Product Diversification
Chapter 21
Financial Institutions Management, 3/e
By Anthony Saunders
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Introduction
Universal FI structure in Germany,
Switzerland and UK.
 Recent Citicorp/Travelers merger.
 Risks of product segmentation

• lack of diversification
• exposure to nonbank competition
» especially MMMFs
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Segmentation in U.S. Financial
Services Industry

Commercial and investment banking
• Glass-Steagall Act 1933 exemptions
» Underwriting Treasuries and municipal general
obligation bonds;
» Engage in private placements.
• 1987 Federal Reserve Board allowed BHCs to
establish Section 20 affiliates.
» Firewalls between banks and Section 20 affiliates.
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Erosion of Glass-Steagall
20 states allow state-chartered banks to
engage in securities activities beyond those
permitted by Glass-Steagall for national
banks.
 OCC ruling in 1996:

• permit national banks on a case-by-case basis to
establish direct subsidiaries to undertake nonbanking activities such as underwriting.
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Further Challenges to Glass-Steagall

International Banking Act 1978
• Foreign banks securities activities
grandfathered.

Investment banks increasing efforts to offer
banking products.
• Cash management accounts
• Deposit brokering
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Banking and Insurance

1986: banks began selling annuities but
traditionally banks prevented from entering
insurance.
• Restricted to agency activities, offering creditrelated products in small towns.
• Garn-St. Germain Act specifies restrictions on
BHCs establishing insurance affiliates.
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Banking and Insurance (continued)
• Delaware: liberal laws allowing state-chartered
banks to engage in P&C and life insurance.
• Nonbank banks as a route for insurance
companies and commercial firms to engage in
banking.
• Current challenge to Bank Holding Company
Act’s restrictions
» Citicorp and Travelers
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Commercial Banking and Commerce
Banks can only engage in commercial
activities “incidental to banking”
 Restrictions on BHCs are a more recent
phenomenon.
 1956 Bank Holding Company Act.

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Issues Involved in Expansion of Product
Powers

Overview
•
•
•
•
•
•
Safety and soundness issues
Economy of scale and scope issues
Conflict of interest issues
Deposit insurance issues
Regulatory oversight issues
Competition issues
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Safety and Soundness

Risk of securities underwriting
• Firm Commitment
• British Petroleum
• Firewalls as protection from securities affiliate
» Risks from upstreaming or affiliate loans
» Risks from contagious confidence problem
• Benefits from product diversification and
geographic diversification
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Economies of Scale and Scope

Economies of scale opportunities for firms
up to $25 billion in asset size.
• Revenue-based for largest FIs

Economies of scope
• May be limited by firewalls between banks and
Section 20 subsidiaries.
• Greater gains possible with universal banking
structure as in Germany.
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Conflicts of Interest

Six potential conflicts
• Salesperson’s stake
» NationsBank example.
•
•
•
•
•
Stuffing fiduciary accounts
Bankruptcy risk transference
Third-party loans
Tie-ins
Information transfer
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Deposit Insurance

Deposit insurance
• may provide competitive advantage to banks
over other FIs.
• Banks may also gain an advantage from being
too big to fail.
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Regulatory Oversight
Large bank holding companies with
extensive nonbank subsidiaries face a
complex structure of regulators.
 If further integration of financial services
then there may be argument for a single
regulatory body.

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Competition

Procompetitive
• Increased capital access for small firms
• Lower commissions and fees
• Reduce degree of underpricing of new issues

Anticompetitive
• Long-run outcome could be oligopoly with
higher prices for investment banking services.
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