benefits and costs of integrated financial services providers

benefits and costs of integrated financial services providers

EU‐CHINA BMT WORKING PAPER SERIES No.006 BENEFITS AND COSTS OF INTEGRATED FINANCIAL SERVICES PROVIDERS (IFSP) ‐ STATE‐OF‐THE‐ART IN RESEARCH Prof. Dr. Horst Loechel Frankfurt School of Finance & Management Shanghai International Banking and Finance Institute 17F/D, World Plaza, 855 Pudong South Rd., Shanghai 200120, P. R. China [email protected] Dr. Heike Brost Frankfurt School of Finance & Management Sonnemannstrasse 9‐11, D‐60314 Frankfurt am Main, Germany h.brost@frankfurt‐school.de Helena Xiang Li (Corresponding author) Frankfurt School of Finance & Management Sonnemannstrasse 9‐11, D‐60314 Frankfurt am Main, Germany h.x.li@frankfurt‐school.de Abstract
This paper aims to review the theoretical findings and empirical evidence of the benefits and
costs of integrated financial services providers (IFSP) and draw inferences of developing
IFSP in emerging markets with special consideration on China. The overall results can not
conclude the superiority of IFSP or of segregated financial institutions. In opposite, the
evaluation of the integration or segregation of financial institutions should always be
embedded in the regulatory and managerial context.
However, we could draw some implications that developing IFSP is of special relevance for
emerging countries: The existing dominance of banking institutions in emerging national
economies with the co-existence of underdeveloped capital markets can be leveraged for
capital market innovation if lending, underwriting and brokerage services are available under
one roof for the current client base. Cross-selling of banking and insurance products through
bancassurance can better serve retail clients with comprehensive advisory for sophisticated
life-time financial planning and can better complement the undeveloped social security
system in emerging countries. Relationship banking and bank monitoring can better solve the
problem of information asymmetry in emerging markets with lower transparency,
underdeveloped corporate governance standard and weaker contract enforcement mechanism.
As China is almost the unique country in the world still with commercial bank law favoring
segregated financial system and the current ongoing deregulation process on the incremental
trial basis is progressing, understanding the benefits and costs of IFSP can be of special
importance as the next cornerstone for China’s banking reform.
Keywords: Integrated financial services provider; universal banking; bancassurance;
emerging countries; China
JEL classification: G20, G21, G28
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Introduction
The discussion about the advantages and drawbacks of an integrated approach of financial
institutions has a long history of over eighty years. This fundamental financial system design
question was intensively debated already in the 1930s when the enforcement of the GlassSteagall Act 1933 in the USA finally declared the overhand of a segregated banking system
strictly prohibiting commercial banks from the involvement in investment banking business.
However, this segregated system was criticized by academics since its birth. Especially the
costs of forgone advantages from economies of scale and economies of scope speak strongly
against the separation of different service lines in the financial service industry. Global
competition and the financial market deregulation trend accelerated the erosion of the
segregated banking system in recent years and the implementation of Gramm-Leach-Bliley
Financial Services Modernization Act in 1999 finalized the end of the era of segregated
banking system in the USA.
The global trend towards IFSP was already observed in the early 90s by Ferrara (1990). He
argues the shrinking information and transaction costs realized through modern
communication technology makes securitization more important as substitute for traditional
bank credit function and he emphasizes the efficiency gains from more market competition
and risk reduction through diversification in a financial system with IFSPs. The more
developed capital market a country has, the greater are clients’ needs for more sophisticated
and individualized financial products. A money market fund could for example substitute
bank deposit. A bank with solely traditional deposit taking and lending functions can hardly
survive in the fierce global competition on the financial markets with increasing complicity of
product innovation and deepening capital securitization.
In light of the current credit crisis, the discussion of benefits and costs of IFSP became even
pronounced. The bankruptcy of Lehman Brothers with over 150 years of history, and the sale
of leading investment banks Bear Stearns to JP Morgan Chase, Merrill Lynch to Bank of
America raised the question about the end of era of the pure style investment banking. The
left two leading investment banks Morgan Stanley and Goldman Sachs both turned to be bank
holding companies with the allowance to enter into commercial banking business of deposit
taking to enlarge funding basis. Kevin (2008) from American Banker renews the debate on
universal banking and argues that more diversity in the business mix can provide financial
institutions more consistency of funding and stability, giving universal banks Citi Group,
Bank of America and JPMorgan Chase as examples. The risk diversification effect of IFSP
turned out to be the decisive competitive advantage for the survival of financial institutions in
times of system shock.
The lessons learned regarding the development of IFSP in industrialized countries are
especially valuable for financial system design in transition countries. Comparing the cost of
financing in the second industrial revolution in the United States and Germany between 1870
to 1913, Calomiris (1995) concludes that the universal banking system contributed the
industrial development in Germany by offering lower financing costs for large-scale
production and new products and technologies due to lower information and control costs
with the universal bank system in Germany. He underlines the importance of the development
of IFSP for contemporary emerging countries: “Developing countries designing financial
systems should take a lesson from U.S. financial history and avoid a costly, lengthy detour
through financial fragmentation.”
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As one of the largest emerging countries in the world, China made great effort and success in
the last thirty years of reform in transforming a mono banking system in a plan economy to a
competitive modern banking system in pace with the development of the socialistic market
economy (Loechel, Zhao, 2006). A current striking fact of banking regulation and supervision
in China is however the lag of its Banking Act with strict separation of banking from
securities and insurance services behind the global deregulation trend and market
development. In a survey of banking regulation in 107 countries over the world done by Barth,
Caprio and Levine (2001), China receives the highest score in overall banking activities and
ownership restrictiveness. Claessens and Klingebiel (2001) note China is the only country
with segregated financial system among 51 industrial and emerging countries surveyed by the
Institute of International bankers in 1998. In a latter Global Survey 2007 of Institute of
International Bankers about banking regulation in 51 developed and developing countries,
China is the only country with strict prohibition of banks’ engagement in securities, insurance,
real estate and industrial firms. Deregulation and building up a financial system based on
IFSPs could be the next cornerstone of the banking reform in China.
