Regulation on Bank Activities and Mixing Banking and Commerce
Almost in all countries in the world there has been a discussion about whether to allow banks to engage ‘non-traditional’ activities, such as securities underwriting, insurance underwriting and real estate investment, and mixing banking and commerce, that banks own and control non-financial firms, or non-financial firms own and control banks.
In economic theory there are two opposite views about regulations on bank activities and mixing banking and commerce. The supporters of regulatory restrictions stress the following arguments:
1. Conflicts of interest may arise.
Close ties between a commercial bank, engaged in securities business, and its underwriting operations can increase the public’s perceptions of conflicts of interest in the bank and impair the bank’s ability to certify credibly the value of securities it underwrites. There are two sources of conflict (Randall S. Kroszner and Raghuram G. Rajan ,a a, (1997)):
· Banks may have an incentive to bail out of bad bank loans by refinancing these firms in the public market: if a client firm’s prospects deteriorate without the public realizing it, a commercial bank could attempt to persuade its underwriting operation to bring out a public issue on behalf of the firm, misrepresent the issue’s quality to the investing public in order to sell it, and use the proceeds to repay earlier bank loans made to the firm.
· Banks will “cherry pick” their best clients; if the market does not know the quality of the bank’s clients, the bank could attempt to continue funding their best clients through bank loans and take only the weaker firms to the market.
There are four potential conflicts of interest when banks own non-financial firms (Saunders, 1993):
· A bank may restrict the supply of credit to the competitors of its non-financial firm affiliate, while showing preferences toward its affiliated firm. So, bank can suppress the competitive performance of a rival of its non-financial bank affiliate and generate credit rationing, which may have a harmful effect on commercial firms. But for this to work markets loans have to be in-competitive. And it may be the problem only for firms that do not have excess to the other sources of loans. But it is not clear that small firms are the ‘rivals’ to large bank owning commercial firms.
· A bank may use its lending to tie consumers to the products produced by its commercial firm affiliate. For example a consumer gets interest subsidy for credit from bank and pays a non-financial price for the car.
· A bank may make either subsidized or unsound loans to its failing non-financial firm affiliate to keep it in business (to preserve its reputation or to save its failing investment). This may finally threaten the safety of bank itself.
· A bank may acquire some ‘private’ information during conducting its banking activities, which will be useful for its non-financial firm affiliates (a new investment technique or new product). This information is secret for the other party, even if there are regulatory firewalls, unless the penalties for discovery are very severe, or a loss of reputation imposed by the market. (Gnehm and Thalmann, 1989).
There may also arise conflicts of interest when non-financial firms own banks (a commercial firm owns a holding company to which bank is affiliated; Saunders, 1993):
· Excessive fees - If commercial firm charges the bank excessive fees for management and other services this may decrease the earnings and thus the capital of the bank and increases profits of firm/ company.
· Excessive dividends – As in the case of fees, if commercial firm/holding company require the bank to pay excessive dividends, it decreases the capital of the bank and enhances that of the firm/company.
· Bad asset transfers – Bad assets (such as debt or equity) may be transferred from the holding company or its affiliates to the bank however commercial firms would not be able to transfer its bad assets (equipment, etc).
· Contagion risk – Bad news about a commercial bank/holding company may have contagious effect and discourage bank customers from depositing or lending from this bank. Contagion risk is more relevant in bank holding company, because it is engaged in activities closely related to banking.
· Corporate separateness –If the legal separation between a commercial firm and a bank is unclear, than creditors of failed commercial firms may make claims on bank assets.
2. Moral hazard problems can easily arise when banks are engaged in broader range of activities and encourage riskier behavior of banks. Moral hazard in banking can take two forms. It may arise in the relationship between banks and the agents to whom they provide funds. In addition, it may arise between banks and providers of deposit insurance. If a bank is not allowed to take equity position in the firm to which it lends, then it will always try to control the moral hazard problem between borrowers and themselves. This fact will also reduce the range of obligations of the provider of deposit insurance, since banks fail less often [Kareken and Wallace (1978) and Merton (1977)]. When a bank is allowed to take equity position in firm, the incentive of a bank to control moral hazard is very small. Banks can get benefits by forcing the firms to ‘misallocate’ resources and they can easily pass losses on a provider of deposit insurance. There are several factors under which moral hazard problem is severe: low real returns on savings; higher return to misallocated funds, high cost to banks to determine moral hazard, banks possess relatively large equity positions in banking. Besides the fact that the banks choose among the broader range of risky ventures, the set of external risks affecting banks increases and as a consequence bank fragility increases (Boyd, Chang and Smith, 1998).
3. Complex banks are difficult to monitor and they may use their influence to shape banking regulations and policies
4. Banks become politically and economically powerful and it is difficult to discipline.
5. Large banks may reduce competition and efficiency by increasing concentration and monopolization in banking.
The contradicting view stresses the following arguments:
1. To exploit economies of scale and scope (Claessens and Klingebiel, 2000). Economies of scale result if a bank grows in size and its average cost of producing banking service decreases, so it measures the effect of product size on cost. Economies of scope measure the effect of bank product mix on cost. So, if bank produces many products in an optimal combination, aggregate costs may decrease (Saunders, 1993)
2. May increase franchise value of banks and thus increase incentives for prudent behavior.
3. Diversify income streams/ sources of profits and thus create more stable banks.
4. Information benefit - commercial banks are able to obtain relatively low-cost access to current information about their borrowers financing needs (Randall S. Kroszner and Raghuram G. Rajan ,a a, (1997)).
5. Coordination benefit - putting both functions under a unified management could improve the coordination of these functions and minimize competition between the lending and underwriting operations for a customer. (Randall S. Kroszner and Raghuram G. Rajan, a a, (1997)) .
Country Data on Bank Regulations
Table 6 represents the regulatory environment in 1997. It lists six indicators for the regulatory environment and a summary index of the first three indicators for each country. It shows that there are countries with very restrictive regulatory environment, such as Japan, Mexico, Ecuador, Indonesia, United States, etc (3 Restrict) and countries with only few restrictions, such as Switzerland, South Africa, Luxembourg, United Kingdom, New Zealand, Austria, etc (Restrict > 1.75). The table shows that there is a cross-country diversity in the individual regulatory restrictions, in other words a country may have higher restrictions on one activity, but less restrictions on the other.
Table 7 presents summary statistics of cross-country variation in the data. It shows that banks are operating in quite restrictive environment around the world (Restrict = 2.40). Securities activities are the most common compared to insurance and real estate activities. It is more frequent when non-financial firms own and control banks, but banks are more restricted to own and control non-financial firms.
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