Centre for Economic Policy Research

participation of stocks, bonds, debentures, notes or other securities.
64
Section 21
made it illegal for investment banks to accept deposits, and Section 32 stipulated
that no bank officer or director could be associated with any business engaged in
these activities.
65
The effect of the Glass-Steagall Act was to force commercial banks to eliminate
their securities affiliates and shrink their bond departments. National City Bank
liquidated its affiliate. First Boston Corporation was formed out of the security
affiliates of Chase and First National Bank of Boston. Morgan decided to pursue
deposit banking, while some of Morgan’s partners left and created Morgan Stanley
& Co. (White, 2000). For the next several decades, there was no challenge to the
separation of commercial and investment banking and insurance.
5.5
Testing the myths
So firm was the acceptance of the legal separation engineered first by the 
post-Armstrong state legislation and the Glass-Steagall Act that there were very
few studies of the actual behaviour of universal banks prior to the 1990s. No 
significant work has been carried out on the combination of insurance and
investment banking prior to 1906. Of the three conflicts identified in the Pecora
hearings, only the conflict between commercial bank lending and underwriting
has received significant attention. 
The central question addressed in the literature on conflicts of interest from
combining commercial and investment banking is whether the benefits from the
added ‘certification’ from a universal bank outweigh the costs from the exploita-
tion of ‘conflicts of interest’. In making and monitoring loans, commercial banks
gain information about firms that is not usually known to outside investors.
Investment banks also collect similar information; but by forming long-term 
lending relationships and providing transaction services, commercial banks may
acquire complementary information. By combining commercial and investment
banking, a universal bank will benefit in the reduction of costs from the
economies of scope in information collection. Universal banks may thus be better
informed than independent investment banks, and the issues they underwrite
may be perceived as having better ‘certification’. Similarly, universal banks may
be considered to be better advisers for mergers and acquisitions. Given this syner-
gy, the market should be willing to pay a higher price (or accept a lower yield) on
securities that are underwritten by universal banks compared to independent
investment banks. 
The value of this superior certification by universal banks will be offset by any
perceived conflicts of interest. Conflicts of interest between lending and 
underwriting may arise in several contexts. A firm that has obtained a loan from
the bank may suffer an adverse shock that the bank, which is monitoring it 
closely, is aware of but which is unknown to the investing public. The bank may
Conflicts of Interest in Universal Banking 65

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exploit its information advantage by issuing securities to repay the loan, selling
them to the public. A bank could also exploit its superior knowledge of its clients
by ‘cherry picking’, retaining the best clients to fund by bank loans and 
underwriting securities for the weaker customers. If the public fears that a bank
will exploit conflicts of interest to its disadvantage and the advantage of the
bank’s shareholders, a conflict of interest effect will lead the market to demand a
discount on the price (a premium on the yield) of securities issued by universal
banks.
Whether the ‘certification effect’ or the ‘conflict of interest effect’ is stronger
will depend on the bank’s ability to persuade the market that there is no conflict
of interest. The organizational structure of a universal bank may help to reduce
the potential and the perception for conflicts of interest by creating appropriate
incentives for managers and increasing the distance within the overall organiza-
tion between lending and underwriting. If both lending and underwriting are
conducted in departments within a bank, the public may not be able to discern if
the two units are cooperating closely to exploit a conflict of interest. The creation
of a separate affiliate or subsidiary for underwriting could provide a clearer picture
of its activities within a bank. If, however, separation in a subsidiary is effective in
containing conflicts of interest, it may also lead to a reduction in the information
economies of scope. Thus, there is a trade-off in the closer integration of activities
between economies of scope and potential conflicts of interest.
While contemporary critics of universal banking in the 1920s were thought to
have made a persuasive case that conflicts of interest were pervasive, recent
research has overturned this conventional wisdom. Not only was there a strong
certification effect, but also universal banks learned how to improve their organi-
zation to convince the market that they were not taking advantage of conflicts of
interest. 
Examining all securities issued from January 1927 to the end of the third 
quarter of 1929, Puri (1996) found that industrial bonds and preferred stock
underwritten by bank securities affiliates had lower yields than similar issues
underwritten by independent investment banks. In a related study, Ang and
Richardson (1994) estimated that bank affiliate issues had lower ex-ante and