The Advantages and Limitations of Universal Banking or All Purpose Financial Institutions - Essay Example

The advantages and limitations of “universal banking” or “all purpose financial s” Introduction Universal banking, its potential benefitsand associated costs has become an important theme for the debates on banking in many different countries (Ber et al., 2001). There are different views on this concept. Those who support the concept of universal banking ague that it enables banks to achieve economies of scope in information gathering, as bank underwriters gain wider access to the information about clients (Ber et al., 2001). However, the opponent believe that due to this information access, the universal banking may cause a potential conflict of interest between bank lending and bank underwriting (Ber et al., 2001). There are some other arguments pro and against adopting the universal banking mode. While some countries have adopted already this approach, other countries are still on the way of considering it as one of the alternatives available. China is one of the countries who claims to plan to adopt this system (Kynge, 2000). However, before introducing universal banking in China, it is important to analyse the major advantages and limitations of universal banking system mode. The aim of this paper is to investigate what are the major advantages and limitations of “universal banking” or “all purpose financial institutions” with a focus made on banking system in China. The remainder of this paper is structured as follows: Section 2 provides a brief overview and key definitions of universal banking and approach to universal banking in China; Section 3 discusses the major advantages of universal banking, Section 3 provides an overview of major limitations; Section 4 is concluding part of the report, discussing and summarizing key findings. The concept of Universal Banking: brief overview Universal bank is a “financial institution which may offer- and often does offer – a broad range of banking services, including most, though not necessarily all of the following: retail, business and corporate banking, services for financial institutional clients, asset and wealth management, payment services and investment banking” (Schildbach, 2012:3). Universal banks can have a number of different types. The first type of universal bank is a fully-integrated universal bank, which provides comprehensive financial services under single corporate culture (Walter, 1997). The second type is a partially integrate universal banks, which carries out financial services (commercial and investment banking) within the same entity but undertakes specialized services such as insurance underwriting, lease financing, mortgage banking, factoring and other services through separately-capitalised subsidiaries (for example, Deutsche Bank) (Walter, 1997). The third type of universal bank implies that there is a commercial bank, which is the parent company of subsidiaries, involved in insurance activities, securities activities and other financial services (for example, Barclays plc.) (Walter, 1997). The forth type of universal banking structure implies that there is a holding company, which has control over its affiliates, engaged in banking, securities, and insurance activities (for example, JP Morgan) (Walter, 1997). Universal banking is common in such European countries as Germany, Netherlands, and Switzerland. In the USA this system was prohibited by the Glass-Steagall Act 1933, but later these restriction were removed (Law, 2009). China is in the transformation stage, shifting from divided operation mode to universal banking mode (Loechel and Li, 2009). More detailed overview of China’s approach to universal banking is given below. Universal banking in China The financial sector in China has undergone significant evolution, which can be phased into three major stages: divided operation, division and coexistence, and mixed operation (Yu, 2014). From 1993, there was pursued separate operation, sub-sector management” mode in the banking and securities industry. The Chinese commercial banks were divided from insurance, securities, and trust, adopting thus divided operation approach (Yu, 2014). However, in June 2011, there management of the People’s Bank of China has issued the provision, whereas commercial banks were allowed to run financial derivatives, agency securities, investment funds, insurance agency business and other investment banking operations (Yu, 2014). This was a gradual shift to the phase of division and coexistence. Today, China has implemented divided operation system, however, it is gradually stepping into the primary stage of mixed operation, also known as universal banking (Yu, 2014). The bankers and officials in China increasingly stress the necessity of adopting universal banking system. Thus, for example, the switch in views has been reflected in the claims of the president of one Chinese state bank, who explained that: "In the past, nobody would dare talk about universal banking. Now, everyone is talking about this, even the central bank.” (Kynge, 2000: n.p.). China is quite reluctant in terms of implementing universal banking system rapidly mainly because of differences in legal systems and lack of a comprehensive monitoring system. Sudden release of banking institutions may have negative consequences for the financial environment in China (Yu, 2014). Moreover, there is lack of confidence in universal banking approach as the risks associated with this mode are viewed to be high. As Yu (2014: 298) explains, “financial security is crucial and the financial sector will not develop rapidly when a country’s financial security cannot be guaranteed”. However, the country faces with a necessity to introduce changes to its banking system in order to become more effective and efficient on both domestic and international markets. Chinese scholars learn the lessons of countries that have already introduced a universal banking model (Loechel and Li, 2009). Before introducing universal banking in China, it is important to analyse the major advantages and limitations of universal banking system mode. Universal banking: key advantages As it has been already mentioned, there are two different positions in relation to universal banking: supporters and opponents of this concept. In order to better understand the major positive and