A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Focarelli, Dario; Marqués-Ibáñez, David; Pozzolo, Alberto Franco Working Paper Are universal banks better underwriters? Evidence from the last days of the Glass-Steagall Act ECB Working Paper, No. 1287 Provided in Cooperation with: European Central Bank (ECB) Suggested Citation: Focarelli, Dario; Marqués-Ibáñez, David; Pozzolo, Alberto Franco (2011) : Are universal banks better underwriters? Evidence from the last days of the Glass-Steagall Act, ECB Working Paper, No. 1287, European Central Bank (ECB), Frankfurt a. M. This Version is available at: http://hdl.handle.net/10419/153721 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. 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EVIDENCE FROM THE LAST DAYS OF THE GLASS-STEAGALL ACT by Dario Focarelli, David Marques-Ibanez and Alberto Franco Pozzolo WORKING PAPER SERIES NO 1287 / JANUARY 2011 ARE UNIVERSAL BANKS BETTER UNDERWRITERS? EVIDENCE FROM THE LAST DAYS OF THE GLASS-STEAGALL ACT 1 by Dario Focarelli 2, David Marques-Ibanez 3 and Alberto Franco Pozzolo 4 NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. In 2011 all ECB publications feature a motif taken from the €100 banknote. This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1573177. 1 Acknowledgements and disclaimer: Opinions expressed are those of the authors only and do not necessarily reflect the views or involve any responsibility of ANIA or of the European Central Bank. We are grateful to an anonymous referee as well as Patrick Bolton, Santiago Carbo, Bob DeYoung, Doug Evanoff, Craig Furfine, Luigi Guiso, Harri Huizinga, Paolo Mistrulli, Steven Ongena, Manju Puri, Richard Rosen and Lucy White for useful comments and/or discussions. We are in particular grateful to Barbara Sianesi for her advice on the matching procedure. We would also like to thank seminar participants at presentations and conferences at the Federal Reserve Bank of Chicago, at the University of Rome “Tor Vergata” Conference on Banking and Finance, at the EFMA Meeting, at the Global Finance Conference, at the XLIV Annual Conference of the Italian Economics Association for useful suggestions and at the joint BIS-JFI-CEPR conference on Systemic risk and financial regulation – causes and lessons from the financial crisis, Basel. 2 ANIA and Università di Roma “La Sapienza”; e-mail: [email protected] 3 European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany; email: [email protected] 4 Università del Molise, Centro d’Agliano and Mo.Fi.R.; e-mail: [email protected] © European Central Bank, 2011 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Internet http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the authors. Information on all of the papers published in the ECB Working Paper Series can be found on the ECB’s website, http://www. ecb.europa.eu/pub/scientific/wps/date/ html/index.en.html ISSN 1725-2806 (online) CONTENTS Abstract 4 Non-technical summary 5 I. Introduction 6 II. The institutional framework 8 III. The literature 10 IV. Data and summary statistics 13 V. Regression results 15 V.a Baseline specifi cation 15 V.b Alternative econometric specifi cations 17 V.c Discussion 18 VI. Additional evidence 19 VI.a Ex-post defaults 199 VI.b Ex-ante conditions 20 VI.c Further controls 21 VII. Conclusions 22 References 24 Tables 27 ECB Working Paper Series No 1287 January 2011 3 Abstract: It has often been argued during the recent credit crisis that commercial banks’ involvement in investment banking activities might have had an impact on the intensity of their underwriting standards. We turn to evidence from the period prior to the complete revocation of the Glass-Steagall Act in the United States and analyze whether investment banks or – section 20 subsidiaries of – commercial banks underwrote riskier securities. We compare actual defaults of these deals for an extensive sample of about 4,000 corporate debt securities underwritten during the period of the de facto softening of the Act’s restrictions. Securities underwritten by commercial banks’ subsidiaries have a higher probability of default than those underwritten by investment houses. This evidence is stronger in the case of ex-ante riskier and more competitive issues, and during the first years of bank securities’ subsidiaries’ entry into the market. Based on our results, it is not possible to reject that the repeal of the Glass-Steagall led to looser credit screening by broad (universal) banking companies trying to gain market share and/or to the lower initial ability of these banks to correctly evaluate default risk. Keywords: Glass-Steagall Act, securities underwriting, default, investment banking. JEL-classification: G21, G24, N22. ECB Working Paper Series No 1287 4 January 2011 Non-technical summary Over the last 30 years there has been a profound deregulation of investment banks’ activities in the United States which lead to the creation of large financial institutions with a wide range of banking business. One of the most notorious examples of regulation setting up restrictions on banks’ business models was the banking Act of 1933, commonly known as the Glass-Steagall Act, which imposed a functional separation between commercial and securities activities. At the time, the enactment of the Glass-Steagall was to a large extent motivated by concerns about conflicts of interest between the lending, underwriting and proprietary trading functions. In the last decades of its existence the Glass-Steagall was progressively relaxed. In April 1987 the Fed allowed US commercial bank holding companies to establish affiliates which authorized to underwrite certain corporate securities. Finally, in 1999, the Glass-Steagall Act was formally repealed. The dismantling of the Glass-Steagall Act was based on three main arguments. First, its revocation would allow banks to attain favorable economies of scope. Second, it would help banks to achieve greater opportunities for diversification derived from the different business lines with heterogeneous revenue cycles. Third, the repeal of the constraints introduced by the Glass-Steagall Act was expected to enhance the ability of US financial institutions to compete with foreign universal banks. The rescission of the Glass-Steagall prohibitions was also buttressed by increasingly persuasive evidence from academic studies of the impact of broad banking on the pre-Glass-Steagall era. They consistently showed that securities underwritten by commercial banks’ subsidiaries did not have a higher probability of default than those underwritten by investment banks. We revisit the issue and present new empirical evidence on the impact of banks’ business models on credit screening of corporate bonds. We examine empirically about 4,000 corporate bonds underwritten by investment houses and commercial banks’ subsidiaries during the period of the progressive repeal of the Glass-Steagall (between 1991 and 1999) in the United States and analyze their ex-post credit quality using a unique data base of corporate defaults running until the end of 2008. We find that over the ten years of the progressive repeal of the Act, debt securities issues underwritten by commercial banks had a higher probability of default than those underwritten by investment houses, the more so in the case of ex-ante riskier and more competitive issues, and during the first years of bank subsidiaries entry into the market. Based on our results, it is not possible to reject that the repeal of the Glass-Steagall led to looser credit screening by broad (universal) banking companies, although this seems to be due to banks’ relative more aggressive underwriting standards in order to gain market share and/or the lower initial ability of these banks to correctly evaluate default risk rather than to