HIAS-E-8

Monitoring, cross subsidies, and universal banking
Jay Pil Choi
Department of Economics, Michigan State University, East Lansing, MI 48824, USA
Hitotsubashi Institute for Advanced Study, 2-1, Naka, Kunitachi 186 - 8601, Japan

Christodoulos Stefanadis
Department of Finance, University of Piraeus, 80 Karaoli and Dimitriou, Piraeus 18534, Greece

August 2015

Hitotsubashi Institute for Advanced Study, Hitotsubashi University
2-1, Naka, Kunitachi, Tokyo 186-8601 Japan
tel:+81 42 580 8604
http://hias.ad.hit-u.ac.jp/
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Monitoring, Cross Subsidies, and Universal Banking
By
Jay Pil Choi*
Christodoulos Stefanadis**
August 2015

ABSTRACT: We formalize the idea that a financial conglomerate may utilize
commercial banking activities to cross-subsidize investment banking through bundledoffers. The investment banking sector entails supra-normal profits due to incentive
problems with security underwriting. Universal banks may aim to capture (some of)those profits by providing discounts on commercial loans. This practice has an adverse
effect on commercial banks’ monitoring incentives, encouraging the pursuit of private
rents by entrepreneurs. It also leads to lower underwriting fees and a lower probability ofsuccessful public offerings. The social welfare effects of universal banking can be either
positive or negative.
JEL Classification: G21, L10.
Keywords: universal banking, moral hazard, monitoring, cross subsidy, bundledoffer.

* Department of Economics, Michigan State University, East Lansing, MI 48824, USA
and HIAS, Hitotsubashi University, Japan, choijay@msu.edu** Department of Finance, University of Piraeus, 80 Karaoli and Dimitriou, Piraeus
18534, Greece, cstefana@unipi.gr
We thank Yongmin Chen, Sung-In Jun, Yongjin Kim and an anonymous referee for
helpful suggestions. We are also grateful to participants in the KAEA-Bank of Korea
Joint Conferences on Growth Potential and Financial Reform in Korea. The first author
gratefully acknowledges the HIAS for financial support and hospitality during his visit
there.

“Did we lend money in hopes of getting lots of other deals? Absolutely…”-- An anonymous managing director at JP Morgan Chase 1
1. INTRODUCTION
Since the passage of the Gramm-Leach-Bliley Act in the U.S. in 1999, whichremoved most of the barriers between commercial and investment banking, financial
conglomerates have dominated the U.S. investment banking market. This is similar toprevious developments in the United Kingdom, where after the legalization of financial
conglomerates in 1986, most pure investment banks merged with commercial banks(Smith and Walter (2003)). Some executives comment that commercial lenders often
focus on snatching business from investment banks because underwriting activities are
more profitable than giving commercial loans (Economist (2002), Association for
Finance Professionals (2004)). However, after the onset of the Great Recession in 2008,
several economists have also argued that large financial conglomerates, which engage ina broad range of diverse activities, can be socially harmful and may need to be
dismantled by the authorities (Johnson and Kwak (2010), Duffie (2010, 2011)). Thus inrecent years the mechanics and the social welfare implications of universal banking are
an important issue in economics.
This paper presents a theoretical industrial organization model that analyzes theinterplay between commercial and investment banking activities and formalizes the
popular (among practitioners) idea that a financial conglomerate may engage incommercial banking to strengthen its position in investment banking through bundledoffers of financial services. We also study the welfare implications of universal banking.
In particular, in the model the investment banking sector is characterized by supra-normal
profits that cannot be competed away due to incentive problems inherent in the security
underwriting business; excessively low underwriting fees are unacceptable toentrepreneurs because they discourage investment banks from exerting a sufficient effort
in underwriting. 2 We argue that engaging in commercial lending activities through1

As quoted in Beckett and Sapsford (2002).
Similarly, in labor economics supra-normal “efficiency wages,” which are not eroded by competition, areoften offered to workers so that workers are provided with incentives to work harder (e.g., Akerlof andKatz (1990), GनFKWHU and Lehmann-Waffenschmidt (2002)).
22

universal banking provides a cross subsidization channel to secure profits in theinvestment banking sector.

This mechanism provides unilateral incentives to form

financial conglomerates if, of course, the legal framework, such as the Gramm-LeachBliley Act in the U.S., allows such conglomerates. However, since in equilibrium all
investment banks establish commercial bank divisions, they experience a neutralizationof the advantages of a unilateral move toward universal banking and an erosion of (someof) their profits.
We show that commercial banks’ equilibrium monitoring incentives in a universalbanking system are weaker than in a financial system with functionally separated
commercial and investment banks.

In particular, since the equilibrium terms ofcommercial loans are more favorable to entrepreneurs (and less favorable to commercial
banks) in a universal banking system, universal banks are less motivated to monitor theirborrowers’ projects. Borrowers obtain greater private rents in equilibrium, and corporate
governance deteriorates. The model also predicts lower underwriting fees and a lower
probability of successful underwriting in the investment banking sector under a universalbanking regime.

This lower probability stems from commercial banks’ reduced

monitoring incentives under a universal banking regime and from the effects of such
reduced monitoring on investment banks’ underwriting efforts.
The overall social welfare effects of universal banking stem from the changes in
the amount of monitoring. If there is socially insufficient equilibrium monitoring on a
local scale in a functionally separated banking system, the universal banking system iswelfare-reducing because it exacerbates the inadequacy of monitoring. If, on the other
hand, there is socially excessive equilibrium monitoring on a local scale in a universalbanking system, the universal banking system is welfare-increasing because it eases theexcess of monitoring. Otherwise, the social welfare effects of universal banking are
ambiguous.
On the business front, several analysts point out that the use of lending
relationships for the advancement of investment banking is often an important part of auniversal bank’s strategy (Economist (2002), Association for Finance Professionals(2004)). Our paper formalizes this idea by presenting a mechanism for cross subsidies
between commercial and investment banking. Our conclusions are consistent with the3empirical findings of Drucker and Puri (2005) that the joint provision of lending andunderwriting services increases a universal bank’s probability of obtaining underwriting
business, leads to discounted loan yields and decreases underwriting fees for clients. Our
analysis also implies that the joint provision of commercial and investment banking
services reduces the probability of success of public offerings or of underwriting
campaigns.

