, PA	PNC Securities Corp.
Saban/Republic N.Y. Corp.	New York, NY	Republic N.Y. Securities Corp.
SouthTrust Corp.	Birmingham, AL	SouthTrust Securities, Inc.
SunTrust Banks, Inc.	Atlanta, GA	SunTrust Capital Markets
Synovus Financial Corp.	Columbus, GA	Synovus Securities, Inc.

Twenty-three of the 36 Section 20 affiliates currently active are subsidiaries of U.S.-based bank holding companies. Fourteen of the 23 were granted Section 20 powers between 1987 and 1990, while five are relative newcomers, receiving Section 20 authorization in 1993 or 1994. About one-third of them have been given limited corporate debt and underwriting privileges.

¹ All Section 20 subsidiaries are authorized to underwrite and deal in certain municipal revenue bonds, mortgage-related securities, commercial paper and asset-backed securities.

SOURCE: Federal Reserve Board, National Information Center

Commercial banks have not been the only winners in this erosion: Investment bankers and securities brokers have been allowed to engage in limited commercial bank activities, such as making loans and offering money market management accounts that are very similar to bank deposits. Such regulatory interpretations have generally been upheld by the courts, including in some cases the U.S. Supreme Court.3

The Act's potency has also been diminished by some of its exceptions and exclusions. Sections 16, 20 and 32, for example, apply only to members of the Federal Reserve System, that is, nationally chartered and state member banks; because of these exclusions, state nonmember banks and thrifts are legally free to affiliate with securities firms. The Act also applies only to the domestic activities of U.S. commercial banks; most of the country's large money center banks—ironically, the Act's main targets—have significant securities underwriting and securities brokerage operations outside the United States.

Why Reconcile?

Despite these gains, most banking industry analysts and economists believe the erosion of Glass-Steagall is not enough. For example, though all commercial banks are able to engage in many mutual fund-related activities, most banks must still contract with outside providers to organize or underwrite a mutual fund.4 Similarly, the revenue cap on certain securities activities conducted by Section 20 subsidiaries forces banking organizations to forego profit opportunities.

Although policymakers have previously debated dismantling Glass-Steagall, support for its repeal has always been effectively countered by opposition from bank competitors and small banks. Lately, however, the tide appears to have shifted in favor of repeal, and many observers believe some version of two current Congressional bills and a Clinton Administration proposal for reform will become law this year (see below). Is the reunion of commercial and investment banking a good idea?

The Case for Reconciliation

The calls for Glass-Steagall repeal usually go hand in hand with a broader appeal for expanded bank powers. Citing U.S. banks' continuing loss of market share to less regulated financial services firms, proponents of repeal argue that banks need to be able to offer new products and services to make up for declining profit margins in their traditional loan and deposit lines of business. Most observers believe that restrictions on U.S. commercial bank activities not only hinder U.S. banks' competitiveness in domestic and global markets but also endanger their safety and soundness by inhibiting diversification of assets.

Only two major industrial nations currently feature a legal separation between commercial and investment banking: the United States and Japan.5 Other large industrial countries like Germany and Switzerland have universal banking, allowing banks to affiliate with other financial services firms, including insurance, real estate and securities firms.

As money and capital markets become more globalized, proponents of universal banking argue, it will be increasingly difficult for U.S. banks, as currently structured, to compete with large, international, financial conglomerates for corporate and consumer business. They also argue that allowing nonbanking firms to own and affiliate with banks will bring additional capital into the banking industry, bolstering its safety and soundness; higher capital, all else equal, reduces the probability of bank failure and hence losses to the FDIC and to taxpayers.

Increased bank diversification is another benefit to be expected if Glass-Steagall is repealed. One of the leading causes of bank failure is overdependence on one product or geographic region, a recognition that spurred last year's passage of interstate branching legislation.6 By broadening the range of products that a banking organization can offer, its revenue stream is also broadened, making it less likely that losses in one product area would cause losses for the whole organization. The potential revenue stream would also be enhanced by the cross-marketing of banking and investment products, like deposits and securities or insurance. And product diversification, of course, is decidedly pro-consumer.

Another argument in favor of universal banking is the possibility of increased efficiency in the provision of financial services. Any cost reductions are likely to result from the presence of economies of scale or economies of scope. Economies of scale are said to exist if average costs fall as output increases; economies of scope exist if the cost of joint production of two or more products is less than the costs of separate production. Joint production costs may be lower because inputs like computers and personnel can be shared. If scale or scope economies are present in banking, then policies that would allow banks to become larger or produce additional services would increase efficiency and presumably benefit banks in the form of higher profits and businesses and consumers in the form of lower prices.7

The Case for the Status Quo

Critics of universal banking argue that breaking down the wall between commercial and investment banking (or between commercial banking and commerce) will lead to fewer banks and increased concentration and monopoly power in the industry, resulting in less credit extended and higher prices. There is little evidence to support this assertion, however. Despite substantial consolidation in the banking industry through mergers and failures over the last decade and a half—the number of banks has declined from 14,836 in 1980 to 10,358 in 1994—measures of industry concentration have hardly changed.

