Centre for Economic Policy Research

5.7
Universal banking and conflicts of interest outside the 
United States
The literature on conflicts of interest may leave the impression that it is only a US
problem. The US banking system’s characteristic of arms’ length transactions
instead of relationship banking certainly heightens the awareness of conflicts of
interest. While the potential problem may not be as visible, however, the issues
remain.
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Although the Canadian banking system has some important structural 
differences with the US system, the Anglo-Scottish tradition of arms’ length 
transactions allows the examination of potential conflicts of interest. Until the
Bank Act of 1987, Canadian chartered banks were prohibited from underwriting
corporate securities and offering investment advice. This legislation permitted
Canadian banks to enter investment banking by organizing a direct subsidiary of
the bank. Hebb and Fraser (2002) compared the yields on all Canadian corporate
bonds underwritten by commercial bank affiliates and independent investment
banks between 1987 and 1997. Controlling for other factors, regression results
show that the former have yields that are 19 basis points lower. Even the presence
of a commercial banking relationship does not alter this difference, suggesting
that any conflict of interest effect is dominated by the certification effect.
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This
result was stable over time, which may be noteworthy since Canadian banks
quickly dominated investment banking, achieving a high level of concentration.
While the Canadian case provides similar evidence of general absence of
exploitation of potential conflicts of interest, one study of the Israeli system 
suggests the opposite. Examining Israeli IPOs in the 1990s, Ber et al. (2000) found
that issuing firms whose equity was underwritten by an affiliate of a bank that had
provided credit to the firm had significantly lower than average stock 
performance but better accounting profitability. If an investment fund managed
by the bank bought into the new IPO, the stock performance was even lower.
They tentatively concluded that bank affiliates provide more certification, but
that there is some exploitation of the conflict of interest between banks and their
investment funds. 
The most widely admired system of universal banking appeared in nineteenth-
century Germany, where there were no legal constraints on universal banking.
First private banks then joint-stock banks combined commercial and investment
banking. Providing both loans and investment banking services and taking lead
roles in founding and managing industrial companies, they have been viewed as
essential to the rapid industrialization of the then backward German economy
(Fohlin, 1999; Guinnane, 2002). The banks’ size and prominence relative to 
markets was reinforced by German law. A transactions tax encouraged banks to
settle securities trades internally, and the requirement that any issue must be fully
subscribed before a company could begin operation gave advantage to large
banks, which could carry the issue. These universal banks’ information advantage
has been seen as arising not only from the provision of commercial and 
investment banking services, but also from their ability to place representatives on
firms’ supervisory boards. In accordance with the pecking order theory of 
corporate finance, the ability of universal banks to service firms better has been
viewed as a consequence of their ability to adjust financing as companies
matured, making use of their accumulated information (Calomiris, 1995). 
This German relationship banking may have allowed banks to manage and 
distribute risk better than banks that had more arms’ length transactions, but it
also produced a highly concentrated industry. By 1913, the three largest firms in
Germany were banks, and they comprised 17 of the largest 25 German firms. They
were able to exercise considerable power to promote the business of clients and
cartels. Case histories of the banks (Guinnane, 2002) indicate, however, that they
protected clients’ national and international projects, but also decided which of
their own clients to favour. In a vast literature on the subject, there is almost no 
discussion of conflicts of interest, although there was clearly potential. In one
exception, Fohlin (1999) suggests that internalization of securities trading within
universal banks may not have provided investors with the best execution of their
trades. The literature does consider the ability of the concentrated and sometimes
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collusive banking industry to extract rents from industry, which suggests some
exploitation of asymmetric information by less than transparent banks.
Unfortunately, just as there are no historical studies of conflicts of interest in
European banking to compare to those examining the United States, there is an
absence of research on conflicts of interest in contemporary European banking, in
spite of the fact that the diversity of regulation provides a natural laboratory.
Surveying European countries, Santos (1998) found that, as of 1997, all Western
European countries permitted securities activities both within the bank and
through a bank subsidiary. Although regulations varied considerably, banks in
Austria, Finland, Germany, Italy, Luxembourg, the Netherlands, Sweden and
Switzerland conducted their securities operations directly. Greece and Ireland 
preferred to use a subsidiary; and there was no dominant type in Portugal, Spain
and the United Kingdom. While there are no empirical studies, there are 
perceptions of conflicts of interest. In Germany there are concerns about conflicts
of interest where banks serve clients in more than one capacity. Potential conflicts
are seen in the fiduciary responsibilities of a bank and its role as investment
banker, assisting mergers and acquisitions, and the stuffing and churning of 
portfolios (Saunders and Walter, 1994).