Universal Banking

Background

Universal banking, in general, refers to a bank offering wide varieties of financial services under one roof. Such services include deposit taking, lending, trading of financial instruments, foreign exchange, derivatives trading, underwriting of securities, brokerage, managing public issue, investment management, insurance, etc. Therefore, universal banking is the combination of commercial banking and investment banking. The concept of investment banking envisages multiple business activity. If specialized banking is the one end, universal banking is the other.

In a very broad sense, the term ‘universal banks’ refers to those banks that offer a wide variety of financial services, especially insurance. International experience indicates that there has been deregulation of combining of commercial banking and investment banking. However, deregulation concerning the combination of banking and insurance business has been somewhat limited.

Advantages of Universal Banking

One of the potential advantages of a bank entering into universal banking is the information advantage. Banks gain informational advantages about firm over its life cycle. In the introduction stage, a firm has to rely heavily upon funds from promoters and its internal generation of funds. When it starts growing after its successful operations, such dependence tends to shift more towards loans and advances from banks. When the firm reaches prosperity and earns a good reputation in the market, it starts seeking cheaper funds directly from the market and reduces heavy dependence on bank loans. In such a situation, a universal bank will be able to fulfill the needs of a firm in a better way.

Another advantage of universal banking is that it results in greater economic efficiency. Such a efficiency arises in the form of lower cost, higher output and better products. When a bank produces a variety of products, its fixed overhead can be spread over the wider net of products. The large branch-network and their existing distribution channels can be used for the marketing and delivery of additional products at lower marginal cost. Universal banks can use their reputation on some particular products towards the marketing of other products as well. Also, clients can save their time and money as the universal bank provides a wide variety of services to them under one roof.

Universal banks can well diversify their risk by undertaking various functions and reduce the overall business risk. Banks face greater risk than commercial firms for the simple reason that the regulatory restriction on bank portfolios can render their potentially diversifiable risks undiversifiable. Therefore, universal banks are most likely to achieve overall risk reduction by combining commercial and investment banking activities.

Disadvantages of Universal Banking

When a bank enters into universal banking it tends to grow larger in size. However, larger the banks, the greater the effects of their failure on the system. Also, there is the fear that such institutions would gain monopoly power in the market. This can have undesirable consequences for economic efficiency.

Universal banks are likely to present substantial risks of conflict of interest. A conflict of interest arises when one is serving two or more interests. For example, when a bank undertakes managing public issue of shares of a company its advisory role obligates it to promote the issue. This role may persuade the bank to underwrite the shares even if the better invest opportunities are available before it. Therefore, combining commercial banking and investment banking functions by a universal bank can give rise to conflict of interests. Conflict of interests was one of the major reasons for the introduction of Glass-Steagall Act in the US.

Consolidation in the financial-services industry has brought renewed interest in universal banks, financial intermediaries that perform both commercial and investment banking. In principle, universal banks can exploit economies of scope in production and consumption and can benefit from the creation of internal capital markets. By closely monitoring their portfolio companies, universal banks can also improve the quality of corporate governance. However, critics associate universal banking with excessive risk, moral hazard created by the expectation of government bailouts, monetary instability, the concentration of political and economic power, a lack of consumer choice and availability of credit.

Regulatory Concern

Universal banking also concerns the bank safety and soundness. Underwriting securities or acquiring ownership by banks in different client companies increases the risk of bank portfolios. This would increase the costs for the regulatory authority to provide safety net against the risks of bank failure.

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