Studies of the German banking system also indicate no evidence of concentration of power within the financial services industry or monopolization of universal banks over nonbanks. Most economists believe that the threat of entry or competition is enough to deter banks from exercising monopoly power. And when it's not, antitrust laws can be invoked to alleviate the problem.

Potential conflicts of interest and abusive practices are other reasons for maintaining the separation. These are the same charges that Carter Glass and his allies made against bank securities affiliates in the 1930s. Critics worry, for example, that bank creditors and the FDIC could suffer losses if a bank transferred insured funds to an ailing affiliate. They also cite the potential for abusive practices like"tying," that is, requiring the joint purchase of a number of products. To get a mortgage, for example, a borrower may be forced to purchase homeowners insurance and mortgage life insurance from the same organization.

This argument can also be countered. First, the securities activities of banks in the 1920s and 1930s have largely been vindicated by recent studies. One study, for example, found no evidence that commercial banks of that era dumped low quality securities on the public or that their securities were overpriced. In fact, the authors found that bank affiliates actually underwrote higher quality securities than did investment banks. Second, as proponents of universal banking maintain, appropriate "firewalls" can be constructed to ensure that transactions between banks and nonbank affiliates are done at arm's length.

Opponents of universal banking also argue that the marriage of commercial and investment banking or banking and commerce will destabilize the banking system by blurring the distinction between insured and noninsured activities. They worry that bad news about a bank affiliate or parent company will cause a bank run or that excessive dividend payments from the bank to the parent will jeopardize the bank's financial health.

A final concern is that these larger institutions will be "too big to fail," necessitating an extension of the federal safety net—the deposit insurance system, the payments system and the Federal Reserve's discount window—to nonbanks. As with the conflict of interest concerns, however, most analysts believe that the necessary safeguards are available to contain a severe financial crisis.

Happily Ever After...

Is the union between commercial and investment banking an unholy alliance as many thought in the 1930s? A closer look at the evidence has convinced most policymakers and economists today that the split between the two was a mistake. Permitting banks to diversify into other lines of business, while at the same time building adequate safeguards to ensure that insured deposit funds are not jeopardized, will promote efficiency and stability in the U.S. banking system and more choices for U.S. consumers and businesses. This is one couple that should probably get back together.

Will Glass Steagall Shatter in 1995?

Proposals to modify or repeal Glass-Steagall have been introduced repeatedly over the past 20 years without avail. But handicappers are giving current proposals the best odds in years, largely because the Republican-controlled Congress is deemed more sympathetic to banks' pleas for expanded powers.

Qualified support from the securities industry—a traditional opponent of expanded bank powers—is also working in the banking industry's favor.

Three versions of a partial repeal plan have been introduced since the start of the year, two in Congress and one by the Clinton Administration. Though all three would permit affiliations between banking and securities firms, they differ in many important respects, including how these new firms would be regulated and what other types of financial and nonfinancial affiliations would be allowed.

House Banking Committee Chairman Jim Leach was first out of the gate, introducing "The Financial Services Competitiveness Act of 1995" in early January. Leach's bill, which has won qualified endorsement from Federal Reserve Chairman Alan Greenspan, among others, is the most modest of the three proposals.

His bill would allow banks and securities firms to affiliate through a financial services holding company (FSHC) structure that would replace the current bank holding company framework. This affiliation would be a "two-way street," meaning a bank or thrift could acquire a securities firm and vice versa. Because the joining of banking and commerce is expressly forbidden in this bill, however, an investment banking firm that acquires a bank would be required to divest itself of any nonfinancial businesses within five years.

To protect the safety and soundness of banks generally and the deposit insurance fund specifically, the affiliates of an FSHC would be separately capitalized and have strict firewalls between them. For example, a bank affiliate would be forbidden from purchasing securities underwritten by or making loans or issuing guarantees to a securities affiliate.

FSHCs would be required to hold minimum capital levels and would be supervised by the Federal Reserve, though the bank and securities affiliates would be subject to functional regulation: The appropriate federal banking agencies would regulate the bank affiliates, and the SEC would regulate the securities affiliates. Leach expects to have a bill ready to be voted on by the full House in June.

Senator Alfonse D'Amato and Representative Richard Baker have introduced virtually identical bills in the Senate and House that would go much further than the Leach approach. "The Depository Institution Affiliation Act of 1995" would permit banks and thrifts to affiliate not only with securities firms, but also with other financial firms, like insurance companies, and nonfinancial firms, like auto companies.

