Moral hazard under commercial and universal banking, Banking & growth
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Federal Reserve Bank of Minneapolis
Research Department
Moral Hazard Under
Commercial and Universal Banking
John H. Boyd, Chun Chang,
and Bruce D. Smith*
Working Paper 585D
Revised January 1998
ABSTRACT
Many claims have been made about the potential benefits, and the potential costs, of adopting a
system of universal banking 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 universal banks to take equity positions will
often be strongest when these problems are most severe.
*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; and Bruce D. Smith is a professor of
economics at the University of Texas at Austin. We have benefitted from the helpful comments of Doug Diamond,
Joe Haubrich, Ross Levine, Stan Longhofer, Jaoa 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.
Introduction
For many decades, commercial 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 restriction
1
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 banking” 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 banking” 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-making. In Germany, the
control rights of owner-banks are further enhanced by the fact that they can vote the shares of other
agents which they hold in trust (auftragsstimmrecht).
2
These important differences in banking arrangements have not escaped the notice of scholars
and there is a large literature, both theoretical and empirical, that compares the two types of banking
systems. Indeed, many academics—as well as policymakers—have proposed that the United States
adopt a form of universal banking and this issue is under active, ongoing debate in the Congress.
3
The obvious point is that this subject is of significant public policy concern, as well as of academic
interest.
A second issue that looms very large in discussions of banking and bank regulation is the
control of moral hazard problems. Moral hazard in banking can clearly take either or both of two
forms. Moral hazard problems can easily arise in the relationship between banks and the agents to
whom they provide funds. In addition, it has long been recognized that the presence of deposit
insurance gives rise to a moral hazard problem between banks and the providers of deposit insurance
2
(the FDIC). [See, for instance, Kareken and Wallace (1978) and Merton (1978).] And indeed,
regulators have often expressed the concern that the establishment of universal banking in the U.S.
could extend the “governmental safety net” far too broadly, that moral hazard problems could be
exacerbated as a consequence, and that they could, potentially, be transmitted beyond the financial
sector. [See, for example, Corrigan (1983, 1987) or Saunders (1994).]
In this paper we investigate the severity of both kinds of moral hazard problems under both
commercial and universal banking. In particular, we investigate optimal bank behavior under each
regime, and then pose the following two questions: (i) how severe is the moral hazard problem
between banks and “borrowers;” and (ii) how severe is the moral hazard problem between banks and
the FDIC?
We begin by studying a system of commercial banking where banks are precluded from taking
equity positions in the firms to which they lend. We show that under commercial banking, banks will
always take some actions to control the moral hazard problem between borrowers and themselves.
These actions also tend to limit the implied obligations of the FDIC, since the active control of moral
hazard problems by banks implies that banks fail less often and, on average, have assets of greater
value when they do fail.
We then contrast this with a banking system (universal banking) where banks take equity
positions in the firms they serve.
4
When banks are allowed to take equity positions, and to assume
some control rights, their incentives to control moral hazard problems can be substantially attenuated.
Indeed, under universal banking banks can share more easily in the benefits of “misallocating” funds,
and they can more easily pass losses onto the FDIC. This exacerbates problems of moral hazard
along both dimensions. Moreover, by exercising their control rights, banks can force firms to
“misallocate” funds even when this is beneficial neither to the firm nor to society (although clearly
it is beneficial to the bank). This alteration in the allocation of funds also has adverse consequences
3
for the FDIC. Finally, we identify some economic factors that are conducive to problems of moral
hazard being particularly severe under universal banking. These factors include: (i) low real returns
on savings, (ii) a relatively high return to misallocated funds, (iii) a high cost to banks associated with
deterring moral hazard, and (iv) banks obtaining relatively large equity positions under universal
banking.
Having analyzed these issues we then ask a third question: When will a bank, if given a
choice between a debt and an equity claim, choose to take an equity position in a firm? Loosely
speaking, we find that banks prefer equity claims when: (i) the return to misallocating funds is
relatively high, and hence the moral hazard problem is relatively severe, (ii) their probability of failure
as a commercial bank is relatively high (it will then be even higher under universal banking, again
reflecting greater moral hazard), (iii) ex post state verification costs are relatively low, and (iv) the
bank is able to obtain a relatively large equity position under universal banking. (The latter factor
again is associated with moral hazard problems being more severe under universal banking).
Finally, we show that the two types of banking systems have sharply differing
general
equilibrium
implications for resource allocations. In particular, under universal banking a larger
portion of the surplus generated by externally financed investment accrues to banks, and less accrues
to the originating investor. This clearly can have far-reaching implications for aggregate investment
activity. In addition, problems of moral hazard in investment will often, as we have noted, be of
greater concern under universal than under commercial banking. Together, these observations suggest
that universal banking can easily have adverse consequences for the overall efficiency of investment.
Our vehicle for addressing the issues just described is a model in which all deposits are fully
insured by the FDIC. Such insurance is socially valuable in our framework because, by assumption,
banks are unable to perfectly diversify risk and most depositor-savers are risk-averse. Further, all
savings and investment is intermediated through banks. The FDIC charges a fixed-rate insurance
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