Separation of Banking and Commerce

Published by the Government Accountability Office on 1997-03-17.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Office of the Chief Economist


      March 17, 1997

      The Honorable James A. Leach
      Chairman, Committee on Banking and Financial Services
      House of Representatives

      Subject: Senaration of Banking and Commerce

      Dear Mr. Chairman:

      In a recent discussion with you about financial services modernization
      legislation, you asked us to review the literature regarding the potential
      benefits and risks of eliminating the current separation of banking related
      activities and commerce, and to assess the extent of the empirical support
      for taking such action. In your subsequent letter of February 12, 1997, you
      expanded your request by asking for any recommendation that we might
      have for the Banking Committee on this issue. In that letter, you also asked
      for our views, and any recommendations that we might have, on the need for
      consolidated supervision of bank holding companies. To respond to your
      request, we (I) obtained and reviewed relevant economic literature
      concerning the mixing of banking and commerce, (2) interviewed academic
      experts, and (3) reviewed our prior work related to this issue and the need
      for consolidated supervision of bank holding companies.

      Our review of existing literature found that the potential benefits of
      eliminating the current separation of banking and commerce generally lacked
      empirical support and that most such benefits could be realized through
      other means. Our review of these studies and our own prior work also
      indicated that there are risks associated with conglomerations of banks and
      commercial firms that could affect the safety and soundness of the financial
      system, the deposit insurance funds, and consumers and taxpayers. The
      exact magnitudes of such risks, however, are uncertain and depend, in part,
      upon the effectiveness of regulatory and legislative safeguards. Moreover,
      these benefits and risks may be affected by the rapid changes that are
      occurring in the industry today. Although Congress must ultimately make its
      own policy judgment, we thus urge that Congress proceed cautiously if it

                                               GAO/OCEYGGD-97-61RBarking and Commerce

decides to relax the current restrictions. If Congress does decide to relax
these restrictions, the associated risks could be reduced by doing so in an
incremental manner.

Regarding supervision of bank holding companies, we have stated in previous
reports and congressional testimony that financial services holding
companies should be subject to comprehensive regulation on both a
functional and consolidated basis.’ Based on our extensive work assessing
the severe problems that affected thrifts and banks in the 1980s and early
1990s and evaluating the effectiveness of financial institution examination
and supervision, we believe an umbrella supervisory authority needs to exist
to adequately assess how risks to insured depository institutions may be
affected by risks in the other components of a holding company structure. If
the current separation between banking related activities and commerce is
eliminated, having an umbrella supervisory authority would thus imply an
extension of some regulatory supervision to commercial firms.


Our review of existing studies, as well as our own prior work assessing past
financial institution failures, indicated that eliminating the separation of
banking and commerce might subject the financial system, the deposit
insurance fund, and consumers and taxpayers to a variety of risks.2 The
exact magnitudes of almost all of these risks are uncertain, and would
depend, in part, upon what types of protections or firewalls were included in
any financial services modernization legislation to insulate banking
operations from nonbanking activities, and how well regulators monitor and

‘See, for example, Financial Remilation: Modernization of the Financial Services Retiatorv
Svstem (GAO/T-GGD-95-121,Mar. 15, 1995); Bank Oversighk Fundamental Princiules for
Modernizin9: the U.S. Structure (GAO/T-GGD-96-117,May 2, 1996); Bank Oversight Structure:
U.S. and ForeiPn Exberience Mav Offer Lessons for Modernizinn U.S. Structure (GAO/GGD-
97-23, Nov. 20, 1996); and Bank Powers: Issues Related to Reueal of the Glass-Steagall Act
(GAO/GGD-88-37,Jan. 22, 1988).

‘See, for example, Thrift Failures: Costlv Failures Resulted From Regulatorv Violations and
Unsafe Practices (GAO/AFMD-89-62,June 16, 1989), Bank Suuervision: OCC’s Sunervision of
the Bank of New En@and Was Not Timelv or Forceful (GAO/GGD-91-128,Sept. 16, 1991),
and Bank Insider Activities: Insider Problems and Violations Indicate Broader Management
Deficiencies (GAO/GGD-94-88,Mar. 30, 1994).