In this context, this paper reviews relevant theoretical findings and empirical evidence to date
regarding benefits and costs of IFSP and draws implications for future financial system design
in emerging countries with China in focus. Section 1 gives definition of IFSP. Section 2 and
section 3 discuss the benefits and costs of IFSP respectively. Section 4 draws implications of
the relevance and limitations of IFSP for emerging countries, especially for China. Section 5
provides conclusions and outlook.
Section 1: Definition
An IFSP is defined as a financial institution which provides a wide range of services including
mixtures of consumer banking, commercial banking, investment banking, asset management,
insurance services or any other kind of financial services. Compared to a universal bank
which combines commercial and investment banking businesses, an IFSP extends the service
to other finance-related business lines, especially insurance services. IFSP can be performed
in different combinations like commercial banking with investment banking, bancassurance,
and financial conglomerate either through direct participation or subsidiaries.
According to EU Financial Conglomerate Directive 2002, an IFSP can be structured through
four different organisation forms: the integrated model with all services provided within one
entity; the parent-subsidiary model; the holding company model and the horizontal group
model through contracts of association instead of through direct or indirect capital links. To
protect the interest of insured parties, EU Life Assurance Directive and Non-Life Insurance
Directive regulate that insurance business can only be undertaken by separate legal entities.
Saunders and Walter (1994) summarize the four organisation types of universal bank (see also
Biswas, Loechel, 2001):
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When a universal bank extends its business to insurance, the question arises how to integrate
the insurance business into conventional banking business. Are banking managers capable to
manage risks in insurance business of total different kind such as the risk of accrual
estimation? Saunders and Walter (1996) underline the following similarities of insurance with
banking: mortality analysis in insurance is comparable with loan default rate analysis in
lending; both insurance asset return and loan return depend on interest rate development; both
face similar adverse selection and moral hazard problems; reinsurance and sale of loan
portfolio have similar pattern of risk transfer; synergies can be gained through joint
management for exposure of liquidity risk. Sharing the distribution channel of banks to crosssell insurance products proves to be the successful model of bancassurance in Western Europe.
Section 2: Benefits
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2.1. Economies of scale and scope
Economies of scale and scope are regarded as the strongest argument for the integrated
banking model among the advocates of IFSP and are driving forces for bank merges.
Economies from scale effect and enhanced scope can be achieved both from revenue
enhancement and costs reduction.
On the revenue side, economies of scope can be realized through “cross-selling”. IFSP
benefits from the insider information gained in the previous client relationship and through
the individual client life-cycle for cross-sell new products. Retail banking clients have the
opportunity to choose products from a basket of products provided by the same bank to meet
their individual financial needs. While specialized investment bank will loss underwriting
clients in time of “cold” equity market, IFSP can offer its corporate client a suited loan
product to finance investment projects. Underwriting of corporate bonds in foreign currency
can be bundled with currency swaps to better align the capital market sentiment to corporate
financing needs.
On the costs side, reduced information and transaction costs by sharing monitoring activity
based on the same client information, the usage of the same information technology platform
and the spread of managerial overhead costs provide IFSP advantages of economies of scale.
A lender and a broker for example may face the same market interest risk for the existing loan
portfolio and for corporate bonds trading. The consolidated management of overall market
risk, liquidity risk, counterparty risk and operational risk can generate synergies for cost
savings. Sharing the same brand for multiple products can leverage the existing reputation to
promote new products and realize marketing savings. Information gained from one-time client
transaction is valuable in the context of relationship banking. For example, an investment
banking affiliate can use client information generated from the lending relationship and save
information gathering costs for underwriting due-diligence. A bank with established money
management facility can use the capacity to set up mutual funds management affiliates for
retail customers. For bank clients, cost savings can be achieved through reduced search and
contract costs as well as switching costs.
Geographic scope of an international bank can be an extra source of revenue enhancing by
offering clients global solution of custody, clearance and cash management, the so-called
“network economies” (Walter (2003)).
In contrast to the theoretical possibilities of scale and scope economies, the empirical
evidence shows economies of scale and scope only exist for small- and middle-sized financial
institutions, whereas the diseconomies of scale and scope dominate in large institutions due to
inefficient management for complex large scale of business.
Based on Walter (2003), economies of scale are only empirically proven for small financial
institution with assets below USD 100 million. Rime and Stiroh (2003) examine the scale and
scope economies of 289 Swiss universal banks from 1996 to 1999 and find evidence of scale
economies for small to middle-sized banks. Clark (1996) finds scale economies in the sense of
both production and economic efficiency can not be achieved if a bank’s total asset expands
over USD 2 billion.
There is some evidence that European universal banks can better channel economies of scale
and scope. Vennet (1998) analyzes 2,375 banks covering the period of 1995 to 1996 from 17
countries in the European Union where financial conglomerate is legally allowed through EU
Second Banking Directive (1989). He finds evidence that financial conglomerates are more
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cost efficient in non-traditional banking activities than specialized banks, whereas the cost
efficiency of the two bank types differs not much in traditional intermediation activities.
Compared to specialized banks, universal banks have superior profit efficiency related to
comparative information advantage. Using bank data of 850 banks from France, Germany,
Italy and Spain in 1988, Altunbas and Molyneux (1996) document the existence of economies
of scale in European banking markets and economies of scope in Germany.
A special form of IFSP with the combination of banking and insurance is bancassurance,
either through horizontal merger, through joint-venture or through strategic alliance and
cross-selling agreements. The original idea is to leverage banks’ branch and other distribution
channels to cross-sell insurance products to generate commission income and diversify
revenues, providing motorcycle insurance for lenders of motorcycle loan for example. This
concept meets clients’ needs for convenience buy and for comprehensive advisory for
sophisticated life-cycle finance planning. The established relationship between life-time
finance advisors and clients especially generated from life insurance products can help banks
boost the potential of cross-selling based on gained clients information, for example,
establishment of the client relationship through granting education loan in early years and
promotion of child endowment account for the “event” of clients’ child’s birth in later years
of client’s life cycle. The drawback of bancassurance is that some of the life insurance
product could substitute some depositary products and the product knowledge of banking
advisor especially for property/casualty insurance products is limited.