negative aspects of universal banking it might be helpful to discuss major advantages and benefits associated with it. Below is presented more detailed overview of the key advantages of the universal banking. Broad range of services and convenience The model of universal banking implies a “one-stop shop” for customers, whereas they gain access to comprehensive financial services without a necessity to visit numerous banking and financial institutions offering limited set of services (Schildbach, 2012). This feature is especially attractive to corporations and large international companies, that often need to carry out various financial solutions. In addition to comprehensive set of services, universal banks have greater opportunities for offering tailor-made financial services to its customers. Due to comprehensive knowledge and wider access to the financial information about its customers, universal banks may offer better solutions and advices to its clients (Schildbach, 2012). Lower costs for customers and the real economy The model of universal banks is designed in such a way, that the banks are able to achieve economies of scale and scope. Universal banks save costs on necessity to establish a customer profile only once. This aspect enables banks to reduce both costs and time associated with gathering data about the customer every time, creating all the documents and establishing profiles (Schildbach, 2012). Cost synergy is also achieved through various fixed costs, including: IT costs, treasury expenditures, risk management, costs for economic and market research, etc. Thus, the banks can offer their services at lower costs due to achieved cost synergies and leveraged revenue (Schildbach, 2012). Moreover, there are greater opportunities for revenue synergies related to cross-referencing and cross-selling between different business units within the system. Resistance to financial instability or downturn also is supported by universal banks due to their ability to deal better with loan-deposit mismatches (Schildbach, 2012). Greater financial stability Due to diversified mix of operations, universal banking institutions are rated as more stable to downturn in specific market sector and even financial crises (Schildbach, 2012). The concept of universal banking by itself assumes that there is diversified set of services, and therefore, the risks are balanced among different funding sources. Large universal banks tend to have more stable financial position than specialist banks not only due to diversified approach, but achieved economies of scales and capability to monitor the financial state of its clients (Schildbach, 2012). Focus on long-term relationship One of the main advantages of universal banking is its intangible power to encourage development of long-term relationships between a banking/financial service provider and its customers. This approach contributes to a more sustainable life cycle of a firm due to flexibility in varying the bank-firm relationships. For the firm switching from one banking institution to another requires additional costs, time and human resources (Lamoreaux and Raff, 1995). Investors Trust Another advantage of universal banking relates to the trust of investors. Investors have greater confidence and trust in universal banking institutions than in specialized banks. While this approach is based also on psychological factor and belief that universal banks are more reliable for investment solutions, the benefits of it contribute to more favourable investment environment (Singh, 2014). Some other advantages of universal banking include: new sources of bank equity funds well-balanced funding and liquidity, effective resource utilization, increased revenue generation due to cross-selling, strong global networks, increase revenue diversification, and a broad scope of risk management (Jain, 2013; Saunder and Walter, 1996). Disadvantages and limitations of Universal Banking In addition to some obvious benefits, universal banking has limitations and disadvantages. Some of the major limitations of universal banking are discussed below. Conflict of Interest Due to the nature of the universal banking system, the increased risk of conflict of interest between bank lending and bank underwriting is viewed as its major limitation (Ber et al., 2001). Investors tend to use affiliate analysts for earnings forecasts and stock recommendations. While they expect accurate and unbiased equity research, analysts may not be interested in the same outcomes because of personal/institutional interests (Bessler and Stanzel 2009). The conflict of interest appears when a company, employing an analysts, is a broker or an investment bank that also provides services in corporate finance. Bessler and Stanzel (2009) have carried out a study attempting to investigate the potential conflicts of interest based on the empirical evidence from IPO underwriting in Germany. The results of the study have shown that the analysts belonging to the lead-underwriter gave inaccurate, biased stock recommendations and too optimistic earnings forecasts to the customers. The researchers also have analysed the work of unaffiliated analysts, and found out that their stock recommendations and earnings forecasts were more realistic (Bessler and Stanzel, 2009). Based on the results of this empirical study it is necessary to recognize the problem of conflict of interest as one of the major limitations of universal banking, as there is increasing risk of long-run underperfomance for investors (Bessler and Stanzel, 2009). Another study carried out by Xie (2007) also provides the evidence of negative effect of universal banking on firm’s growth. The negative effects of conflicts of interest offset the positive effect of economies of scale. However, it is worth to mention that the countries that have higher level of information efficiency and stronger legislation protecting creditors’ rights, the risk of conflict of interest is lower (Xie, 2007). Effect of failure on banking system While proponents of the universal banking system believe that universal banks contribute to the financial stability, the critics of universal banking argue that universal banks could increase the risk of financial instability in case of failure (Benston, 1994). The major argument used to support this view is based on the assertion that universal banks are large