An empirical implication that is unique to our model is that the joint

provision of lending and underwriting services leads to an increase in entrepreneurs’
private rents and thus to a deterioration of corporate governance in borrowing enterprises.
This implication has not been tested in the empirical literature yet.
In the theoretical literature, Kanatas and Qi (1998, 2003) examine universalbanking in the presence of informational economies of scope. A financial conglomerate
incurs a one-time fixed cost to establish a relationship with a client; the client may obtain
multiple services from the conglomerate at no additional informational cost. Then,
universal banks have weaker incentives to apply costly efforts to a client’s underwriting
campaign because they know that they will still be able to profitably serve the client’s
credit needs if the underwriting campaign fails. 3 Laux and Walz (2009), on the other
hand, argue that the effect of universal banking on underwriting can be the opposite. A
universal bank may have stronger incentives to apply efforts to underwriting because afailed underwriting campaign may have an adverse effect on the value of the client’s
outstanding loans that the universal bank has already given. Loranth and Morrison(2012) point out that a universal bank’s private decision about whether to offer lending
and underwriting services jointly, as well as the socially optimal decision, may be nonmonotonic in the investment banking surplus. Furthermore, more intense investmentbanking competition may make the joint provision of lending and underwriting services
less likely. 4
Our paper has a different focus from the literature, examining moral hazard andthe related monitoring role of commercial banks. Moral hazard stems from the pursuit ofprivate rents by entrepreneurs after financing is obtained.

3

The effects of universal

Puri (1999) also examines a universal bank’s trade-off between informational economies of scope andconflicts of interest, deriving implications for the prices of underwritten securities.
4banking on welfare and the market structure stem from changes in such equilibrium
monitoring. Kanatas and Qi (1998, 2003) and Laux and Walz (2009), on the other hand,examine adverse selection (rather than moral hazard) and the related screening role ofbanks; banks may screen the quality of an entrepreneur’s projects before financing isgiven.
2. THE MODEL
Our model contains four classes of agents, namely, an entrepreneur, commercial
banks, investment banks and outside investors. All agents are assumed to be risk neutral.
An entrepreneur has two consecutive long-term projects, X and Y, which need to be
funded; he first seeks financing for project X and then, shortly thereafter, for project Y.
We normalize the upfront cost of projects X and Y to $1 and $ K , respectively. The
entrepreneur has no funds of his own and thus needs to seek financing from outside
sources.
Project financing is subject to moral hazard. In particular, once the long-term
projects are funded and initiated, the entrepreneur may seek to abandon the projects andobtain private rents instead, ʊ i.e., a rent VX from project X and a rent VY from projectY, ʊat the expense of the banks or the outside investors that have financed the projects(in the spirit of Boot and Thakor (1997), Holmstrom and Tirole (1997) and Freixas andRochet (2008)). If the entrepreneur succeeds in obtaining private rents, both projects
yield a payoff of 0 with probability 1, and thus banks or outside investors obtain a zero
payoff (although the entrepreneur obtains a private rent VX  VY with probability 1). The
pursuit of private rents is an entrepreneur-specific, rather than a project-specific,
endeavor. Such a pursuit is either successful in all the entrepreneur’s activities (i.e., inboth projects X and Y), or unsuccessful across the board.
If the entrepreneur does not obtain private rents, project X is successful and yields
a payoff x with probability J . With probability 1  J , on the other hand, the project
fails and yields a payoff 0. Thus, the failure of the project does not constitute foolproof
4

In a different vein, Greenbaum, Kanatas and Venezia (1989), Rajan (1992), Marquez (2002) and Anandand Galetovic (2006), among others, examine the role of long-term client relationships in banking. Barros(1999) focuses on multi-location competition in commercial banking.
5evidence of wrongdoing on the part of the entrepreneur. 5 We assume that the payoff of a
project is observable and verifiable. Similarly, if the entrepreneur does not obtain private
rents, project Y is successful and yields a payoff y with probability O . With probability
1  O , the project fails and yields a payoff 0. 6 For simplicity, we assume that the successof project X is independent of the success of project Y. However, our results carrythrough to any level of correlation between projects X and Y.

We assume that

VX ! J x  1 and VY ! O y  K , which implies that the entrepreneur prefers to pursue
private rents VX and VY after he obtains financing. We also assume that J x ! VX andO y ! VY which implies that the pursuit of private rents is socially inefficient.
There are two commercial banks, CB1 and CB2, which can give loans for a
project to the entrepreneur. A loan contract specifies the repayment rate, rB , that theentrepreneur is required to pay to the commercial bank after the completion of the
project. 7 However, if the project yields a zero payoff, it inevitably goes bankrupt, and azero amount is repaid to the bank. Banks are unable to stake a claim to any private rents
that the entrepreneur may have obtained. CB1 and CB2 compete in a Bertrand manner inthe repayment rate, rB , that they offer to the entrepreneur.

We assume that anentrepreneur’s contract with a commercial bank is publicly observable. Furthermore, as
is standard in finance theory, commercial banks are able to engage in monitoring
activities that aim to prevent the pursuit of private rents by the entrepreneur. 8 Monitoringis costly, however. We assume that private rents can be prevented with probability T if
commercial banks incur a monitoring cost CM (T ) , where CM (0) 0 , CM '(T ) ! 0 andCM ''(T ) ! 0 .

Banks’ monitoring activities are not contractible because monitoring

expenditures are either unobservable or non-verifiable in courts.

