Organization Structure and Credibility: Evidence from Commercial Bank Securities Activities before the Glass-Steagall Act
Randall S. Kroszner
Booth School of Business, University of Chicago; National Bureau of Economic Research (NBER)
Raghuram G. Rajan
University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)
Journal of Monetary Economics, Vol. 39, No. 4 (1997).
The following is a description of the paper, and not the actual abstract:
This paper investigates empirically whether the internal organization of the firm can play an important role in affecting a firm's ability to commit to a particular quality of business practices and, if so, whether competition would be sufficient to lead firms to adopt that structure. In particular, we study how commercial banks have developed "firewalls" to address potential conflicts of interest when they are also engaged in investment banking. Before the 1933 Glass-Steagall Act forced banks out of investment banking, commercial banks organized their securities activities in two ways: as an internal securities department within the bank and as a separately incorporated affiliate with its own board of directors.
Although the internal departments underwrote seemingly higher quality firms and securities than did comparable affiliates, the departments obtained lower prices for the issues they underwrote. The greater risk premium associated with the internal department is consistent with investors discounting for the greater likelihood of conflicts of interest when lending and underwriting are within the same structure. Commercial banks responded to this pricing disadvantage for the internal departments by moving strongly toward adopting the separate affiliate structure during the period. We find that increasing the proportion of affiliate directors who are independent from the parent bank reduced the risk premium for the securities underwritten by the affiliate. Independent directors thus appear to have provided an important mechanism by which the affiliates could enhance their credibility in the market. Overall, our results suggest that organizational design can be an effective commitment device and, absent other distortions, competitive pressures would provide sufficient incentives for banks to adopt an organizational design that would address regulatory concerns about potential conflicts of interest.
JEL Classification: G21, G24, L22, N22Accepted Paper Series
Date posted: May 9, 1998
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