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The Transformation of the Us Financial Services Industry WILMARTH.PARTALL.DOC 5/24/2002 3:58 PM THE TRANSFORMATION OF THE U.S. FINANCIAL SERVICES INDUSTRY, 1975–2000: COMPETITION, CONSOLIDATION, AND INCREASED RISKS Arthur E. Wilmarth, Jr.* The structure of the U.S. financial services industry has changed dramatically during the past quarter century. Large banks, securities firms, and life insurers have pursued aggressive expansion strategies by merging with direct competitors as well as firms in other financial sectors. The Gramm-Leach-Bliley Act of 1999 has encouraged this consolidation trend by authorizing the creation of financial holding companies that engage in a full range of banking securities, and in- surance activities. The Act’s proponents have claimed that these new “financial supermarkets” will produce favorable economies of scale and scope, offer convenient “one-stop shopping” to customers, and achieve a safer diversification of risks. In contrast, Professor Wilmarth contends that the motivations for a probable outcome of financial conglomeration are very differ- ent. In his view, managers of large, diversified financial firms have sought growth to build personal empires, to increase market power, and to secure membership in the exclusive club of “too big to fail” in- stitutions. By virtue of their too big to fail status, major financial conglomerates are largely insulated from market discipline and regu- latory oversight, and they have perverse incentives to take excessive risks at the expense of the federal “safety net.” Based on past experi- * Professor of Law, George Washington University Law School. B.A. Yale University; J.D. Harvard University. I wish to thank Dean Michael K. Young and former Dean Jack H. Friedenthal for summer re- search grants that supported my work on this article. I am also grateful for the excellent research assis- tance provided by my former students Eleanor Chen, Gabrielle Duvall, and Todd Lasky, and by Ger- maine Leahy, Head of Reference for the Jacob Burns Law Library. Finally, I greatly appreciate the helpful comments and encouragement I received from Raj Bhala, Bill Bratton, Theresa Gabaldon, Helen Garten, Howell Jackson, Larry Kreider, Robert Litan, Greg Maggs, Patricia McCoy, Geoff Miller, Tom Morgan, Richard Painter, Steve Saltzburg, Elinor Solomon, Peter Swire, and Stuart Ya- kona. I am, of course, solely responsible for all remaining errors. Unless otherwise indicated, this article includes developments through October 31, 2001. 215 WILMARTH.PARTALL.DOC 5/24/2002 3:58 PM 216 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2002 ence, the new financial megafirms are likely to encounter disecono- mies of scale and scope, shrinking profit margins, increased customer dissatisfaction, and greater vulnerability to sudden disruptions in the financial markets. In addition, the federal government will feel com- pelled to support these risky behemoths during economic crises. Pro- fessor Wilmarth calls for fundamental reforms to our system of finan- cial regulation because current regulatory approaches cannot control the potential risks associated with financial conglomeration. TABLE OF CONTENTS Introduction..................................................................................................219 I. The Reconstruction of the Banking Industry Since 1975...............225 A. The Traditional Lending Business of Banks Has Declined Substantially ........................................................................................227 1. Banks Specialize in Lending to Borrowers that Lack Access to the Capital Markets ........................................................................227 2. Securitization and Competition from Nonbank Lenders Have Eroded Significant Portions of the Traditional Bank Lending Franchise..........................................................................................230 a. Large Firms Have Shifted Much of Their Borrowing from Banks to the Capital Markets ....................................................231 b. Banks Continue to Serve as “Standby Sources of Liquidity” to Large Companies and as Primary Lenders to Small Firms ....235 c. Banks Face Intense Competition in the Consumer Lending Market..........................................................................................238 B. Bank Profit Margins Have Declined as Investors Have Shifted Funds from Bank Deposits to Capital Markets ..............................239 C. Banks Face Continuing Threats to Their Profitability...................241 D. Consolidation Is Creating a Two-Tiered Banking Industry ..........250 1. The Banking Industry Has Consolidated Rapidly Since 1980...251 2. The Banking Industry Has Separated into “Global” and “Community” Sectors.....................................................................254 3. Will Bank Consolidation Reduce the Availability of Credit to Small Businesses? ...........................................................................257 a. Banks Are the Leading Lenders to Small Firms .....................258 b. Large and Small Banks Have Different Approaches to Small Business Lending ........................................................................261 c. Can Small Banks Survive the Consolidation Trend?..............268 4. Despite Their Growing Frequency, Big Bank Mergers Have Produced Disappointing Results...................................................272 a. Most Large Bank Mergers Do Not Improve the Efficiency or Profitability of the Resulting Institutions.................................272 b. What Factors Explain the Poor Results of Most Big Bank Mergers?.......................................................................................279 WILMARTH.PARTALL.DOC 5/24/2002 3:58 PM No. 2] THE FINANCIAL SERVICES INDUSTRY, 1975–2000 217 i. Diseconomies of Scale and Scope .........................................279 ii. Managerial Self-Interest and Hubris.....................................288 iii. The Pursuit of Market Power ................................................293 iv. The Quest for “Too Big to Fail” Status................................300 E. Large Banks Have Shifted to High-Risk Activities, Including Many Ventures Linked to the Capital Markets .........................................312 1. Risky Lending by Large Banks Led to the Banking Crisis of 1980–92.............................................................................................313 2. High-Risk Activities Among Large Banks Have Grown Rapidly in Recent Years...............................................................................316 a. Underwriting, Dealing, and Investing in Securities ................318 i. Large Banks Have Become Major Competitors in the Securities Industry...................................................................318 ii. Entry by Domestic and Foreign Banks into the Securities Business Has Produced Mixed Results.................................321 iii. Big Banks Have Assumed Substantial Risks in the Junk Bond and Venture Capital Markets......................................326 b. Dealing and Trading in Over-the-Counter Financial Derivatives...................................................................................332 i. Derivatives Activities Have Become a Major Line of Business for Big Banks ...........................................................332 ii. Banks Have Focused Their Derivatives Activities Within the OTC Market ............................................................................335 iii. OTC Derivatives Create Major Risks for Bank Dealers and the Financial Markets .............................................................337 (a) Market Risk....................................................................338 (b) Liquidity Risk.................................................................341 (c) Model Risk .....................................................................343 (d) Operational Risk, Moral Hazard and Inadequate Regulatory Oversight................................................................350 (e) Credit Risk .....................................................................359 (f) Legal Risk.......................................................................361 (g) Systemic Risk .................................................................368 c. The Growing Reliance of Large Banks on Proprietary Trading and Portfolio Investments Has Resulted in Significant Losses During Financial Crises..............................................................373 d. High-Risk Syndicated Lending..................................................378 i. Large Banks Face Expanding Risks in Their Domestic Syndicated Loans ....................................................................381 ii. Big Banks Have Assumed Growing Risks in Their Foreign Syndicated Loans ....................................................................385 e. Risky Consumer Lending...........................................................388 i. Large Banks Rapidly Expanded Their Involvement in Consumer Lending During the 1990s ...................................388 WILMARTH.PARTALL.DOC 5/24/2002 3:58 PM 218 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2002 ii. Big Banks Confront Significant Interest Rate and Prepayment Risks in Their Mortgage Lending Activities..390 iii. Large Banks Face Growing Default Risks in Their Consumer Lending Operations .............................................392 (a) Banks Have Expanded Their Lending to Subprime and Highly leveraged Borrowers ....................................................392 (b) Risky Consumer
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