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Moral hazard under commercial and universal banking

  • John H. Boyd
  • Chun Chang
  • Bruce D. Smith

Many claims have been made about the potential benefits, and the potential costs, of adopting a system of universal banking in the United States. We evaluate these claims using a model where there is a moral hazard problem between banks and “borrowers,” a moral hazard problem between banks and a deposit insurer, and a costly state verification problem. Under conditions we describe, allowing banks to take equity positions in firms strengthens their ability to extract surplus, and exacerbates problems of moral hazard. The incentives of universal banks to take equity positions will often be strongest when these problems are most severe.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Working Papers with number 585.

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Date of creation: 1998
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Publication status: Published in Journal of Money, Credit, and Banking, Part 2 (Vol. 30, No. 3, August 1998, pp. 426-468)
Handle: RePEc:fip:fedmwp:585
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  1. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
  2. Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July.
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  9. Saunders, Anthony & Walter, Ingo, 1994. "Universal Banking in the United States: What Could We Gain? What Could We Lose?," OUP Catalogue, Oxford University Press, number 9780195080698.
  10. João Cabral dos Santos, 1995. "Bank capital and equity investment regulations," Working Paper 9515, Federal Reserve Bank of Cleveland.
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  12. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
  13. Randall J. Pozdena, 1991. "Why banks need commerce powers," Economic Review, Federal Reserve Bank of San Francisco, issue Sum, pages 18-31.
  14. Gary Gorton & Frank A. Schmid, 1996. "Universal Banking and the Performance of German Firms," NBER Working Papers 5453, National Bureau of Economic Research, Inc.
  15. Mitchell Berlin & Kose John & Anthony Saunders, 1995. "Bank equity stakes in borrowing firms and financial distress," Working Papers 96-1, Federal Reserve Bank of Philadelphia.
  16. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  17. John, Kose & John, Teresa A. & Saunders, Anthony, 1994. "Universal banking and firm risk-taking," Journal of Banking & Finance, Elsevier, vol. 18(2), pages 307-323, January.
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