Centre for Economic Policy Research

New Stock Issues
 1919-1941
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1919
1921
1923
1925
1927
1929
1931
1933
1935
1937
1939
1941
$ Millions
Total
Corporate Bonds
Figure 5.4 New stock issues, 1919-41
Total
Corporate Bonds

---

3. the bank appointed a panel of trustees who held the shares of the affiliate 
in trust for the bank, appointed the same board of directors as the bank and
delivered the dividends to be distributed to the shareholders of the bank; 
4. the bank owned the stock of the affiliate as an investment. 
The affiliates nominally had separate boards of directors, but they often shared
some of the directors and upper management with the bank (Peach, 1941). 
The number of banks operating a securities business in an internal bank depart-
ment grew from 62 to 123 between 1922 and 1931. Even more rapid was the
development of separate securities affiliates, which rose from 10 in 1922 to 114 in
1931. Among these were the industry leaders – the Chase Securities Corporation
and the National City Corporation affiliated with the Chase National Bank (now
part of JP Morgan Chase) and the National City Bank (the precursor of Citibank)
respectively. Affiliates and the bond departments of commercial banks quickly
penetrated underwriting. While the share of all bond originations for 
independent investment banks fell from 78 to 55% between 1927 and 1929, 
commercial banks’ share climbed from 22 to 45% of the market from 1927 to
1929. Affiliates dominated this expansion, accounting for 41%, while internal
bond departments attained only 4% (Peach, 1941).
56
A commercial bank with an investment banking business could take advantage
of an affiliates’ larger and more specialized research staff to analyse securities for
its purchases or use as collateral. Unlike investment bankers, which had had a
small clientele of the well-to-do, commercial banks had large numbers of poten-
tial customers who could purchase some securities and place them in the banks’
safe deposit boxes. The banks acted as the contemporary equivalents of ‘discount
brokers’ charging a quarter of the fee of New York brokerages. This new clientele
helped to broaden the market for securities. Thus, commercial banks found that
underwriting, distributing and dealing in securities complemented their existing
services (White, 1986). While drawn to the highly profitable securities business,
commercial bankers were aware that the accompanying conflicts of interest would
be damaging and many were very careful to maintain their reputations.
57
Although the economy was already showing some signs of weakness in the
summer of 1929, the stock market crash in October stunned the public. In two
days, 28-29 October, the Dow Jones index fell 24%. In November it fell another
22%. Although the market enjoyed a brief recovery in early 1930, it continued to
drop downwards during the next two years; and the public questioned why they
had been induced to buy so much equity. 
In response to public outcry and pressure from the White House, the Senate
Banking and Currency Committee began an investigation that became known as
the Pecora hearings. Among the various ‘abuses’ discovered by the Congressional
hearings, several appeared to be conflicts of interest between commercial and
investment banking.
58
First, bankers were blamed for selling new issues of
‘unsound and speculative securities’ generated by their affiliates to their cus-
tomers. Second, commercial banks were accused of converting bad loans into
security issues that were sold to an unsuspecting public or to affiliates and invest-
ment trusts managed by the bank. Finally, security affiliates conducted pool oper-
ations, often in the stock of parent banks, with officers as private participants,
adding an element of personal conflict of interest. 
The first charge arose in the depressed markets of the early 1930s. The public
saw that the prices of their stocks that had plunged would not soon recover, and
many bonds were in default. Securities firms were blamed for selling low quality
bonds and stocks to uninformed or misinformed investors. It should be noted that
examples provided in Congressional hearings and subsequently cited in the 
62 Conflicts of Interest in the Financial Services Industry

---

academic literature (see Carosso, 1970) are biased in their selection. Three issues
underwritten by the National City Bank were investigated by the Senate
Committee on Banking and Currency in 1933-34, but they were the only issues
that were in default at that time (Benston, 1990). One of the supposedly infamous
examples cited in Congressional hearings were the bond issues floated by National
City Company for the Republic of Peru that went into default in 1931. Evidence
was uncovered that representatives of the National City Company had written
unfavourable reports about the condition of Peru in 1921, 1923, 1925 and 1927.
They pointed out that Peru had a bad debt record, was an adverse moral risk, and
the international situation was bad. Prospectuses distributed with the bond issues
made no mention of this information, suggesting that the bank had concealed
information from investing customers to the benefit of its underwriting business.
Yet, the bank was not alone in its initial favourable assessment. These bonds were
graded A by Moody’s in 1927, and though they were downgraded to BAA in 1928,
their market price exceeded the issue price until May 1930 (Benston, 1990). Many
of the facts were publicly known and the default was primarily the result of the
unanticipated worldwide depression. National City Company did not specialize in
low quality issues, and Huertas and Silverman (1986) report that 85% of National
City Company’s underwritings were initially investment grade or better. Even if
the bonds had been wholly purchased by the customers of National City Bank,
which they were not, there does not appear to have been an effort to exploit a
conflict of interest.
The second allegation of the Pecora hearings was the conversion of bad 
commercial loans into securities. One often cited example is the case of General
Theaters and Equipment (GTE). Chase National Bank financed GTE’s acquisition
of the failing Fox Motion Picture Company in 1929 with a $15 million loan. This
loan was repaid out of part of the proceeds from a $53 million issue of common
stock and debentures underwritten by Chase’s securities affiliate, Chase Securities
Company. When GTE ran into trouble in 1930, Chase Securities underwrote
another $30 in debentures; GTE went bankrupt two years later. The Congressional
investigation concluded that a conflict of interest led Chase to underwrite ‘poor
securities to pay off its own loans’, concealing or misrepresenting information
(Wigmore, 1985). The conflict of interest may not have been the key factor, 
however, as the economy was in the middle of the Great Depression and Chase
held most of the securities, taking a loss of $70 million, having been unable to sell
them to the public (Benston, 1990; Kroszner and Rajan, 1994).
In a similar case, National City Bank loaned $30 million to Cuban sugar 
producers. When the price of sugar collapsed after World War I, the bank held
these loans as ‘slow and doubtful’. On 15 February 1927, the capital stock of the
bank and its affiliate were each increased by $25 million. The next day, National
City Company acquired the General Sugar Corporation (into which the producers
had been amalgamated) at a price of $25 million, permitting the sugar company
to pay the loans held by the bank. Peach (1941) commented that while this might
appear to be a contribution of the shareholders to a write-off that would otherwise
have reduced the bank’s capital, the shareholders were not informed of the 
purpose of increasing the stock. Likewise, shareholders did not appear to have
been informed when Chase National Bank converted credits for public works in
Cuba into bonds with the intention of selling them to the public. When the bond
prices sagged, the bank purchased the issue. Peach (1941) concludes that the
Chase National Bank took $10 million into its portfolio in order to assist its 
affiliate.
The third charge of conflict of interest in the Pecora hearings was that 
managers had used their position and knowledge to privately benefit at the