Did Banks' Security Affiliates Add Value? Evidence from the Commercial Banking Industry during the 1920s
Ramirez, Carlos D., Journal of Money, Credit & Banking
BEFORE THE GLASS-STEAGALL ACT of 1933, close ties between commercial and investment banks in U.S. financial markets were common. According to Carosso (1970), during the 1880s it was typical for investment bankers to form syndicates with powerful and resource-rich commercial banks, which could ensure the flotation of large issues of securities in the still undeveloped financial markets. During the 1920s these ties developed more distinctively as investment banking by commercial banks and became a well-defined service provided either through a bond or investment department (formed as an internal division in the bank) or through a security affiliate (formed as a separate subsidiary of the bank).
Recent research has established, both at the theoretical and empirical level, that commercial bank involvement in the securities business fulfilled an important and beneficial role in financial markets. Theoretical research shows that it is easier for commercial banks than for arm's-length lenders to overcome asymmetric information problems because banks have an advantage in the collection and gathering of information about their client firms. (1) Empirical research also shows that this advantage, developed through long-term relationships and close monitoring, translated to fewer financing problems and higher market value for client firms. (2) Because of the synergies that the acquisition of information brings, these arguments suggest that there may have been economies of scale and scope in the commercial and investment banking industry, which may have justified the close association between these activities.
While theory suggests that there were scale and scope economies, few researchers have actually investigated them empirically in detail. There are at least two reasons for this. First, modern attempts to model or estimate economies of scale and scope in the banking industry have yielded largely ambiguous results in terms of the parameters in question. Problems ranging from the choice of a functional form of the production technology to the choice of the framework and estimation techniques have precluded researchers from reaching a consensus on this topic. (3) Second, although there have been recent improvements in estimation techniques and in the framework used (for example, Berger and Mester 1997), calculating parameters for economies of scale and scope is an extremely data-intensive exercise because it involves the estimation of many parameters (not just scale and scope elasticities, but many cross-elasticities as well). Because detailed bank financial data for this period are spotty at best, it is almost impossible to conduct a detailed and reliable study of economies of scale and scope, even if the model were to be estimated under the most restrictive functional forms. In light of these difficulties, it is unlikely that studies in economies of scale and scope can reveal the true nature of the cost structure of banks that were involved in the securities business during this period.
While estimating economies of scale and scope parameters may not be possible in a practical sense, measuring the impact of economies of scale and scope on banks' charter values is much more feasible. Clearly, the existence of economies of scale and scope implies that large banks that also offered investment banking services should have enjoyed a cost advantage over small, unit banks. All else being constant, this cost edge should consequently translate into higher market value for the bank.
In this paper I investigate whether this assertion can be empirically verified. I do this by examining whether financial markets attached a premium to the market value of banks with security affiliates or bond departments. To accomplish this I estimate Tobin's q for a random sample of banks operating in 1926-28 and test whether having an affiliate increased the value for the bank, after controlling for a large array of financial variables. …