Separation of investment and commercial banking services 1
SEPARATION OF INVESTMENT AND COMMERCIAL BANK SERVICES IS
UNLIKELY TO REDUCE SYSTEMIC RISK
Swiss Management Center (SMC) University
June 22, 2012
The banking crisis that originated in 2007 led to renewed calls for the separation of
commercial and investment banking services. The regulation and supervision of financial
markets (in particular financial intermediaries) are in public interest, but the cost of regulation
and supervision should not exceed the benefits. Revisiting the lessons learnt from the reforms
that were introduced with the passage of the Glass-Steagall Act leads to the conclusion that
the introduction of barriers between commercial and investment banking services as a
measure to manage systemic risk was ineffective. An analysis of the current arguments in
favour of, and against a forced separation of commercial and investment banking services,
and the possible unintended consequences that may result from of such a separation, indicates
that the current market reforms are misguided. The enforcement of the separation of
commercial and investment banking services is unlikely to prevent the failure of financial
intermediaries resulting in systemic crises.
Key words: Bank regulation, Commercial banking, Investment banking, Financial crisis,
Separation of investment and commercial banking services 2
The financial markets crisis that started in 2007 is the result of a secular
transformation of the global economy (El-Erian, 2008), and the inability of regulators, the
financial industry, and politicians to anticipate and manage the transformation (Fullenkamp
and Sharma, 2012; Taleb, 2010). Despite the frequent financial fallouts over the past century,
and the subsequent systemic banking crises, few institutional changes have been made to
improve the current reactive regulatory cycle (Reinhart and Rogoff, 2009), which entails
hurried regulatory responses and reforms undertaken in the aftermath of the crisis
(Fullenkamp and Sharma, 2012; Taleb, 2010). The failure by regulators to recognise that
there usually are remarkable similarities with past financial crises, often gives rise to the
‘this-time-is-different’ syndrome (Reinhart and Rogoff, 2009), leading to radical financial
reforms without taking into account the lessons learnt from past experience. In addition,
considering that recessions associated with banking crises are severe, and that it takes a long
time for the financial system to rebuild its lending capacity (Bernanke, 1983), politicians and
policy makers facing their own electoral incentives, experience pressure to be seen to react as
soon as possible. These hurried responses may not always result in good financial regulation
(Fullenkamp and Sharma, 2012).
Following the collapse of Lehman Brothers in July 2007, panic in financial markets
spread globally at an alarming rate. The possibility of contagion of liquidity problems that
started with the bank run on Northern Rock in the United Kingdom in 2007, and the
subsequent guarantee of all deposits in U.K. banks, indicated that the subprime crisis was
spreading from the investment banking system to the commercial banking system, an
indication that investment banks and commercial banks were ‘too interconnected to ignore’
(Hawley, 2012; Tett, 2009). Following initial measures to stem the crisis by ensuring that
Separation of investment and commercial banking services 3
liquidity issues are resolved, the attention of regulators and politicians soon focussed on
providing a regulatory response, with renewed calls for the separation of commercial and
investment banking services (Volcker, 2009; Vickers, 2011), and for remedies to deal with
‘too big to fail’ financial institutions (Moosa, 2010; Sorkin, 2009). This debate is fuelled,
firstly, by the public outcry for revenge in view of the taxpayer-funded safety-net bailouts to
a high moral hazard industry (Bootle, 2009; El-Erian, 2008); secondly, by politicians’
growing concern with the spiralling National debts resulting from supporting money markets
(Tett, 2009); and thirdly, by the realization that markets are inefficient (Bootle, 2009;
Greenspan, 2008), i.e. markets are affected by the biases and ignorance (often irrational) of
investors (Soros, 1987). This paper examines the case for the separation of commercial and
investment banking services. Section 2 discusses the rationale for regulation and supervision.
Section 3 provides a historic perspective, revisiting the lessons learnt from past regulation.
Section 4 considers the renewed case for separation. Section 5 sets out the arguments against
such a separation. Section 6 considers the possible unintended consequences of enforcing a
separation. Section 7 concludes with a submission that the forced separation of commercial
and investment banking services is an ineffective tool for the prevention of systemic risk.
