Universal Banking

Josh Nelson 0299945

Business 4039 FA Financial Institutions Management Ken Hartviksen

November 17, 2008

Table of Contents Bibliography..................................................................................................8

Josh Nelson Thesis Statement

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What is Universal Banking and the major issues surrounding the concept of Universal Banking? What impact can Universal Banking have on the current financial turmoil in North America?

History of Universal Banking The concept of Universal Banking or a bank that engages in a broad range of financial service activities began to creep into the banking system in the 1930s and 1940s. Europe is considered the home of the Universal banking system however it has been adopted around the world in varying degrees. However it wasnt until around 1999 that the United States lifted prohibitions blocking the idea of a Universal Bank making them one of the last countries willing to adopt the model.1 A Universal Bank normally has three distinguishable services which include: Commercial Banking This is the routine operations of the bank which comprise mostly of deposit taking and lending as well as the associated functions that go with these tasks. Commercial banking was implemented to provide individuals with a secure place to store their funds. Investment Banking This section of the Universal Banking model deals with the securities, which including issuing, underwriting and distributing them. Investment banking was introduced in North America through the United States shortly after the Revolution. The main reason for the introduction of Investment banking was for the governments to issue bonds to finance wars, banks and internal improvements.2

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Hughes, Jane and MacDonald, Scott (2002) International Banking Text and Cases Carosso, Vincent P. (1970) Investment Banking in America, a History

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Insurance The final division of a Universal Bank is the insurance sector. This is basically the division where the bank offers products for individuals to transfer risk from one party to another for a premium. It can be seen as taking a small loss to prevent a catastrophic loss. There are many different types of insurance products for all cases, these ranges from auto insurance to life insurance to credit insurance. Universal Banking can be potentially beneficial since it allows the commercial bank to diversify into other activity areas and thus reduces the risk of failure. On the other hand, some nonbank activities may be more risky than banking activities when viewed on a stand-alone basis.3 Therefore universal banking may increase the probability of bank failure, do the returns out weigh the risk?

Universal Banking Structure The idea of offering all financial services under one roof is a good concept, however there needs to be structure in place in order for this concept to work. There are three main types of different universal banking structure models they include: Full Universal Banking Activities Securities Activities Other Activities
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This structure the banking activities, securities activities and other activities like selling insurance are conducted within in a single organization through different departments.

Saunders, Anthony (1994) Universal banking in the United States [electronic resource]: what could we gain? What could we lose? 4 Saunders, Cornett, McGraw (2006) Financial Institutions Management A Risk Management Approach 3rd ed.

Josh Nelson Universal-Subsidiary

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Bank Parent

Other Activities

Securities Activities Subsidiary

This is where there is a banking parent who controls a securities subsidiary as well as another subsidiary that deals with other activities. An example of this would include CIBC being the banking parent and then CIBC World Markets being this securities subsidiary. Financial Services Holding Company
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Financial Services Holding Company

Bank Subsidiary

Financial Services Subsidiary (Securities)

Other Activities

Under this structure each of the universal banking activities is done under individual subsidiary. This is the least integrated of the three structures. Each of the three subsidiaries acts as its own company with the financial holding company being the link between them.

Saunders, Cornett, McGraw (2006) Financial Institutions Management A Risk Management Approach 3rd ed.