Our results carry through when project X yields a payoff x with probability J ' and a payoff 0 withprobability 1  J ' when the entrepreneur obtains a private rent, where J '  J .
6Similarly to note 5, our results carry through when project Y yields a payoff y with probability O ' and a5

payoff 0 with probability 1  O ' when the entrepreneur obtains a private rent, where O '  O .
7If, for example, the entrepreneur borrows an amount z, he is required to repay an amount zrB .
8See, for example, Diamond (1984), Besanko and Kanatas (1993) and Freixas and Rochet (2008) for a
discussion of the interplay between commercial banking and monitoring.
6

There are two investment banks, IB1 and IB2, which can assist the entrepreneurin obtaining financing for a project from competitive outside investors. We assume thatthe success of such capital market financing depends on the investment bank’s efforts. In
particular, a probability D of a successful public offering can be achieved at a cost
CU (D ) , where CU (0) 0 , CU '(D ) ! 0 and CU ''(D ) ! 0 .

For simplicity, it is also

assumed that CU '''(D ) ! 0 which, as we will see, is a sufficient (but not necessary)condition for the entrepreneur’s profit from a project to be a concave function of theunderwriting fee. 9 An investment bank’s effort, D  is not contractible. If the public
offering is successful, the entrepreneur obtains financing (via the assistance of theinvestment bank) from the outside investors that require the lowest repayment rate, rI ,for their funds. If, on the other hand, the public offering fails (and given that theentrepreneur has chosen to obtain financing from outside investors, rather than from acommercial bank), the project is not implemented. 10
An investment bank charges an underwriting fee, P $s in Kanatas and Qi(2003) and Laux and Walz (2009) (and as is often the case in practice), the entrepreneur
is required to pay P only if the public offering is successful. Thus with the upfront costof a project being, for example, z and the underwriting fee being P the amount offunding for the project that the entrepreneur needs to obtain from outside investors isz  P . IB1 and IB2 compete in a Bertrand manner in the underwriting fee, P that they
offer to the entrepreneur. For incentive compatibility reasons, we assume that investmentbanks can compete only in terms of P They are unable, for example, to offer up-front
lump-sum cash payments to the entrepreneur in an attempt to secure underwriting
business. In particular, if such up-front cash payments were utilized, the entrepreneur
could have an incentive to obstruct successful public offerings in an attempt to pocket the
up-front cash payments from the investment bank and possibly repeat the public offering(and obtain additional up-front cash payments from investment banks) in the future. 11
9Many standard cost functions meet this condition.
Our results would be similar if in case of a public offering failure, the entrepreneur could still finance theproject (e.g., from commercial banks), but at an increased cost (e.g., because of the delay).
11
For example, contract incompleteness would impede (or make very costly) the efforts of an investmentbank to protect itself against such perverse incentives on the part of the entrepreneur if up-front cash
10

7

Investment banks do not have the capability to monitor entrepreneurs.

In

particular, as is well-known, in practice investment banks usually do not provide theirown funds to entrepreneurs; they merely assist entrepreneurs in obtaining financing fromoutside investors and give their seal of approval to such outside financing (Brealey andMyers (2003)). Thus since investment banks are usually not involved in entrepreneur
projects in the long run (but only in the very short run), they are indifferent to theentrepreneur’s subsequent moral hazard problem, ʊ which occurs after financing is
obtained, ʊ and do not develop any monitoring capabilities. We also make the standard
assumption that outside investors lack monitoring capabilities. For example, the small
size of each outside investor’s stake in a project may be too small to justify private
monitoring (Diamond (1984), Freixas and Rochet (2008)). Overall, in the spirit of thedelegated monitoring theory of financial intermediation, we assume that only commercial
banks have the ability to monitor entrepreneurs; in this way, commercial bank loans are“unique” (e.g., Diamond (1984), Besanko and Kanatas (1993), Freixas and Rochet(2008)). 12
In the model at least one project needs to be financed by commercial banks for astrictly positive amount of monitoring to occur (since only commercial banks havemonitoring capabilities). As, for example, in Laux and Walz (2009) and Loranth andMorrison (2012), we assume that the entrepreneur seeks financing from commercial
banks for project X and from outside investors (via investment banks’ underwriting) for
subsequent project Y. This is in the spirit of Fama (1985), Diamond (1991), Rajan (1992)
and Freixas and Rochet (2008), among others, who imply that entrepreneurs may tend to
rely more on financing from commercial banks in their earlier projects. 13

payments were utilized. A similar problem that has been studied extensively in labor economics concerns“efficiency wages.” Firms often offer workers supra-normal “efficiency wages” so that workers areprovided with incentives to work harder. However, in practice, workers usually do not pay (and neither are
required by firms to pay) any up-front entrance fees into the job to gain access to such supra-normal“efficiency wages” (although up-front fees would not affect their subsequent incentives to work hard);
supra-normal wage rents are not eroded by competition among workers (e.g., Akerlof and Katz (1990),*नFKWHU and Lehmann-Waffenschmidt (2002)).
12
For example, when the development of monitoring capabilities entails scale economies, commercial
banks have a comparative advantage since a commercial bank typically finances many projects (Freixas
and Rochet (2008)).
13
Our results carry through even if there is investment banking activity prior to a commercial loan as longas there is also investment banking activity subsequent to the commercial loan.
8We have a five-stage game that is summarized in figure 1. Given the long-term
nature of projects, monitoring by commercial banks occurs after the end of theentrepreneur’s financing campaign. Financing merely signifies the start of a project
while monitoring affects a project’s long-term implementation.

FINANCING

Stage 1:
Commercial
banks CB1and CB2
compete forthe financing
of project X.

Stage 2:
Investmentbanks IB1and IB2
compete toprovideunderwriting
services for
project Y.

IMPLEMENTATIONStage 3: The
investmentbank thatprevailed atstage 2chooses its
effort levelD Nature
determines
accordingly
whether the
publicoffering
succeeds or
fails.

Stage 4: The
commercialbank thatprevailed atstage 1chooses its
monitoringlevel T .
Naturedetermines
accordingly
whether the
pursuit ofprivate rents
by theentrepreneur
succeeds or
fails.


COMPLETION

Stage 5:
Projects arecompleted.
If payoffs are
not zero,commercial
banks andoutsideinvestors arerepaid.

