Universal Banking in an Emerging Economy:

The Conflict-of-Interest Hypothesis

Chih-Pin Lin, Director, Department of Business Administration, Aletheia University, Taiwan

ABSTRACT

Past research on universal banking, or the practice of providing multiple financial services under the same roof,
has various findings. Some studies have found synergies in universal banking, while others have found conflicts of
interest. Drawing on institutional-based view, I hypothesize that universal banking in emerging economies such as
Taiwan gives rise to conflicts of interest. Because market-supporting institutions in emerging economies are less
developed, universal banking there are more likely to result in conflicts of interest. Data from 211 IPO firms provide
evidence for the hypothesis. Implications for both managers and regulators and future research directions are provided.
Keywords: Universal banking; financial holding companies; conflicts of interest; institution-based view; multiple
agency theory

INTRODUCTION

Universal banking has been prohibited in the United States since 1933, when the Glass-Steagall Act was enacted
to forbid commercial banks from engaging in underwriting corporate securities, separating commercial banking, and
investment banking (underwriting). Underlying this separation was the belief that combining commercial banking and
underwriting would result in conflicts of interest (Benston, 1996). For example, when a commercial bank finds out that
the default risk of a loan client firm has increased, it could underwrite securities for that client firm, sell the securities to
nave investors, and ask the firm to repay the loan to the bank using the proceeds received by issuing the securities, thus
transferring the increased default risk to the nave investors (Kroszner and Rajan, 1994; Kroszner, 1996; Rajan, 1996).
However, the Glass-Steagall Act has been gradually repealed since the late 1980s, and was finally replaced by the
Financial Services Modernization (Gramm-Leach-Bliley) Act of 1999, which permits the establishment of financial
holding companies (FHCs; a special kind of universal banks) that own commercial banks, underwriters, and other
financial institutions simultaneously. At about the same time, several other countries also removed the regulations that
separate commercial banking and underwriting, including Canada, Japan, and Taiwan. The Glass-Steagall Act was
repealed in part due to the belief that integrating commercial banks, underwriters, and other financial institutions under
the same roof would yield synergies. For instance, when a commercial bank makes loans to a client firm, the bank must
incur substantial costs investigating the client firms credit. Meanwhile, the underwriter also needs credit information
regarding the issuing firm when providing underwriting services. If credit information gathered by the bank can be
transferred to the affiliate underwriter within an FHC, the underwriter can access more information about that client
firm when providing underwriting service to that firm, thereby reducing the probability that the underwritten securities
turn out to be low-performing and creating synergies.
Past research has argued that if conflicts of interest dominate universal banking, investors will discount the prices
of securities underwritten by bank-affiliated underwriters; by contrast, if synergies outweigh conflicts of interest,
investors will pay higher prices to buy the securities underwritten by bank-affiliated underwriters. Whether synergies or
conflicts of interest dominate universal banking is an empirical question (Puri, 1994; 1996; Hebb and Fraser, 2002; Ber
et al., 2001; Kroszner and Rajan, 1994). However, the empirical results are vague. Some studies have found that
conflicts of interest predominate (Ber et al., 2001; Kang and Liu, 2007; Agarwal and Elston, 2001), while others found
that synergies are more salient (Puri, 1994; 1996; Gande et al., 1997; Kroszner and Rajan, 1994; Hebb and Fraser, 2002;
Jensen, 2003).
 Drawing on the institution-based view and multiple agency theory, this study argues that in countries where
market-supporting institutions are less developed, universal banking may result in conflicts of interest. Institutions can
be broadly defined as the formal and informal rules of the game (North, 1990; Peng et al., 2008). This study focuses on
formal institutions, such as market-supporting regimes or market institutions (Meyer et al., 2009), and argues that
formal institutions play crucial roles in determining synergies and conflicts of interest in universal banking. The
multiple agency theory models agency relationships among a group of agents and principals, and at least one of the
agents is connected with two or more principals (Arthur et al., 2008). Multiple agency relationships, when combined
with institutions, determine whether synergies or conflicts of interest do present in a universal bank. Thus, this study
contributes to the institutional-based view by arguing that one form of organizations (i.e., universal banks or FHCs),
when embedded in different institutional contexts, can produce two contrary results (i.e., synergies and conflicts of
interest); namely, institutions do matter.
The study addresses the following research questions: (1) How do institutions and multiple agency relationships
interplay to determine synergies and conflicts of interest in universal banking? (2) Where and when does universal
banking create synergies or conflicts of interest? (3) Does universal banking in Taiwan result in synergies or conflicts of
interest?
Using data from 211 initial public offering (IPO) firms in Taiwan from 2003-2005, this study empirically tests the
hypotheses. Taiwanese IPO firms offer promising research data for this agenda because they are often small, young, and
entrepreneurial, characteristics that make information regarding firm credit and prospects difficult to access. The
resulting increased information asymmetry among IPO firms, banks, underwriters, and market investors in turn
increases both potential synergies and conflicts of interest in universal banking. Furthermore, because it is widely
believed that market institutions in Taiwan are less developed than those in the United States (Luo and Chung, 2005;
Chuang and Lin, 2008), the research results can be compared to those of prior research that uses U.S. data.

