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STUDY OF THE EFFECTS OF SIZE AND COMPLEXITY OF FINANCIAL 

INSTITUTIONS ON CAPITAL MARKET EFFICIENCY AND ECONOMIC 

GROWTH 

PURSUANT TO SECTION 123 OF THE DODD-FRANK WALL STREET 

REFORM AND CONSUMER PROTECTION ACT OF 2010 

BY THE CHAIRPERSON OF THE FINANCIAL STABILITY OVERSIGHT 

COUNCIL

January 2011 

 
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Table of Contents

I. OVERVIEW .................................................................................................................................. 4

Introduction ..................................................................................................................................5

A Brief Historical Background ................................................................................................ 6

Overview of Costs and Benefits of Financial Regulation ....................................................... 7

The Nature of this Study .......................................................................................................... 8

II. REVIEW OF POSSIBLE LIMITATIONS REQUIRED BY SECTION 123 ........................................... 9

Section A: Costs and Benefits of Explicit or Implicit Limits on the Maximum Size of Banks, 

Bank Holding Companies, and Other Large Financial Institutions .............................................9

Review of the Literature ........................................................................................................ 10

Summary ................................................................................................................................ 12

Section B: Costs and Benefits of Limits on the Organizational Complexity and Diversification 

of Large Financial Institutions ...................................................................................................14

Review of the Literature ........................................................................................................ 15

Summary ................................................................................................................................ 17

Section C: Costs and Benefits of Requirements for Operational Separation Between Business 

Units of Large Financial Institutions in Order to Expedite Resolution in Case of Failure ........19

Review of the Literature ........................................................................................................ 19

Summary ................................................................................................................................ 22

Section D: Costs and Benefits of Limits on Risk Transfer between Business Units of Large 

Financial Institutions ..................................................................................................................23

Review of the Literature ........................................................................................................ 24

Summary ................................................................................................................................ 26

Section E: Costs and Benefits of Requirements to Carry Contingent Capital or Similar 

Mechanisms ................................................................................................................................28

Review of the Literature ........................................................................................................ 30

Summary ................................................................................................................................ 33

Section F: Costs and Benefits of Limits on Commingling of Commercial and Financial 

Activities by Large Financial Institutions ..................................................................................35

Review of the Literature ........................................................................................................ 36

Summary ................................................................................................................................ 38
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Section G: Costs and Benefits of Segregation Requirements between Traditional Financial 

Activities and Trading or Other High-Risk Operations in Large Financial Institutions ............39

Review of the Literature ........................................................................................................ 39

Summary ................................................................................................................................ 47

REFERENCES ................................................................................................................................. 48

 
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I. OVERVIEW

Section 123 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Pub. 

L. 111-203) (hereafter, “Dodd-Frank Act”) calls on the Chairperson of the Council to carry out a 

study of the economic impact of possible financial services regulatory limitations intended to 

reduce systemic risk and to make recommendations regarding the optimal structure of any limits 

considered. This report has been prepared in response to this mandate. The following 

introduction section provides a brief discussion of the rationale for financial regulation, the 

history of financial regulation in the United States, and the potential costs and benefits of 

regulations; it also outlines the scope and limitations of this study. 

The subsequent sections address potential costs and benefits of particular types of financial 

regulations. Each section is devoted to a topic identified in Section 123. Section A discusses 

explicit or implicit limits on the maximum size of banks, bank holding companies, or other large 

financial institutions. Section B discusses limits on the organizational complexity and 

diversification of large financial institutions. Section C discusses requirements for operational 

separation between business units of large financial institutions in order to expedite resolution in 

case of failure. Section D discusses limits on risk transfer between business units of large 

financial institutions. Section E discusses requirements to carry contingent capital or similar 

mechanisms. Section F discusses limits on commingling of commercial and financial activities 

by large financial institutions. Finally, Section G discusses segregation requirements between 

traditional financial activities and trading or other high-risk operations in large financial 

institutions. 

Section 123(a)(1)(H) also calls for the study of the benefits and costs on the efficiency of capital 

markets, on the financial sectors, and on national economic growth of other limitations on the 

activities or structure of large financial institutions that may be useful to limit systemic risk. The 

Dodd-Frank Act contains many provisions designed to help limit systemic risk, some but not all 

of which are discussed in this study. Most of these provisions, however, are or will be the 

subject of rulemakings by the responsible regulatory agencies, who typically have substantial 

statutory discretion to determine how to implement these provisions. Given the significant 

number of provisions in Dodd-Frank that provide regulators with new authority to adopt 

conditions or limitations on large financial institutions which have not yet been proposed or 

implemented, it is not possible at this time to assess the effectiveness of these changes and 

whether additional limitations would be useful. As such, the study recommends that this 

consideration should be addressed in the next periodic study required by Section 123, which is 

due in 2016. 
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INTRODUCTION

A healthy financial system is essential to economic growth and stability. By mobilizing savings 

and channeling funds to borrowers, the financial system promotes investment in plant and 

equipment, new technologies, human capital and housing. Banking institutions (including 

commercial banks, credit unions, thrifts and bank holding companies; hereafter “banks”) perform 

two special roles in the financial system. First, they engage in maturity transformation by 

investing in long-term, illiquid assets created by borrowers and issuing short-term, liquid 

liabilities to investors. Second, they allocate credit, using their expertise in screening credit risk 

ex-ante and monitoring borrower behavior ex-post to help direct credit flows to the highest 

valued uses. 

Because banks and other financial institutions (including securities firms, investment banks and 

other financial intermediaries; hereafter “FIs”) are so important in creating credit flows, adverse 

shocks to FIs can have an outsized impact on the overall economy. Actual insolvencies and 

investor panic triggered by insolvency concerns played important roles in triggering the recent 

recession, as well as recessions in 1893 and 1907 and the Great Depression in 1929. 

An under-regulated financial system is prone to excessive instability. By its nature, maturity 

transformation exposes banks to credit risk and liquidity risk. In the absence of regulation, 

investors have incentives to monitor bank behavior and withdraw funds from institutions that are 

viewed as being too risky. This market discipline encourages banks to limit risk and to hold 

adequate buffers of capital and liquid assets. However, from a public policy perspective, banks 

tend to carry too much risk in an under-regulated system because they do not internalize the 

external costs that their distress imposes on the financial system. For example, if a bank is 

forced to sell illiquid assets quickly, other banks holding similar assets would experience 

mark-to-market balance sheet losses. As another example, failure of one bank typically triggers 

investor concerns about solvency of other banks that hold similar assets or are counterparties to 

the failed institution. Such concerns can trigger liquidity runs and systemic turmoil. However, 

banks do not incorporate these external costs when weighing the marginal benefits and costs 

ex-ante of holding additional capital or liquidity. 

The need to limit systemic risk is a compelling rationale for financial regulation. Public credit 

guarantees and liquidity provisioning—such as deposit insurance and access to the discount 

window—are essential backstops for preventing bank runs. However, such backstops inhibit the 

incentive of investors to monitor bank behavior. Absent market discipline, banks will be 

emboldened to take on more risk, expecting that some of their downside risk will be borne by 

taxpayers. Public backstops must thus be accompanied by regulations, such as limits on 

activities and minimum capital requirements. Of course, poorly-designed regulations can stifle 

competition and innovation or create inefficiencies in credit allocation. Financial regulation 

must strive to limit systemic risk while not hindering efficient financial intermediation. 
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A BRIEF HISTORICAL BACKGROUND

Historically, the U.S. financial system has undergone increasing levels of regulation over time. 

The National Bank Act of 1863 generally limited the types of activities that could be conducted 

by national banks to those that are part of, or incidental to, the business of banking. The 

McFadden Act (1927) limited interstate branch banking, implicitly limiting bank size and 

geographic diversification. The Banking Act of 1933 (known as Glass-Steagall) separated 

commercial banks from investment banks. Commercial banks could not underwrite securities, 

while securities firms could not engage in commercial banking. The Bank Holding 

Company Act of 1956 prohibited banks from affiliating with companies engaged in commercial 

activities. 

However, beginning in the late 1960s, innovation and deregulation gradually eroded these 

restrictions. Commercial banks lost market share to new financial instruments and institutions 

such as commercial paper and money market mutual funds. In response, banks were allowed to 

expand and diversify their activities. The Riegle-Neal Interstate Banking and Branching 

Efficiency Act of 1994 significantly eased interstate banking restrictions. The 

Gramm-Leach-Bliley Act of 1999 expanded the range of financial activities that may be 

conducted by qualifying banking organizations. 

The early 2000s saw the rise of large, complex FIs engaged in a broad spectrum of financial 

activities, as well as the rise of a new model of financial intermediation, referred to as shadow 

banking, in which maturity transformation increasingly took place outside the formal banking 

sector. In this new model, illiquid and (sometimes) risky assets were funded by asset-backed 

commercial paper or loans financed by repurchase agreements (repo loans) collateralized with 

asset backed securities; credit and liquidity backstops of liabilities were implicit rather than 

explicit; and capital requirements and other restrictions were less stringent for shadow banks 

than for traditional banks. 

Inadequate regulation played a major role in the recent crisis. The Dodd-Frank Act addresses 

this failure. It establishes the Financial Stability Oversight Council (“FSOC”), which may 

designate for supervision by the Board of Governors of the Federal Reserve System (“Federal 

Reserve”) any financial firm whose material financial distress could pose a threat to the financial 

stability of the United States. The Dodd-Frank Act provides for the establishment of enhanced 

supervision and prudential standards for nonbank financial companies designated for supervision 

by the Federal Reserve and bank holding companies with assets equal to or greater than $50 

billion. The Dodd-Frank Act creates comprehensive federal oversight of the derivatives market 

and imposes safeguards and transparency on the process of securitizing pools of loans for 

investors. The FSOC also has clear accountability for identifying emerging threats to financial 

stability and coordinating regulators’ efforts to address such threats. To protect the taxpayer, the 

Act restricts commercial banking firms from engaging in proprietary trading or investing in or 

sponsoring private equity or hedge funds (the Volcker Rule). The Federal Reserve is provided 
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authority to require nonbank financial companies designated for supervision by the Federal 

Reserve, and bank holding companies with assets of $50 billion or more, to reduce their size or 

divest business lines if the company poses a grave threat to the financial stability of the United 

States. In the event a major financial firm fails, the Dodd-Frank Act supplies the federal 

government with authority to wind it down in an orderly fashion that protects the economy and 

does not impose the cost on taxpayers. 

OVERVIEW OF COSTS AND BENEFITS OF FINANCIAL REGULATION

The subsequent sections of this report address the potential costs and benefits of particular types 

of financial regulation. Before proceeding, we articulate the two main channels through which 

financial regulation can affect the economy. 

First, regulations can affect the supply and cost of credit. Regulation affects credit supply in part 

through its effect on allocative efficiency. Ideally, the financial system should equalize the 

marginal social benefit of credit across different borrowers, and should equalize the marginal 

benefit of credit to its social marginal cost. Financial regulation can promote allocative 

efficiency by narrowing differences between marginal costs and marginal benefits, but it can also 

exacerbate such differences. For instance, policies that combat discrimination and promote fair 

market practices can improve allocative efficiency by eliminating artificial gaps between price 

and marginal cost, while policies that artificially limit entry (such as restrictions on branching) 

can lead to market power distortions that push the price of credit above its marginal cost. It is 

important to note that promoting allocative efficiency does not always reduce the cost of credit. 

If credit is priced below its social cost, regulation should aim to raise the price of credit. 

Regulation can also affect credit supply through its impact on technological efficiency. 

Regulations that prevent innovation or preclude FIs from achieving economies of scale or scope 

may increase the cost of credit. 

Second, financial regulation can affect the riskiness of individual FIs and the financial system as 

a whole. As mentioned above, FIs may take on too much risk because of their failure to account 

for costs imposed on other institutions in the event of distress, and this tendency is magnified 

when public backstops reduce market discipline. Reducing default risk reduces the expected cost 

of resolutions and benefits the economy by making systemic financial crises less likely. 

Therefore, regulations that reduce excessive risk can benefit the economy. However, poorly 

designed regulations may unintentionally increase risks. For example, restrictions that are 

imposed only on formal banks may encourage the growth of lightly-regulated shadow banks that 

are more vulnerable to runs. 
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THE NATURE OF THIS STUDY

A few points about the nature of this study are in order. First, this study does not evaluate the 

costs and benefits of the Dodd-Frank Act. While the Act has undoubtedly had a significant 

effect, it is too soon to attempt to quantify its aggregate impact let alone the specific impact of 

various provisions within certain channels of our financial system. Instead, this study contains a 

critical review of existing research on the impact of the types of financial regulation identified in 

Section 123. Most of this research was conducted prior to the enactment of the Dodd-Frank Act, 

and thus does not comment directly on the Act, although some of the reported findings are 

indicative of the potential benefits of particular provisions of the Act. 

Second, this study will in general refrain from making specific quantitative assessments. Section 

123 calls for follow-up studies every five years. This study recommends that the periodic study 

due in 2016 consider the experience of implementing the Dodd-Frank Act and any further 

original research, and consider making more specific recommendations. 

