Moral Hazard under Commercial and Universal Banking

Abstract

Many claims have been made about the potential benefits and the potential costs of adopting a system of banlcing in the United States. We evaluate these claims using a model where there is a moral hazard problem between banks and borrowers, a moral hazard problem between banks and a deposit insurer, and a costly state verification problem. Under conditions we describe, allowing banks to take equity positions in firms strengthens their ability to extract surplus, and exacerbates problems of moral hazard. The incentives of banks to take equity positions will often be strongest when these problems are most severe. FOR MANY DECADES, banks in the United States have been prohibited from making equity investments in the firms they serve. Rather, they are restricted to providing them with loans in the form, essentially, of debt contracts. This longstanding regulatory restriction1 results in distinctly different roles for bank lenders and equity investors, and has had important implications for the entire financial sector. The American system of commercial presents a sharp contrast with the banking systems of some other countries, most notably Germany, in which banks are permitted to take equity positions. Under such universal arrangements, banks can make equity investments as well as loans, vote their equity shares, and even hold seats on the boards of directors of nonfinancial firms. In general, they can be actively involved in all aspects of firm decision malQing. In Germany, the control rights The authors have benefitted from the helpful comments of Doug Diamond, Joe Haubrich, Ross Levine, Stan Longhofer, Joao Santos, and an anonymous referee. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. 1. The key legislation which constrains U.S. banks equity investments is the Glass-Steagall Act of 1933. However, a number of other laws also pertain to this issue, particularly the Bank Holding Company Act of 1956 and its 1970 amendments. Incidentally, there are some important exceptions to the equity investment prohibition. In default situations, banks are perrnitted to restructure loans into equity positions with the requirement of divestiture after a few years (see James 1993). Also, bank holding companies are permitted to form (separately capitalized) venture capital subsidiaries for the expressed purpose of investing in start up enterprises. JOHN H. BOYD is a professor of finance in the Carlson School of Management at the University of Minnesota and an adjunct consultant with the Federal Reserve Bank of Minneapolis. CHUN CHANG is an associate professor of finance in the Carlson School of Management at the University of Minnesota. BRUCE D. SMITH is a professor of economics at the University of Texas atAustin.