Figure 1: The Timeline for the GameWe adopt the standard tie-breaking convention that when the entrepreneur isindifferent between the offers of the two commercial banks, CB1 and CB2, at stage 1, or
between the offers of the two investment banks, IB1 and IB2, at stage 2, he randomly
chooses between the two tied offers, picking each offer with probability 0.5.
Furthermore, if a universal bank is present, ʊ i.e., if CB1 has merged with IB1 and/or
CB2 has merged with IB2, ʊ the universal bank may make a stage 1 bundled offer that iscontingent upon a commitment (by the entrepreneur) to obtain underwriting business atstage 2. In such a bundled offer there is a very simple form of commitment on the part ofthe entrepreneur. In particular, at stage 1 the entrepreneur may simply commit to show9

preference to a universal bank at stage 2 in case there is a tie between the universal
bank’s offer and competing offers at stage 2, i.e., if the universal bank’s stage 2 offer is
not worse than competing offers. 14 This simple form of bundled offers is consistent withthe casual observation that in practice universal banks may give loans merely in implicit“hopes” of, rather than under an explicit contract for, obtaining future underwriting
business (see, for example, note 1); it is also compatible with various legal restrictions insome countries. 15
3. EQUILIBRIUM IN A FUNCTIONALLY SEPARATED BANKING SYSTEM
In this section we examine a functionally separated banking system, in which
commercial banks, CB1 and CB2, and investment banks, IB1 and IB2, are independent
entities. To solve for the equilibrium we proceed by backward induction. Let rB be therepayment rate that the entrepreneur has agreed (at stage 1) to pay to a commercial bankin exchange for obtaining financing, $1, for project X. At stage 4, the commercial bankchooses a monitoring level T? rB ) according to the following maximization problem: 16

T? rB )= arg max{TJ rB  M T .
T(1)

The commercial bank faces a trade-off between the payoff rB that it will obtainwith probability J (i.e., in case project X is successful) if the generation of private rents
is prevented and the monitoring cost CM (T ) that it incurs to prevent the generation ofprivate rents. The first-order condition is J rB 㣮'( M )T 0. By totally differentiating thefirst order condition, we can easily verify that the monitoring level is increasing in rB :14

Such a simple agreement is consistent with the notion that the entrepreneur may agree to show preference
to the universal bank as his provider of underwriting services in the future as long as the underwriting terms
that the universal bank will offer will not be too unfavorable compared with competing offers.
15
For example, in the U.S. an explicit contract in bundled offers may be illegal. Furthermore, according tosections 23A and 23B of the Federal Reserve Act, national banks are not allowed to charge interest rates on
their loans that are below market to benefit or cross-subsidize investment banking affiliates. The form of
bundled offers in our model is consistent with such restrictions.
16
Since (1) is continuous and strictly concave on T  [0,1] , it has a unique argument of the maximum on
T  [0,1] .

10

dT (rB )drB

J[d 2CM (T ) 1
] ! 0.
dT 2(2)

A higher repayment rate rB encourages the commercial bank to apply greater monitoring

T to the entrepreneur so that it can have a higher probability TJ of actually obtaining
this repayment rate.
Let P be the underwriting fee that the entrepreneur has agreed (at stage 2) to pay
to an investment bank in exchange for a successful public offering. At stage 3, the? P ) according to the following maximization
investment bank chooses its effort D
problem: 17?D P )= arg max{DP  CU (D )} .
D

(3)

The investment bank faces a trade-off between the fee P that it will obtain if theunderwriting campaign is successful and the cost CU (D ) of such a campaign. The firstorder condition is P  CU '(D ) 0 . By totally differentiating the first-order condition, we
can see that dD ( P ) / d P 1/ CU ''(D ) ! 0 .
In case the public offering is successful at stage 3, competitive outside investors(who earn a zero expected profit) require a repayment rate rI that is equal to 1/ [T (rB )O ](and thus a repayment amount that is equal to ( K  P ) / [T (rB )O ] ) in exchange forproviding an amount K  P to the entrepreneur. Outside investors anticipate that theentrepreneur has a probability T (rB )O of repaying the amount ( K  P ) / [T (rB )O ] .

Since (3) is continuous and strictly concave on D  [0,1] , it has a unique argument of the maximum on
D  [0,1] .

17

11

At stage 2 Bertrand competition between investment banks IB1 and IB2 drives theunderwriting fee to the level P (rB ) that maximizes the entrepreneur’s expected payofffrom project Y. 18?P rB )= arg max{D ( P )[T (rB )O y  ( K  P )  (1  T (rB ))VY ]} .

(4)

P

The first-order condition of (4) is
dD ( P )[T (rB )O y  ( K  P )  (1  T (rB ))VY ]  D ( P ) 0 .
dP(5)

A larger underwriting fee encourages the investment bank to apply a greater effort, butalso implies a larger payment on the part of the entrepreneur. The optimal level, P (rB ) ,of the underwriting fee incorporates those two opposing effects. Thus in the stage 2
subgameequilibrium theentrepreneur’s

expected

profitfrom projectY

is

3 YE (rB ) D ( P (rB ))[T (rB )O y  ( K  P (rB ))  (1  T (rB ))VY ] . By applying condition (5) tothis expression, we can also see that ?3 YE rB )=D ( P (rB )) 2 / D '( P (rB )) .
Thus at stage 2 both investment banks, IB1 and IB2, offer an underwriting freeP (rB ) to the entrepreneur and have an equal probability, 0.5, of being chosen by theentrepreneur. Condition (3) implies that in interior solutions, the chosen investment bank
earns

a

strictly

positive(orasupra-normal)

expected

profit,3 IB (rB ) D ( P (rB )) P (rB )  CU (D ( P (rB ))) ! 0 ; similarly, before the choice of theentrepreneur is made, each investment bank has a strictly positive expected profit,
0.53 IB (rB ) ! 0 . 19 Bertrand competition among investment banks (which offer
homogeneous services) cannot erode such a strictly positive profit because the(4) is continuous and strictly concave (since CU '''(D ) ! 0 ) on P  [0, T (rB )O y  (1  T (rB ))VY  K ] andthus has a unique argument of the maximum on P  [0, T (rB )O y  (1  T (rB ))VY  K ] . We can see that theentrepreneur will never offer an underwriting fee P that is strictly larger than T (rB )O y  (1  T (rB ))VY  K
since in this case the entrepreneur’s expected payoff would be strictly negative.
18