This study is confined to the existing literature, in which some topics are addressed more 

thoroughly than others. For instance, the discussion of limits on bank size draws on an extensive 

literature on economies of scale in banking; however, there is much less existing literature on 

contingent capital requirements. In some cases, literature is sparse because there is little realworld experience with certain types of regulation; in other cases, necessary data are not 

available. When appropriate, the report will identify specific topics for which additional 

research and additional data would be especially valuable. 
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II. REVIEW OF POSSIBLE LIMITATIONS REQUIRED BY SECTION 

123 

SECTION A: COSTS AND BENEFITS OF EXPLICIT OR IMPLICIT LIMITS 

ON THE MAXIMUM SIZE OF BANKS, BANK HOLDING COMPANIES, AND 

OTHER LARGE FINANCIAL INSTITUTIONS

This section discusses the costs and benefits of limits on the size of banks, bank holding 

companies, and other large financial institutions, hereafter collectively referred to as financial 

institutions (FIs). The costs and benefits of such limits depend on the importance of scale 

economies, large FIs’ ability to abuse market power, and market perceptions that large FIs have 

access to a government safety net. 

The potential cost of limits on the size of FIs is that such limits may prevent FIs from achieving 

economies of scale and benefiting from diversification. 

One potential benefit of limits on the size of FIs is that such limits may prevent FIs from 

acquiring market power and abusing it by setting prices at socially inefficient levels. Another 

possible benefit of such limits is that they may prevent FIs from growing so large that they are 

perceived by the market as “too big to fail.” Limiting the perception that some FIs are “too big 

to fail” will constrain excessive risk taking by preventing the moral hazard associated with the 

perceived access to a government safety net. 

Prior to the advent of interstate banking, U.S. commercial banks faced functional limitations that 

generally prevented them from growing too big. The Riegle-Neal Act of 1994 removed many 

barriers to interstate banking but imposed a concentration limit on commercial banks, based on 

the share of insured deposits held by the bank. The Dodd-Frank Act eliminates some existing 

limits on branching and imposes an additional concentration limit on the financial sector by 

preventing any financial company from conducting a merger or acquisition that would result in 

the financial company accounting for more than ten percent of the liabilities of the financial 

sector. The Dodd-Frank Act requires the FSOC to release a report, together with a 

recommendation, regarding the implementation of this concentration limit. Following the 

release of this report, the Federal Reserve will adopt regulations to implement this concentration 

limit. 

The concentration limit in the Dodd-Frank Act is an example of a restriction that may help 

prevent FIs from becoming so large that they are perceived by the market to be “too big to fail,” 

and may also constrain FIs from acquiring market power. Concentration limits work with other 

provisions in the legislation, such as the orderly liquidation authority of Title II, to protect 
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taxpayers. The effectiveness of these limits will depend on implementation, how they interact 

with other regulations, and on FI responses to the regulations. 

REVIEW OF THE LITERATURE

BANK SIZE AND SCALE ECONOMIES 

An increase in the size of a FI could reduce the cost of the credit it provides, because large FIs 

may benefit from improved efficiency associated with scale economies. One specific type of 

scale economy is that larger FIs may be more diversified, which could reduce their costs of 

funding. Accordingly, a potential cost of limits on the size of FIs is that such limits may prevent 

FIs from enjoying improved efficiency from scale economies, and raise the cost of credit as a 

result. 

The economics literature identifies scale economies by studying the relationship between FI 

performance (measured by either costs or by profitability) and the size of the FI. Early empirical 

analysis found limited bank scale economies that tended to peak at relatively low asset levels 

(see Wheelock and Wilson (2009) for discussion). However, this research was restricted to data 

from the 1980s and may not have adequately accounted for differences across FIs in their credit 

production processes (Mester 2005). 

Research using more recent data and improved methods finds substantially stronger evidence of 

increasing returns to scale among FIs. For example, Wheelock and Wilson (2009) estimate that 

during the period 1984-2006, many commercial banks benefited from increasing returns to scale, 

regardless of ownership structure and branch banking restrictions (see also Hughes, Mester, and 

Moon (2001) and Feng and Seriletis (2010)). Much has changed since 2006 and further research 

is needed to make any conclusions about the current environment. In addition, although research 

suggests that scale economies do exist for large FIs, there is no consensus on the ‘optimal’ FI 

size, due to limitations on data availability and research design, and difficulties in measuring 

costs over a long time horizon. Additionally, there is no clear evidence to indicate that scale 

economies continue increasing as FIs approach a very large size. 

The drivers of efficiency gains in large FIs are multifaceted. Large FIs disproportionately enjoy 

the efficiency gains from technological progress, such as automated small business credit 

scoring, because the benefits of the new technology are more likely to outweigh the upfront fixed 

investment costs for large FIs (Berger, Dick, Goldberg, and White 2007). Another driver is that 

there may be significant scale economies in implementing either paper-based or electronic-based 

payment systems (Bauer and Hancock 1993). 

Diversification is specifically addressed in Section B of this report. However, diversification 

also interacts with FI size because larger FIs may be better positioned to diversify risk, and may 
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be able to access low-cost funding as a result. In this way, diversification represents another way 

in which large FIs benefit from scale efficiency (McAllister and McManus 1993). Empirical 

studies have shown that geographic expansion diversifies region-specific risk and tends to reduce 

FI failures (Hughes, Lang, Mester, and Moon 1996). It is worth noting that reduced costs of 

funding due to diversification may contribute to large FIs taking on additional risk. Moreover, 

diversification of large FIs tends to increase their complexity, which may raise their risk 

management costs, reduce transparency, and complicate resolution. 

BANK SIZE AND MARKET POWER

Large FIs in concentrated markets may abuse their market power, leading to elevated credit 

prices that are socially inefficient. Limitations on the relative size of FIs may prevent high levels 

of concentration and the socially inefficient pricing of credit. 

There is a regulatory history on concentration limits that pre-dates the Dodd-Frank Act. The 

Riegle-Neal Act of 1994 prohibited interstate mergers that would result in a bank and its 

branches controlling more than ten percent of national deposits of insured depository institutions 

or more than 30 percent of insured deposits in a state. Section 622 of the Dodd-Frank Act 

imposes a concentration limit on the financial sector by preventing any FI from conducting a 

merger or acquisition that would result in the FI accounting for more than ten percent of the 

liabilities of the financial sector. 

The economics literature generally supports the conclusion that market power contributes to 

socially inefficient price setting. Bank merger activities that result in dramatic increases in 

market concentration result in less favorable prices for customers (Prager and Hannan 1999), 

while other mergers and acquisitions, such as market-extension mergers and acquisitions that 

unite institutions with little or no geographic overlap, have less effect on retail customers 

(Simons and Stavins 1998). Jeon and Miller (2005) find that higher concentration at the U.S. 

state level is associated with higher FI profits. There are some studies that draw different 

conclusions, such as one study that shows that increased market power may boost cost efficiency 

(Maudos and Fernandez de Guevara 2006). However, another study suggests that increased 

market power leads to decreases in efficiency, which may be consistent with FIs abusing market 

power (Berger and Hannan 1998). 
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BANK SIZE AND “TOO BIG TO FAIL” 

One benefit of limits on the size of FIs is that such limits may prevent FIs from growing so large 

that they are perceived by the market as “too big to fail.” Limiting this perception will constrain 

excessive risk taking by preventing the moral hazard associated with the perceived access to a 

government safety net. Moreover, limiting the relative size of any single financial firm will limit 

the adverse effects from the failure of any single firm for reasons specific to that firm. 

A few studies in the economics literature have focused on how bank size contributes to the 

perception that a FI is “too big to fail.” Huang, Hao, and Haibin (2010) conclude that bank size 

is directly related to how the financial market perceives the net impact of the failure of a specific 

FI on the overall financial sector. Prior to the recent crisis, several studies showed, using data 

from equity markets and from mergers, that the value of large FIs potentially reflected the market 

perception that they were “too big to fail,” which may have contributed to increasing their size, 

reducing their capitalization, and their taking on excessive risk (O’Hara and Shaw (1990), 

Brewer and Jagtiani (2009)). Another study showed that the ‘issuer ratings’ of large FIs, which 

determine their financing costs, may reflect a perception that these large FIs are “too big to fail” 

(Rime 2005). Access to cheap financing contributes to moral hazard, and moral hazard may 

have been partially responsible for large banks taking on excessive risk prior to the crisis. 

A distinct segment of the literature has focused on how concentration may lead to excessive risk 

taking, potentially through the market perception that certain FIs are “too big to fail.” For 

example, Boyd, De Nicolo, and Jalal (2006) find that in countries with more concentrated 

financial markets, FIs have taken on a disproportionate amount of risk, relative to their capital 

buffer. Other studies have found that more concentrated banking systems actually have a 

decreased probability of financial crises, potentially due to better diversification of risks within 

the large FIs (Beck, Demirguc-Kunt, and Levine 2006). 

SUMMARY

The costs and benefits of limits on FI size depend on scale economies, large FIs’ potential to 

abuse market power and whether the market perceives large FIs as “too big to fail.” The 

economics literature suggests that there are both costs and benefits to limiting bank size. 

Some studies examining the relationship between FI performance and FI size find that there are 

scale economies associated with large FIs. Large FIs disproportionately enjoy the efficiency 

gains from technological progress and the benefits associated with the ability to diversify risk. 

Strict limits on bank size therefore could pose a cost to large FIs, which are best positioned to 

accrue these benefits. 

Conversely, there are benefits to limiting FI size. Large FIs in concentrated markets may abuse 

their market power, leading to elevated credit prices that are socially inefficient. Limitations on 
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the relative size of FIs may prevent high levels of concentration and the socially inefficient 

pricing of credit. Section 622 of the Dodd-Frank Act addresses this issue by imposing a 

concentration limit on the financial sector that prevents any FI from conducting a merger or 

acquisition that would result in the FI accounting for more than ten percent of the liabilities of 

the financial sector. Limiting FI size, together with other restrictions in the legislation, also may 

prevent FIs from growing so large that they are perceived by the market as “too big to fail.” 

Limiting the perception that some FIs are “too big to fail” will constrain excessive risk taking by 

preventing the moral hazard associated with the perceived access to a government safety net. 

Moreover, limiting the relative size of any single financial firm will limit the adverse effects 

from the implosion of any single firm for reasons specific to that firm. 

This study will not make recommendations regarding limits on the maximum size of banks, bank 

holding companies, and other large financial institutions. Section 123 calls for follow-up studies 

every five years. The concentration limit under section 622, once implemented, may provide 

information regarding the costs and benefits of a limitation on size. The study that will be 

prepared in 2016 may take this information into consideration.
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SECTION B: COSTS AND BENEFITS OF LIMITS ON THE 

ORGANIZATIONAL COMPLEXITY AND DIVERSIFICATION OF LARGE 

FINANCIAL INSTITUTIONS

This section reviews the existing literature on the effects of increased scope, organizational 

complexity, and diversification of large financial institutions. Increased organizational 

complexity and diversification of large financial institutions in the U.S. may have contributed to 

the recent financial crisis. While internationalization, consolidation and conglomeration offer 

potential benefits to financial institutions, diversification may also lead to shifts in risk taking 

behavior and the development of new and more sophisticated mechanisms to transfer risk, which 

in turn may increase interconnectedness among financial institutions, and therefore, systemic 

risk. 

Some of the benefits of functional diversification (that is, across business activities and markets) 

and organizational complexity mentioned by the existing literature are: lower risks, better access 

to internal capital markets, increased supply of financial services, and operational synergies 

through economies of scope and economies of information. Potential costs include inefficient 

rent-seeking; bargaining problems and bureaucratic rigidity; intensification of agency problems 

between insiders and outsiders, between the divisions of the conglomerate, and between the 

conglomerate firm and its customers; increased systemic risk due to negative externalities and 

more interdependencies; and higher regulatory costs arising from multiple supervision efforts.1

Whether the benefits of diversification are larger than the costs cannot be determined from 

theory alone and is therefore an empirical question. This issue is important because limits on the 

organizational complexity and diversification of large financial institutions may have important 

implications not only for risks and market valuation of large financial firms, but also for 

corporations, households and other financial institutions through the supply of financial services, 

the sources of credit available to borrowers, and the allocative efficiency of capital markets. 

The empirical evidence on costs and benefits of diversification and organizational complexity is 

mixed. On the one hand, more diversified and organizationally complex financial institutions 

can provide a wider array of financial services, which could improve the supply of credit and 

other financial services. For example, there is evidence for economies of scope in combining 

deposit taking and lending, the classic commercial banking activities. On the other hand, there is 

less evidence that other forms of functional diversification create value. The economic literature 

has raised the concern that more diversified and complex financial institutions may be perceived 

by the market as “too big to fail,” leading to problems with moral hazard and excessive risk 

taking. 