 2                                               GAO/OClYGGD-97-61RBanking and Commerce

enforce such firewalls.     Thus, it is not possible to measure or quantify these
risks at this time.

The primary risks include those associated with (1) a potential expansion of
the federal safety net provided banks to commercial operations, (2) the
potential for increased conflicts of interest within a banking and commercial
conglomerate, (3) the potential for contagion effects from commercial
operations spreading to insured banks, and (4) a potential increase in
economic power exercised by large conglomerate enterprises.

Potential Expansion of the Federal Safetv Net

The federal government provides a safety net to the banking system that
includes federal deposit insurance, access to the Federal Reserve’s discount
window, and final riskless settlement of payment system transactions. Alan
Greenspan, Chairman of the Board of Governors of the Federal Reserve
System, recently testified that this safety net, while helping to ensure the
safety and soundness of the banking system, also provides a subsidy to
commercial banks and other depository institutions by allowing them to
obtain low-cost funds.3 Allowing conglomerations of banks and commercial
firms would increase the risk that the safety net, and any associated subsidy,
might be transferred to commercial operations and result in inappropriate
risk-taking, misallocations of resources, and uneven competitive playing
fields in other industries. While such risks could be mitigated by establishing
firewaIls between banks and their commercial affiliates, our work has shown
that such firewalls may not work in times of stress, or where managers are
determined to evade them.4 Moreover, firewalls require regular monitoring
and enforcement by regulators and, if set too high, may prevent the
realization of whatever potential benefits were expected to derive from
allowing such conglomerations to occur.

3Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve
System, before the Subcommittee on Financial Institutions and Consumer Credit of the
Committee on Banking and Financial Services, U.S. House of Representatives, Feb. 13, 1997.

4Using Firewalls in a Post Glass-Steagall Bank%! Environment (GAO/T-GGD-88-25,Apr. 13,

3                                                GAOIOCWGGD-97-61RBanking and Commerce

Potential for Increased Conflicts of Interest

Allowing conglomerations of banks and commercial firms could also add to
the potential for increased conflicts of interest and raise the risk that banks
might engage in anticompetitive or unsound practices. For example, some
have argued that, to foster the prospects of their commercial affiliates, banks
might begin to restrict credit to their affiliates’ competitors, or tie the
provision of credit to the sale of products by their commercial affiliates.”
Perhaps more likely, banks might begin to extend credit to their commercial
affiliates when they would not have done so otherwise, thus increasing the
risks to the deposit insurance fund and to taxpayers.6 Such behavior could
also undermine the valuable monitoring function that banks provide in our
economy. As long as banks are perceived as providing credible, objective
assessments of the creditworthiness of companies and their activities, bank
 credit decisions can provide valuable information to the market about the
soundness of these companies and their activities. The value and reliability
 of such signals could be diminished if banks were viewed as having conflicts
 of interest that adversely affected the objectivity of their credit decisions.

Potential for Increased Contagion Effects

Allowing conglomerations between banks and commercial firms could also
increase risks to the deposit insurance fund and taxpayers if affiliated
commercial firms were to extend any financial stress they experienced to
their banking affiliates. Even if firewalls were able to keep such problems
from actually being transmitted to bank affiliates, depositors who believed
that commercial affiliates were experiencing financial problems might decide
to withdraw their funds from the commercial firms’ bank affiliates for fear
that the banks’ soundness might also be in jeopardy. If enough depositors
did this, the fear could be self-fulfilling in that the viability of both the
affiliated banks and the commercial firms could become threatened.

5A. Saunders, “Banking and Commerce: An Overview of the Public Policy Issues,”Journal of
Banking and Finance, 18 (1994), 231-254.

‘In our review of the 286 bank failures that occurred in 1990-1991,we found that insider
problems and associated conflicts of interest were cited as contributing factors in 175 of the
failures. See Bank Insider Activities: Insider Problems and Violations Indicate Broader
Management Deficiencies (GAO/GGD-9488, Mar. 30, 1994).