12

entrepreneur is unwilling to accept an underwriting fee strictly lower than P (rB ) . In
practice, it is well-known that investment banking is considerably more lucrative thancommercial banking (Hayes and Spence (1983), Pugel and White (1985), Rajan(1996)). 20 Our model thus provides a possible explanation, ʊ i.e., the presence ofinherent incentive problems with securities underwriting, ʊ for the persistence of supranormal profits in the investment banking sector. 21
Lemma 1: Each investment bank earns a strictly positive expected profit 0.53 IB (rB ) ! 0 .
Proof: It follows from the discussion above.
We can see that the underwriting fee, P (rB ) , in the stage 2 subgame equilibriumis increasing in the repayment rate, rB , that was specified in the entrepreneur’s loan
contract at stage 1, i.e., d P (rB ) / drB ! 0 . Furthermore, the investment bank’s expected
profit, as well as the entrepreneur’s expected profit from project Y, is increasing in rB ,i.e., d 3 IB (rB ) / drB ! 0 and d 3 YE (rB ) / drB ! 0 . We summarize in lemma 2.

Lemma 2: A higher repayment rate, rB , in project X subsequently leads to a larger
underwriting fee in project Y and to greater expected profits from project Y for theinvestment bank and the entrepreneur, i.e., d P (rB ) / drB ! 0 , d 3 IB (rB ) / drB ! 0 and
d 3 YE (rB ) / drB ! 0 .

Proof: The proof is in the appendix.

For very low levels of P (rB ) , it may be possible (if P (rB )  CU '(0) ) to have a corner solution in which
the investment bank exerts a zero effort and earns a zero profit. We focus on interior solutions.
20
Rajan (1996), for example, points out that “the important question that is often left unasked is why these
alleged excess profits exist in investment banking.”
21
Similarly, in labor economics companies often offer supra-normal “efficiency wages” to their employees
to provide them with incentives to work harder. See notes 2 and 11.
1913

Intuitively, a higher repayment rate, rB , in project X increases the level ofmonitoring, T , that the commercial bank applies to the entrepreneur (condition (2)).
Furthermore, before the entrepreneur obtains financing for project Y, he anticipates thatthesuccessful

financing

of

Y

will

generateanexpected

profit,T (rB )O y  ( K  P )  (1  T (rB ))VY , that is increasing in the level, T (rB ) , of monitoring. 22
In particular, competitive outside investors in project Y always incorporate into therepayment rate, rI

1/ [T (rB )O ] , the risk of private rent-seeking by the entrepreneur sothat the expected repayment amount, K  P , is constant. The entrepreneur’s expected
revenue, on the other hand, is increasing in the level of monitoring since private rentseeking is socially inefficient and decreases expected revenues ( O y ! VY ). Then, such anincrease in expected profits that results from more monitoring encourages theentrepreneur to offer a larger underwriting fee to investment banks so that the latter canapply a greater underwriting effort and the probability of successful financing canincrease. Investment banking thus becomes more lucrative when monitoring increases.
At

stage

1

a

commercial

bank’sexpected

profit,3 CB (rB ) T (rB )J rB  CM (T (rB ))  1 , is an increasing function of the repayment rate rB
that the bank secures, i.e., d 3 CB (rB ) / drB ! 0 . There is a thus unique rate rB ( rB ! 1/ J )so that 3 CB (rB ) 0 . 23 A commercial bank will never offer a repayment rate strictly
lower than rB since it would then have a strictly negative expected profit. Then, at stage
1 Bertrand competition between commercial banks CB1 and CB2 drives the repayment
rate on project X to a level rB t rB that maximizes the entrepreneur’s expected payoff(from both projects X and Y), 3 E (rB ) T (rB )J ( x  rB )  [1  T (rB )]VX  3 YE (rB ) . 24
22

Of course, as we explained in section 2, after the entrepreneur obtains financing, he prefers to pursue
private rents ( VY ! O y  K ).
23
An application of the envelope theorem to condition (1) implies that d 3 CB (rB ) / drB T (rB )J ! 0 . We
can see that 3 CB (1/ J ) T (1/ J )  CM (T (1/ J ))  1  0 and lim 3 CB (rB ) f . There thus exists a unique
rB of

rB ! 1 / J so that 3 CB (rB )0.

24

Notice that a lower repayment rate rB in project X is not always desirable for the entrepreneurs since rB(and the resulting level of monitoring by the commercial bank) also affects the entrepreneur’s expected
payoff in subsequent project Y. The entrepreneur aims to maximize his overall payoff.
14

To bring out the effects of universal banking in a straightforward manner, we
assume that 3 E (rB ) is strictly decreasing in rB for all rB t 1/ J .

d 3 E (rB )drB

dT (rB )d 3 YE (rB )[J ( x  rB )  VX ]  T (rB )J 
 0 , rB t 1/ J .
drB
drB

(6)

Thus the entrepreneur is better off when commercial banks offer lower repayment rates inproject X; the entrepreneur always prefers to borrow for project X at the lowest possible
repayment rate. 25
At stage 1 competition between commercial banks CB1 and CB2 leads to an
equilibrium repayment rate rB , i.e., to the lowest repayment rate that allows commercial
banks to earn non-negative expected profits.

Then, the entrepreneur’s equilibrium

expected profit is 3 E (rB ) , and the commercial bank’s expected profit is zero, i.e.,
3 CB (rB ) 0 . The equilibrium underwriting fee is P (rB ) while each investment bank’s
equilibrium expected profit is 0.53 IB (rB ) (since each investment bank has a probabilityof 0.5 of being chosen as the underwriter at stage 2). We summarize in lemma 3 (which,as we explained, stems from assumption (6)).