 

1

 See Klein and Saidenberg (2010) and Elsas, Hackethal and Holzhauser (2010) for more details and references. 
- 15 - 

REVIEW OF THE LITERATURE

DIVERSIFICATION

The broad empirical literature on corporate diversification has generally found that 

conglomerates are less efficient than standalone firms. Most studies find a “diversification 

discount”: diversified firms trade at a discount relative to a portfolio of comparable standalone 

firms (see, for example, Lang and Stulz (1994)). The diversification discount found for 

nonfinancial corporations also seems to be applicable to financial institutions (see, for example, 

Laeven and Levine (2007), although Baele, De Jonghe and Vander Vennet (2007) find a strong 

positive correlation between franchise value and the degree of diversification for a sample of 

European banks). 

Demsetz and Strahan (1997) and Stiroh and Rumble (2006) find that potential diversification 

benefits such as lower risks and a broader range of financial services could be offset by riskier 

lending portfolios, lower capital ratios, and increased exposure to more volatile non-interest 

activities (e.g. brokerage or underwriting). Specifically, Stiroh and Rumble find little evidence 

of gains in risk-adjusted returns from the recent shift toward fee and other non-interest income 

for U.S. commercial banks. They argue that banks have shifted towards these activities because 

managers focus more on the benefit of higher expected profits than on the cost of higher return 

volatility. As they point out, this focus makes sense if managers reap the gains of higher profits, 

but do not bear all of the costs from increased risk; for example, if managers are equity-holders, 

they have an incentive to take risk beyond what debt-holders and supervisors would prefer. 

Another potential benefit of increased diversification derives from the presence of economies of 

scope between different activities in the banking industry. Economies of scope provide a 

rationale for why commercial banks combine the provision of deposits and credit services. As 

Kashyap, Rajan, and Stein (2002) argue, banks should combine demand deposits with loan 

commitment lines offered to households and firms as long as the demand for liquidity of these 

two types of customers is not too highly correlated. Gatev and Strahan (2006) extend this 

argument and highlight the ability of commercial banks to provide liquidity insurance against 

systemic liquidity shocks. Using both aggregate and bank-level data, they find that in periods 

when liquidity dries up and commercial paper spreads widen, banks experience funding inflows 

in the form of deposits. These deposit inflows allow banks to meet loan demand from borrowers 

drawing funds from commitment lines without running down their holdings of liquid assets. 

While the literature suggests economies of scope between deposit taking and loan provision, 

there is limited evidence for other kinds of economies of scope. An additional potential concern 

about exploiting economies of scope is that increased diversification may make financial 

institutions’ organizational structure more complex, which would increase managerial costs. 
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ORGANIZATIONAL COMPLEXITY

To our knowledge, there is only one existing empirical study that focuses on the benefits and 

costs of organizational complexity per se. Klein and Saidenberg (2010) suggest that existing 

estimates of the costs of diversification (e.g. the diversification discount) reflect not only the 

effects of higher diversification itself, but also the effects of more complex organizational 

structures. The authors’ attempt to disentangle these two concepts by looking at the effect on 

bank holding company (BHC) profitability and market value of having additional separately 

chartered subsidiaries (which the authors interpret as a more complex organizational structure), 

controlling for BHC diversification as proxied by size and the number of states in which the 

BHC operates. They find that BHCs with many subsidiaries are less profitable and have lower 

market values than similar BHCs with fewer subsidiaries. These differences are statistically 

significant even after controlling for size, diversification, local market conditions, and the 

possible endogeneity of the decision to add subsidiaries. Furthermore, the authors argue that the 

cost of managing complex organizations increases with subsidiary heterogeneity. 

SYSTEMIC RISK

On the impact of increased diversification and organizational complexity on systemic risk, 

De Nicoló and Kwast (2002) point out that increased scope of financial firms’ activities, both 

across countries and across business lines, may lead to increased systemic risk, since a larger 

fraction of financial firms will become more “complex” to manage, and their interconnectedness 

(or what the authors refer to as interdependencies) will become more difficult to monitor. They 

argue that systemic risk depends fundamentally on firms’ interdependencies, both direct (e.g. 

inter-firm on- and off-balance sheet exposures from interbank loans, derivatives, and payment 

and settlement) and indirect (e.g. potential losses through loan concentrations to the same 

industry, or otherwise highly correlated portfolios). The authors find that stock returns of large 

U.S. banks became more positively correlated with one another over the period 1988-1999, 

suggesting that interdependencies have increased over time. In their view, these increased 

interdependencies raise systemic risk. 

More recent work suggests that diversification of large financial institutions could reduce their 

individual probability of failure yet increase the probability of a systemic crisis. For example, 

Wagner (2010) develops a theoretical framework in which diversification makes financial 

institutions more similar to each other by exposing them to the same risks. Since full 

diversification requires all institutions to hold the market portfolio, diversification increases the 

correlation of asset risks across institutions, increasing their chance of failing jointly. While 

previous work assumes a constant efficiency loss from the liquidation of assets during a crisis, in 

Wagner’s model there are social costs in the form of larger efficiency losses when institutions all 

have to liquidate at the same time. In such a setup, full diversification is not optimal, because the 

marginal benefit of diversification (from lower return variance of a portfolio) is declining in the 
- 17 - 

degree of diversification and becomes zero at full diversification, while the marginal cost of 

correlated failures increases in the degree of diversification. Wagner concludes that the marginal 

costs of diversification in terms of more severe systemic crises must outweigh the marginal 

benefit for a sufficiently large degree of diversification. 

De Nicolo, Bartholomew, Zaman and Zeohirin (2004) use data on the 500 largest financial firms 

worldwide, and on large financial institutions in about 90 countries, and find that complexity 

resulting from conglomeration and consolidation increases systemic risk (as they define it). In 

particular, they find that (1) large conglomerate financial institutions exhibited levels of 

risk-taking no lower than those of smaller and specialized firms in 1995, and exhibited higher 

levels of risk-taking in 2000; (2) highly concentrated financial systems exhibited higher levels of 

systemic risk potential than less concentrated systems during the 1993–2000 period, and this 

relationship strengthened during the 1997–2000 period. As a result, the authors argue that 

consolidation and conglomeration do not necessarily yield safer financial firms or more resilient 

financial systems. 

SUMMARY

If diversification and organizational complexity have more costs than benefits in terms of more 

risky activities, lower capital and higher exposure to systemic risk, then limits on diversification 

could help enhance financial stability and economic growth. 

Although some findings are mixed, most of the empirical literature suggests that diversification 

and complexity expand the supply of financial services and reduce institutions’ individual 

probability of failure, but at the same time shift institutions towards more risk-taking, increase 

the level of interconnectedness among financial firms, and therefore may increase systemic

default risk. These potential costs may be exacerbated in cases where the market perceives 

diverse and complex financial institutions as “too big to fail,” which may lead to excessive risk 

taking and concerns about moral hazard. The literature thus provides some support for limits on 

degree or scope of diversification and organizational complexity of large financial firms. 

That said, there may well be benefits of organizational complexity and diversification that are 

not yet addressed in the literature. In addition, it is important to note that little research exists on 

the effects of specific limits on diversification and organizational complexity (as opposed to 

research on the costs and benefits of diversification and organizational complexity themselves). 

For example, the existing literature does not provide meaningful insights into the following 

questions. Which types of limits would guard against excessive risk taking? Which types of 

limits are most “cost-effective”? Do such limits have unintended consequences on other aspects 

of financial intermediation? More research on these topics could be helpful. 
- 18 - 

This study will not make specific recommendations on the structure of limits to diversification or 

organizational complexity. Section 123 calls for follow-up studies every five years. This study 

recommends that the periodic study due in 2016 consider the experience of implementing the 

Dodd-Frank Act and any further original research, and consider making more specific 

recommendations. 

 
- 19 - 

SECTION C: COSTS AND BENEFITS OF REQUIREMENTS FOR 

OPERATIONAL SEPARATION BETWEEN BUSINESS UNITS OF LARGE 

FINANCIAL INSTITUTIONS IN ORDER TO EXPEDITE RESOLUTION IN 

CASE OF FAILURE

The Report and Recommendation of the Cross-border Bank Resolution Group (Basel Committee 

on Bank Supervision 2010) finds that interdependency among the various legal entities 

belonging to a financial institution is a major impediment to resolving such financial institutions 

in the event of failure. The main problem occurs when legally separate entities cannot operate 

independently. In contrast to a mere legal separation of entities, which allows different legal 

entities to be integrated by sharing assets and fixed costs across lines of business, a separation of 

business units aims to establish units that can operate independently from each other. Under a 

separation of business units, each unit may still comprise numerous legal entities, but these 

entities are interdependent only within the business unit, not across business units. The focus of 

this section is the possible costs and benefits of requiring separation of business units within 

large financial institutions. 

The main benefit of requiring separation of business units is that ex-ante, separated units could 

potentially be sold more quickly in the event that resolution is necessary, which may mitigate the 

reduction in the supply of credit that often occurs in the event of bank failures. An efficient 

resolution process also increases confidence in the stability of the financial system. 

On the other hand, requiring separation of business units could also create costs. First, market 

pressures lead to organizational structures that mitigate conflicts of interest in financial markets. 

Imposing restrictions on organizational structure may exacerbate these conflicts of interest and 

therefore reduce the supply of credit (allocative efficiency). Second, financial institutions with 

separated business units may lose economies of scale (technological efficiency), increasing the 

cost of credit. Third, limited liability of separate business units may lead to excessive risk taking 

in each unit. 

REVIEW OF THE LITERATURE 

MARKET DEMAND FOR SEPARATION OF BUSINESS UNITS

Why do markets sometimes require the separation of business units? Kroszner and Rajan (1997) 

argue that market forces can lead financial institutions to adopt an efficient organizational 

structure. In particular, the authors examine the two ways of organizing investment banking 

operations in the U.S. before the 1933 Glass-Steagall Act: as an internal securities department 

within the bank and as a separately incorporated affiliate with its own board of directors. The 
- 20 - 

authors find that internal departments obtained lower market prices for their issues, even though 

these issues appeared to be of higher quality. This reflects a risk premium associated with 

greater conflicts of interest when lending and underwriting occur within the same structure. As a 

result, many commercial banks chose the separate affiliate structure. In this case, organizational 

structure was an effective commitment mechanism for some entities, and market pressures 

propelled some banks to adopt an internal structure that was designed to address concerns about 

internal conflicts of interest. In general, one can argue that the organizational structure of 

financial institutions is chosen to maximize firm value while achieving compliance with legal, 

regulatory, and tax requirements in all host countries. Therefore, the optimal organizational form 

is expected to enhance the efficiency of capital markets. 

Houston and James (1998), studying internal capital markets of banks, provide a second example 

of how an optimally chosen organizational structure can improve the allocation of capital. They 

show that loan growth of banks affiliated with a multi-bank holding company is typically less 

sensitive to the bank's cash flow, liquidity, and capital position than loan growth among 

unaffiliated banks. All banks find external capital to be more expensive than internal capital. 

Easy access to an internal capital market enhances the efficiency of affiliated banks even though 

they operate as separate entities. 

Regulation that requires the separation of business units beyond market requirements is likely to 

increase costs to individual financial institutions. Hence, the cost of credit may increase, if these 

costs are not outweighed by other benefits that derive from separation. If the separation also 

affects intra-group allocation of resources, then additional separation may lead to a less efficient 

allocation of credit. 

BENEFITS OF SEPARATION

The legal and operational separation of business units may be beneficial for financial institutions 

as it allows for diversification. In particular, separation implies that financial institutions can 

benefit from non-core income, while the associated core financial activity is protected from 

losses on non-core activities. Templeton and Severiens (1992) argue that diversified financial 

institutions are less exposed to income shocks and are therefore more stable. A second benefit of 

legal and operational separation is that it may facilitate the fast and efficient sale of profitable 

units in case of liquidation. Legal and operational separation also simplifies the establishment of 

bridge banks and bad banks.2 McDill (2004) finds that large banks usually suffer lower loss rates 

in the event of resolution, in part because not all business units are affected. 

Perhaps the best evidence for the benefits of separation of business units in case of resolution is 

the case of Bank of Credit and Commerce International (BCCI). Baxter and Somner (2005) show 

 

2

 For a summary of the options for resolution in more detail, see Santomero and Hoffman (1999). 
- 21 - 

that United States authorities were able to separate and reorganize First American, a bank 

holding company owned by BCCI, precisely because it had few interaffiliated operational, credit, 

or reputational relationships with BCCI. Supervisors succeeded in the reorganization because 

they reestablished trust in the bank holding company and its affiliated banks.3

 

Fast and efficient resolution of troubled financial institutions also increases the confidence of 

financial market participants in the overall soundness of the financial system. First, fast and 

efficient resolution reduces the likelihood of runs on troubled institutions or on institutions that 

are exposed to them. Second, Ashcraft (2005) shows that the FDIC-induced failures of healthy 

local subsidiaries of failed multi-bank holding companies have real effects on local economies 

through a severe reduction in bank lending. The effects of these loan supply shocks can be 

dampened if subsidiaries consist of separate business units that can be sold fast and continue to 

operate. 