Josh Nelson Issues Surrounding Universal Banking

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The common perception of a Universal Bank is that they are large power banks with every financial service being offered under one roof. However there are many underlying issues involved in a bank becoming and being universal. The first issue is the safety and soundness of the policy of the bank, which refers to the protection borrowers and lenders have over the risk of financial institution failure. The introduction of security activities and other non-bank activities into the bank could affect the banks current safety and soundness. For example if the banks security division undertakes a risky securities underwriting and incurs substantial losses will this cause the financial institution to fail?5 It is ideal for the bank to be adequately insulated from these kinds of risks the securities or insurance affiliates may bring on. Another issue with universal banks is there large size and the too big to fail doctrine that is associated with that. If these large banks run into solvency issues, regulators will be confronted with this issue and in principal should shut the bank down. However a closure of this size could send shockwaves throughout the economy causing a ripple down effect. 6 Along with universal banks being naturally large, is the concentration of power that these banks yield. The most prevailing issue around the universality of a bank is the varying different conflicts of interest that arise under this model, which can call into question a banks ethicalness and professionalism. The conflict of interest can include 7: Salesperson Stake This occurs when a bank can sell non-bank products like insurance. The bank employee goes from giving unemotional advice to clientele Saunders, Cornett, McGraw (2006) Financial Institutions Management A Risk Management Approach 3rd ed. 6 Rich, Georg and Walter, Christian The Future of Universal Banking 7 Saunders, Cornett, McGraw (2006) Financial Institutions Management A Risk Management Approach 3rd ed.
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to taking a salesperson mentality and tries to push new bank products even at the harm of their client. Bankruptcy Risk Transfer An example of this is when a firm has an outstanding loan with the bank and either stops making payments or is late on payments which in turn increase their credit risk or bankruptcy risk. The bank could use this private knowledge and allow the firm to use their securities affiliate to issue bonds to the public in order to pay down the loan. In turn, the bank gains in three different ways, they have the outstanding loan paid down, they transfer the bankruptcy risk from themselves to unknowing outside investors and finally the banks securities affiliate makes an underwriting commission on the issue of bonds. Third-Party Loans Banks offer cheap loans to third-party investors with a clause that states the loan is to be used to buy securities that are underwritten by the direct affiliate. This ensure that underwriting of a security goes smooth, if this backfires the bank also has an option of using their trust company to buy out this shares to avoid potential losses this is called stuffing Information Transfer This is when a bank gains inside information about their cliental because of being a lender. They then use this information to target certain cliental with either securities products or insurance products. As you can see, the issue around conflict of interest is pivotal to a bank acting in a professional and ethical way. If banks act ethically and in the best interest of the client they will gain a better reputation which could lead to a larger market share and greater profits. The return for acting professionally outweighs the risk of acting unethical.

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The final issue around universal banking is the regulatory issues surrounding the different divisions of a universal bank. This issue is primarily only within Canada. The Office of the Superintendent of Financial Institutions was created to regulate and supervise all banks, insurance companies, trust funds etc on a federal level. Whereas in Canada the regulation of securities is done on a provincial level for example the Ontario Securities Commission is responsible for the province of Ontario. Thus creates problems when regulating universal banks within Canada because of the cross between federal and provincial regulation.

Impact of Universal Banking on the Current Financial Situation of North America The subprime mortgage crisis has cause a significant downturn in the North American economy creating bare stock markets, as well as a recession in the United States. This has caused a ripple down effect scaring a lot of average investors into making irrational decisions about their finances. The supervisory frameworks of a universal banking model can have a positive impact on the current financial situation in North America. The capital structure, risk management, control frameworks that we see with a universal banking model will increase confidence into the average investor community.8 This well give the average individual a better feeling of security because of the ability a universal bank has to diversify risk. The risk of financial institution failure is reduced through the universal banking model. Looking into the future Universal banks will continue to play an important role. They possess a number of advantages over specialized institutions. The only advantage

McCaul, Elizabeth. Inside Look: Will the Bailout Work?

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specialized institutions have over a universal bank is the probability of a universal bank becoming to large and it effecting profitability because the universal bank becomes inflexible and bureaucratic. The returns of implementing a universal banking model definitely outweigh the risks and the concept will grow outward as time progresses.

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Bibliography Saunders, Anthony (1994) Universal banking in the United States [electronic resource]: what could we gain? What could we lose? New York: Oxford University Press. Retrieved November 1, 2008 from Lakehead University, Chancellor Paterson Library, Website: http://library.lakeheadu.ca/ Rich, Georg and Walter, Christian The Future of Universal Banking Retrieved: November 4, 2008. from Website: http://www.cato.org/pubs/journal/cj13n2/cj13n2-8.pdf Saunders, Cornett, McGraw (2006) Financial Institutions Management A Risk Management Approach 3rd ed. McGraw-Hill Ryerson Hughes, Jane and MacDonald, Scott (2002) International Banking Text and Cases. Addison Wesley. Canals, Jordie (1997) Universal Banking International Comparisons and Theoretical Perspectives Oxford University Press. Retrieved November 14, 2008 from Website: http://www.questia.com/PM.qst?a=o&d=26044505 Carosso, Vincent P. (1970) Investment Banking in America, a History. Cambridge, Mass: Harvard University Press McCaul, Elizabeth. Inside Look: Will the Bailout Work? Retrieved November 4, 2008. From Website: http://video.aol.com/video-detail/inside-look-will-the-bailoutwork/3251262134

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