 4                                                 GAO/OCWGGD-97-61RBanking and Commerce

Possible Increased Concentration of Economic Power

There are also concerns that ending the current restrictions between banking
and commerce could promote the formation of very large conglomerate
enterprises with substantial amounts of economic power. Such enterprises
could adversely affect the efficient operation of the economy and place
consumers at risk of increased prices if they began to exert market power in
either their banking or commercial operations. This risk would be enhanced
to the extent that these new conglomerates could effectively access the
subsidy inherent in the safety net and gain advantages over their competitors.


The major potential benefits that have been mentioned in recent years in
support of eliminating the separation of banking related activities and
commerce include (1) increased economies of scale, (2) greater
diversification of risks, and (3) synergies that may result from affiliations
between banks and commercial firms. In our review of the literature, we
found that these potential benefits generally lacked empirical support and
that such benefits could be realized without having to remove the barriers
between banking and commerce.

Increased Economies of Scale

Some observers claim that the U.S. banking industry would benefit from the
relaxation of banking and commerce restrictions because it would allow
banks to expand their scale of operations and lower their unit costs of
production. While some early studies seemed to indicate the presence of
significant scale economies in banking,7 the results of more recent work have
been mixed.’ Moreover, to the extent that scale economies exist and are
significant in banking, banks should be able to capture them through mergers

7A review of the literature is provided in G. Bentson, G. Hanweck, and D. Humphrey, “Scale
Economies in Banking: A Restructuring and Reassessment,”Journal of Monev Credit and
Bankinq, 14 (1982), 435-456.

‘See L. Mester , “Efficient Product of Financial Services: Scale and Scope Economies,”
Federal Reserve Bank of Philadelphia Business Review, January/February (1987), 15-25, and
S. Shaffer, “A Revenue-Restricted Cost Study of 100 Large Banks,” mimeo, Federal Reserve
Bank of New York, 1988,.

5                                                GAOIOCWGGD-97-61RBanking and Commerce

with other banks. Banks do not need to combine with commercial firms to
be able to achieve scale economies.

Greater Diversification of Risks

Some observers also claim that banking and commercial conglomerations
would be beneficial because they would allow for greater diversification of
risks across more product lines and thus reduce the variability of corporate
earnings. Because the gains from this type of diversification rise when firms’
earnings are less correlated, and fall when firms’ earnings are more
correlated, this argument rests on the assumption that the earnings of
commercial firms fluctuate independently of the earnings of banks. We
found the empirical evidence on this point to be inconclusive. One study we
reviewed found some evidence that the returns on banking stocks and
commercial firm stocks were not highly correlated, and thus concluded that
diversification benefits were possible. ’ However, a more comprehensive
study that examined a longer time period and controlled for more factors
found that the variation in the stock returns of bank holding companies and
nonfinancial companies are reasonably highly correlated and concluded that
the benefits of diversification are overstated.10

Moreover, banks do not need to combine with commercial firms to reduce
the variability in their earnings through diversification. For example, banks
can diversify their assets through their loan portfolios and other investments,
and their ability to diversify geographically was recently enhanced by the
Interstate Banking and Branching Efficiency Act of 1994.


Some observers argue that conglomerations of commercial firms and banks
might result in other efficiencies, often referred to as synergies. Two
possible sources of synergies are economies of scope and information
efficiencies. Economies of scope exist if a combined firm can produce a mix
of products at a lower cost than if the products were produced separately.

‘A. Saunders, and P. Yourougou , ‘Are Banks Special: The Separation of Banking from
Commerce and Interest Rate Risk,” JournaI of Economics and Business, 42 (1990), 171-182.

“M.J. Isimbabi, “The Stock Market Perception of Industry Risk and the Separation of
Banking and Commerce,”Journal of Bankine and Finance, 18 (1994), 325-349.

6                                               GAO/OCWGGD-97-61RBanking and Commerce

The main source of the cost savings comes from using the same inputs to
produce multiple outputs. The virtually unanimous finding in the literature is
that economies of scope are insignificant in banking.” We were unable to
find any studies on the existence of potential economies of scope between
banking and commercial activities.