COSTS OF SEPARATION

Large financial institutions are usually complex. For instance, Lehman Brothers Group consisted 

of 2,985 separate legal entities in about 50 countries. In this case, legal separation did not map 

into a clear separation of business units that were able to operate independently. On the contrary, 

the Group’s main functions, such as liquidity management, were centralized (Basel Committee 

on Bank Supervision 2010). Centralizing certain functions to take advantage of economies of 

scale is common in large financial institutions. A requirement to separate business units may 

result in duplication of previously shared assets and fixed costs and may reduce economies of 

scale. 

In some cases, the organizational and legal separation of business units can lead to excessive risk 

taking. Broome (1993) notes that prior to 1989, bank holding companies had an incentive to 

increase risk in individual member banks. Since a bank holding company was liable only up to 

its equity investment in the subsidiary bank, bankruptcy risk was shifted to the FDIC. Following 

the FDIC Improvement Act (FDICIA) of 1989, the affiliated banks within a bank holding 

company system were subject to cross-guarantee liability for the FDIC’s losses incurred due to 

the failure of an affiliated bank. Even prior to the FDICIA, however, Cornyn, Hanweck, 

Rhoades, and Rose (1986), argued that bank holding companies are generally inclined to support 

ailing affiliates out of reputational and credibility concerns, even when they are legally liable 

only up to their equity investment. Such concerns could dampen the incentives to take on 

excessive risk in separated business units. 

Baxter and Somner (2005) argue that most complex organizational structures with a large 

number of interdependent legal entities are established to achieve tax efficiency, but not 

 

3

 For a detailed discussion of the resolution process of BCCI, see Herring (2005). 
- 22 - 

necessarily economic efficiency, once the cost of supervision in the event of resolution is taken 

into account. From a supervisory point of view, a clear mapping from legal entities to business 

units may be desirable, since separate business units may be sold faster in the event of resolution. 

The authors advocate regulation that encourages a reduction in interdependencies in order to 

facilitate a fast, orderly resolution. Such regulation, however, may reduce the number of 

subsidiaries, which may result in lower bank profits due to higher tax liabilities. This could 

increase the cost of credit. 

SUMMARY

The separation of business units may expedite the resolution of a financial institution. A fast and 

efficient resolution regime can dampen loan supply shocks due to a failure of a financial 

institution. Efficient resolutions also enhance trust in the soundness of the financial system, 

which is crucial to the efficiency of capital markets. Market forces lead financial institutions to 

choose their organizational structure that maximizes efficiency. This sometimes leads to a 

separation of business units in order to reduce conflicts of interest. However, the separation of 

business units can reduce the firm’s ability to centralize functions such as liquidity management, 

and can thus result in a reduction in economies of scale. Restrictions on the organizational 

structure of financial institutions might also distort the allocation of capital in the economy, 

increase tax liability, increase risk taking, and reduce overall capital market efficiency. Rajan and 

Zingales (1998) study the relationship between finance and growth and find that external 

finance-dependent industries grow slower in countries with less efficient capital markets. 

The literature on the separation of business units is sparse. Future research could aim to 

(1) quantify the increase in the cost of credit due to a reduction in economies of scale caused by 

the separation of business units, (2) provide comparative case studies of bank resolutions to help 

determine the optimal separation of business units, (3) estimate the effect of separated business 

units on risk taking behavior relative to an integrated corporate structure, and (4) examine the 

implications of tax liability for allocative efficiency and the cost of credit. 

This study will not make specific recommendations on the structure of requirements for 

operational separation between business units of large financial institutions. Section 123 calls 

for follow-up studies every five years. This study recommends that the periodic study due in 

2016 consider the experience of implementing the Dodd-Frank Act and any further original 

research, and consider making more specific recommendations. 

 
- 23 - 

SECTION D: COSTS AND BENEFITS OF LIMITS ON RISK TRANSFER 

BETWEEN BUSINESS UNITS OF LARGE FINANCIAL INSTITUTIONS

The transfer of risky assets among subunits of the same firm may either occur among business 

units that are financially commingled—meaning, in accounting terms, that their balance sheets 

are “consolidated”—or they may occur between a firm and an off-balance sheet entity, such as a 

“qualifying” special-purpose vehicle (SPV), or between a bank and an affiliated firm that 

engages in non-banking activities. Risk transfer among consolidated business units is an integral 

part of the internal capital allocation decisions of firms. An allocation mechanism that transfers 

operating capital from one business unit to another effectively increases the risk of the transferor 

and decreases the risk of the transferee. In the case of asset transfers from a firm to an 

off-balance sheet entity or an affiliate, the concern is that the transferor retains some portion of 

the risk without openly disclosing this exposure or accounting for the risk in its financial 

statements. This tacit transfer of risk back to the balance sheet of a transferor is known as 

implicit recourse. 

Financial Accounting Standard No. 140 (FAS 140), issued in September 2000, allowed offbalance sheet treatment only for “true sales” in which the asset is sold to a “qualifying SPV” and 

in which the transferor surrendered control rights over the receivables. In principle, FAS 140 did 

not allow sponsoring firms to subsidize or otherwise provide recourse to off-balance sheet SPVs 

in bad states of the world, since the courts would interpret such recourse as evidence that there 

was no true sale of assets to the SPV to begin with. In practice, there is evidence (discussed 

below) that firms provided ex-post assistance to sponsored SPVs on many occasions, even 

though they could not commit to such assistance ex-ante. Financial Accounting Statements 166 

and 167 (FASB 166/167), which took effect at the beginning of 2010, reduce the ability of firms 

to engage in implicit recourse by abolishing qualifying SPVs and requiring firms to disclose 

more information about continuing involvements with transferred financial assets. However, 

because the different means by which implicit recourse can be provided are broad, and because 

there is not always a straightforward test of whether a given act is a form of recourse, it would be 

difficult to close the regulatory loopholes that enable implicit recourse entirely even if doing so 

were desirable. 

This section discusses both the literature studying implicit recourse and the literature studying 

risk transfer among consolidated business units. Before proceeding, it is important to clarify that 

this section does not concern the costs and benefits of securitization per se. Securitization, like 

other forms of asset sales (such as loan sales), creates potential adverse selection and moral 

hazard problems due to asymmetric information; for instance, investors may be concerned that 

firms will be more likely to sell or securitize loans about which they have adverse private 

information. 
- 24 - 

As discussed below, concerns about asymmetric information were one reason that firms provided 

implicit recourse to SPV investors, and some existing research on implicit recourse uses data 

from credit card securitizations. However, securitizations did not necessarily create a 

presumption of implicit recourse among investors; for instance, recourse for investors in 

asset-backed commercial paper and mortgage backed securities was available only in explicit 

pre-specified circumstances. Conversely firms provided implicit recourse in many cases that did 

not involve securitization, such as recourse to sponsored hedge funds. 

REVIEW OF THE LITERATURE

IMPLICIT RECOURSE

Implicit recourse manifests itself in many different forms. Examples include the transferor 

selling assets to an SPV at a discount; buying assets from the SPV at a premium; exchanging 

performing assets for nonperforming assets; and providing new credit enhancements such as 

additional “overcollateralization” of the trust beyond what was agreed to under the original terms 

of the deal. The frequent occurrence of implicit recourse in securitization deals that involve 

revolving asset pools is especially well-documented. For example, Higgins and Mason (2004) 

study 17 actual recourse events related to credit card securitizations. They find that following 

each recourse event, the market reacted favorably and rewarded providers of recourse with 

higher short- and long-term stock price performance and better long-term financial performance.4 

Further studies are required to understand the reactions to recourse events that occurred during 

the recent financial turmoil. However, even if individual firms benefit from providing implicit 

recourse, the existing literature has less to say about the overall effect of implicit recourse on the 

health of financial markets. 

The existence of implicit recourse is typically regarded as either an efficient response to market 

failures caused by asymmetric information or a form of regulatory capital arbitrage. Gorton and 

Souleles (2005) take the former view. They develop a model in which the ability to sell assets 

into an off-balance sheet SPV benefits the transferor by allowing it to economize on bankruptcy 

costs: bankruptcy procedures entail the long and cumbersome transfer of control rights over 

assets to creditors, and because SPVs are bankruptcy-remote, off-balance sheet financing reduces 

the quantity of assets that are subject to such transactions. However, the transferor is subject to 

an adverse-selection problem: investors may refuse to finance the SPV if the firm has private 

information about asset quality before it decides which assets to sell into the SPV. Investors 

would rationally assume that the transferor has an incentive to offload assets that are poor in 

ways not observed by the market, reducing their willingness to pay for the deal. If the transferor 

 

4

 However, the authors find that sponsoring firms face long delays before being able to issue new securitizations. 
- 25 - 

and the investors only interact one time, the former cannot commit to not engage in strategic 

adverse selection. However, if firms interact repeatedly, implicit recourse facilitates 

securitization because the transferor can gain a reputation for supporting the pools of assets that 

become distressed. This effectively provides the transferor a strong incentive to not engage in 

adverse selection. The model implies that implicit recourse may lower the costs of obtaining 

financing by addressing concerns of asymmetric information; accordingly, limits that prevent 

implicit recourse may raise the cost of financing and final cost of credit. The model makes no 

predictions about the effect of requiring explicit recourse or risk retention, as required in Section 

941 of the Dodd-Frank Act. 

Calomiris and Mason (2004) focus on implicit recourse as a form of regulatory arbitrage: 

implicit recourse allows sponsoring firms that are subject to capital requirements to reduce 

regulatory capital while retaining exposure to risky assets. This form of arbitrage may have 

either beneficial or detrimental effects. One the one hand, the ability to take on hidden risks 

opens the possibility of firms abusing the government’s safety net (e.g., deposit insurance and 

access to the Federal Reserve discount window). On the other hand, the authors argue that 

regulatory arbitrage may be socially beneficial if regulatory capital requirements are inefficiently 

high. In this case, implicit recourse merely restores capital to its most efficient use. 

Implicit recourse provided by financial institutions to outside investors raises many of the same 

issues as subsidized funding provided by banks and other insured depository institutions to 

affiliated entities that engage in non-banking activities. Forms of the subsidy may include 

overpaying for securities issued by the affiliated firms or extending loans on terms more 

favorable than what would be extended to unaffiliated firms, with the result that risk is 

transferred from the affiliated firm to the depository institution. 

Certain regulatory “firewalls” currently in place limit such transfers of risk between insured 

depositories and affiliated firms. Most notably, Sections 23A and 23B of the Federal Reserve 

Act limit the total volume of “covered transactions” between a member bank and affiliates and 

prohibit the extension of terms more favorable than what in good faith would be extended to 

unaffiliated firms. Sections 23A and 23B limit, but do not entirely eliminate risk transfer. 

However, the extent to which depositories actually exploit loopholes in the firewall and engage 

in risk transfer to affiliates is a little-studied question (for example, see Whalen, 1997, who 

documents the limited literature.) More generally, the extent to which implicit recourse 

enhances allocative efficiency or leads to abuse of the safety net is an empirical question and 

deserves closer study. 

RISK TRANSFER AMONG CONSOLIDATED SUBUNITS OF A FIRM

Many firms engage in “enterprise-wide risk management,” which is the practice of evaluating 

risk exposures at the level of the entire firm, taking into account the marginal contribution of 
- 26 - 

each subunit’s activities to overall risk. The allocation of financing across subunits through 

internal capital markets allows firms to manage overall risk exposures while preserving 

decentralized decision making. For example, a subunit that increased exposure to a particular 

risk would have to purchase additional capital from the rest of the firm, forcing the subunit to 

pay a “market” price for taking on that additional risk. Through the transaction, some of that risk 

is effectively transferred to the rest of the firm. 

A number of studies in management science analyze the implementation of enterprise-wide risk 

management. Nocco (2006) discusses enterprise risk management for firms in general, while 

Cumming and Hirtle (2001) and Saito (1999) specifically discuss enterprise risk management for 

financial firms. Most of these studies imply that restrictions on risk transfer are likely to be 

costly for firms and thus could increase the cost of credit and other financial services. For one 

thing, restrictions may force firms to adopt a more “balkanized” risk management approach that 

does not take into account interactions among the activities of different subunits. Moreover, 

business units may be forced to seek external counterparties for transactions that would be more 

efficiently carried out internally. For example, complementary activities at different subunits 

often serve as “natural hedges” for each other, reducing reliance on external hedges (Cumming 

and Hirtle 2001). Contracting with external parties tends to be costlier due to transaction costs 

across firm boundaries. Restrictions on risk transfer may also limit an additional benefit of 

enterprise-wide risk management, which is that it gives firms an incentive to put effort into 

identifying the shadow cost of each business unit’s activities to the overall riskiness of the firm. 

To the extent that restrictions on risk transfer reduce such effort, hidden risks may remain 

unexposed. 

Not all of the evidence favors the use of internal market mechanisms for risk transfer, however. 

For one thing, there are many different types of risk (credit, liquidity, operational, reputational, 

etc.), and it is not clear that any capital allocation mechanism is capable of managing all of these 

risks (Cumming and Hirtle 2001). Moreover, intra-firm risk transfer programs can sometimes 

generate perverse managerial incentives. For example, Tufano (1998) gives an example of how 

business unit managers may have an incentive to engage in “cash flow hedging” —measures to 

ensure that the business unit always has excess cash, in order to reduce reliance upon the internal 

capital market. This practice may shield inefficient projects from scrutiny and allow managers to 

act against the best interest of shareholders. 