THEORY AND HYPOTHESIS

As I have noted, a universal bank is a financial institution that provides commercial banking, underwriting, and
other financial service under the same roof (Saunders and Walter, 1994). A financial holding company (FHC) is a
universal bank that provides various financial services with separately capitalized affiliates, which are believed to
mitigate some potential conflicts of interest (Kroszner and Rajan, 1997).
Past research in both the financial and managerial literature has demonstrated that mingling commercial banking
and underwriting creates synergies. Using U.S. data from before the Glass-Steagall Act, Kroszner and Rajan (1994)
found that corporate bonds underwritten by commercial banks had a lower default rate than those underwritten by
independent underwriters. They argued that the lower default rate might result from the information advantages that
commercial banks enjoy over independent underwriters. Through previous loan transactions, a commercial bank may
have credit information regarding a certain loan client that an independent underwriter lacks. Consequently, a
commercial bank can better overcome information asymmetry when providing underwriting service to that client firm
than an independent underwriter can (Rajan, 1996; Kroszner, 1996; Kanatas and Qi, 2003). Other research in the United
States that employed both pre-Glass-Steagall and recent data has confirmed this result (Puri, 1994; 1996; Gande et al.,
1997), as has Canadian data. Analyzing the Canadian corporate bonds issued after a 1987 deregulation that permitted
commercial banks to underwrite corporate bonds, Hebb and Fraser (2002) found that the yields of bonds underwritten
by commercial banks are significantly lower (i.e., prices are higher) than those of similar bonds underwritten by
independent underwriters. They argued that bank-underwritten bonds have lower yields (higher prices) because
investors believe banks have better knowledge about their clients and perceive less default risk regarding these bonds,
and thus ask for lower yields and are willing to pay higher prices.
However, other research, using data from outside North America, has demonstrated conflicts of interest in
universal banking. For example, Ber et al. (2001) used Israeli data and found that universal banking that mixes
commercial banking, underwriting, and fund management results in conflicts of interest; specifically, IPO firms whose
underwriters were also their lending banks showed significant lower first-day returns. When IPO firms equity was
purchased by the mutual funds managed by the underwriter lender, the first-day returns were even lower. The
researchers argued that because universal banks could underwrite lemons (i.e., bad goods that cannot be identified by
buyers ex ante; Akerlof, 1970) and shift the heightened credit risk from banks to nave public investors, investors would
discount the equity prices underwritten by universal banks.
Similarly, using German data, Agarwal and Elston (2001) found that firms that are strongly tied to banks pay
higher interest rates to their banks than firms without such ties do. This suggests that a conflict of interest results when a
universal bank simultaneously holds debt and equity in a firm. When this is the case, the bank will require the firm to
pay a higher interest rate to the bank first, and then distribute remaining earnings to the bank and other shareholders
accordingly. And when Kang and Liu (2007) analyzed recent Japanese data, they found that universal banks will
leverage their monopoly power by depressing the prices of the securities issued by borrowing firms and underwritten by
these banks in order to favor the institutional investors who purchase the securities.
This study maintains that universal banking in countries where market-supporting institutions are less developed
create conflicts of interests, rather than synergies. When an underwriter receives credit information from a bank within
an FHC, whether the underwriter will underwrite good (synergy hypothesis) or bad (conflict-of-interest hypothesis)
securities to sell to investors depends on the multiple agency relationships among the FHC, the underwriter, and