Another possible synergy might result from improved informational flows
within a combined entity. For example, by combining with commercial
firms, banks might obtain better information about the commercial firms’
activities, which the banks could then use to reduce the default rate on their
loans. In addition, the commercial firms could benefit by obtaining bank
loans at lower interest rates. However, the increased information flows
might also induce banks to approve more risky 10ans.‘~ We were unable to
find any studies that attempt to quantify these potential effects.

Other Theoretical Arguments

Some observers have also argued that restrictions on bank affiliations lead to
inefficiencies, because such restrictions impede the free flow of capital or
managerial resources.‘3 Although impediments to resource flows can lead to
inefficiencies in certain cases, we found no clear evidence that such
inefficiencies exist in the banking industry at the present time.

Those who argue that there is a capital shortage in banking believe that
banks have a difficult time attracting capital, and that allowing banks and
commercial firms to affiliate is necessary to allow the banking industry to
attract capital from other industries. However, there are many sources of
capital, such as new stock issues, that are open to banks and we are not
aware of any empirical evidence that the U.S. banking industry is currently
suffering from a capital shortage. In fact, the banking industry currently is
very well capitalized by historic standards. The average capital asset ratio in

“Mester (1987) surveys a number of studies.

=A swnmary of the trade-off is provided in K John, T.A. John, and A. Saunders, “Universal
Banking and Firm Risk-taking.” Journal of Bankiw and Finance, 18 (1994)j 307-323.

13SeeA Saunders, (1994).

7                                                GAO/OCEYGGD-97-61R
                                                                  Banking and Commerce

the industry in 1996 was 8.3 percent, compared to 6.7 percent in 1991.14By
regulatory standards, capital in the banking industry is also high, At the end
of 1995, 98.4 percent of banks were considered well capitalized, compared to
93.8 percent at the end of 1992.15

Another argument, which holds that separating banking and commerce
causes inefficiencies by blocking resource flows, focuses on managerial
talent and cost consciousness. According to this argument, allowing banks
and commercial firms to merge would generate fears of a potential takeover
resulting from poor performance and thus would induce managers to
increase efficiency. It should be noted, however, that this type of discipline
can take place even if banks and commercial firms are not allowed to merge.
As long as better managed banks are allowed to purchase weaker banks, this
efficiency-enhancing mechanism, to the extent that it works, would still be


It is important to recognize that the benefits and risks associated with ending
the separation of banking and commerce may be affected by the rapid
changes that are currently occurring in both the regulatory environment and
the structure of the financial services industry. For example, in recent years,
a number of large mergers have occurred and some of the major effects of
past legislative and recent regulatory actions are only beginning to appear.
Until the effects of such developments are better understood, Congress may
wish to act cautiously if it decides to relax the current restrictions.

One recent major legislative change was the Interstate Banking and
Branching Efficiency Act of 1994, which authorizes interstate mergers
between banks beginning June 1, 1997, regardless of whether the transaction

p. 5.
 15SeeBank and Thrift Regulation: ImDlementation of FIDICIA’s PromM Retiatorv   Action
 Provisions (GAO/GGD-97-18,Nov. 21,1996), p. 28.

 8                                              GAO/OCWGGD-97-61RBanking and Commerce

is prohibited by state law.16 The act also allows banks to branch across state
lines if the host state has a law permitting the establishment or acquisition of
branches by out-of-state banks. Even before the passage of the act, and
certainly since its passage, there has been a strong tendency toward
consolidation in the banking industry. In 1991, there were 12,000 banks and
2,600 thrifts. By September 1996, there were 9,586 banks (a ZO-percent
reduction) and 1,961 thrifts (a 25-percent reduction). Because the act allows
multistate bank holding companies to become banks with multiple branches,
the number of banks is likely to continue to shrink.

Not only has there been a large decline in the number of banks, there has
also been considerable consolidation among large banks. This consolidation
is driven by forces similar to those causing the decline in the number of
banks, as well as by changes in the banking business, as more large banks
enter into securities brokerage and underwriting, mutual funds, and
insurance sales. In 1986, the 10 largest banks controlled 26.3 percent of
industry assets. By 1994, they controlled 33 percent of assets.