machines, the collapse of which may result in a systemic financial crisis (Benston, 1994). Until recently, this approach lacked evidence-based historical records, whereas the failure of large universal financial institutions caused the failure of the financial system in a country. However, the recent financial crisis has shown that the failure of very large universal banks may have extremely negative consequences across several countries (Singh, 2014). During 2008-2009 the financial crisis has provided strong evidence, illustrating how large universal banking institutions could introduce problems based on the approach “too-big-to-fail” (Berger, Molyneux and Wilson, 2014) The recent crisis has illustrated the problems existing in large universal banking institutions (Berger, Molyneux and Wilson, 2014). Even though the claims that universal banks contributed to the recent financial recession, the reason of failure may be viewed not in the structure of the universal banks, but management failure (Schildbach, 2012). However, whatever the reason is, in case of failure there is a strong negative effect on the whole banking system, which is a major disadvantage of universal banking structure. Monopoly and formation of industrial cartels Large banking institutions are more likely to cause a monopoly of the financial industry squeezing out small and medium banks. Large companies have more power and increased financial strength to occupy market share in financial sector (Yu, 2014). In addition to increased monopoly, critics believe that universal banking may encourage formation of industrial cartels (Lamoreaux and Raff, 1995). However, taking an example of Germany, the country where universal banking system has been successfully integrated, this limitation may not be relevant. As Lamoreaux and Raff (1995) explained, development and enforcement of industrial cartels relates to all forms of coalitions among banks rather than only to universal banking mode. Some other limitations of universal banking are associated with the following costs: potential reduction in competition in result of greater market concentration; reduced incentives for financial innovation; increase threat of regulatory safety net; etc. (Saunders and Walter, 1996). Discussion and Conclusions Universal banking, its potential benefits and associated costs has become an important theme for the debates on banking in many different countries. There are different views on this concept. On the one hand, universal banking has a great potential for achieving cost and scope economies and increased revenue generation through cross-selling approach. In addition to these major benefits, universal banking has a number of distinctive advantages, such as: one-stop shopping for customers due to comprehensive set of services offered; lower costs for customers; focus on long-term relationships; increased investor’s trust and reliability; new sources of bank equity funds well-balanced funding and liquidity; increased revenue diversification; broad scope of risk management, etc. In addition to numerous benefits and advantages of universal banking there were identified some significant limitations and disadvantages, such as: conflict of interest, effect of failure on banking system, monopoly and formation of industrial cartels; increased threat of regulatory safety net; etc. While analyzing the balance of costs and benefits of universal banking there was identified one challenging issue related to the financial stability of universal banking institutions. On the one hand, it was argued that due to diversified mix of operations, universal banking institutions are more stable to downturn in specific market sector and even financial crises (Schildbach, 2012). On the other hand, the evidence of the recent financial crisis challenged the theory that large universal banks tend to have more stable financial position than specialist banks. While some experts explain the failure of large financial institutions by inappropriate managerial decisions, a strong negative effect on the whole banking system is a significant limitation in case of failure. One more important limitation of universal banking identified throughout the research is referred to the conflict of interests. The evidence-based research based on German case study illustrates that despite effective legal system and long-term practice of universal banking, the problem of conflict of interest is a significant problem. The negative effects of conflicts of interest offset the positive effect of economies of scale and other major advantages associated with universal banking. These findings illustrate that universal banking in theory is an attractive and efficient way that can be adopted in the banking industry of different countries. However, in order to manage key limitations and address major pitfalls, countries need to ensure stronger legal framework aiming to protect creditors’ rights and improved information efficiency. These findings can be in particular helpful for China, the country, which is gradually stepping into the primary stage of universal banking (Yu, 2014). While there are some obvious reasons of why China needs to adopt universal banking system, the findings of this research illustrate a necessity of adjusting legal framework in the country. This process is time-consuming and it might be easy to introduce universal banking system rapidly. It is important to weight all the risks associated with adoption and management of universal banking institutions and consider the above discussed advantages and limitations of universal banking system mode. References: Ber, H., Yafeh, Y., Yosha, O., (2001), “Conflict of interest in universal banking: bank lending, stock underwriting, and fund management”, Journal of Monetary Economics, 47 pp. 189-218. Berger, A., Molyneux, P. and Wilson, J. (2014). The Oxford handbook of banking. Benston, G.J. (1994), "Universal banking", The journal of economic perspectives, vol. 8, no. 3, pp. 121-143. Bessler, W. and Stanzel, M. (2009), Conflicts of interest and research quality of affiliated analysts in the German Universal Banking System: Evidence from IPO underwriting, European Financial Management, vol. 15 (4), pp. 757-786. Jain, A. (2013). Global universal banks offer unique benefits to society, says Anshu Jain. [online] Db.com. 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