investors. Although the underwriter in an FHC is an agent that operates underwriting activities for the FHC (the
principal), it is also an agent to the investors (the principals) who purchase securities from the underwriter, thus creating
a multiple agency relationships. The underwriter must decide which principals (the FHCs or investors) interests to
serve.
I argue that, because the FHC monitors the underwriter better than investors do, the underwriter will serve the
FHCs interests more than those of investors. Consider that the underwriter and the FHC belong to the same firm, and
that information and knowledge are more easily transferred within a firm than across a market (Kogut and Zander, 1993;
Almeida et al., 2002; Kachra and White, 2008; Teece, 1986). When the FHC is family owned, its affiliates can be
connected by family or other pluralistic ties, further facilitating the information flow (Luo and Chung, 2005; Peng et al.,
2005; Khanna and Palepu, 2000). By contrast, investors monitor the underwriter through external capital markets,
which are usually less efficient than the internal capital market (Williamson, 1975; Teece, 1982). Consequently, an FHC
underwriter will serve the FHC more than it will serve investors. From among the affiliated bank loan clients, it will
choose the client firms in which default risks have increased and underwrite them to shift the default risk from the FHC
to nave investors, resulting in a conflict of interest.
Conflicts of interest will be particularly salient where market institutions are less developed, in that investors
monitor underwriters through external capital market. When market institutions are weak or less developed, it is more
difficult for investors to monitor underwriters, and thus underwriters will serve more for the FHCs than for investors,
resulting in conflicts of interest. It has been reported that the market institutions in Taiwan are less developed than those
in the United States (Luo and Chung, 2005; Chuang and Lin, 2008; Hamilton, 1997). Because market institutions are
less developed in Taiwan and investors cannot efficiently monitor FHC underwriters through capital market, this study
argues that the conflict-of-interest hypothesis will hold in Taiwan. By contrast, in countries where market institutions
are well established, such as the United States and Canada, underwriters in FHCs are better monitored by market
investors; thus, synergies, rather than conflicts of interest, may be salient.
Synergies or conflicts of interest will ultimately be reflected in the stock price or the first week returns of the IPO
firm underwritten by FHC underwriters. When market investors perceive conflicts of interest that FHC underwriters
will leverage their information advantage and sell lemon to shift increased default risk to them, they will discount the
securities prices and thus the first week returns will be lower (Puri, 1994; 1996; Hebb and Fraser, 2002; Ber et al.,
2001). Because investors in Taiwan perceive conflicts of interest in FHCs, as argued above, this study predicts that the
first week returns of IPO firms underwritten by FHC underwriters are lower.
Hypothesis 1: In countries where market-supporting institutions are less developed, such as Taiwan, the first-week stock
return of an IPO firm whose lead underwriter and lender bank belong to the same FHC will be lower
than that of other IPO firms.
 METHODS
Sample
Using data from 211 initial public offering (IPO) firms in Taiwan from 2003 to 2005, this study tests the
hypothesis above. The analysis begins in 2003 because, although the FHC Act came into effect in November 2001, it
was not until January 2, 2003 that all 14 FHCs were established. The fifteenth FHC, Taiwan FHC, a state-owned FHC,
was established in 2008; because it falls outside of the sample period, it is excluded from this study. In addition to the
14 FHCs established during the sample period, the Taiwan Industrial Bank is also included. The Taiwan Industrial Bank
engages in commercial loans; it also owns a securities affiliate that performs underwriting. Because it engages in
universal banking, it is included in this studys definition of FHCs. The source of the data was the Taiwan Economic
Journal.

