Economists debated the latest in banking research at a conference early this month sponsored by the Federal Reserve Bank of Cleveland and the Journal of Money, Credit, and Banking. For copies of the following papers, call 216-579-3079.
Universal banks are better than commercial banks at working out problem loans during economic downturns, University of Washington professors Alan C. Hess and Kathryn L. Dewenter write in "An International Comparison of Banks' Equity Returns."
The researchers examine the betas-or numerical estimates of the amount of risk a specific company faces-of universal and commercial banks. (Universal banking, an ownership structure prevalent in foreign countries, permits the mingling of banking and commerce.) Investors normally demand a return equal to the beta plus the amount they could earn in a risk-free instrument such as a Treasury bond.
They find that betas fall for universal banks during recessions and rise for commercial banks.
From this, they conclude that the equity stake gives universal banks a closer tie to their customers, making them better able than commercial banks to restructure loans to avoid losses.
However, universal banks would pose a greater threat than traditional commercial banks to the deposit insurance fund, according to researchers John H. Boyd, Chun Chang, and Bruce Smith.
In their analysis, the economists ran computer models to mimic how a universal bank and a commercial bank would react when presented with two investment options-assuming the U.S. permitted universal banking.
The model finds universal banks are more likely to choose the riskier investment because deposit insurance ensures the cost of funds do not vary with an institution's investment strategy.
Writing in "Moral Hazard Under Commercial and Universal Banking," they said commercial banks have no incentive to finance riskier projects because they will not share in the profits. So commercial banks would be less likely to subject the deposit insurance fund to losses.
Imposing double liability on bank stockholders may reduce the number unsafe and unsound investments by insured depositories, write Edward J. Kane of Boston College and Berry K. Wilson of the Federal Communications Commission.
Double liability means the government can force shareholders to cover some of the debts of a failed bank. The researchers write in "A Contracting Theory Interpretation of the Origins of Federal Deposit Insurance" that the system safeguarded U.S. banks in the 1920s because it gave investors an added incentive to monitor the investment decisions of bank management. The government lost this authority in 1927.
They recommend that regulators in developing countries implement a double liability system, saying their banking systems are similar to the U.S. system of the 1920s.
Research Scan runs on the second and last Fridays of the month. Submissions should be sent to American Banker, 1325 G St. NW, suite 900, Washington, D.C. 20005.