SUMMARY

Restrictions on risk transfer can, in theory, have both positive and negative effects. The overall 

effect is likely to depend upon their specific implementation. Implicit recourse is a way for 

sponsors of SPVs to commit to not engaging in adverse selection through long-run reputational 

effects. Limits on implicit recourse would remove a form of contracting that is efficiency 

enhancing from the perspective of individual firms, and would likely prevent certain types of 
- 27 - 

asset sales from occurring. The cost of obtaining funds would rise for some sponsoring firms, 

such as originators of riskier assets for which private information plays a larger role. Whether or 

not preventing such deals from occurring is beneficial for the economy as a whole deserves 

further study. 

Implicit recourse may allow firms to circumvent capital regulations and take on more risk than 

they are charged for through capital requirements. Restrictions on such risk transfers may limit 

banks’ ability to exploit the government safety net. However, an argument against limiting 

regulatory arbitrage is that doing so would, at least in theory, prevent firms from avoiding capital 

requirements that could be inefficiently high. 

Limits on risk transfer among consolidated business units would reduce the ability of firms to 

use enterprise-wide risk management. Firms would most likely be forced to adopt a more 

balkanized, and potentially costlier, approach to internal capital allocation. Restrictions on risk 

transfer may also reduce the efficient use of “natural” hedges generated by activities at different 

business units, forcing individual business units to seek outside sources of hedging at a higher 

overall cost. Firms may also have a reduced incentive to identify the true shadow cost of each 

business unit’s activities to overall riskiness of the firm. 

The above arguments must be tempered by the consideration that, in practice, internal capital 

allocation mechanisms may not adequately account for all the different types of risk that a firm 

may face. If not, then the firm’s internal market for capital may not be an effective way to 

manage risk. Moreover, perverse managerial incentives may lead to cash flow hoarding that 

shields inefficient projects from scrutiny. Each of these factors would tend to reduce the 

costliness of limiting risk transfers. 

Section 941 of the Dodd-Frank Act addresses adverse selection by requiring securitizers to retain 

a share of the credit risk of transferred assets. However, Section 941 leaves great discretion to 

regulators to implement this requirement. Regulators will determine the amount of risk 

securitizers will retain, the form(s) in which they may retain it, and other critical elements. The 

regulators are still in the process of formulating a proposed regulation for comment. The Chair 

of the FSOC is coordinating the rulemaking process, as required by Section 941. The study 

required by section 946, which is being released simultaneously with this study, considers these 

issues and contains recommendations. 

 
- 28 - 

SECTION E: COSTS AND BENEFITS OF REQUIREMENTS TO CARRY 

CONTINGENT CAPITAL OR SIMILAR MECHANISMS

Contingent capital or similar mechanisms are arrangements that are intended to bolster the 

solvency of a financial institution following a trigger event (typically a measure of distress). 

Such arrangements can include debt-to-equity swaps or a permanent write-down of debt. These 

instruments have been discussed as a potentially lower-cost form of loss-absorbing capital that 

could be helpful in addressing some of the challenges faced in the most recent financial crisis. 

For example, in the recent crisis: (i) traditional hybrid securities did not always absorb loss in the 

manner anticipated ex-ante; (ii) many market participants discounted the value of such traditional 

hybrid capital instruments, by focusing on measures such as tangible common equity; and 

(iii) the level of total capital was insufficient to absorb the losses incurred by the firms. 

Accordingly, policy makers have sought to improve both the quality (loss absorbency), as well as 

the level of capital. Contingent capital seeks to facilitate both, by ensuring that investors in 

contingent capital instruments can be made to take losses by converting to capital when a 

financial institution reaches or approaches insolvency, and by reducing the overall cost of 

maintaining such higher levels of capital. Although widespread agreement on the structural 

design of contingent capital arrangements remains unresolved, some research suggests that 

contingent capital requirements implemented when the chances of a downturn or a financial 

panic seem remote could make them relatively cheap compared to raising new capital in the 

midst of a recession or after a financial panic in a period of great uncertainty (see Kashyap, 

Rajan and Stein (2008), Rajan (2009), and Squam Lake Working Group (2009)). 

Moreover, contingent capital arrangements may increase market discipline and help to contain 

some governance problems at financial institutions, such as banks.5 Once in place, contingent 

capital mechanisms may provide incentives for managers to raise capital when they anticipate 

losses are on the horizon. For example, institutions that remain well-capitalized through 

earnings retention could avoid the dilutive effect of forced debt-to-equity conversion under some 

arrangements. In this sense, contingent capital can buttress market discipline, reduce the 

likelihood of failure, and deter excessive risk-taking. Therefore, such arrangements may be a 

more efficient way to reduce the probability of financial institution failures than requiring higher 

capital levels in good times and bad. 

For such reasons, some policymakers have expressed an interest in potentially employing 

contingent capital or similar mechanisms to reduce systemic risks, to implement countercyclical 

 

5

 Kashyap, Rajan, and Stein (2008) discuss how agency problems play an important role in shaping bank capital 

structures. They argue that banks mainly fund their balance sheets with short-term debt because such creditors are 

better protected from the actions of wayward bank management. These authors also argue that the reduced cost of 

additional capital can dampen a bank’s incentive to engage in regulatory arbitrage. 
- 29 - 

capital buffers, or to reduce the exposure of taxpayers to losses. To achieve such ends, various 

triggers have been proposed, either referencing the financial condition of the individual 

institution, or more broadly, the condition of the financial system (often referred to as ‘macro’ 

triggers). Firm specific triggers may include, but are not limited to: (i) regulatory capital based 

triggers; (ii) regulatory discretion, whereby the instrument would convert at the direction of the 

firm’s regulator; (iii) a market based trigger, referencing liquid and broadly quoted instruments, 

such as a firm’s stock price or credit default swap (CDS) pricing; and (iv) when the firm reaches 

a point of non-viability.6

As noted herein, there have been limited issuances of contingent capital instruments to date. 

Some have expressed concerns about the feasibility of contingent capital, including the ability to 

market these instruments in sufficient sizes, the pricing such instruments would achieve, the 

ability for such instruments to generate capital when needed, and the efficacy of such capital 

generation in mitigating runs. Accordingly, the arguments in support of contingent capital 

requirements are largely theoretical, and will not be resolved absent further analysis by policy 

makers, and ultimately, the future sale of such securities, if deemed prudent. 

To date, contingent capital and similar mechanisms remain in the nascent stage of development. 

The academic literature on such mechanisms is growing rapidly with interest in the topic from 

policymakers, but it remains scant. Section 115(c) of the Dodd-Frank Act requires the Financial 

Stability Oversight Council to release a study within two years of enactment on the feasibility, 

benefits, costs, and structure of a contingent capital requirement for designated nonbanks and 

large bank holding companies. Pursuant to the release of this study, the Council may make 

recommendations to the Board of Governors to require these firms to maintain a minimum 

amount of contingent capital. 

On the international front, the Basel Committee on Banking Supervision is currently assessing 

whether such arrangements are appropriate for meeting a portion of required maintained capital 

buffers held by banking organizations and/or for assisting in the resolution of institutions that are 

under stress. Moreover, in October 2010, the Financial Stability Board recommended that 

greater loss absorbency capacity could be drawn from a menu of viable alternatives including “a 

quantitative requirement for contingent capital instruments and a share of debt instruments or 

other liabilities represented by “bail-inable” claims, which are capable of bearing loss at the 

 

6

 The Basel Committee on Banking Supervision released a Proposal to ensure the loss absorbency of regulatory 

capital at the point of non-viability for comment in August 2010 that defined non-viability as: “(1) the decision to 

make a public sector injection of capital, or equivalent support, without which the firm would have become nonviable, as determined by the relevant authority; and (2) a decision that a write-off, without which the firm would 

become non-viable, is necessary, as determined by the relevant authority.” 
- 30 - 

point of non-viability, i.e. within resolution, thus enabling creditor recapitalization and recovery 

while maintaining vital business functions.”7 

REVIEW OF THE LITERATURE

The existing literature is not advanced enough to justify quantitative statements on the impact of 

contingent capital on growth. Moreover, the few financial institutions that have made such 

arrangements have not provided sufficient data to assess how various potential features 

(e.g. different trigger types) would affect costs. 

Lacking empirical evidence, the literature has generally focused on theoretical analyses of 

alternative types of contracts designed to provide capital when it is needed, in a manner that 

solves the debt overhang problem.8

 Flannery (2009), for example, proposes “contingent capital 

certificates,” a form of debt that would convert to equity when a firm’s contemporaneous market 

value falls below a pre-specified threshold value (e.g., 4 percent of total assets). He envisions 

that the face value of converted debt would purchase a quantity of shares implied by the market 

price of common equity on the date of conversion. He argues that contingent capital certificates 

would (1) recapitalize a firm promptly after it has suffered losses, (2) lower the firm’s probability 

of default and loss following the debt-to-equity swap, and (3) lower the all-in cost of loss 

absorption capacity, since such instruments are likely to receive a favorable tax treatment. 

Moreover, he argues that conversions would tend to mitigate the pro-cyclical effects of capital 

standards, since new equity would be provided when loan losses are exceptionally high. 

Building on Flannery’s proposal, Pennacchi, Vermaelen and Wolff (2010) have proposed that 

financial institutions issue Call Option Enhanced Reverse Convertible (COERC) bonds, a form 

of subordinated debt that converts to equity when the market value of equity falls below a 

pre-specified trigger. In their proposal, the conversion price would be set significantly below the 

trigger price, and shareholders would be provided the option to buy back the shares from the 

bond holders at the conversion price. These authors reason that the first feature would severely 

dilute existing shareholders upon conversion, giving the shareholders a strong incentive to 

exercise the call option and buy back the shares from the bondholders at the low conversion 

price. As a result, the combined effect of reaching the trigger is that the bondholders are paid in 

full, while the shareholders inject new equity into the financial institution in the amount of the 

convertible bond. If existing shareholders do not desire to hold more shares in the firm, then 

they can simply sell their call options to others. Pennacchi, Vermaelen and Wolff argue that 

COERC bonds would force capital into the firm at a time of financial distress while retaining 

 

7

 See Financial Stability Board, 2010, “Reducing the Moral Hazard Posed by Systemically Important Financial 

Institutions: FSB Recommendations and Time Lines,” October. 

8

 The firm faces a debt overhang problem when the face value of the existing debt is bigger than the expected payoff 

to debt holders. In such circumstances, debt holders will not finance the firm. 
- 31 - 

some of the desirable features of debt (e.g. the discipline on managers), and would reduce the 

cost of contingent capital, because bondholders would typically be repaid at full. Also, because 

bondholders would never get more than par, COERC bonds would have a lower risk of “death 

spirals,” in which the share price drops sharply once it gets sufficiently close to the conversion 

trigger merely because of the prospect of imminent dilution of existing shareholders. 

Other researchers have considered whether more than one trigger event should be included in a 

contingent capital contractual arrangement. For example, the Squam Lake Working Group on 

Financial Regulation (2009) proposes a contingent capital instrument that would convert from 

debt to equity only when two conditions are jointly met, namely (1) a declaration has been made 

by regulators that the financial system is suffering from a systemic crisis, and (2) the financial 

institution has violated the covenants in the hybrid-security contract (e.g. a covenant based on 

capital adequacy, such as a minimum ratio of Tier 1 capital to risk-adjusted assets). The 

Working Group argues that the double trigger is important for three reasons: (1) debt is 

valuable, since debt holders can put a firm into bankruptcy; (2) the institution-specific trigger 

assures that sound firms will not convert debt to equity unnecessarily; and (3) conversion is 

limited to periods of systemic crisis, so that the hybrid security functions like debt except in the 

most extreme circumstances. That is, the hybrid security would not morph into equity merely 

because the firm suffers idiosyncratic losses, so market discipline would be preserved even while 

the financial system would be better protected against systemic risk. 

Similarly, McDonald (2010) has proposed a contingent capital instrument that would convert 

from debt to equity only when two conditions are met, namely (1) the financial institution’s stock 

price is at or below a trigger, and (2) the value of a financial institutions index is also at or below 

a trigger value. In addition, McDonald’s proposal stipulates that the underlying debt would 

convert into a fixed number of shares at a premium price. He argues that his instrument would 

(1) protect financial institutions by reducing their debt load during a crisis when all firms are 

performing poorly, while permitting a financial institution that is in poor condition in normal 

times to go bankrupt; (2) avoid the problem that regulators may not declare the existence of a 

crisis until it is too late to restructure firms; and (3) avoid potential “death spiral” problems, 

because the number of shares that debt holders would receive in a conversion is fixed. 