Several studies confirm empirically the potential of economies of scope and risk reduction
through the combination of banking and insurance. Chen, Li, Moshirian and Tan (2006)
analyze 213 bancassurance mergers in Europe from 1986 to 2004 and conclude the systematic
risk of acquirers falls while the short-term abnormal return is negative for bidders. Fields,
Fraser and Kolari (2007) examine 129 bancassurance merges among U.S. and non-U.S.
companies from 1997 to 2002 and prove small positive bidder return after announcement,
whereas the merger does not alter the risk profile of acquiring firms. Chen, Li, Liao,
Moshirian and Szablocs (2008) provide a comprehensive study of 71 bancassurance
companies in 28 developed and developing countries for the period between 1999 and 2003.
Their finding confirms the risk reduction through diversification and cost savings in large
operations. Okeahalam (2008) finds retail bancassurance products are six percent cheaper
than the sum of stand-alone products in South Africa indicating cost savings through
economies of scale and scope passed through to customers.
However, large scale economy goes hand in hand with increased bank size and lower
competition on the market. The abuse of oligopolistic market power can reduce the scale
economy for the social welfare through increased interest margin and less competition on the
market can lead to reluctance of efficiency improvement. This drawback is discussed in detail
below in section 3.4.
2.2. Risk diversification and contribution to financial market stability
Another significant benefit of IFSP is the risk reduction due to low correlation of revenues
from different business lines and reduced bankruptcy risk which leads to higher credit rating
and lower refinancing costs. From the macroeconomic perspective, risk reduction of universal
banks also promotes the stability of the entire financial system due to reduced counterparty
risk in inter-bank markets and lower probability of bank-run. In an IFSP, losses from one
business line, let’s say, from investment banking which is inherent more volatile to market
fluctuations, can be first absorbed by profits generated in lending business, instead that the
whole bank goes bankruptcy which affects the stability of the whole financial system due to
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the interlinks in the banking industry. The current financial crisis and the relative stability of
banks comprising both commercial banking and investment banking business like Citi Group
and Bank of America provided evidence of risk reduction through the integration of different
service lines.
The World Economic Outlook October 2008 issued by International Monetary Fund confirms
empirically the pro-cyclicality of leverage of investment banking and commercial banking in
a more arm’s-length financial system, which leads to higher vulnerability to system risk in
economic downturns or recessions. This is in line with the finding that the overall impact of
the financial turmoil is greater in the United States than in Europe where the universal
banking system dominates.
Empirically, the risk reduction in universal banking can be proven through correlation
analysis between income from banking and non-banking businesses, Nurullah and Staikouras
(2008) summarize the correlation analyses in previous studies as follows:
As shown in the table above, the returns from banking and non-banking activities are in
general negative correlated (negative sign in the brackets). The combination of banking with
life insurance has the greatest potential to reduce the return volatility due to the significant
negative correlation of returns. Rich and Walter (1993) also find slightly negative correlation
between net interest income from loans and income from commissions among Swiss universal
banks indicating risk reduction potential of combining lending and underwriting.
The study on risk and return impact of banks’ expansion in non-banking businesses remains
another research interest on IFSP. Boyd and Graham (1986) examine the risk feature of 64
largest bank holding companies in the United States from 1971 to 1983 and find no altering of
the risk pattern after the expansion in non-banking activities. Boyd and Graham (1988) further
analyze the risk and profitability effects of allowing bank holding companies to merge with
other financial firms based on simulated mergers using dataset of 249 publicly traded banks
and non-bank firms from the period of 1971 to 1984. Their study show the expansion in
securities or real estate sector increases the risk of failure of bank holding companies whereas
the combination with life insurance companies decreases the volatility of return and achieves
risk diversification. Their findings could provide implications for the regulatory setting of
allowed activities of IFSP. Chong, Liu and Altunbas (1999) show the repeal of segregated
financial system through the Financial System Reform Act in 1992 and the development of
universal banking in Japan increased Japanese financial institutions’ exposure to market risk
and lowered the interest rate exposure. Allen and Jagtiani (2000) find combining banking with
securities and insurance activities reduces the overall risk. Nurullah and Staikouras (2008)
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study empirically the impact of European banks’ diversification into life, non-life insurance
underwriting and insurance broking on risk and profitability. They conclude the return of
enter into life underwriting and insurance broking increases significantly, whereas banks’ risk
with combination with life and non-life insurance underwriting also increases.
Claessens (2002) further emphasizes the increase of fee-income in IFSP can compensate the
decline of interest income with the trend of dis-intermediation when firms tend to raise funds
more directly from the capital market. This revenue diversification in IFSP establishes the
revenue resources and prevents banks from riskier lending.
Moreover, the expansion of geographic scope of banks can contribute to overall risk reduction.
Covering data from 38 international banks from eight industrialized countries during 1995
and 2004, the study of Garcia-Herrero and Vazquez (2007) reveals foreign subsidiaries
especially in emerging countries where the business cycle is not so synchronized with that of
home countries contribute to enhanced risk-adjusted return of the whole banking Group.
Another question regarding IFSP and banks’ risk taking is how the setting of IFSP is subject
to risk enhancing or risk reduction and thus should draw special attention by regulators. Using
stylized models, John, John and Saunders (1994) prove banks’ equity holding in firms with
veto rights over borrowing firms’ investment policy increases the investment efficiency but at
the same time increases the risk of banks’ asset. Banks’ equity holding with firm controlled
investment can however increase investment efficiency and reduce the risk of banks’ portfolio.
Regulators should take into account the impact of different combination patterns of permitted
banking services on risks and incentives of bank and corporate.
There are some studies on the relationship of IFSP with the financial crises in past years.
Wilmarth (2005) asks the role of universal banks in the U.S. boom-and-bust cycle of 1921 to
1933. He argues universal banks fueled oil in the economic expansion between 1924 and 1929
through loan to securities, securities investment, public offerings of securities, real estate
mortgages and consumer credit. The analysis of the relationship between banking system
architecture and banking crisis in IMF’s World Economic Outlook October 2008 provides the
contradictory conclusion: one lesson learned from financial distresses in 17 advanced
economies over the last 30 years is “economies with financial systems dominated by morearm’s-length transactions, as opposed to traditional relationship-based intermediation, tend to
exhibit higher procyclical leverage”, which increases the finance system fragility. In some
countries, the limitation of the functional scope is the result from regulatory restrictions.
