The recent financial crisis has seen the demise of large investment banks in the U.S. This major change in the financial landscape has also rekindled interest in discussion of optimal banking models. All over the world, perceived costs and benefits of combining bank activities of various kinds have given rise to a wide variation in allowed bank activities. Should banks operate as universal banks, a model which allows banks to combine a wide range of financial activities, including commercial banking, investment banking and insurance; or should their activities be restricted?
To some policymakers the universal banking model may appear to be a more desirable structure for a financial institution due to its resilience to adverse shocks, particularly after the crisis. However, others have called for the separation of commercial and investment activities (along the lines of the Glass-Steagall Act of 1933 in U.S. which was repealed by Gramm-Leach-Bliley Act in 1999) to minimize the crisis-related costs imposed on taxpayers through the financial safety net. So which model is more desirable?
Theory, as usual, provides conflicting predictions about the optimal asset and liability mix of an institution. On the one hand, banks gain information on their customers in the provision of one financial service that may prove useful in the provision of other financial services to these same customers. Hence, combining different types of activities – non-interesting earning, as well as interest-earning assets – may increase return as well as diversify risks, therefore boosting performance. This argues for the merits of universal banks.
On the other hand, if a bank becomes too complex, bank managers may actually start taking advantage of this complexity for their own private benefit (what are sometimes known as “agency costs”) at the expense of the bank. So, too much diversification may actually not be optimal, increasing bank fragility and reducing overall performance. This tends to support the separation of commercial and investment activities.