Two recent examples of actual contingent capital contracts are Lloyds Banking Group and 

Rabobank Group. On November 3, 2009, Lloyds Banking Group offered to swap 16.5 billion 

pounds of bonds and preference shares for equity and new dated notes—known as contingent 

core Tier 1 securities—that will automatically become equity if the bank’s core capital falls to 

less than 5 percent. This offering was designed to bolster the institution’s capital so that it 

would not have to take part in the UK government’s Asset Protection Scheme. These new bonds 

counted toward core capital because they could convert to equity. On March 12, 2010, 

meanwhile, Rabobank Group issued 1.25 billion Euro of a 10-year, fixed-rate, Senior Contingent 

Note. This note will be written down to 25 percent of its face value if Rabobank's equity ratio 

declines below 7 percent. The Senior Contingent Note was considerably oversubscribed when it 
- 32 - 

was launched. However, the issuer’s unusually strong credit profile raises questions about 

whether this transaction is indicative of broader investor demand. 

Although the foregoing examples are focused on restructuring a solvent financial institution, 

other proposals have focused on the process for resolving a failing financial institution. For 

example, Calello and Ervin (2010) argue that regulators should be given legal authority to dictate 

the terms of a recapitalization, subject to an agreed-upon framework. The details would vary 

from case to case, but the process would work as follows: First, the assets would be written 

down. Second, if existing shareholders are wiped out, then preferred-stock and 

subordinated-debt investors would have their stakes converted to equity at pre-specified terms. 

Third, if the firm remains undercapitalized, then senior unsecured debt holders would have a 

portion of their stake converted to equity. Under the Calello and Ervin proposal, the financial 

institution’s previous shareholders would receive warrants if the firm’s losses have wiped them 

out. These warrants would only have value if the new financial institution rebounded. Existing 

management would be replaced after a brief transition period. This is an example of a “bail-in” 

contractual arrangement, and is similar to contingent capital mechanisms. 

Still other proposals have focused on using contractual arrangements to stabilize the financial 

system during a severe downturn or systemic event. For example, Kashyap, Rajan and Stein 

(2008) propose using an insurance contract to recapitalize financial institutions upon the 

occurrence of a systemic event—defined as a situation in which aggregate write-offs of major 

financial institutions in a given period exceed a pre-specified trigger level. This insurance 

contract would be default-proof, since the insurer (e.g. a sovereign wealth fund or a pension 

fund) would at inception put cash and Treasury securities into a “lock-box.” If there is no 

systemic event over the life of the contract, the cash and securities would be returned to the 

insurer, who would also receive an insurance premium from the financial institution as well as 

the interest on the Treasury securities. However, if there is a systemic event, the cash and 

securities would be transferred to the balance sheet of the insured entity, thereby increasing its 

capital and liquidity. 

These brief descriptions of various contingent capital proposals, actual contracts in place, and 

related mechanisms, demonstrate the diversity of contractual arrangements that could potentially 

be used by financial regulators. At this time, there is no consensus on the optimal contractual 

arrangement that would promote financial stability, increase market discipline, and foster 

prudent risk-taking by financial institutions. Clearly, more work is needed to identify 

arrangements that would most effectively stabilize credit provided by financial intermediaries 

and most closely align private and social costs of financial institution risk exposures. Moreover, 

the investor appetite for such ideal contractual arrangements is unclear. 
- 33 - 

SUMMARY 

The benefits and costs of contingent capital and similar mechanisms for financial firms and the 

wider economy will critically depend on the specific features of the contracts—what kind of 

structure is employed (e.g. debt-to-equity swap or insurance contract), what type of trigger is 

used (e.g. firm-specific or systemic), and what threshold is set for actions such as a 

recapitalization through a cash injection or a debt write-down. Such features will affect how 

frequently recapitalization or other actions take place and whether the mechanism achieves the 

desired results (e.g. greater market discipline, more stable credit, greater loss absorption capacity 

through larger capital buffers, and less systemic risk). Equally important for cost-benefit 

analysis are the tax, legal, and regulatory frameworks in place over the life of the contract. 

On the benefit side, much of the academic literature has focused on the potential for contingent 

capital to (1) reduce systemic risk; (2) augment market discipline on systemically-important 

financial institutions; (3) reduce incentives to shift activities to unregulated firms during boom 

times; (4) align private costs with the social costs associated with systemic risks through 

privately-provided “tail-risk” insurance; and (5) provide incentives for systemically-important 

firms to raise capital when they anticipate losses. 

It is unclear to what extent these benefits could be realized in practice. With regard to potential 

costs, much of the academic literature has focused on whether specific contingent capital 

contracts would result in unfavorable market dynamics, such as “death spirals” or a “run” on 

financial firms with similar exposures. Another concern addressed by the literature is that 

debt-to-equity conversions or other actions to recapitalize a firm could be taken too early or too 

late. For example, a financial institution may remain subject to a “run” by short-term liability 

holders even if it has buffer of contingent capital in place, because such investors may perceive 

that capitalization will remain thin enough after the triggering event to encourage the 

management to “bet-the-bank” by taking on excessive risk. Importantly, some recent research 

has used back-testing to explore the performance of various contingent capital mechanisms.9

 

This study will not make specific recommendations on the structure of requirements to carry 

contingent capital or similar mechanisms. Section 123 calls for follow-up studies every five 

years. This study recommends that the periodic study due in 2016 consider the experience of 

 

9

 DeMartino, Libertucci, Marangoni, and Quagliariello (2010) have back-tested contingent capital structures like the 

one proposed by the Squam Lake Working Group using data on the largest 15 banks in terms of total assets across 

eight countries (Canada, France, Germany, Italy, Spain, Japan, the UK, and the US) over 1994-2009. They consider 

several financial institution-specific triggers, based on the total capital ratio, the Tier 1 capital ratio, leverage, return 

on equity, and abnormal returns over several different horizons. For the financial index, they consider returns of 

domestic banking indices over different horizons and a deviation of GDP over trend. The authors report that their 

simulations indicate that common thresholds across jurisdictions with definitions of supervisory capital do not work 

well, but market-based triggers work better at identifying banks that are troubled. 
- 34 - 

implementing the Dodd-Frank Act and any further original research, and consider making more 

specific recommendations. The study required by section 115(c) will also consider these issues. 

 
- 35 - 

SECTION F: COSTS AND BENEFITS OF LIMITS ON COMMINGLING OF 

COMMERCIAL AND FINANCIAL ACTIVITIES BY LARGE FINANCIAL 

INSTITUTIONS

This section reviews the existing literature on the commingling of commercial and financial 

activities by large financial institutions. This literature typically focuses on what is often called 

“the mixing of banking and commerce,” which involves the entry of commercial firms into the 

market for banking products or services or, conversely, the entry of banking firms into the 

market for commercial products or services. Although many of the issues are transferable, the 

discussion does not address the related issue of whether banking organizations should be allowed 

to take long-term positions in the equity of commercial firms to which they lend.10 

Historically, the United States has legally separated the business of banking from that of general 

commercial activities. The Bank Holding Company Act includes general restrictions on the 

mixing of banking and commerce and federal law has long prevented commercial banks from 

affiliating with commercial companies. A recent Treasury report argued that existing restrictions 

on the mixing of banking and commerce have prevented conflicts of interest, risks to the federal 

safety net, regulatory and supervisory difficulties, potential biases in the allocation of credit and 

concentration of economic power. The report concluded that “the wall between banking and 

commerce should be retained and strengthened.”11 Other countries, notably Japan, have made 

different choices and have allowed the mixing of commerce and banking. 

Clearly, there are benefits and costs to limiting the mixing of banking and commerce. In relation 

to lending, these limits could affect the supply and cost of credit. For example, limits on the 

mixing of banking and commerce may help prevent conflicts of interest such as preferential 

funding of the commercial affiliate or real and perceived tying of products, as addressed in the 

anti-tying restrictions of section 106 of the Bank Holding Company Act. This would improve 

the allocative efficiency of credit by preventing the misallocation of credit for the purpose of 

commercial gain. However, it is possible that limits would prevent the entry into banking of 

commercial firms that could improve competition for credit, increase innovation and promote 

economies of scope. 

Limits could also affect the amount of risk in the financial system. Separation of banking and 

commerce can protect the safety and soundness of a bank by preventing the risks of an 

organization’s commercial activities from directly or indirectly affecting the financial health of 

an affiliated bank. Similarly, separation would prevent a bank from inappropriately supporting a 

 

10 Although officers of banking organizations in the U.S. may sit on the board of directors of firms to which they 

lend, the ability of U.S. banking organizations to own significant, long-term equity interests in commercial firms is 

limited by U.S. law. Banks are allowed to hold corporate equity in other countries, such as Germany and Japan. 

11 Financial Regulatory Reform: A New Foundation, Department of Treasury, 2009, p. 34, 
- 36 - 

failing commercial parent or affiliate, which could jeopardize the bank’s solvency. These 

precautions would be in line with Sections 23A and 23B of the Federal Reserve Act, which limit 

bank transactions with parents and affiliates. Separation would also prevent inadvertent 

expansion of the federal safety net. Without separation, a bank’s commercial parent or affiliates 

could indirectly benefit from the bank’s status as an insured depository institution. However, 

one of the costs of such limits would be to prevent certain entities from providing equity capital 

to establish a financial institution or assist in purchasing a troubled institution. 

While Gramm-Leach-Bliley expanded the range of financial activities that may be conducted by 

qualifying banking organizations, it intentionally left in place the separation of banking and 

commerce (i.e., the separation of financial and nonfinancial activities). According to Krainer 

(2000), many of the architects of Gramm-Leach-Bliley argued that the United States should 

maintain its existing separation of banking and commerce. 

There are several existing loopholes within current U.S. law concerning the barrier between 

banking and commerce. One of the most significant involves industrial loan companies (ILC). 

Current law allows commercial firms to operate an ILC without being subject to the same 

regulatory oversight and capital requirements as bank holding companies. Currently, only seven 

states allow for an ILC Charter and the vast majority of assets under ILC control are located in 

three states. In many respects, ILCs have similar authorities to those of commercial banks, 

including access to the federal safety net, although there are limits on their ability to accept 

demand deposits. In 2005, the debate over the integration of banking and commerce resurfaced 

when several major commercial companies applied to acquire an ILC. The following year, the 

FDIC announced a moratorium on all ILC applications and encouraged Congress to address the 

issue through legislation.12 The Dodd-Frank Act places a temporary legal moratorium on new 

acquisitions of ILCs by commercial firms, but this moratorium will expire on July 21, 2013.13 

The Treasury has proposed ending the ILC loophole and requiring holding companies of ILCs to 

become bank holding companies.14 

REVIEW OF THE LITERATURE

Due to the specific nature of the policy issue, there is not a large economic literature in this area. 

There is empirical evidence on the experience with universal banking in Europe, but the 

 

12 At the time, there were 58 ILCs operating in seven states. 

13 Prior to the Gramm-Leach-Bliley Act, commercial firms also were permitted to acquire a single FDIC-insured 

savings association and become a “unitary” savings and loan holding company. In the GLB Act, Congress closed 

the unitary savings and loan holding company loophole in order to prevent the formation of new unitary holding 

companies. 

14 Financial Regulatory Reform: A New Foundation, Department of Treasury, 2009, p. 35. 
- 37 - 

European model permits the mixing of different kinds of financial activity, as opposed to the 

mixing of banking and commerce. Empirical evidence from Japan on the mixing of banks and 

corporations has shown that misdirected lending played a role in prolonging the Japanese 

macroeconomic stagnation that began in the early 1990s (Caballero, Hoshi and Kashyap 2008). 

Focusing on the literature relevant to the U.S., there are several survey articles that lay out the 

issues on both sides of the debate.15 

Saunders (1994) and Blair (2004) provide an overview of the public policy case for and against 

relaxing the separation between banking and commerce in the United States. The studies cite as 

potential costs the concentration and potential monopolization of financial services activities, 

increased conflicts of interest, and concerns about bank soundness and expansion of the bank 

safety net to commercial activities. The studies also cite potential benefits, which could include 

cost and revenue synergies, product and geographic diversification, new sources of capital, and 

increasing competitive pressure on inefficient management. 

Krainer (2000) offers another perspective on the mixing of banking and commerce. He notes 

that a number of large banks today began as the finance arms of commercial enterprises. The 

author also addresses potential issues arising from informational advantages. For instance, 

finance companies can use the parent firm’s knowledge of a product or demand to secure a 

funding advantage over traditional lenders. While this offers potential opportunities for 

economies of scope, policy makers may also be concerned about potential abuses of this 

information for anticompetitive purposes due to conflicts of interest. 

Reichert, Wall and Lang (2008) analyze the potential diversification benefits of mixing banking 

and commerce. They argue that financial theory suggests that combining assets in an efficient 

portfolio allows an investor to obtain a given return at lower risk. The authors calculate the 

correlation of returns across ten major industry categories and find that diversification benefits 

could result from combining banking with construction, retail, or wholesale trade. This work 

does not address potential costs associated with mixing banking and commerce. 

Going forward, additional empirical work analyzing the effects of current U.S. policy on the 

separation of banking and commerce would be helpful in better understanding both the costs and 

benefits of our current policy. Work that analyzes the effects of this separation in light of the 

financial crisis of 2008 would be of particular interest, as would work that analyzes the ILC 

loophole’s effect on various commercial companies and markets. 