Based on their survey data on bank regulations of 142 countries, Barth, Caprio and Levine
(2008) find that regulatory restrictions increase the possibility of banking crisis. They explain
the result with the argument that diversification reduces the fragility of banks to shocks. The
regulatory setting for or against the integrated banking model should therefore always be put
in the context of maintaining system stability and enhancing the system ability to prevent and
encounter system shocks.
2.3. Information advantage and relationship banking
The financial service industry is characterized with higher information and transaction costs.
Banks as delegated monitors (Diamond (1984)) for information gathering and monitoring
have inherent advantage over capital markets. Sharing client information for different services
in a universal bank can significantly reduce the costs of information collection and enhance
information usage. The life-time relationship induces banks to collect inside information even
with higher information gathering costs which financial institutions in a single transaction
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relationship are hardly ready to bear. More important, information gained from one business
line, credit history, for example, can give important indication for other businesses, like debt
issuing. Using this information, banks can explore the cross-selling potential to meet clients’
individual needs at lower costs. The “house bank” principle furthermore adds value over the
whole client life cycle. In relationship banking, banks collect more private information, the
loan contracts are more flexible and in favor of long-term projects and moral hazard problems
are less predominant.
Boot (2000) emphasizes long-term relationship can induce the debtor to disclose more private
information not available to the financial market and the bank to invest more in information
gathering. The contracts in relationship banking tend to have more flexible feature and are
easier for renegotiation than other capital markets instruments like corporate bonds. Bank
monitoring of collateral reduces the problem of moral hazard. The reduced information
asymmetry can facilitate inter-temporal smoothing in favor of the realization of long-term
projects. As potential drawbacks, he highlights the soft-budget problem if the bank is lack of
the enforcement power and the hold-up problem if the bank misuses its informational
monopoly and negotiation power.
Allen and Gale (1999) prove in their model the importance to maintain long-term relationship
in the enforcement of implicit contracts between banks and investors with high ex-ante cost.
Cabral and Santos (2001) prove in a stylized way that increased points of contracts in a
repeated relationship can improve contract efficiency in a one-sided or two-sided moral
hazard context even in the absence of efficiency of information gathering.
Burghof (1999) analyzes the advantage of banking lending in gathering private information
by examining actual credit files of six medium-sized corporate customer of a major German
universal bank. He documents on average 94% of information gathered in the credit files are
private information not available on the security market and creditors actively use interaction
with bank for signaling and bonding in cases of turnaround or bankruptcy. He confirms the
importance of banks as delegated monitors in firm lending. Based on data of 1,302 Japanese
domestic bond issuance for the period of 1994 to 1999, Yasuda (2007) provides evidence that
lending relationship positively affects firms’ underwriter choice and this relationship
especially in a multiple relationship context benefits firms with significant underwriting fee
discount.
The relationship banking benefits firms with smoothed loan lending over the business cycle
and is especially crucial in times of firms’ financial distress. Using UK syndicated loan data
from 1996 to 2005, Steffen (2008) reveals remaining lending relationship with banks can help
firms to smooth loan lending rates over the business cycle. Ramírez (1999) also finds the
sharp decrease of bank-firm affiliation after the enactment of the Glass-Steagall-Act increased
the cash-flow sensitivity of former bank-affiliated companies for investment and demonstrates
relationship banking in a universal banking context can facilitate firms to encounter financial
constrains. Hoshi, Kashyap and Scharfstein (1990) provide evidence that financially
distressed firms with close relationship with “main bank” in Japan invest and sell more
compared to firms not in such relationship. They argue relationship banking can avoid the
free-rider problem in renegotiation of financial claims and reduce information asymmetry
about firms’ investment prospects in times of financial distress. Elsas and Krahnen (2004)
analyze the German setting of relationship banking (Hausbank relationship) and show
evidence the Hausbank relationship is beneficial for small firms as credit insurance in times of
workouts and financial distress.
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Herrera and Minetti (2007) focus on the role of relationship banking in fostering firms’
technological innovation. Based on data of over 4,000 Italian manufacturing firms for the
period of 1998 to 2000 and their credit relationship, they uncover the main banks help to
channel funds for the introduction and acquisition of new technologies.
Relationship banking can also be of interest for retail clients. Analyzing the allocation data of
72 IPO underwritten by German universal banks from 1997 to 2004, Puri and Rocholl (2008)
reveal retail customers of banks acting both as deposit taker and lead underwriter can benefit
from relationship banking by being better informed and encouraged to subscribe underpriced
IPO securities issued by the same bank. They also uncover banks benefit from this
relationship for cross-selling brokerage service and retail customer loans.
2.4. More efficient internal capital market
The decision, if certain financial service line should be integrated in one financial Group or be
executed arms-length through external market, depends on the efficiency comparison of
internal versus external capital markets. Current financial crisis demonstrates the importance
of internal capital market especially for liquidity management in case of distortion of external
financing on the inter-bank markets. The drawback is however that cross-subsidization could
decrease the incentives of profitable business lines or lead to over-investment in low NPV
projects.
Koeppl and MacGee (2005) provide valuable evidence that cross-subsidization of a broad
bank can achieve higher levels of aggregate investment, higher output and less fluctuation in
the presence of liquidity and asset shocks compared to regional bank linked with interbank
markets. In general, the incentive system for internal valuation of business lines should be
based on the market discipline. Setting up internal rules of reward and penalty for intra-Group
transactions remains the core task of setting up proper incentive mechanism in IFSP.
2.5. Bank monitoring and promotion of firm performance
Possessing internal information about the lenders in relationship banking, banks can better
judge a firm’s financial situation and the prospect of its long-term investment. Banks can
leverage their industrial expertise to advise bank clients’ investment decisions. In a universal
bank model with banks’ equity holding, it’s of banks’ own interest to foster firms’ growth and
provide finance insurance in times of restructuring and distress.
Benston (1994) emphasizes the transaction costs of takeovers and mergers in case of firm
restructuring are higher in a stock market system than in a universal bank. He further posits
bank’s holding of both debt and equity in a firm can facilitate the firm to find the best debtequity mix and can give firms better finance support in time of distress.