2. Rationale for regulation and supervision
The issue relating to the separation of commercial and investment banking services
needs to be assessed against the need for, and role of financial market regulation and
supervision. The role of regulators in a democratic (free market) society is to create a
supervisory environment within which financial markets can operate (Rajan, 2010), thereby
promoting efficient credit allocation, protecting consumers, and maintaining systemic
stability (Fullenkamp and Sharma, 2012). This is required because the efficiency of free-
market capitalism (and its unforgiving market competition nature) conflicts with human
Separation of investment and commercial banking services 4
desire for stability (Greenspan, 2008). Governments and regulators also need to protect the
interests of individual investors who are not able individually to protect their interests
(Walter, 2009; Wolf, 2009; West, 1983). This translates into an ongoing debate between
supporters of regulation and supervision (Fullenkamp and Sharma, 2012) and those who
oppose interference with markets (Somnath, 2010), arguing that regulation dilutes the
benefits of Adam Smith’s ‘invisible hand’ process (Greenspan, 2008) and the Schumpeter
‘creative destruction’ effect (Lamfalussy, 1989). Finding the right balance, and weighing the
cost and benefits of regulation and supervision are important because regulators are faced
with the possibility that inadequate regulation may result in failures, whilst overregulation
may result in financial inefficiencies and lower innovation (Walter, 2009; Lamfalussy, 1989).
The aim of policy is to create conditions under which gains are maximised and risks are
managed (Wolf, 2009). The cost of separating commercial and investment banking services
therefore needs to be weighed against the expected benefits. Revisiting the lessons learnt
from past experience would provide some guidance when assessing the benefits that a
mandated separation would yield.
3. Historic perspective
The regulatory reforms - in particular the introduction of barriers between commercial
and investment banking activities - following the market crisis that prevailed during 1929-
1933 were controversial, and the reforms have been the subject of a fierce debate (Walter,
2009). These regulatory reforms, introduced with the passage of the Glass-Steagall provisions
of the Banking Act of 1933, shaped the financial industry in the U.S. until the introduction of
deregulation 66 years later with the passage of the Gramm-Leach-Bliley Financial Services
Modernization Act of 1999. The introduction of the Glass-Steagall provisions was motivated
at the time as a means to reduce the perceived ‘conflict of interest’ risk relating to
Separation of investment and commercial banking services 5
commercial bank involvement in securities underwriting, for example, resulting from the use
of privileged insight into the financial status of clients to encourage clients with financial
difficulties to issue securities and to use the proceeds to repay debts to the relevant bank; or
resulting from the increased risk that securities warehousing poses to commercial banks
(Walter, 2009; Tabarrok, 1998). Research, however, shows (Walter, 2009) that the
approximately 40 percent of banks that failed following the 1929 crisis would have collapsed
even if they had not held long term securities at all, and, moreover, that there is no evidence
that large universal banks at the time exploited the conflict of interest that arose from their
role as commercial lenders and underwriters of securities (Tabarrok, 1998). To the contrary, a
number of studies (Ang and Richardson, 1994; Kroszner and Rajan, 1994) found that
underwritings by commercial banks prior to the introduction of the Glass-Steagall provisions
significantly outperformed those of investment banks. The main argument in favour of the
introduction of the Glass-Steagall mandated separation of commercial and investment
banking services therefore appears unjustified. It is therefore submitted that the ‘conflict of
interest’ argument does not support the reintroduction of provisions enforcing a separation.
Citigroup is an example of a universal bank that suffered major losses following the
2007 market crisis as a result of warehousing subprime securities (Tett, 2009; Walter, 2009;
El-Erian, 2008). It is, however, submitted that the mere separation of commercial and
investment banking services, with a view to limit future government bailouts to distressed
deposit taking institutions only, will not reduce systemic risk. This is evidenced by the fact
that the 2007 financial crisis started with the failure of Lehman Brothers, an investment bank
(Sorkin, 2009; Tett, 2009). Moreover, the crisis may have started earlier if Bear Stearns, also
an investment bank - the failure of which the Treasury and the Fed considered to be a
systemic risk - was not rescued following a Fed-initiated purchase by JP Morgan,
(Greenspan, 2008). In addition, although a discussion of the ‘too big to fail’ doctrine is
Separation of investment and commercial banking services 6
beyond the scope of this paper, considering the smaller size of Bear Stearns, the hypothesis is
that not only large financial intermediaries are worthy of protection (Bootle, 2009). Imposing
a forced separation of commercial and investment banking services to reduce the size of
‘systemically important financial institutions’ will therefore not reduce systemic risk
(Ackermann, 2009), and regulators and policy makers should rather focus on the ‘too
interconnected to fail’ risk (Hawley, 2012; Greenspan, 2008).