Lemma 3: CB1 or CB2 finances project X with an equilibrium repayment rate rB andearns a zero profit. Each of IB1 and IB2 has a equal probability 0.5 of becoming theunderwriter and thus has an equilibrium expected profit of 0.53 IB (rB ) ! 0 .
Proof: It directly follows from the discussion above.
4. EQUILIBRIUM IN A UNIVERSAL BANKING SYSTEM
In this section we examine universal banking systems. We first suppose thatcommercial bank CB1 and investment bank IB1 constitute a single entity, namely
universal bank UB1, while CB2 and IB2 are independent entities. Thus at stage 1 UB125

If, on the other hand, condition (6) does not hold, universal banking may not generate any effects.
15

can make bundled offers, jointly offering commercial banking and underwriting services;
as explained in section 2, UB1’s repayment rate in project X is offered jointly with anagreement that UB1 will be the preferred provider of underwriting services at stage 2 incase UB1 and IB2 make similar underwriting offers (and the entrepreneur is otherwise
indifferent between the two).
We saw in section 3 that the lowest repayment rate in project X that CB2 is able tooffer is rB .

Then, UB1 can undercut CB2 by offering a rate rB  H , where H isinfinitesimal. As is standard, in technical terms such undercutting can be expressed
through the assumption that in case of a tie the entrepreneur chooses to borrow from a
universal bank at stage 1; UB1 thus offers a rate rB and finances project X. At stage 2
UB1 becomes the entrepreneur’s underwriter by offering an underwriting fee P (rB ) , ʊ
the same as IB2’s offer, ʊ and by being chosen according to the terms of UB1’s bundledstage 1 offer. It follows that the bundled offer of commercial banking and underwriting
services allows CB1 to earn an expected profit 3 IB (rB ) from investment banking as
compared to 3 IB (rB ) / 2 if CB1 and IB1 were independent entities (in which case IB1
would only have a probability 0.5 of becoming the underwriter). We summarize inlemma 4.
Lemma 4: In the presence of a universal bank, UB1, and of two independent entities,
CB2 and IB2, UB1 makes a bundled offer of commercial and investment banking
services and finances project X with an equilibrium repayment rate rB . UB1 always
becomes the underwriter of project Y and earns an equilibrium expected profit of
3 IB (rB ) ! 0 .

Proof: It directly follows from the discussion above.

16

Intuitively, a universal bank makes bundled offers of commercial and investmentbanking services. 26

As we have explained, incentive problems with the process ofunderwriting, ʊ the entrepreneur’s need to encourage the investment bank to apply theappropriate effort to the underwriting process, ʊ prevent the underwriting fee fromfalling below P (rB ) ; a financial institution is thus prevented from competing for the
supra-normal investment banking profits by offering lower underwriting fees.

A

universal bank may then offer discounts on commercial banking services (even if suchdiscounts only need to be infinitesimal in case there is only universal bank on thefinancial market) to obtain lucrative underwriting business; in bundled offers commercial
banking cross-subsidizes underwriting. 27
An independent investment bank is unable to compete with universal banks since,
as we have explained, incentive compatibility reasons prevent the utilization of up-front
cash payments by an investment bank to the entrepreneur to secure subsequent lucrative
underwriting business. Such up-front cash payments would distort the entrepreneur’s
incentives, possibly encouraging him to obstruct successful public offerings and repeat
the public offering process in the future to pocket additional up-front cash payments frominvestment banks (also see note 11). However, a universal bank that offers a discount ona loan (rather than up-front cash payments) to secure lucrative underwriting business does
not face a similar incentive compatibility problem. Since the loan is largely a major onetime arrangement that (unlike up-front cash payments) cannot be (easily) repeated in the
future, the entrepreneur does not have any incentive to obstruct the public offering inhopes of further future gains.
We now suppose that commercial bank CB2 and investment bank IB2 also
constitute universal bank UB2; there are two universal banks, UB1 and UB2, in thefinancial market. We can see that when a universal bank makes a bundled offer ofcommercialandinvestmentbanking

services,

26

it

has

an

expected

profit,Such bundled offers of commercial and investment banking services are rather common in practice(Economist (2002), Association for Finance Professionals (2004)).
27
Lemma 4 is consistent with the empirical findings of Drucker and Puri (2005) that the joint provision ofcommercial and investment banking services increases the financial institution’s probability of obtaining
underwriting business and also leads to discounted commercial loan yields.
17

3 CB (rB )  3 IB (rB ) , that is increasing in rB . 28 We also have 3 CB (rB )  3 IB (rB ) ! 0 . Therethus exists a unique rB  [0, rB ) so that 3 CB (rB )  3 IB (rB ) 0 . 29 The lowest repayment
rate in project X that a universal bank is able to offer is rB ; if rB  rB , the universal bankearns a strictly negative profit. Furthermore, in section 3 we explained that a larger rB
has opposing effects, ʊ i.e., both positive and negative effects, ʊon 3 E (rB ) . Let
rB

arg max 3 E (rB ) . 30 It follows that competition between CB1 and CB2 drives therB [ rB , rB ]repayment rate of project X to rB

max{rB , rB } , i.e., the entrepreneur’s most preferredrate subject to a universal bank’s non-negative profit constraint.
33
3 CB (rB )  3 IB (rB )3 CB (rB )  3 IB (rB )3 E (rB )3 E (rB )rˆB rB rB
CASE I: rB

rB

rB
rB

rB

rB

rB

CASE II: rB

rB ! rB

Figure 2: Equilibrium Commercial Loan Rates under Universal Banking

An application of the envelope theorem to condition (1) implies that d 3 CB (rB ) / drB T (rB )J ! 0 .
Furthermore, lemma 2 and an application of the envelope theorem to condition (3) imply thatd 3 IB (rB ) / drB [d 3 IB ( P ) / d P ](d P / drB ) D ( P )dP (rB )/drB ! 0 .