Under the D'Amato/Baker approach, banks and other firms would affiliate under an FSHC. Unlike the Leach proposal, however, these FSHCs would not have capital requirements, nor would they be subject to Federal Reserve regulation. Bank affiliates would continue to have capital requirements, and functional regulation would apply to the bank and nonbank affiliates of the FSHCs.

As in the Leach proposal, strict firewalls would be placed between insured depository institutions and securities firms within the FSHC framework, and current Federal Reserve regulations relating to transactions between affiliates, insider lending and anti-tying would remain in effect.

A new federal agency, the National Financial Services Committee, would be formed to establish uniform principles and standards for the examination and supervision of financial services providers. Officials from the Administration and the federal financial regulatory agencies would sit on this committee.

The Clinton Administration has outlined a plan to repeal Glass-Steagall that falls somewhere between the Leach and D'Amato/Baker proposals. The Administration would allow banks and thrifts to affiliate with any financial entity, including insurance firms, but not with commercial firms. Unlike the other two proposals, affiliations between banks and financial firms could occur at the bank or the holding company level—the structure would be decided by individual firms.

Whatever the structure, the Clinton plan requires firewalls between bank and financial affiliates to protect the deposit insurance fund. As with the other plans, banking and other affiliates would be subject to functional regulation. The Federal Reserve would maintain its authority to impose capital requirements on bank holding companies. As in the D'Amato/Baker bill, a federal council would be formed to oversee these new FSHCs.

What's the likely outcome? Most observers believe that a modified version of the Leach bill has the best chance for congressional passage and presidential approval. The only foreseeable issue that could severely dampen the bill's chances is bank insurance powers; banking trade groups have vowed they will fight to kill the whole bill if amendments rolling back banks' current insurance powers are attached. Although many applaud the D'Amato/Baker approach, others say the United States is not yet ready for as radical a change as the merger of banking and commerce, though it may happen some day.

Thomas A. Pollmann provided research assistance. The author would like to thank Patricia A. Marshall of the Bank's Legal Department for helpful comments.

Endnotes

See Fein (1993) for an overview of banks' current securities powers. [back to text]
See Greenspan (1993) for a detailed analysis of permitted Section 20 activities. [back to text]
The U.S. Supreme Court has upheld, for example, regulatory rulings regarding bank holding companies acting as investment advisers for open-end and closed end mutual funds and providing discount brokerage services. [back to text]
This prohibition does not extend to state nonmember banks. FDIC regulations permit state nonmember banks to sponsor and underwrite mutual funds through "bona fide" subsidiaries. In addition, bank holding companies are permitted to underwrite and distribute closed-end mutual funds. [back to text]
Japan was forced to adopt U.S.-like banking laws after WWII. Japanese banks, like U.S. banks, are currently permitted limited underwriting powers. [back to text]
See Clark (1994) for an analysis of the benefits and costs of interstate branching. [back to text]
Most bank cost studies have found that scale economies, while they exist in banking, are exhausted at relatively low levels of output. Studies of economies of scope are fewer, and the results more mixed. The studies' acknowledged problems are the difficulty in defining and measuring inputs and outputs and the lack of data on the joint production of bank and nonbank products. Thus, the argument that universal banking is superior on efficiency grounds is yet to be proven. See Mester (1992). [back to text]

References

Benston, George J. The Separation of Commercial and Investment Banking (Oxford University Press, 1990).

Clark, Michelle A. "Going Interstate: A New Dawn for U.S. Banking," Federal Reserve Bank of St. Louis The Regional Economist (July 1994), pp. 5-9.

Fein, Melanie L. Securities Activities of Banks (Prentice Hall Law & Business, 1993).

Greenspan, Michael A. "Section 20 of the Glass-Steagall Act," The Review of Banking & Financial Services, Vol. 9, No. 18 (October 27, 1993), pp. 179-84.

Kroszner, Randall S., and Raghuram G. Rajan. "Is the Glass-Steagall Act Justified? A Study of the U.S. Experience with Universal Banking Before 1933," American Economic Review, Vol. 84, No. 4 (September 1994), pp. 810-32.

Mester, Loretta J. "Banking and Commerce: A Dangerous Liaison?," Federal Reserve Bank of Philadelphia Business Review (May/June 1992),pp. 17-29.

Perkins, Edwin J. "The Divorce of Commercial and Investment Banking: A History," The Banking Law Journal, Vol. 88, No. 6 (June 1971), pp. 483-528.

Saunders, Anthony. "Banking and Commerce: An Overview of the Public Policy Issues," Journal of Banking and Finance, Vol. 18, No. 2 (January 1994), pp. 231-54.

About the Author

Michelle Clark Neely

Michelle Clark Neely is a visiting scholar with the Supervision Policy, Research and Analysis team at the Federal Reserve Bank of St. Louis.