Product Diversification Chapter 21

1. Product DiversificationChapter 21 Financial Institutions Management, 3/e By Anthony Saunders

2. Introduction • Universal FI structure in Germany, Switzerland and UK. • Recent Citicorp/Travelers merger. • Risks of product segmentation • lack of diversification • exposure to nonbank competition • especially MMMFs

3. Segmentation in U.S. Financial Services Industry • Commercial and investment banking • Glass-Steagall Act 1933 exemptions • Underwriting Treasuries and municipal general obligation bonds; • Engage in private placements. • 1987 Federal Reserve Board allowed BHCs to establish Section 20 affiliates. • Firewalls between banks and Section 20 affiliates.

4. Erosion of Glass-Steagall • 20 states allow state-chartered banks to engage in securities activities beyond those permitted by Glass-Steagall for national banks. • OCC ruling in 1996: • permit national banks on a case-by-case basis to establish direct subsidiaries to undertake non-banking activities such as underwriting.

5. Further Challenges to Glass-Steagall • International Banking Act 1978 • Foreign banks securities activities grandfathered. • Investment banks increasing efforts to offer banking products. • Cash management accounts • Deposit brokering

6. Banking and Insurance • 1986: banks began selling annuities but traditionally banks prevented from entering insurance. • Restricted to agency activities, offering credit-related products in small towns. • Garn-St. Germain Act specifies restrictions on BHCs establishing insurance affiliates.

7. Banking and Insurance (continued) • Delaware: liberal laws allowing state-chartered banks to engage in P&C and life insurance. • Nonbank banks as a route for insurance companies and commercial firms to engage in banking. • Current challenge to Bank Holding Company Act’s restrictions • Citicorp and Travelers

8. Commercial Banking and Commerce • Banks can only engage in commercial activities “incidental to banking” • Restrictions on BHCs are a more recent phenomenon. • 1956 Bank Holding Company Act.

9. Issues Involved in Expansion of Product Powers • Overview • Safety and soundness issues • Economy of scale and scope issues • Conflict of interest issues • Deposit insurance issues • Regulatory oversight issues • Competition issues

10. Safety and Soundness • Risk of securities underwriting • Firm Commitment • British Petroleum • Firewalls as protection from securities affiliate • Risks from upstreaming or affiliate loans • Risks from contagious confidence problem • Benefits from product diversification and geographic diversification

11. Economies of Scale and Scope • Economies of scale opportunities for firms up to $25 billion in asset size. • Revenue-based for largest FIs • Economies of scope • May be limited by firewalls between banks and Section 20 subsidiaries. • Greater gains possible with universal banking structure as in Germany.

12. Conflicts of Interest • Six potential conflicts • Salesperson’s stake • NationsBank example. • Stuffing fiduciary accounts • Bankruptcy risk transference • Third-party loans • Tie-ins • Information transfer

13. Deposit Insurance • Deposit insurance • may provide competitive advantage to banks over other FIs. • Banks may also gain an advantage from being too big to fail.

14. Regulatory Oversight • Large bank holding companies with extensive nonbank subsidiaries face a complex structure of regulators. • If further integration of financial services then there may be argument for a single regulatory body.

15. Competition • Procompetitive • Increased capital access for small firms • Lower commissions and fees • Reduce degree of underpricing of new issues • Anticompetitive • Long-run outcome could be oligopoly with higher prices for investment banking services.