Centre for Economic Policy Research

5.8
Remedies for conflicts of interest
While there is currently debate over increasing the regulation of investment banks
to reduce the internal analyst-underwriter conflicts of interest, the debate over
universal banking is focused more on reducing regulation to gain from economies
of scope without inducing the exploitation of conflicts of interest. Universal 
banking focuses on deregulation because until recently US public policy was guid-
ed by the Glass-Steagall Act that has inclined towards the most extreme remedy
of separation.
5.8.1
Separation
Separation of the activities of a financial intermediary is a matter of degree not
kind. There are basically three degrees of separation:
1. separate in-house departments;
2. separately capitalized subsidiaries of a bank or bank holding company; 
3. a prohibition on a combination of activities by any organizational form.
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The gains in economies of scope and the potential costs from conflicts of 
interest will depend on the degree of integration and the organizational structure.
Presumably, there is a trade-off – the greater the degree of separation, the smaller
the economies of scope and the lower the potential conflicts of interest.
At one extreme, prohibiting any form of universal banking eliminates the 
conflicts of interest but deprives banks of any benefits from economies of scope.
The US Glass-Steagall Act of 1933, copied by the Japanese, exemplified the 
complete separation. Although it is difficult to disentangle the costs of this 
regulation, it may have contributed to the relative decline in the domestic and
international competitiveness of US commercial banks (Saunders and Walter,
1994). Competitive pressures on the banks, coupled with the new evidence 
discussed above, convinced Congress to allow firms to combine commercial and
investment banking through separately capitalized affiliates of bank holding 
Conflicts of Interest in Universal Banking 71

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companies, each with its own management and accounting records. Flows of
information, personnel and other inputs are controlled. Limited liability is aimed
at protecting each unit’s shareholders and depositors from losses if another unit
fails. Separation also permits different compensation for each unit’s management
that can reduce incentives to exploit conflicts. 
Essentially, this is the new banking regime in the United States under the
Gramm-Leach-Bliley Financial Services Modernization Act of 1999 that allows
banks, securities firms and insurance companies to affiliate within a financial
holding company. Evidence from the early, more limited, expansion of commer-
cial banks into investment banks strongly suggests that firewalls were not so high
as to prevent gaining some economies of scope. According to Saunders and Walter
(1994), the firewalls were found by a 1990 General Accounting Office study to be
sufficiently stringent that no conflicts of interest were found between Section 20
subsidiaries and their affiliated banks. While it is too early for any judgement
about the effects of the 1999 Act, banks have moved to take advantage of the law
presumably to gain potential complementarities. 
Although keeping investment banking in a subsidiary may not allow it full
exploitation of the economies of scope, it may be appropriate if a closer affiliation
would expand the safety net in banking. If the safety net were not a concern, a
bank could select the most efficient organizational form, providing some 
investment banking services in-house and others through subsidiaries. In the 
presence of distortions created by deposit insurance and the doctrine of too-big-
to-fail, segregating investment banking activities in a subsidiary may be an 
inferior choice of corporate form from a pure efficiency point of view, but it may
limit the potential liabilities of deposit insurance. At the same time, it will prevent
universal banks from benefiting from the safety net in competition with 
independent investment banks, keeping the playing field level.
While substantial firewalls are thought to play a key role in the emerging 
system of American universal banking, it is generally believed that legally and
operationally separate units are not truly independent. There are strong incentives
to manage them as an integrated entity to gain economies of scope rather than as
a portfolio of independent companies. Studies of US banking holding companies
indicate that policies are usually centralized at the holding company level.
Furthermore, universal banks have incentives to protect their units from 
bankruptcy because they are fearful of reputational effects; and the courts may
hold the parent companies legally liable. Thus, the holding company does not
necessarily restrict connections, and banks can provide capital infusions, offer
credit, exchange information or purchase assets and services from their 
subsidiaries (Santos, 1998). These considerations may help to explain why the
Congress and the Federal Reserve have allowed the weakening of some firewalls
beginning in the 1980s. The Gramm-Leach-Bliley Act is certainly not the final
word on financial architecture, as further deregulation will, no doubt, await the
evaluation of the performance banking under this new regime.