28

29

If 3 CB (0)  3 IB (0) ! 0 , we have a corner solution in which rB 0 and 3 CB (rB )  3 IB (rB ) ! 0 .
According to assumption (6), d 3 E (rB ) / drB  0 , rB t 1/ J . However, this is not necessarily the casewhen rB  1/ J .
30

18

rB

In terms of a universal bank’s expected profit, there are two possible cases (seefigure 2). If rB

rB , the commercial bank that is chosen by the entrepreneur earns a zero

expected profit (case 1 in figure 2). If, on the other hand, rB ! rB , competition between
the two universal banks does not dissipate the entire profit since the entrepreneur prefersa repayment rate strictly larger than rB (case 2 in figure 2). Then, each commercial bankhas a probability 0.5 of being chosen by the entrepreneur and earns an expected profit
0.5[3 CB (rB )  3 IB (rB )] ! 0 . We summarize in lemma 5.
Lemma 5: In the presence of two universal banks, CB1 and CB2, each bank makes abundled offer of commercial and investment banking services with an equilibrium
repayment rate rB

max{rB , rB } in project X. Each bank has a equal probability 0.5 ofbeing chosen by the entrepreneur and has an equilibrium expected profit of
0.5[3 CB (rB )  3 IB (rB )] , which is zero if rBrB

rB and strictly positive if rB

rB ! rB .

Proof: It directly follows from the discussion above.
According to the above discussion, the repayment rate in the loan that theentrepreneur takes to finance project X is lower in a universal banking than infunctionally separated banking system, i.e., rB

max{rB , rB }  rB . Then, lemma 2 also

implies that the underwriting fee in project Y is lower under a universal banking thanunder a functionally separated banking regime, i.e., P (rB )  P (rB ) . 31

4.1. Equilibrium Banking Structure
We now examine the merger incentives of financial institutions when theformation of universal banks is legal (as, for example, in the U.S. after the Glass-Steagall
Act was repealed and replaced by the Gramm-Leach-Bliley Act in 1999); CBi and IBi,19

i  {1, 2} , can make an endogenous decision about whether to merge. We can see that inequilibrium investment banks and commercial banks decide to merge to take fulladvantage of the opportunity to use commercial banking services to cross-subsidize
underwriting activities.

However, the endogenous decision of commercial andinvestment banks to merge has a prisoner’s dilemma aspect; a universal banking system
leads to lower profits for financial institutions than a functionally separated banking
systemwheretheformationofuniversal

banks

is

illegal( 0.5[3 CB (rB )  3 IB (rB )]  0.53 IB (rB ) ). The ability of universal banks to use commercial
banking to cross-subsidize underwriting activities intensifies competition and erodes, ʊpartly if rB

rB ! rB , or completely if rBrB

rB , ʊ the supra-normal profits in theinvestment banking sector. Proposition 1 follows.
Proposition 1: In equilibrium CB1 merges with IB1 and CB2 merges with IB2. The
equilibrium profits of financial institutions are strictly lower than in a functionallyseparated banking system.
Proof: The proof is in the appendix.
The ability of universal banks to cross-subsidize underwriting activities fromcommercial banking leads to a lower equilibrium repayment rate for project X ( rB  rB ).
Thus there is a reduced equilibrium level of monitoring in a universal banking system( dT (rB ) / drB ! 0 according to condition (2)); commercial banks have a weaker incentive
to monitor entrepreneurs since they expect a lower repayment rate on their investment inproject X. Compared with a functionally separated banking system, there is a higher
probability 1  T of an entrepreneur obtaining private rents; thus worse corporate
governance is observed in entrepreneurial enterprises.

Furthermore, the reduced

underwriting fee in a universal banking system ( d P (rB ) / drB ! 0 according to lemma 2)
31This is consistent with the empirical findings of Drucker and Puri (2005) that the joint provision ofcommercial and investment banking services leads to lower underwriting fees and discounted commercial
loan yields.
20

leads to a lower probability D ( P ) of a successful public offering for project Y (condition(3)). We summarize in proposition 2.
Proposition 2: (i) The equilibrium level of monitoring by commercial banks is strictly
lower in a universal banking system ( T (rB )  T (rB ) ) while the probability of anentrepreneur obtaining private rents is strictly higher ( 1  T (rB ) ! 1  T (rB ) ).
(ii) The equilibrium probability of a successful public offering for project Y is strictly
lower in a universal banking system ( D ( P (rB ))  D ( P (rB )) ).

Proof: It directly follows from the discussion above.
Social welfare, TS (rB ) , is the sum of expected payoffs of all the agents, i.e., of theentrepreneur, the two commercial banks and the two investment banks. Thus social
welfare, or total surplus, is TS (rB ) 3 E (rB )  3 CB (rB )  3 IB (rB ) . 32 For simplicity, we
assume that TS (rB ) is strictly concave on [rB , rB ] . 33 Then, the legalization of universalbanking unambiguously decreases social welfare when TS '(rB ) t 0 , i.e., when
VX d J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] . It unambiguously increases social welfare
when TS '(rB ) d 0 , i.e., when VX t J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] . If neither ofthese inequalities holds, the effects on social welfare are ambiguous. Proposition 3
follows.
Proposition 3: The legalization of universal banking unambiguously decreases social
welfare if VX d J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] and unambiguously increasessocial welfare if VX t J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] . In all other cases, theeffects on social welfare are ambiguous.

32

Competitive outside investors in project Y always earn a zero expected payoff.
21

Proof: The proof is in the appendix.
The effects of universal banking on social welfare stem from the reduction in theequilibrium level of monitoring ( T (rB )  T (rB ) ); all the other changes only constitutezero-sum transfers between the various agents. In general, the equilibrium levels ofmonitoring in the game are not necessarily socially optimal. At stage 1 competition
between commercial banks in rB (which shapes the expected level, T (rB ) , of monitoring)aims to capture the entrepreneur and does not consider the positive effects of expected
monitoring on the payoffs of financial institutions (commercial and investment banks);
this may lead to a socially inadequate level of monitoring.