2.6. Bank loan in small and middle sized enterprises (SME) financing
The impact of the universality of banks on SME financing is not obvious. On the one hand,
reduced information asymmetry and monitoring costs and enlarged product portfolio can
better serve the special needs of SME which hardly have entrance to capital markets for
financing, since SME are less subject to mandatory disclosure, weakly monitored by rating
agencies and draw less attention on the capital market. On the other hand, increased bank size
alongside with enlarged scale and scope facilitates the tendency of centralized credit rationing
which speaks against the support of financing SME.
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Peterson and Rajan (1994) reveal the lending pattern of firms in the United States and show
the smallest firms more relay on debt financing from concentrated sources of one lender and
prove empirically that closer ties with banks can increase the availability of funding due to
reduced information asymmetry and agency costs. They also uncover firms with lending
relationship with multiple banks are charged with higher interest rate. Ely and Robinson
(2004) however find no significant difference of the proportion of small business portion at
commercial banks with or without securities affiliates. Montoriol-Garriga (2008) investigates
the impact of domestic bank merges in Spain between 1996 and 2005 on small business
lending and observes a higher possibility of termination of the lending relationship with the
consolidated bank for smallest borrowers. However, there is a significant reduction in loan
interest rate to smallest and youngest borrowers which are capable to continue the lending
relationship after the merger. She accounts this positive effect to efficiency gains from
economies of scale and scope as well as risk diversification after the merger. How to facilitate
the credit entrance of SME in a financial system in line with the IFSP model should be well
considered by regulators.
Section 3: Costs
3.1. Conflicts of interest
The problem of conflicts of interest remains the loudest voice against the development of
IFSP and has been intensively discussed in the context of financial system re-design
especially in the United States for the introduction of segregated financial system in 1933 and
the deregulation in 1999. Conflicts of interest can arise in different ways: Banks could use the
private information to remove loans with lower quality from the balance sheet by converting
the loans into public securities (conflict of interest); Banks could tie loan terms with firms’
willingness to mandate the bank with underwriting business (tying) etc.
Conflicts of interest arising in IFSP can be classified according different roles of IFSP:
3.1.1. Lender and underwriter
A large body of literature investigates conflicts of interest in a universal bank providing both
lending and underwriting services. The core question lies in whether universal banks use their
private information of loan clients to sell “lemons” to uninformed investors by underwriting
loans of lower quality and removing them from their own balance sheet to the capital market.
Another focus is on banks’ tie-in sales such as setting the engagement as security
underwriting advisor as pre-condition for lending or granting investor loan with below-market
interest rate to purchase securities underwritten by affiliated unit.
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Theoretically, the combination of lending and underwriting brings cost savings in information
gathering. Puri (1999) proves with a stylized model that the private information gained by
commercial banks through the prior claim relationship can help banks better certify the true
value of the firm for the underwriting. This link holds especially when the costs of
information gathering are high.
Empirically, evidence of conflict of interest for banks acting both as lender and underwriter is
rare. In contrast, the information advantage gained from the lending relationship for
underwriting securities is predominant.
An early study of Puri (1996) analyzing the ex-ante yield of underwritten securities by
commercial banks and investment banks of pre-Glass-Steagall period has shown that investors
are willing to pay more (lower ex-ante yield) for securities underwritten by commercial banks
as the reward of the certification role of banks with private information generated from the
loan making and monitoring activities. This effect is more salient for junior and information
sensitive securities. Similarly to Puri’s study, Hebb and Fraser (2002) document a lower yield
for securities underwritten by commercial banks based on data from 1987 to 1997 after the
revoke of law separating commercial and investment banking in Canada in 1987 and
contradict the conflict of interest hypothesis.
Compared to the U.S. experience, Kang and Liu (2007) examine corporate bonds issues in
Japan between 1995 and 1997 after the issuance of Financial System Reform Act (1993)
which repealed the separation of commercial banking from investment activities. They find
bank-underwritten bonds carry higher yields thus are lower priced compared to bonds
underwritten by investment houses. The underpricing is more pronounced for issuer with
lower credit rating or the bank serves as main bank. Their explanation is the lending power of
commercial banks presses the issuing price in order to attract investors. They call for caution
of commercial banks’ certification role in underwriting especially for emerging countries
where the heavy reliance of corporate on banks could strengthen banks’ power and conflicts
of interest between lender and underwriter could be intensified.
Ber, Yafeh and Yosha (2001) analyze the post-issue performance of 128 Israeli IPOs
underwritten by universal banks also acting as creditor and fund manager and find evidence of
significant post-issue superior accounting performance of IPOs underwritten by bank
affiliates with lending relationship in the same year of the IPO. Their results can be
interpreted as evidence of the information advantage gained by a bank underwriter through
the lending relationship. However, the performance of IPOs purchased by the investment fund
affiliates of the underwriting bank exhibits both low first day and first year performance
which indicates potential conflict of interest in affiliated fund management at the cost of fund
investors.
Drucker and Puri (2005) further reveal the majority of firms engaged in concurrent lending
and underwriting with the same bank are highly leveraged and noninvestment-grade rated
firms and argue the information advantage gained from the lending relationship reduces the
underwriting fee significantly especially for noninvestment-graded firms.
Krishnan (2007) examines the behavior of U.S. banks between 1990 and 2003 after firms’
debt issuance and demonstrates that banks do not punish loan clients with less credit and
higher spread if the client did not give the bank underwriting mandate as supposed in “tying
hypothesis”. Instead, banks use information gathered in the underwriting process to avoid
loan approval to clients with lower quality. Thus, access to both lending and underwriting
leads to lower financing costs and better loan allocation and the argument of conflict of
13
interest is in this case contradicted. Laux and Walz (2007) confirm Krishnan’s results in their
modeling and emphasize universal banking tend to underwrite less innovative firms while
specialized investment banks more possibly serve innovative start-up underwriters or
seasoned equity offerings of growth firms. Based on the examination of 270 IPOs of German
firms between 1997 and 1999, Klein and Zoeller (2003) observe the long-term performance of
IPOs underwritten by universal banks does not distinguish much from those underwritten by
specialized investment banks. They therefore contradict the presumption of universal banks’
underwriting of lower quality securities.
3.1.2. Lender and equity holder
With bankers sitting on the board, firms can improve the information flow with its creditors
and establish a reliable credit relationship especially valuable for long-term financing and in
times of financial distress and restructuring. Having bankers as board members, firms can
benefit from the bank’s certification role indicating that the firm has less possibility of default.