Measures
Dependent Variables
This study uses the first-week returns after the IPO to measure investor perceptions of synergies and/or conflicts
of interest in the stock market. Traditional first-day returns are not applicable in this study given a seven percent
maximum-change-rate constraint on the first trading day in Taiwan during the sample period. This study calculates both
the straight first-week returns (R1) and the first week abnormal returns (AR1). The first-week return is the difference
between the closing price of the fifth trading day and the offer price, divided by the offer price of the IPO stock. To
calculate the first-week abnormal returns, this study uses the following one-factor model
Rit i i Rmt it
where Rit is the weekly return on the stock of firm i in week t; Rmt the weekly return on market portfolio in week t;
i the measure of market risk; i the intercept; it the error term and abnormal return for firm i in week t. Using
returns in the first to 52th weeks during 2007, this study estimates i and i . Finally, the first-week abnormal return,
AR1, is it .
Independent Variables
The prior lending tie is whether or not an IPO firm borrows from affiliate banks of the FHC whose affiliate
underwriter is also the lead underwriter of that IPO within two years before the IPO date. If yes, the variable is equal to
1; otherwise, it is equal to 0.
Control Variables
This study controls the IPO firm size, which is measured by the natural log of total assets of the IPO firms at the
end of the previous year before the IPO date. This study also controls the lead underwriter status, measured by the
number of cases underwritten by the lead underwriter of an IPO case in the previous year of the IPO date (Hebb and
Fraser, 2002; Gulati and Higgins, 2003). Finally, because I employ panel (time-series cross-section) data, which usually
result in the problem that data are dependent within the same year, I impose a dummy variable on each year, which is
the fixed effects approach for panel data (Greene, 2000).

Statistical model
Using the following regression model, this study tests the hypothesis empirically.
y 0 1 Lendingtie 2Underwstat us 3 Size 4Year 2004 5Year 2005
Where ys are the first-week returns and the first-week abnormal returns.

RESULTS

Table 1 demonstrates the means, standard deviations, and correlations of variables. Table 2 demonstrates the
results OLS estimates. The dependent variables in Model 1 and Model 2 are the first-week returns of the IPOs; the
dependent variables in Model 3 and Model 4 are the first-week abnormal returns. Model 1 and Model 3 contain only
control variables, and the main variable in this study is added in Model 2 and Model 4. Note that the results of Model 2
and Model 4 are quite similar. The Prior lending ties have significant negative effects in both Model 2 and Model 4,
supporting the conflict-of-interest hypothesis.

Table 1: Means, standard deviations, and correlations of variables

Mean S.D. 1 2 3 4 5 6 7
1 First week return (R1) 7.01 19.07 1.00
2 First week abnormal return(AR1) 6.78 19.34 0.97 1.00
3 Prior lending tie 0.91 3.19 -0.07 -0.06 1.00
4 Underwriter status 16.28 7.86 0.01 0.03 -0.04 1.00
5 ln(total assets) 13.94 1.09 0.12 0.12 0.02 0.02 1.00
6 Year dummy 2004 0.39 0.49 0.02 0.00 0.00 -0.09 -0.04 1.00
7 Year dummy 2005 0.13 0.34 0.34 0.36 0.07 0.04 -0.01 -0.31 1.00

Table 2: Results of the spline and modified spline regressions

First week return (R1) First week abnormal return (AR1)

Variables Model 1 Model 2 Model 3 Model 4

Prior lending tie -5.73 ** -5.20 *

(3.45) (3.48)
Underwriter status 0.00 -0.01 0.05 0.04
(0.16) (0.16) (0.16) (0.16)
ln(total assets) 2.28 ** 2.33 ** 2.26 ** 2.30 **
(1.12) (1.12) (1.13) (1.13)
Year dummy 2004 5.89 ** 5.98 ** 5.45 ** 5.54 **
(2.65) (2.64) (2.66) (2.66)
Year dummy 2005 21.96 *** 22.46 *** 23.20 *** 23.65 ***
(3.79) (3.78) (3.81) (3.82)
Intercept -29.98 * -29.77 ** -30.71 * -30.51 *
(15.98) (15.91) (16.09) (16.04)
R squared 0.15 0.16 0.16 0.17
Adjusted R squared 0.14 0.14 0.15 0.15
F 9.31 *** 8.07 *** 10.13 *** 8.60 ***
N=211. One tailed tests for main variables; two tailed tests for control variables.
Standard errors are in the parentheses; the based year is 2003.
*p<0.1
**p<0.05
***p<0.01