4. A renewed case for mandatory separation
The repeal in 1999 of the Glass-Steagall provisions with the passage of the Gramm-
Leach-Bliley Financial Services Modernization Act of 1999 was soon followed by a number
of financial scandals, such as the collapse of Enron and WorldCom (Ferguson, 2008), in
which commercial banks were involved, resulting in large losses for the banks and their
clients. It has been argued (Walter, 2009) that the desperate quest by commercial banks to
chase after market share resulted in regulatory violations, exploitation of conflict of interests,
and acting on corrupted research, all as a result of acting simultaneously as lender and
investor. These failures are considered by some as evidence that the deregulation in 1999
resulted in greater systemic risk. In a speech in April 2008, referring to previous failures, the
former Federal Reserve Chairman, Paul Volcker, stated that the 2007 financial crisis was the
culmination of a series of systemic breakdowns, which is an indication of a fragile system
that repeatedly threatens financial stability, with great cost to society (Volcker, 2008). In
2009, Paul Volcker proposed the reinstatement of regulations that would enforce the
separation of commercial and investment banking services (Volcker, 2009). The Volcker
Rule, i.e. the section of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(originally proposed by Paul Volcker) aims to introduce provisions that would, to some
extent, separate commercial and investment banking services, such as the ban on proprietary
Separation of investment and commercial banking services 7
trading by commercial banks. Similarly, on June 14, 2012 the U.K. Government published a
White Paper containing detailed proposals for the implementation of the recommendations by
the Independent Commission on Banking, chaired by Sir John Vickers (The Vickers Report),
which includes proposals for the separation (ring fencing) of the activities of commercial and
investment banks in the U.K. (U.K. Government White Paper, 2012).
Although the regulatory reform introduced with the passage of the Glass-Steagall Act
was followed initially by relative stability in the U.S financial system (Reinhart and Rogoff,
2009), significant financial failures re-emerged in the 1980s, including the Savings and Loans
crisis in 1989; a number of bank failures in the early 1990s that forced the U.S Government
to recapitalise the FDIC’s Bank Insurance Fund; and the collapse of Long-Term Capital
Management (LTCM) in 1998 which was saved from bankruptcy by a Fed-initiated plan on
the grounds that such failure would result in systemic risk (Moosa, 2010; Walter, 2009;
Ferguson, 2008; Greenspan, 2008; Schroeder, 2008). It is therefore submitted that the Glass-
Steagall provisions failed to ensure the expected stability that proponents, such as Paul
Volcker and the Vickers Report, profess the separation of commercial and investment
banking services would achieve. To argue that the introduction of separation legislation
would have the desired effect of providing financial stability, notwithstanding the apparent
ineffectiveness of the Glass-Steagall Act (see again Section 3 above), would be a
manifestation of the ‘this time is different’ syndrome referred to in the Introduction (Section
5. Arguments against separation
One of the main arguments previously raised by commercial banks as motivation for
the repeal of the Glass-Steagall provisions was that the provisions were anti-competitive,
which prevented these banks from diversifying (Walter, 2009). The acquisition in 1998 of
Separation of investment and commercial banking services 8
Travellers Group by Citcorp even before the repeal of the Glass-Steagall Act was an
indication of the strong desire of commercial banks to be able to compete with investment
banks. Research indicates (Saunders and Walter, 1994) that greater diversification of earnings
attributable to multiple products, clients, and geographies supports more stable and safer
financial institutions. Research by Schmid and Walter (2009), however, shows that greater
functional diversification destroys economic value (measured in terms of shareholder value),
reflected in persistent conglomerate discount among highly diversified financial
intermediaries. This is in line with the large empirical body of literature that conglomeration
destroys value (Boot and Marinc, 2008) and that in general, empirical evidence cannot
readily identify substantial economies of scale and scope. Despite this, it is submitted that the
stability and safety factor (as opposed to shareholder wealth) is more important from
society’s viewpoint. The argument in favour of greater competition is therefore supported.
A large body of literature shows that a strong financial sector supports economic
growth (Booth, 2009; Wolf, 2009; Kerr and Nanda, 2008). A sophisticated global economy
needs large diversified universal banks, and the breakup of these banks would have a
negative effect on economic growth (Casserley, Harle and MacDonald, 2011). In view of the
importance of the financial sector in macroeconomic terms, regulation that is costly and
ineffective should be avoided (West, 1983). Although it is difficult to estimate what the cost
would be for a forced break up of universal banking institutions, initial estimates indicate that
it would be substantial, for example the U.K. Independent Commission on Banking estimates
a cost to the industry of £7 billion, whilst the banking industry estimates the annual cost to be
as much as £10 billion (Goff, 2011). It is submitted, in view of the apparent ineffectiveness of
the Glass-Steagall Act, that the cost associated with the breaking up of universal banking
institutions would exceed the benefit of such action.