In addition to legislative changes, there have been two important regulatory
initiatives in the past year that are intended to allow banks to expand their
nonbanking activities. First, the Federal Reserve enacted a revised
regulation Y that includes (1) an expedited review process for bank and
nonbanking proposals by well-run bank holding companies; (2) an expansion
of the regulatory list of permissible nonbanking activities and removal of
restrictions on those activities by reducing or eliminating certain firewalls
between nonbank subsidiaries and banks; and (3) removal of the regulatory
extension of antitying restrictions that apply to bank holding companies and
their nonbank subsidiaries. Second, the Comptroller of the Currency also
provided the opportunity for national banks to engage in additional
nonbanking activities by establishing operating subsidiaries. Such
subsidiaries might be permitted to engage in activities that are part of, or
incidental to, banking, but are different from those activities permissible for
the parent bank.

“The Interstate Banking and Branching Efficiency Act gives states the right to opt out of this
arrangement if they pass legislation before June 1, 1997 prohibiting merger transactions with
out-of-state banks.

9                                                  GAO/OCE/GGD-97-61RBanking and Commerce


Jn previous testimony before this Committee, we presented our views on the
need for financial services holding company oversight.17 That testimony,
based on our extensive work evaluating the effectiveness of bank supervision
and examination during the 1980s and 1990s discussed the specific
safeguards that we believe should be included in any financial services
modernization legislation to protect against undue risks. These safeguards
include the following:

1. Comprehensive regulation of financial services holding companies on both
a functional and consolidated basis-While firewall provisions are extremely
important to prevent potential conflicts of interest and to protect insured
deposits, we believe an umbrella supervisory authority needs to exist to
adequately assess how risks to insured banks may be affected by risks in the
other components of the holding company structure.

2. Capital standards for both insured banks and financial services holding
companies that adequately reflect all major risks, including market and
operations risk-Because our past work on failed banks and thrifts found that
capital can erode quickly in times of stress, we believe regulators should also
be required to conduct periodic assessments of risk management systems for
all the major components of the holding company, as well as for the holding
company itself.

Our belief in the importance of consolidated oversight and consolidated
capital standards is partly based on the fact that most, if not all, bank
holding companies are managed on a consolidated basis, with the risks and
returns of various components being used to offset and enhance one another.
Such a consolidated supervisory approach is flexible enough to recognize
and account for the contagion risks inherent in a holding company structure,

%ee F’inancia.lReeulation: Modernization of the Financial Services Remlatorv Svstem
(GAO/T.-GGD-95121,Mar. 15, 1995).

 10                                             GAO/OCWGGD-97-61RBanking and Commerce

and is similar to the approach that is now in place under the Bank Holding
Company Act.18

One concern we have with a functional regulatory approach that does not
include consolidated oversight is that it may prove too dependent on the
establishment and maintenance of firewalls to control risks. Lack of a
consolidated perspective could inhibit the ability of functional regulators to
establish appropriate firewalls-i.e., ones that allow for appropriate spillover
benefits but minimize contagion risks. F’urthermore, past experience has
shown that, regardless of whether firewalls are set properly, even periodic
examinations cannot ensure that those firewalls can be maintained in times
of stress if managers are determined to breach them.

Finally, we believe that consolidated holding company supervision is needed
regardless of whether banks and commercial firms are allowed to affiliate
under a holding company structure. Thus, combining banks and commercial
firms under a holding company structure would subject commercial firms to
regulatory oversight. Furthermore, such action might raise issues about the
adequacy of bank supervisory resources and about regulatory burden.

As arranged with your office, unless you announce its contents earlier, we
plan no further distribution of this correspondence until 30 days after the
date of this letter. At that time, we will make copies available to others on
request. If you have any additional questions or wish further clarification,
please call me on (202) 512-6209.

Sincerely yours,

J es L. Bothwell
Chief Economist

“Currently, the Federal Reserve acts as the overall regulator for bank holding companies,
which includes setting consolidated capital requirements for the company as a whole,
exercising supervisory authority over the company, determining what types of activities can
be affiliated with banks under the holding company structure, and approving such holding
company activities as mergers and acquisitions.

11                                                GAO/OCWGGD-97-61RBanking and Commerce
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