Separation of Commercial Banks and Investment Banks Essay

Custom Student Mr. Teacher ENG 1001-04 15 September 2016

Separation of Commercial Banks and Investment Banks

One of the key concerns growing out of the debate on whether to separate or merge retail banking and wholesale/investment banking activities has been the stability of a nation’s banking system. The experience of the US banking system has suggested that merge of commercial and investment banks is a better approach to achieving stability. After the global financial crisis, the American economy went into recession. The policy priority of American government was then to intervene into its banking system so as to mitigate the impact of the crisis.

One advantage of the merger of banks is that it can improve the overall condition of the economy (Khan, 2012). The merger of banks unites small and weak unit banks which will then be able to provide diverse services and with time, to reduce costs and gain competitiveness and efficiency. As will be argued below, contrary to the view that the merge of banks was responsible for the financial crisis in 2008 and Great Depression in 1930s, universal banks constitute one of the key solutions to the underlying cause of the financial turmoil in history.

First of all, in 1930s, the Great Depression in America triggered considerable debates on the primary cause of the stock market crash. Analysts in favour of separation of banks have observed that the fundamental reason was the “overproduction of securities” resulted from the combination of commercial and investment banks (Casserley, Harle, and Macdonald, 2011). Until 1902s, national banks had no authority to issue securities. However, “the Civil War had been an explosion of new securities issued to finance railroads leading to the western Unit States and the expansion in public fields” (Hendrickson, 2012).

Many state-chartered banks captured this chance and were involved in securities underwriting. Historical data has shown that compared to a number of merely 205 banks engaging in securities underwriting in 1922, there were approximately 5 times more national banks that were involved in securities underwriting in 1926 (Hendrickson, 2012). This sharp increase in securities underwriting resulted in deterioration of the quality of new securities and the “overproduction of securities”.

To the contrary, others have opposed the separation of banks, arguing that the Great Depression actually had much to do with small local “unit” banks which constituted the fatal weakness in the banking system (Casserley, Harle, and Macdonald, 2011). This argument, therefore, suggests that the cause of the Great Depression was not the merger of commercial and investment banks but the separation of banks. Accordingly, they have pointed out that the increasing number of small banks as a result of the separation of banks could exacerbate the vulnerability of the financial system (Casserley, Harle, and Macdonald, 2011).

The enactment of the Glass-Steagall Act in 1930s seems to provide an indication that the views in support of the separation of banks had prevailed over those in favour of the merger of banks. However, it is submitted that the Glass-Steagall Act had failed to solve the underlying problem of the US financial system. For instance, in 1980s, despite the operation of the Act, a third of small specialist financial institutions failed during the saving and loan (S&L) crisis (Casserley, Harle, and Macdonald, 2011).

This indicates that the statutory requirement of bank separation is not the right solution to the underlying problems in the US financial system. Secondly, the merger of banks has the advantage of helping small banks to become more competitive in the market because merged banks are able to provide broader and cheaper services than small specialist financial institutions, and consequently, to achieve reduction of operating costs and increase in revenue (Krainer, 2000).

However, proponents of the Glass-Steagall Act have maintained that the merger of banks could generate two critical problems – “conflict of interests” and “too big to fail” – which, in their view, were responsible for the Great Depression in 1930s and the financial crisis in 2007 (Casserley, Harle, and Macdonald, 2011). In our opinion, the fact that the Glass-Steagall Act was repealed in 1980 indicates that the need for statutory permission of the merger of banks in the US had prevailed over concerns about the problems associated with the merger of banks.

This further suggests that since the Glass-Steagall Act had failed to address the underlying cause of the Great Depression which was the fragility of small financial institutions, the repeal of the Act and permission of bank merger seemed to have been considered to be the way toward the establishment of a healthy and strong financial system in the US. Therefore, despite these problems that might arise from the merger of banks, the permission of bank merger has been regarded as a better approach to achieving financial system stability than the statutory requirement of eparation of banks.

Thirdly, another argument for separation concerns the moral hazard issue that may arise from universal banks. According to this argument, the merger of banks may be likely to create incentives for banks to make irresponsible investment decisions at the risk of depositors and investors due to the expectation of universal banks that governments will protect them from failure (Casserley, Harle, and Macdonald, 2011).

However, it can be argued that this issue is not attributable to government policies on bank merger or bank separation but to those which bail out banks at the verge of bankruptcy. In other words, such a moral hazard issue may arise not only in the case of bank merger but also in the case of bank separation as long as governments choose to compensate banks for their damages resulted from irresponsible investment decisions.

Therefore, the key to solving this moral hazard issue is not to turn a policy in favor of bank merger into a policy in favor of bank separation; rather, it is for the governments to cease to provide bail-out for irresponsible banks so as to prevent them from making investment decisions that are harmful to the entire financial system. Indeed, the merger of banks may give rise to problems. However, it is suggested that these problems can be tackled by stricter government policies.

For instance, the excessive involvement of banks in the production of securities may give rise to conflict of interests, an issue concerning the possibility of banks selling securities to customers without disclosing their own interest in such transactions (Casserley, Harle, and Macdonald, 2011). This potential problem can be avoided by government regulations such as the Securities Act 1933 which provided for rules of disclosure on securities offerings and established the Securities Exchange Commission to enforce them (Casserley, Harle, and Macdonald, 2011).

Moreover, the moral hazard issue may also be addressed by government regulations of the financial market such as by requirements that banks must retain sufficient capital on account to compensate for losses and liabilities. The examples above demonstrate that government interventions in the banking system may effectively solve these anticipated problems of bank merger. In short, compared to bank separation, bank merger provides a better approach to fostering a stable and healthy financial system which is essential for the economic recovery of the US (Casserley, Harle, and Macdonald, 2011).

Although the merger of banks has its own disadvantages, these disadvantages are not the root causes of the 1930 financial crisis and can be remedied by stricter government regulations. Therefore, it is suggested that while universal banks should be duly regulated, they are more capable to withstand financial turmoil than small banks, thereby making the merge of banks a better government policy than the separation of banks.

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