Separation of investment and commercial banking services 9
The separation between commercial and investment banking services will deprive
investment banks of access to cheaper funds (Ambler and Saltiel, 2011). This, combined with
the high cost of separation of universal bank activities, in turn will result in an increase of the
cost of funding for their clients. An increase in the cost of funding in the current business
environment would have a negative effect on economic recovery (Bernanke, 1983).
One of the benefits of the universal banking model is the ability to overcome the
problem of asymmetry of information, i.e. the ability of a bank to use information obtained
through a (often longstanding) lending relationship when providing investment banking
services to the same client, which leads to better risk decisions (Walter, 2009; Boot and
Marinc, 2008). Research shows (Freeman & Co, 2003) that, not only is an investment bank’s
knowledge about a client directly proportional to its share of fees from that client, but it also
provides the ability to carefully evaluate its clients which reduces the possibility of
compromise to balance sheet quality. A forced separation of commercial and banking
services would negate this benefit.
6. Unintended consequences of separation
The perceived need for urgency that usually accompanies the introduction of radical
regulatory reform following a financial market crisis may result in failure to fully analyze the
possible unintended consequences that may result from the reform (Neal and White, 2012).
The 1933 market reforms enabled U.S. investment banks to grow rapidly as they were
protected from competition by commercial banks, which in turn allowed them to play a
bigger role as financial intermediaries as financial markets became an important source of
funding for borrowers (Walter, 2009). An unintended consequence of the Glass-Steagall
reforms may therefore have been to provide a fertile environment which led to the current
global dominance of U.S. investment banks. By the early 1990s U.S. investment banks
Separation of investment and commercial banking services 10
dominated the industry globally, with a market share of approximately two-thirds (Walter,
2009). According to Walter (2009), another (arguably) fortuitous consequence of Glass-
Steagall is that investment banking developed into one of the top U.S. export industries,
contributing to the development of ‘too big to fail’ financial intermediaries. This would also
have contributed to the view that global markets have become ‘too interconnected to ignore’
(Tett, 2009), a reason why the 2007 financial crisis spread globally at an alarming rate (El-
Erian, 2009; Bootle, 2009). This was, however, not accompanied by the development of an
international supervisory body that can manage the inherent risks associated with the
globalization of financial markets and the ‘too interconnected to ignore’ phenomenon.
During the 2007 financial crisis, big financial firms in the ‘shadow banking’ system
outside regulated banks suffered material losses (Reinhart and Rogoff, 2009), and subsequent
to this the shadow banking system, which is generally considered to be under regulated, has
come under intense scrutiny. It is clear that the shadow banking system is of systemic
importance (European Commission, 2012; Gorton and Metric, 2010). Alan Greenspan held
the view that the near-collapse of LTCM in 1998 had the potential to cause a systemic crisis
(Bootle, 2009; Greenspan, 2008). The concern is that increased regulation brought about by
the Dodd-Frank Act and Vickers Report submissions, together with the increase in cost of
funding, will result in more banking activities moving into the shadow banking system
(Acharya, 2012; Chan, 2011; Varriale, 2011).
History does not support the case that commercial and investment banking should be
separated (Casserley, Harle and Macdonald, 2011; Tabarrok, 1998). Moreover, the blanket
condemnation of combined commercial and investment banking services introduced in the
1930s is unwarranted in light of the current ongoing experience (Walter, 2009) and the issue
Separation of investment and commercial banking services 11
needs to be considered in the context of the current financial environment. It is submitted
that, rather than looking at separating the services of commercial and investment banks,
regulators and policymakers should focus on more appropriate measures, such as capital
regulation, liquidity management, and generally, that the functions of financial intermediaries
are limited to those that would benefit society (Bootle, 2009; Walter, 2009; Wolf, 2009).
A matter that requires further analysis is the ‘too interconnected to fail’ issue (Section
3 above), and the ways that policymakers and regulators could manage the risk this poses on
the global financial markets. In this regard attention should be given to the creation of an
international supervisory body (or at least a formalized structure for international cooperation
between regulators) that has the power to ensure that the inherent risks associated with the
globalization of financial markets are managed (Lamfalussy, 1989).
Separation of investment and commercial banking services 12
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