Banks’ industrial expertise and know-how in financing and restructuring can provide firms
valuable advices.
In an IFSP with merchant banking, banks with equity holding directly or through trust
affiliates or with proxy rights may influence corporate decision through lending power or
mandates sitting in boards of non-financial companies. This may impose the conflict between
shareholder and creditor in protecting shareholders’ interest due to different payoff structure
of debt and equity, such as banks’ approval of lending with below-market rates in favor of the
shareholder role or neglecting riskier investment project with positive net present value to
protect creditor’s interest
Kroszner and Strahan (2001) observe that one third of large U.S. firms have a banker on
board and regard this as indication that the benefits of banks’ monitoring role outweigh the
costs of conflict of interest. Santos and Rumble (2006) also document that the largest 100
American banks control on average 10% of the voting rights of S&P 500 firms through their
trust business based on data at the end of 2000. In Germany with traditional equity holding of
universal banks, Esen (2001) however observes the shrinking trend of German banks’ shares
in industrial companies and emphasizes the international competition pressure forces German
universal banks to use the capital more flexibly which changes the shareholding pattern of
universal banks.
3.1.3. Lender and asset manager
The sharing of information gained from the lending business can give the in-house asset
manager indication for the quality of issued securities to generate superior return to funds
managed by the same house.
Massa and Rehman (2008) provide valuable insight on the benefits of the combination of
lending and asset management for IFSP on the costs of uninformed investors. They uncover
that mutual funds tend to increase stakes in firms which borrowed from the affiliated banks in
the prior period and these stocks outperform stakes without borrowing from the affiliations.
They suspect financial conglomerate makes use of informal information flows such as
personal acquaintances to generate superior returns.
14
3.1.4. Underwriter and sales broker/researcher
Conflict of interest can occur if sell-side research analysts issue optimistic biased broker
report for securities underwritten by the affiliate underwriting unit to promote issuance of the
same house.
Lehar and Randl (2003) examine the behavior of affiliated analysts in equity research
department of nine German universal banks between 1994 and 2001. They find evidence that
affiliated analysts behave strategically by issuing optimistic forecasts when the consensus
forecast underestimates actual earnings and by hiding among non-affiliated analysts when the
consensus is overoptimistic. Thus, affiliated analysts can cultivate firm-bank relationship by
issuing optimistic forecasts and improve forecast accuracy using superior information
advantage. Their study proves empirically the existence of conflict of interest in IFSP with
both underwriting and sales broking facilities.
Based on sell-side analyst recommendations during 1994 and 2000, Ljungqvist, Marston,
Starks, Wei and Yan (2007) also document the optimistic bias in recommendations issued by
analysts with established investment banking relationship with covered firms and when the
affiliated banks also provide brokerage services. This conflict of interest can be however
limited with the presence of institutional ownership of covered firms since analysts must
balance the pressure from investment banking and brokerage unit with their reputation among
institutional investors linked with career concerns.
3.1.5. Underwriter and asset manager
Concerns arise regarding conflict of interest in IFSP with both underwriting and asset
management facilities, whether asset managers are put in pressure to purchase securities
brought public by the underwriting affiliate of the same house or to buy shares to support
price of cold IPOs of the bank’s clients. Allocating hot IPOs to affiliated funds could in turn
boost the fund’s performance and attract more money flow to the bank.
Johnson and Marietta-Westberg (2005) analyze 2,412 U.S. IPOs between 1993 to 1999 and
provide evidence that asset manager can utilize superior information gained by underwriting
affiliates in IPO to generate abnormal returns, while non-underwriter asset manager trades
mostly short-term momentum. In return, holding big portion of stocks by IPO underwriter’s
asset management unit increases the probability to gain the SEO underwriting business
significantly.
Ritter and Zhang (2007) examine the allocation of 2,257 U.S. IPOs to mutual funds affiliates
from 1990 to 2001 and find no significant evidence of favored allocation of IPOs to affiliated
mutual funds. Only in the internet bubble between 1999 and 2000, investment banks
preferentially allocated underpriced IPOs to affiliated mutual funds to generate superior return.
3.1.6. Asset manager and sales broker/researcher
Conflict of interest can arise with “salesman’s stake” if the asset manager promotes the highmargin house products. Asset manager may also induce frequent trades conducted by the
affiliated sales brokers to generate more commission fees on the cost of retail clients.
As a prominent case for conflicts of interests in multidivisional bank, Walter (2006) gives the
relationship between Citi Group and WorldCom as an example. Citi Group served
15
simultaneously as equity analyst, strategic and finance advisor, lender, underwriter, pension
fund advisor, trader for executive stock options, stock holder and stock trader for WorldCom.
Conflicts of interest of Citi Group played a non-negligible role in the scandal of WorldCom.
As measures to control such conflict of interest, Walter (2006) suggests three channels:
regulation, civil litigation and market discipline. Prudential regulation of insider trading and
the enhancement of market transparency are best measures to encounter conflict of interest.
On the one hand, the establishment of organizational constraints in law by requirement of
conduction of conflicting business lines through segregated subsidiaries or installation of
firewalls between conflicting service lines can provide necessary prevention of the abuse of
information advantages and moral hazard problems in IFSP. On the other hand, strengthening
market discipline, public supervision and shareholder self-protection can supplement
regulation and litigation. At the same time, competitive market pressure and reputation
consideration can also induce IFSP to set up safeguards and structures to avoid conflicts of
interest. Mehran and Stulz (2007) also emphasize the combination of market mechanism such
as pricing discount due to awareness of conflict of interest, analysts and funds reputation in
ranking, market competition along with regulation and litigation can mitigate the adverse
impact of conflicts of interest in IFSP.
3.2. Spill-over effect
The establishment of the segregation of commercial banking and investment banking is borne
in the banking crisis in the United States in 1930s when massive losses from security affiliates
affected the commercial banking arm. How to prevent the spill-over effect of riskier security
trading business to the safety of commercial deposit taking remains the main concern of
opponents of the universal banking system. Spill-over effect can also be reputation-related if a
scandal from one division damages the overall-brand and causes loss of customers for other
sound business lines. Since confidence is crucial in the financial services industry, the spillover effect of reputation damage can overweight the marketing savings from sharing one
brand. Due to the large size of financial institutions to generate economies of scale and scope
in a system with IFSP, how to avoid the negative spill-over effect from the failure of one
business arm in one institution to the total financial system remains a crucial task for
regulators in a financial architecture with integrated models.