On the other hand, acommercial bank’s private decision about the level monitoring at stage 3 does notconsider the entrepreneur’s benefits from rent-seeking. Then, at stage 1 competition
between commercial banks in rB often leads to a corner solution in which the expectedlevel of monitoring is not as low as the entrepreneur would prefer, which may lead to asocially excessive level of monitoring. 34
If the equilibrium level of monitoring in a functionally separated system issocially insufficient on a local scale ( VX d J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] ), thefurther reduction in monitoring that is brought about by universal banking is sociallydetrimental; universal banking is unambiguously welfare-decreasing. If, on the other
hand, the equilibrium level of monitoring in a universal banking system is socially
excessive on a local scale ( VX t J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] ), the further
increase in monitoring that is brought about by functionally separated banking is sociallydetrimental; the universal banking system is unambiguously welfare-increasing.

Ifneither inequality holds, the social welfare effects of universal banking are ambiguous.

33

Our results are similar even if TS (rB ) is not concave as long as the change in the equilibrium level of rB

that is caused by universal banking is rather small, i.e., as long as rB is relatively close to rB .
34

rB

We always have a corner solution ( rB

rB ) under a functionally separated regime (condition (6)). If

rB , we also have a corner solution under a universal banking regime.

225. CONCLUSIONSThe paper presents an industrial organization model to formalize the popular ideathat financial conglomerates may make bundled offers of financial services, using
commercial loans as loss leaders to obtain lucrative investment banking business. By
focusing on the monitoring role of commercial banks, we also examine the impact of
universal banking on social welfare and market structure. In our model there are supranormal profits in the investment banking sector that cannot be eroded by competition due
to incentive problems with underwriting; when underwriting fees are too low, investmentbanks exert an insufficient effort.

Universal banking serves as a mechanism forcompeting for such investment banking profits through cross-subsidization fromcommercial banking. However, the resulting commercial loan terms, which are favorable
to customers and unfavorable to commercial banks, have an adverse effect oncommercial banks’ monitoring incentives, encouraging the pursuit of private rents byentrepreneurs. Less equilibrium monitoring also leads to lower underwriting fees and alower probability of successful underwriting.
The social welfare effects of universal banking stem from the change in the levelof monitoring. If the equilibrium level of monitoring in a functionally separated system
is socially insufficient on a local scale, the universal banking system is unambiguously
welfare-reducing because it exacerbates the inadequacy of monitoring. If, on the other
hand, the equilibrium level of monitoring in a universal banking system is socially
excessive on a local scale, the universal banking system is unambiguously welfareincreasing because it eases the excess of monitoring. Otherwise, universal banking has
ambiguous social welfare effects.

23

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26

APPENDIX
Proof of Lemma 2
By totally differentiating first-order condition (5) we haved P (rB )drBD '( P (rB ))(O y  VY )dT (rB )! 0.
[sec ond  order  condition] drB(A1)

Furthermore, applying the envelope theorem to condition (3) leads to

d 3 IB (rB )drB

D ( P (rB ))d P (rB )
! 0.
drB

(A2)

Applying the envelope theorem to condition (4) implies thatd 3 YE (rB )dT (rB )?
D ( P (rB ))(O y  VY )
!0.
drB
drB

(A3)

Proof of Proposition 1
As the payoff table below demonstrates, if CB1 and IB1 are independent entities,
CB2 and IB2 will decide to merge since 3 IB (rB ) ! 0.53 IB (rB ) . Furthermore, if CB1 andIB1 constitute a universal bank, CB2 and IB2 will also decide to merge since
0.5[3 CB (rB )  3 IB (rB )] t 0 . Thus CB2 and IB2 will always merge. Similarly for CB1
and IB1.
3 CB 2  3 IB 2
Separated Banking

Universal Banking

Separated
Banking0.53 IB (rB ) , 0.53 IB (rB )0, 3 IB (rB )Universal
Banking

3 IB (rB ) , 0

3 CB1  3 IB1

0.5[3 CB (rB )  3 IB (rB )] ,0.5[3 CB (rB )  3 IB (rB )]We have rB  rB (lemma 5) and d [3 CB (rB )  3 IB (rB )] / drB ! 0 (note 23, expression(A2)). Thus a universal banking system leads to lower expected profits for financial

27

institutions
thanafunctionally0.5[3 CB (rB )  3 IB (rB )]  0.53 IB (rB ) .

separatedbankingsystemsince

Proof of Proposition 3
We know that 3 E (rB ) T (rB )J ( x  rB )  [1  T (rB )]VX  3 YE (rB ) , which implies that
3 E '(rB ) T '(rB )J ( x  rB  VX )  T (rB )J  3 YE '(rB ) . Incorporating condition (A3), we have
3 E '(rB ) T '(rB )J ( x  rB  VX )  T (rB )J  T '(rB )D ( P (rB ))(O y  VY ) . Furthermore, applying
the envelope theorem to condition (1) gives 3 CB '(rB ) T (rB )J while condition (A2)gives
It
follows
that
3 IB '(rB ) D ( P (rB )) P '(rB ) .
TS '(rB ) T '(rB ){J ( x  rB  VX )  D ( P (rB ))[O y  VY  P '(T (rB ))]} .
If VX d J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] , we have TS '(rB ) t 0 . Given thestrict concavity of TS (rB ) on [rB , rB ] , we have TS '(rB ) ! 0 , rB  [rB , rB ) , which implies
that TS (rB ) ! TS (rB ) .

Similarly, if VX t J ( x  rB )  D ( P (rB ))[O y  VY  P '(T (rB ))] , wehave TS '(rB ) d 0 . Given the strict concavity of TS (rB ) on [rB , rB ] , we have TS '(rB )  0 ,

rB  (rB , rB ] , which implies that TS (rB )  TS (rB ) . If neither of these inequalities holds,
the effects of universal banking on social welfare are ambiguous.

28