 

15 The existing literature primarily addresses effects on financial firms rather than implications for the real economy, 

so the potential effects on economic growth are not addressed here. 
- 38 - 

SUMMARY

The literature identifies several clear benefits that arise from the separation of banking and 

commerce. Separation of banking and commerce may prevent conflicts of interest that would 

undermine the independence and neutrality of banks in the allocation of credit. Separation may 

also prevent market power distortions that might arise from the cross-subsidization of 

commercial and financial products within large conglomerates. If such market power were used 

inappropriately, it could result in traditional banks being priced out of certain financial services. 

Separation would also prevent the transfer of risk from commercial firms to banking affiliates or 

an unintentional expansion of the federal safety net. 

The literature also identifies potential costs of limiting the mixing of banking and commerce. 

These costs could include reduced supply and increased cost of credit. Separation of banking 

and commerce could reduce technological efficiency by reducing the economies of scope that 

come from cross-selling and “one-stop shopping.” For example, fixed costs of collecting, 

processing and assessing information can be spread across a range of commercial and financial 

services, such as a payments system internal to the commercial entity. Separation of banking 

and commerce could also prevent a bank from diversifying its earnings with multiple income 

streams. Empirical studies of both the benefits and costs, however, are limited. 
- 39 - 

SECTION G: COSTS AND BENEFITS OF SEGREGATION REQUIREMENTS 

BETWEEN TRADITIONAL FINANCIAL ACTIVITIES AND TRADING OR 

OTHER HIGH-RISK OPERATIONS IN LARGE FINANCIAL INSTITUTIONS

The traditional separation of banking and other financial activities in the United States began to 

erode in the 1970s. The last decade saw the emergence of large, complex financial institutions 

engaged in commercial and investment banking, as well as the emergence of a shadow banking 

system outside the formal banking sector. The financial crisis has triggered a reconsideration of 

the costs and benefits of separation between banking and other financial activity. The 

Dodd-Frank legislation contains restrictions on bank engagement with hedge funds, proprietary 

trading and derivatives, as well as provisions designed to limit shadow banking, such as 

expanded resolution authority over nonbank financial institutions. 

This section reviews literature on the costs and benefits of separation of banking from other 

financial activities. Opponents of separation argue that allowing institutions to engage in a broad 

variety of financial activities promotes competition, diversification, and economies of scope. 

Supporters of separation argue that combining banking and nonbanking activities in one 

organization leads to increased risk, at both the institutional and systemic level. According to 

this view, securities underwriting, dealing, proprietary trading and other “nonbank” activities are 

inherently risky and lie outside the core competencies of both bankers and their regulators. 

Moreover, according to this view, since banks have access to deposit insurance and the discount 

window, combining banking and nonbanking activities in one organization exposes the safety net 

to the downside risk of nontraditional activities, encourages capital flows into non-traditional 

activities and may increase systemic risk. This view holds that access to deposit insurance and 

the discount window provides an effective subsidy to nontraditional banking activity, as public 

backstops reduce the cost of funds for qualifying institutions. 

Supporters of separation also argue that allowing lightly-regulated shadow banks to engage in 

bank-like activity, particularly maturity transformation, increases systemic risk. Recent and past 

financial crises suggest that maturity transformation is inherently fragile in the absence of 

explicit public backstops, as runs can rapidly turn investor concerns about insolvency into a 

self-fulfilling prophecy. Supporters of separation argue that the best way to prevent such runs is 

to insist that banking activity be limited to formal banks subject to prudential supervision and 

explicit public backstops. 

REVIEW OF THE LITERATURE

Banks in recent years have increasingly engaged in a variety of nontraditional activities. This 

section first reviews evidence on the costs and benefits of allowing banks to underwrite 

securities. It then discusses the costs and benefits of bank trading of derivatives. This is 
- 40 - 

followed by a discussion of the costs and benefits of allowing banks to engage in other 

nontraditional activities, including proprietary trading. Finally, this section discusses the costs 

and benefits of allowing financial institutions outside the formal banking sector to engage in 

banking activity. 

SECURITIES UNDERWRITING 

The Glass-Steagall Act prohibited commercial banks and their affiliates from underwriting or 

dealing in corporate securities. Supporters argued that this prohibition was necessary to prevent 

lenders with adverse private information from selling securities of weak firms to an unsuspecting 

public in order to offload credit risk. A contrary argument is that commercial banks would want 

to establish a reputation for underwriting high quality securities, and that in equilibrium the 

public could regard lender underwriting as a signal of favorable private information. A number 

of studies have examined the impact on returns of bank underwriting of corporate debt, both 

prior to Glass-Steagall and after 1987, when the Federal Reserve first allowed Section 20 

affiliates of commercial banks to underwrite corporate securities to a limited degree. Krozner 

and Rajan (1994), Ang and Richardson (1994) and Puri (1994) find that corporate bonds 

underwritten during the 1920s by commercial banks or their affiliates had lower ex-post default 

rates than comparable bonds issued by investment banks, and Puri (1996) finds that issues 

underwritten by commercial banks or their affiliates during this period had lower ex-ante yields 

than comparable investment bank issues. Gande, Puri, Saunders and Walter (1997) examine debt 

issued between 1993 and 1995 and find lower initial yields on issues underwritten by Section 20 

affiliates of commercial banks with a prior lending relationship with the firm. Moreover, this 

effect is only present for below-investment grade issues whose stated purpose is not to repay an 

existing loan. This evidence suggests that the public perceives a beneficial certification effect of 

underwriting by lender affiliates, at least for the most information-opaque firms in cases where 

there is no obvious conflict of interest. 

Other studies look at the effect of entry of Section 20 affiliates on underwriting fees charged to 

issuers. Gande, Puri and Saunders (1999) find that the market share of commercial bankaffiliated underwriters rose substantially between 1987 and 1996, especially for below 

investment grade issues, and that this rising market share was associated with lower underwriting 

fees. This result suggests that heightened competition lowered the cost of raising capital for 

information-intensive firms, although Roten and Mullineaux (2002) find no impact of 

commercial bank market share on underwriting fees from 1995 to 1998. Drucker and 

Puri (2005) look at the impact of concurrent lending and underwriting on fees and spreads. They 

find that investment banks charge lower underwriting fees when they have a concurrent or prior 

lending relationship with a firm, while commercial banks charge lower rates on new loans when 

they have a concurrent underwriting relationship with the firm. These results suggest economies 

of scope from spreading the fixed costs of information acquisition over multiple intermediation 

outputs. 
- 41 - 

Another recent literature examines underwriting of asset backed securities (ABS) by commercial 

bank affiliates and other financial institutions. Securitization of mortgages and other assets 

holds the promise of expanding credit supply and making the financial system more resilient, by 

allowing financial institutions to transfer risk from their own balance sheets to outside investors, 

thereby enabling a given amount of internal capital to support more lending. In the case of 

residential mortgages, however, securitization was conducted in an unsafe manner that increased 

risks to individual firms and the financial system. 

Nadalund and Sherlund (2009) find that an SEC rule change in 2003 allowing large brokerdealers to securitize more assets led to increased flows of subprime mortgages. This suggests a 

causal link between securitization and credit creation, although further research should examine 

whether securitization by commercial banks per se also had a causal impact on credit creation. 

One drawback of allowing banks to use securitization to transfer risk to outside investors is that 

banks may have less incentive to screen and monitor loans. There is in fact considerable 

evidence that securitization encouraged underwriters to relax credit quality standards during the 

peak of the housing bubble (Nadalund and Sherlund (2009); Keys, Mukherjee, Seru and Vig 

(2010)) and that servicers of distressed mortgages often act to maximize fees at the expense of 

investors (Levitin 2010). To the extent that risk transfer encourages banks to devote fewer 

resources to screening and monitoring loans, the resulting lower quality of intermediation would 

be a social cost of securitization. Section 941 of the Dodd-Frank Act is meant to reduce this cost 

by requiring securitizers to retain a portion of the credit risk of the underlying assets. 

In some cases, the creators of ABS did retain a considerable amount of risk on their portfolios. 

Even in such cases, however, securitization may have increased systemic risk, because the 

regulatory environment allowed creators of ABS to hold less capital than if they had simply held 

the original assets on their balance sheets. Acharya, Cooley, Richardson and Walter (2009) and 

Krishnamurthy (2010) find that large financial institutions held considerable amounts of 

AAA-rated mortgage-backed ABS on their own balance sheets in 2007 and likely suffered large 

losses as a result. Moreover, banks were required to hold only one-fifth of the capital against 

these ABS that they would have had to hold against the underlying mortgages. Acharya, 

Schnabl and Suarez (2010) study asset backed commercial paper (ABCP) conduits. These 

conduits held long-term, illiquid assets and were financed by short-term debt held by outside 

investors. As a result, they were subject to considerable liquidity risk; if investors became 

concerned about underlying asset quality, they would refuse to roll over, and the conduit would 

struggle to repay investors given the illiquidity of the assets. The authors show that conduits 

sponsored by commercial banks were typically backed by explicit “full liquidity” guarantees, in 

which the bank promised to repay investors in full in the event of a run. Even though banks 

retained the credit risk of the underlying assets, they were required to hold only one-tenth of the 

capital they would have had to hold against comparable assets on their balance sheets. When 

ABCP markets froze in August 2007 over subprime mortgage concerns, sponsoring commercial 

banks paid off ABCP investors in full, often at considerable loss. 
- 42 - 

The Basel III regulatory framework (Basel Committee on Banking Supervision (2010), also 

summarized in Hannoun (2010)), recently endorsed by the G20 countries, includes reforms 

aimed at the concern that securitization was driven in part by a desire to avoid capital 

requirements. The Basel III risk-based capital requirements raise the risk weight on AAA-rated 

tranches of securitizations from 7 to 20 percent (compared to a 35 percent risk weight on 

individual residential mortgages), and apply higher credit conversion factors to short-term 

liquidity facilities provided to off-balance sheet conduits and structured investment vehicles. In 

addition, the framework creates a new leverage ratio requirement, setting a minimum standard 

for a bank’s Tier 1 capital as a share of its total (unweighted) assets, where the latter includes 

balance sheet and off-balance sheet exposures counted on an equal basis. 

Finally, while it is likely that securitization increased credit creation in the past decade, this 

expansion also entailed certain costs, at least in the case of the mortgage market. Mian and Sufi 

(2009), for example, show that the increase in subprime credit enabled by securitization led to 

faster house price appreciation during the bubble period, and larger subsequent price declines. 

Securitization may have enabled lenders to provide mortgage credit at a price lower than its true 

risk-adjusted social cost, both because of regulatory loopholes and because ratings agencies may 

have systematically understated the riskiness of AAA mortgage-backed securities. Coval, Jurek 

and Stafford (2009) and Brennan, Hein and Poon (2009) argue that “ratings arbitrage” was an 

important motivation for mortgage securitization in this period. 

DERIVATIVES

Banks can use interest rate, credit and other derivatives to hedge risks. For instance, traditional 

banks loan long-term and borrow short-term, and are thus vulnerable to rising short-term rates; 

this balance sheet risk can be hedged by using interest rate swaps to create off-balance sheet 

gains when rates rise. However, banks can also use derivatives to take speculative gambles, 

increasing risk. Banks also frequently trade derivatives in an intermediary role in the over the 

counter derivatives market. While banks may have a comparative advantage in making markets 

for certain derivatives, such trading activity exposes banks to counterparty risk. 

Interest rate derivatives are the most common type used by commercial banks. Minton, Stulz 

and Williamson (2009) examine 395 large U.S. bank holding companies, and find that 56 percent 

used interest rate derivatives in 2005, compared to 15 percent for foreign exchange derivatives, 

8 percent for equity derivatives, 6 percent for credit derivatives and 4 percent for commodity 

derivatives. The literature provides mixed evidence on how closely or successfully banks use 

derivatives to hedge interest rate risk. Gorton and Rosen (1995) compare the maturity structures 

of banks’ balance sheet and interest rate swap positions, and find that the largest dealer banks use 

derivatives as a hedge, while large non-dealer banks take derivatives positions that are less well 

hedged by balance sheet risk. Schrand (1997) finds that savings and loans using derivatives have 

lower sensitivity of market value to interest rate movements between 1984 and 1988 than 
- 43 - 

non-derivative users, suggesting that derivatives were used to hedge interest rate risk. Hirtle 

(1997), however, finds the opposite result in a sample of bank holding companies over the period 

1991-1994. Further research would be helpful in reconciling these contradictory results. 

Other recent research looks at the impact of interest rate derivatives on banks’ provision of 

credit. Brewer, Minton and Moser (2000) find that commercial banks using derivatives had 

more rapid growth in commercial and industrial loans over the period 1985-1992 than 

comparable banks not using derivatives, controlling for other factors affecting loan growth. 

Purnanandam (2007) finds that the lending activity of banks using derivatives was more 

insulated from monetary policy shocks during the period 1986-2003 than lending among banks 

not using derivatives. These studies suggest beneficial effects of derivatives on credit supply. 