3.3. Moral hazard and impact on the financial safety-net
The aim of central banks as lender-of-last-resort and the deposit insurance system is to
prevent the chain-effect of bank runs caused by lost confidence of depositors. The interlink of
different business lines in financial conglomerate reduces the transparency of the cause for
bank failure and can induce moral hazard of bank managers for more risk taking. Moreover,
increased size of universal banks can enhance the moral hazard problem by increased bail-out
possibility due to too-big-to-fail-guarantee. Boyd (1999) posits the allowance of universal
banking can expand the government induced moral hazard problem by the existence of
financial safety net like deposit insurance system to other sectors of the economy. In a
financial system with permission of IFSP, how to restrict the shift of risks from securities and
insurance businesses to deposit taking remains crucial.
3.4. Concentration and market power
Another concern about IFSP is that the universality of banks can lead to concentration in the
banking industry with market power of large banks and thus reduces market competition.
16
Fohlin (2000) investigates this issue by comparing the market concentration in pre-war
Germany and the U.K. where universal banking system and separated banking system
respectively dominated. She reveals the market concentration of Germany did not differ much
from that in the U.K. Furthermore, she shows that the competitive pricing pattern of Germany
behaved similarly as in the United States with separated banking system which indicates that
the suggested interlink between universality and the distortion of market competition does not
hold.
Rich and Walter (1993) also show the market share of big banks in Germany with the
dominance of universal banks has not changed much since 1960 while at the same time the
universality of banks has extended. Thus the causality between market concentration and bank
universality is contradicted.
3.5. Conglomerate discount
The phenomenon of conglomerate discount (a share price discount for firms with more
functional diversification compared to peers in the same industry) is well observed in nonfinancial industry.
Laeven and Levine (2005) are among the first to investigate diversification discount of
financial conglomerates with their study based on a sample of banks in 43 countries for a
sample period from 1998 to 2002. Their results show that benefit gains from economies of
scale and scope can not compensate the costs from agency problem between informed
corporate insiders and small shareholders in financial conglomerate which are in result traded
with a discount on the capital market compared to specialized financial institutions. Using U.S.
dataset from 1985 to 2004, Schmid and Walter (2008) reveal comprehensively the existence
of conglomerate discount in the financial services industry and conclude the total balance of
functional diversification is value-destroying. However, with more differentiated analysis,
they show the combination of commercial banking with insurance and the combination
between commercial banking and investment banking produce significant premium.
Some researchers try to reexamine the research design to solve the puzzle of the dominant
finding of conglomerate discount and the positive stock price reaction of diversification
merger. The question focuses if diversified firms are already traded with a discount prior to
diversifying so that there is no causal relationship between diversification and diversification
discount. Campa and Kedia (1999) raise the question of self-selection of diversified firms and
prove that the conglomerate discount drops or sometimes disappears after the control of the
endogenous problem in research methodology. Villalonga (2000) confirms their finding and
show the diversification discount disappears or even turns to a premium when firms’
propensity to diversify is taken into account. However, financial institutions are not included
in the both above studies and evidence engaging this research design problem for financial
institutions is still vacant.
3.6.Negative impact on the development of capital markets
A conventional opinion states that the preponderant role of large banks in a universal banking
system hinders the development of capital markets. The evidence from Swiss capital market
provided by Rich and Walter (1993) questions this assumption. They prove that the fixedincome security market and the equity holding by private households in Switzerland perform
similar pattern as in the United States, whereas Switzerland together with Germany is
regarded as banking markets with full range universality.
17
3.7. Negative impact on financial innovation
As a common view, IFSP is embedded in a bank-based financial system like in Germany
where financial innovation is sparse compared to in a market-based system like in the USA.
Contradicting view argues the combination of different service lines promotes innovation of
new products and distribution models.
Kanatas and Qi (2003) posit the underwriting units of universal banks have less incentive to
promote clients’ securities on the capital market compared to specialized investment banks,
since lending products from the same house are available. They therefore argue the segregated
financial system can better foster financial innovation.
3.8. Requirement for integrated supervision and comprehensive banking management
In pace with the convergence of market segments in IFSP, the sectoral regulatory framework
should be reconsidered. At least, the interaction of different sectoral supervisors should be
strengthened.
The practice of the European Union with the implementation of Financial Conglomerates
Directive in December 2002 in the EU where the concept of IFSP was originated can provide
a unique template for supervision of IFSP. Dierick (2004) highlights the five main risks
involved in a financial conglomerate subject to special regulation: regulatory arbitrage
through intra-group transactions, contagion due to spill-over to economic linked entities,
moral hazard to financial safety net, the lack of transparency from group size and complexity,
conflict of interest and abuse of economic power. The emphasis of financial conglomerate
regulation should be put on group-wide capital adequacy and risk management, monitoring of
intra-group transactions as well as coordination and information exchange between sectoral
supervision authorities.
The difficulties of supervising financial conglomerates can arise in various fields: The
regulatory capital requirements for banking and insurance are different due to different risk
pattern; A financial conglomerate with holding structure has the possibility to book the
products and assets in the business line with the lower capital requirement – “regulatory
arbitrage”; A holding company can raise external capital through debt issuance and infuse the
capital raised as equity in subsidiaries as regulatory capital – the risk of “double leveraging”
(Edwards (1998)).
Freixas, Lóránth and Morrison (2005) investigate the optimal capital requirement for financial
conglomerate through integrated model and through holding structure and prove in their
stylized model that the integrated model induces more risk-taking incentive and should be
subject to more regulatory capital. Cumming and Hirtle (2001) address the challenge of
integrated risk management in financial conglomerate and highlight that financial
conglomerates need longer time to determine the aggregated risk position in changes of
market condition and may not able to react timely compared to specialized institutions. The
complexity and speciality of financial conglomerates should draw special attention in the
regulation and supervision.