DISCUSSION

This study distinguishes where universal banking creates synergies and where it results in conflicts of interest,
which lie in the underwriter decision in multiple agency relationships. In multiple agency relationships (Arthur et al.,
2008) among an FHC, underwriter, and market investors, the underwriter will serve the interest of the principal that
monitors it better. The FHC monitors the underwriter through a hierarchical relationship, while investors monitor it
through a market relationship. Thus, the underwriters will favor market investors and underwrite good securities for
them (the synergy hypothesis) only in countries where market institutions are well developed and investors monitor
underwriters efficiently, as in the United States and Canada. Kroszner and Rajan (1994), Puri (1994; 1996), Gande et al.
(1997), and Hebb and Fraser (2002) have all found synergies in universal banking using U.S. and Canadian data.
However, in countries where market institutions are less developed, market investors monitor underwriters less
efficiently than the FHCs do; thus, underwriters will shift the increased default risks from the FHCs to market investors,
resulting in conflicts of interest. Ber et al. (2001) have found that universal banks in Israel shift the default risks to
equity investors. Similarly, the present study finds that FHCs in Taiwan shift the increased default risks that they absorb
to market investors.
 Germany and Japan, though developed countries, have bank-based financial systems rather than the type of
market-based system seen in the United States (Steinherr, 1996). In a bank-based system, universal banks monitor firms
far better than market investors do because they maintain long-term relationships with client firms and hold both debt
and equity of the firms (Hoshi, 1996; Gorton and Schmid, 2000). Thus, the multiple agency relationships among the
firm (the agent), the bank, and investors (both of which are principals to the firm in that they provide it with capital)
prompt firms to serve the universal bank more than market investors, because the universal bank monitors the firm
better than the investors do. Agarwal and Elston (2001) found that German universal banks, which hold both the debt
and equity of firms, require firms to pay higher interest rates at the expense of other equity holders of the firms.
The results of Kang and Liu (2007) can also be interpreted by the theory developed in this study. In the multiple
agency relationships among the bank underwriter (agent), issuing firm, and institutional investors (both of which are the
principals to the bank underwriter, in that the issuing firm hires the underwriter for underwriting services and investors
purchase securities underwritten by the underwriter), institutional investors monitor the bank underwriter through
long-term relationships. However, the issuing firm cannot monitor the bank underwriter. Instead, the issuing firm is
monitored and controlled by the universal bank, which holds both debt and equity of the issuing firm. In other words,
the bank is the boss and the issuing firm is its subordinate. Thus, it is not difficult to recognize why Kang and Liu
(2007) found that Japanese bank underwriters depress the prices of the securities they underwrite to favor the
institutional investors at the expense of the issuing firms.
On the other hand, in a market-based system such as that in the United States, firms are not tightly controlled by
universal banks and retain more autonomy. Therefore, firms can serve banks and investors in a more balanced way and
can reject bank underwriters depressing the prices when issuing securities. Thus, conflicts of interest found by Agarwal
and Elston (2001) and Kang and Liu (2007) are not found in the United States.

CONCLUSION

This study has successfully predicted that FHCs in countries where market institutions are weak, such as Taiwan,
give rise to conflicts of interest by combining commercial banks and underwriters. To decrease conflicts of interest, I
propose that governments should improve market institutions that allow market investors to monitor both firms and
universal banks. More detailed plans to improve market institutions need further research.
This study not only increases our understanding to the phenomenon that universal banking creates synergies and
conflicts of interest, but also contributes to the theory development. In particular, this study contributes to the
institution-based view by demonstrating that institutions do matter. One organization form, such as a universal bank,
can result in two contrary consequences when it is embedded in different institutional contexts. In countries where
market institutions are well-developed, such as the United States and Canada, universal banks can bring about synergies,
while in countries where market institutions are less-developed, such as Taiwan and other emerging economies, the
same universal banks may result in conflicts of interest. Institutions do matter, particularly when combined with
multiple agency theory. Further research from institution-based view is promising.

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