There is much less research on banks’ use of credit derivatives. Minton, Stulz and Williamson 

(2009) show that credit derivative use among banks is highly concentrated; only 23 out of the 

395 largest bank holding companies in 2005 had any transactions in credit derivatives, and 

virtually all of this volume occurred in just four banks. Moreover, bank credit derivative 

transactions in 2005 were mostly for intermediation purposes rather than hedging. The sum of 

net notional position of sample banks in 2005 was $489 billion, less than ten percent of gross 

positions. The authors estimate that only 2 percent of sample bank loans were hedged with 

credit derivatives. 

The literature suggests several reasons why some banks may not use derivatives to hedge credit 

risk on a large scale. Screening and monitoring idiosyncratic credit risk is a core competency of 

banks, suggesting that banks should not hedge credit risk as they would currency or interest rate 

risk (Diamond 1984). Moreover, adverse selection and moral hazard may make outsiders 

reluctant to sell credit protection at a fair price to banks with private information about particular 

borrowers. Banks have sought to address these concerns through a variety of means, including 

the establishment of informational barriers between commercial loan departments and credit 

derivative trading desks. Acharya and Johnson (2007) find evidence that adverse credit 

information about firms is revealed in the prices of credit default swaps before it is reflected in 

the stock market. In addition, to reduce risk at either the institutional or systemic level, those 

providing credit protection must have the capital and financial resources to honor their 

obligations. This lesson was demonstrated during the financial crisis, when banks hedged 

considerable amounts of subprime mortgage risk prior to the financial crisis by buying credit 

protection from AIG and monoline insurers. As Stulz (2010) points out, however, the 

effectiveness of these hedges in reducing risk was called into question when the financial health 

of the credit protection providers deteriorated as subprime defaults escalated. To the extent that 

derivatives shift credit risk from banks to less regulated and undercapitalized parts of the 

financial system, bank use of credit derivatives could increase systemic risk. 

Large banks that trade in credit derivatives primarily as intermediaries are subject to 

counterparty risk. According to Stulz (2010), 63 percent of derivatives contracts in 2007 were 
- 44 - 

subject to collateral requirements, which provide protection against counterparty default. 

However, this means that over one-third of credit derivatives in 2007 did not have collateral 

protection. Moreover, collateral does not completely eliminate counterparty risk, since 

counterparty default could create unwanted net positions that would force the bank to replace the 

defaulted contracts. This could be costly given that credit derivatives are often idiosyncratic and 

thus illiquid. Another element of counterparty risk to dealer banks is that counterparty exposures 

are opaque to investors, given that most credit derivatives are not traded on organized exchanges. 

If a large counterparty fails, investors will be uncertain about the exposures of other dealers, and 

may panic. Under Title VII of the Dodd-Frank Act, more trades will be shifted to organized 

exchanges and central clearing will be required for a variety of other transactions, which should 

improve transparency and reduce counterparty risk to dealer banks. 

Wagner and Nijskens (2010) examine the impact of credit risk transfer on systemic risk. Using 

data for a sample of banks from 1996 and 2007, the authors find that banks experienced a large 

and significant increase in their stock price sensitivity to market movements after they began 

trading credit default swaps. By separating this increased sensitivity into components due to 

volatility and market correlation, they find that the higher beta is due solely to an increase in the 

banks’ correlations with the market, whereas the volatility of returns actually declines. The 

authors conclude that credit risk transfer reduces bank idiosyncratic risk, but actually increases 

systemic risk by increasing banks’ exposure to aggregate risk. 

OTHER NONTRADITIONAL BANKING ACTIVITIES

Commercial banks have become more reliant on nontraditional sources of income in recent 

decades. Stiroh (2004) documents that the share of bank revenue due to noninterest income rose 

from 20.4 percent in 1980 to 43.4 percent in 2000. As discussed in section B, available 

economic literature suggests that rising shares of noninterest income do not appear to generate 

diversification benefits for banks, having little or no impact on mean returns while increasing 

return volatility (Stiroh (2004), Stiroh (2006), Stiroh and Rumble (2006)). However, this 

evidence does not necessarily imply that banks and their customers derive no benefit from 

nontraditional activities. “Noninterest income” is a broad aggregate that includes trading 

revenue and fiduciary income, but also includes categories that are closely linked to traditional 

bank activities, such as loan commitment fees, late fees on credit card borrowers, and service 

charges on deposit accounts. In fact, Stiroh (2004) shows that over 62 percent of commercial 

bank noninterest income in 2000 was due to “fees and other noninterest income,” while another 

15 percent was due to “service charges.” Stiroh (2004) finds that trading income has the highest 

volatility of any component of noninterest income, but also has the lowest correlation with 

interest income, which he argues may imply potential diversification benefits. Future research 

should isolate the diversification benefits of trading and fiduciary income, should distinguish 

among different types of trading activity, and should contextualize the diversification benefits of 

trading within the increased risk profile that some trading activity generates. 
- 45 - 

Section 619 of the Dodd-Frank Act, also known as the Volcker Rule, prohibits entities that 

benefit from federal insurance on customer deposits and access to the discount window from 

engaging in proprietary trading and from investing in or sponsoring hedge funds and private 

equity funds. Federal subsidies and protections that are provided to the banking industry are 

expressly for activities that benefit the broader economy. Section 619 requires the FSOC to 

release a study on the implementation of the Volcker Rule contemporaneously with this study. 

The Volcker study recommends a comprehensive regulatory framework to ensure that banks 

cease proprietary trading and inappropriate relationships with hedge funds and private equity 

funds. The Volcker study makes recommendations that reduce high-risk activities, but takes 

concrete steps to protect core banking activities, such as certain types of market making, asset 

management, underwriting, and transactions in government securities. 

The Dodd-Frank Act also requires certain large, interconnected nonbank financial firms to hold 

additional capital commensurate with the added risks from trading and certain other activities. 

As discussed in Jorion (2007), trading banks until recently held extra capital in the form of a 

Market Risk Charge (MRC), set at a multiple of banks’ Value-at-Risk (VaR), which in turn is an 

estimate of the worst-case (99th percentile) realization of 10-day trading returns. Beginning in 

1998, large banks that met certain conditions were allowed to use internal models to estimate 

VaR. While banks have an incentive to understate VaR to reduce their MRC, regulators punish 

excessive exceptions (ex-post realizations that are larger than VaR) by raising the MRC 

multiplier; this gives banks an incentive to overstate their VaR. Berkowitz and O’Brien (2002) 

find that banks’ VaRs from January 1998 to March 2002 were conservative relative to the 

ex-post empirical distribution of trading revenue, in that the fraction of exceptions is 

considerably below one percent. While this study suggests that banks were adequately 

capitalized against trading risk during the period 1998-2002, more recent studies (e.g. Basel 

Committee on Banking Supervision 2009) suggest that banks were not adequately capitalized 

against trading risk during the recent financial crisis, as banks experienced large losses on their 

trading books that were outside the 99 percent VaR confidence interval. The Basel III regulatory 

framework (Basel Committee on Banking Supervision (2010), also summarized in Hannoun 

(2010)) contains new risk charges that will require banks to hold roughly four times as much 

capital against trading book assets than under previous regulations. 

In summary, the existing literature on the costs and benefits of limiting bank participation in 

trading and other nontraditional activities is not well developed. Future research could use more 

focused data on such activities and should examine the role that trading losses, hedge fund 

recourse or other losses from nontraditional activities played in weakening bank balance sheets 

during the recent crisis. Future research should also distinguish among different types of 

nontraditional activities, because the risks that they pose are differentiated. For instance, not all 

trading activity poses the same risk; future cost benefit analyses should not homogenize the 

relative costs and benefits of distinct kinds of trading activity. Future research should also 

assess the potential for other measures – such as strengthened capital or other prudential 
- 46 - 

standards – to address the potential risks of nontraditional activities at a lower cost than 

prohibitions. 

SHADOW BANKING

Narrative histories of U.S. financial panics before and after 1933 (such as Acharya, Cooley, 

Richardson and Walter 2009) suggest that the core activity of banking—funding illiquid, risky, 

long-term assets with short-term, liquid liabilities—is subject to considerable institutional and 

systemic risk in the absence of a credible public backstop, because of the possibility of bank 

runs. Perhaps the most important regulatory innovation of the Depression era was the idea that 

banking is best carried out by institutions with access to explicit public backstops and subject to 

prudential supervision and regulation. As such, policymakers should seek to design regulations 

that separate banking and nonbanking activity, to limit the unintended consequence of 

redirecting banking activity to nonbank institutions. 

As documented by Pozsar, Adrian, Ashcraft and Boesky (2010) and Gorton and Metrick (2009), 

a growing share of financial activity in the pre-2007 period took place in shadow banks. 

Examples of shadow banks include an ABCP sponsored by an investment bank, or an investment 

bank manufacturing ABS from a pool of underlying assets and using these securities as collateral 

for short-term loans financed through repurchase agreements (commonly known as repo 

financing). Note that in both cases, the underlying assets may be illiquid and risky, while the 

liabilities are short-term and liquid; thus, in functional terms, these activities are essentially 

banking functions—but without explicit public backstops or regulation. 

Narrative and other evidence suggests that the recent crisis can be regarded in part as a run on 

shadow banks. As described by Brunnermeier (2009), Gorton (2008) and Kacperczyk and 

Schnabl (2010), the decision by BNP Paribas in August 2007 to suspend redemptions on three 

funds holding structured assets, following several months of bad news about subprime assets, led 

to sharply rising spreads and declining volumes of ABCP, as investors stopped rolling over their 

positions. Acharya, Schnabl and Suarez (2010) show that conduits with full credit or liquidity 

guarantees from commercial banks experienced smaller increases in spreads and shrank less 

during this period than conduits with weaker guarantees, suggesting that the credibility of credit 

backstopping was important to investors’ rollover decisions. In subsequent weeks and months, 

continued deterioration of mortgage assets led to increased concerns about the solvency of banks 

and broker/dealers, as reflected in rising interbank lending spreads. As Gorton and Metrick 

(2009) show, these concerns led to rising haircuts and spreads on repo financing throughout 

2008, even for repos collateralized by non-mortgage assets. As the authors discuss, repo terms in 

many cases depend on the solvency of the borrowing institution, even controlling for collateral 

quality, because some asset backed securities used as repo collateral are illiquid. If the borrower 

defaults on a repo, the investor would likely take a loss if he is forced to sell the collateral during 

a market-wide fire sale. This evidence suggests that the fragility of shadow banks was an 
- 47 - 

important reason that adverse shocks to the value of residential mortgages led to a systemic 

financial crisis in 2007-2008. 

The Dodd-Frank Act addresses these concerns by providing government the authority to apply 

appropriate prudential standards to large, interconnected nonbank financial institutions that 

engage in banking activities, as well as the authority to apply strong risk management standards 

to short-term funding arrangements and address other activities that may pose risks to financial 

stability. 

SUMMARY

The limited literature on combining traditional banking and nontraditional higher-risk operations 

does not support either strict separation or unrestricted mixing. Some researchers find that 

allowing banks to engage in nontraditional financial activities appears to have been socially 

beneficial. Other researchers find that removing the barriers separating bank and nonbanks 

appears to have increased systemic risk. In many cases, however, the evidence concerning 

segregation of banking and nonbanking financial activities is still quite limited, suggesting a 

robust agenda for future research. 
- 48 - 

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Boyd, John, Gianni De Nicolo and Abu Jalal. “Bank Risk Taking and Competition Revisited: 

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Brewer III, Elijah and Julapa Jagtiani. “How Much Did Banks Pay to Become Too-Big-To-Fail 

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Feng, Guohua and Apostolos Serletis. "Efficiency, Technical Change, and Returns to Scale in 

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Hughes, Joseph P., Loretta J. Mester, and Choon-Geol Moon. "Are Scale Economies in Banking 

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Jeon, Yonjil and Stephen Miller. “Bank Performance: Market Power or Efficient Structure?” 

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- 49 - 

Maudos, Joaquin and Juan Fernandez de Guevara. "The Cost of Market Power in Banking: 

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Wheelock, David and Paul Wilson. “Are U.S. Banks Too Large?” Working paper 2009-054-A, 

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Section B

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De Nicolo, Gianni and Myron L. Kwast. "Systemic Risk and Financial Consolidation: Are they 

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Gatev, Evan and Philip E. Strahan. "Banks' Advantage in Hedging Liquidity Risk: Theory and 

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Klein, Peter G. and Marc R. Saidenberg. "Organizational Structure and the Diversification 

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Wagner, Wolf. "Diversification at Financial Institutions and Systemic Crises." Journal of 

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Section C

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- 51 - 

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Section E

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Section F

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Section G

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- 55 - 

Krishnamurthy, Arvind. "How Debt Markets have Malfunctioned in the Crisis." Journal of 

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of Subprime Credit.” Working paper 2009-28, Federal Reserve Board, 2009.= 

Nijskens, Rob and Wolf Wagner. "Credit Risk Transfer Activities and Systemic Risk: How 

Banks Became Less Risky Individually but Posed Greater Risks to the Financial System at 

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