Section 4: Relevance and limitations of Developing IFSP in Emerging
Countries
4.1. Relevance
18
To reconsider the benefits and costs of a financial system with IFSP is of high relevance in the
reshaping process of international financial markets, not only because emerging countries are
underway to transfer their banks from institutions with pure deposit taking and lending
functions to modern competitive financial institutions with multiple services to better sustain
economic growth, so the needs for theoretical foundation in IFSP for policy setting are large
and urgent, but also because the finance crisis challenged the weaknesses of the existing IFSP
models in developed countries which shows the simple copying of IFSP models from
developed economies can not guarantee success for IFSP in emerging countries.
There are some characteristics of emerging economies which make the development of IFSP
to be of special relevance. In emerging countries, banking sector usually plays a crucial role in
the financial system by channelling private savings to productive investment. The
development of IFSP can make good use of the existing dominant role of banks as a solid
basis to enhance the variety of financial services to sustain economic growth, stimulate the
development of capital markets and promote the establishment of health and social insurance
system. As the social wealth grows, it emerges to develop financial depth and sophistication
of existing financial institutions.
Especially in an environment of limited contract enforcement, immature bankruptcy
procedure, lace of corporate governance, lower information transparency and less high quality
disclosure like in most emerging countries, the role of IFSP as delegated monitors, promoters
of capital markets and developer of insurance products can be essential. The contribution of
IFSP to promoting economic growth and the development of financial markets can only be
facilitated if the regulatory framework gives banks the allowance to be involved in various
financial sectors, guides financial institutions to explore scale and scope economies and limits
potential conflicting fields. In a comprehensive study based on data from 87 developed and
developing countries between 1980 and 2004, Fernández, González and Suárez (2008) prove
bank concentration with large bank size can foster economic growth in poor-quality of
institutional environment. They explain their finding by stressing the governance function of
bank monitoring in case of higher information asymmetry in countries with weaker market
discipline. Based on a sample of Chinese listed firms from the Shanghai Stock Exchange and
Shenzhen Stock Exchange from 2001 to 2005, Yuan, Xiao and Zhou (2008) confirm the
important role of financial institutions (specially mutual funds) as delegated monitors in firm
performance improvement for economies where the system of corporate governance and
investor protection is not well established.
For emerging countries where the establishment of the social secure system and state
retirement planning is at an early stage, sustaining and accumulating private wealth remains
crucial. As the life time financial planning emerges as clients’ preferred wealth management
pattern (Tomecek (2003)), the enhancement of product range in line with the development of
IFSP becomes a core competence of modern financial services institutions to serve “emerging
middle class”.
Moreover, family-owned conglomerate groups and bank-commerce interlink are more
predominant in emerging countries which provides the pre-condition for the development of
IFSP.
Saunders and Walter (1996) first identify the deregulation trend and redesign of financial
system towards the universal-bank based financial system in the Asia Pacific region.
Claessens (2002) investigates extensively the relevance of IFSP for developing countries. He
outlines the dominant role of banks in developing countries and the current existence of
19
financial conglomerates in emerging countries and concludes the gains of IFSP outweigh the
costs due to higher costs from asymmetric information, higher coordination needs for large
projects and higher concentration of skills in emerging economies.
4.2. Limitations
The main concern of the introduction of IFSP in transition and emerging countries lies in the
question, if the regulatory authority is capable to oversight the complicated intra-group
monetary and information flows in a financial conglomerate to avoid and detect fraud or
corruption to protect the deposits’ interest and ensure the functionality of the whole financial
system, if the legal enforcement can efficiently protect the interest of small investors through
litigation, and if the market discipline with sufficient transparency and competition
mechanism can be established to prevent abuses from conflicts of interest. Even in developed
countries with established systems of supervision, litigation and market discipline as in the
USA, scandals such as the WorldCom case happened with no less participation of large
integrated financial institutions. How to prevent such abuses in emerging countries with less
skilled resources remains the core question in developing IFSP in emerging countries.
The model of relationship banking in emerging countries bears the risk that political
influences and closer family ties instead of market forces could determine the distributions of
finance resources. Another risk lies in overregulation which at the same time restricts the
synergy potential of scale and scope economies.
Section 5: Conclusions
IFSP has the inherent advantage to leverage client information for multiple services in
relationship banking over client’s life time. Scale and scope economies enable IFSP the
ability of providing superior financial services at lower costs. Closer bank-client relationship
and banks’ equity holding in IFSP better foster firms’ growth and provide firms finance
insurance in times of financial distress. The risk diversification effect through the combination
of various service lines contributes to the system stability in a financial system with IFSP
model.
However, diseconomies of scale and scope due to inability to manage complex large-scope
operations and conflicts of interest in various roles of IFSP as debt holder, equity holder,
advisor, sales broker, asset manager and insurer at the same time can diminish the benefits of
IFSP and lead to overall conglomerate discount. The large size of IFSP to reach scale
economy can induce more moral hazard of banks’ risk taking and the spill-over of failure in
one business line or one bank can put the whole financial safety-net in danger.
The overall results show no superiority of one system over another. Probably it is a case of
path dependency and history. As the conclusion of Demirguc-Kunt and Maksimovic (2000) in
their analysis of the influence of market-based and bank-based financial systems in 40
countries between 1989 and 1996 on firm external financing: The legal contract environment
other than the type of financial system is the premier determinant of firms’ availability of
external financing. The evaluation of the integration or segregation of financial institutions
should always be embedded in the regulatory and managerial context. How to balance the
benefits and costs of IFSP to better serve economic growth remains the core question for
financial system design and strategic banking management.
20
Developing IFSP can be of special relevance for emerging countries. The existing dominance
of banking institutions and family-owned finance groups build the ideal basis to develop the
integrated model. Leveraging the existing bank client basis and services can further stimulate
the development of capital markets and insurance markets. In an integrated model, limited
skills can be allocated more efficiently and inefficiencies from asymmetric information and
higher coordination needs can be reduced. How to avoid the disadvantages and prevent abuses
of conflicts of interest remains the core task of regulators in emerging countries.
As China is an unique country in the world still with commercial bank law favoring
segregated financial system and the current ongoing deregulation process on the incremental
trial basis is progressing, understanding the benefits and costs of IFSP can be of special
importance as the next cornerstone for China’s banking reform. To figure out the impact on
business models and financial stability of the gradual deregulation process of China’s banking
sector towards IFSP is of special interest for further research and of utmost importance for the
ongoing smooth development of China’s financial system and macroeconomy.
21
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