Commercial Banking Research Paper

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Commercial banks traditionally have performed three primary functions: they held time deposits (savings accounts), demand deposits (checking accounts), and they issued credit, primarily to firms but also to individuals. But commercial banks have played other roles as well, from the underwriting of securities to providing a range of fee-based financial services to corporations. They have also been significant players in a range of national and international business communities, and their degree of power and influence in these communities has been the source of major controversy among scholars. More recently, a series of rapid changes have occurred in the commercial banking world that have raised questions about whether this institution will remain a distinct corporate form. In this research paper, research by social scientists on commercial banks is examined, focusing on their relations with nonfinancial corporations. Given the significant cross-national variation among banking systems and the legal environments within which they operate, emphasis will be primarily on the United States, although non-US examples will be referred to at various points.

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1. Financial Systems And Commercial Banks

Zysman (1983) has suggested that there are two types of system into which most of the industrialized capitalist countries fall. In credit-based systems, such as those in France, Germany, and Japan, banks are the primary providers of long-term capital, and are permitted to own and vote stock in nonfinancial corporations. In capital market-based systems, as in the UK and the USA, securities issues (stocks and bonds), handled primarily by investment banks and insurance companies, are the principal sources of long-term debt, while commercial banks specialize in short-term debt. Gershenkron (1962) noted that the capital market-based systems are associated with relatively early industrialization while the credit-based systems are associated with later industrialization. Banks historically have played a particularly dominant role in the credit-based systems. But although there is no comparable period of bank influence in Britain, there have been periods of bank ascendance in the USA.

2. The Rise Of Commercial Banks: The United States, Germany, And Japan

American commercial banks arose shortly after the Revolution, as businesses began to specialize and international trade expanded (Chandler 1977, pp. 28–31). The number of banks increased rapidly after 1790, to more than 200 by 1815. An important event in the development of American commercial banking occurred in 1832, when President Andrew Jackson refused to support a bill to recharter the Second Bank of the USA, a bank of national scope that had 22 branches located in several states. Three decades later, the National Bank Acts of 1863 and 1864 outlawed branch banking altogether (Roe 1994, pp. 54–9), and it was not until 1927 that American banks were allowed to branch even within states (Roe 1994, pp. 94–5). The resulting, relatively decentralized, commercial banking system is distinct from more centralized systems such as the one that developed in Germany in the late 1800s.

Despite anti-branching laws, the leading US commercial banks became increasingly concentrated in the late nineteenth and early twentieth centuries. During this period, corresponding with socialist movements in Europe, and progressive and populist movements in the USA, a major chorus of analysts and critics emerged on both continents. In Europe, Rudolf Hilferding produced a Marxist analysis of what he called ‘finance capital,’ the domination of the German economy by a handful of leading banks. Bank power in both the USA and Germany emanated from the rapid growth and consolidation of industry, in which companies were increasingly dependent on the financing that the banks provided. The concentration of banking, and the alliances among the banks, made it difficult for nonfinancial corporations to leverage banks against one another, further increasing the banks’ power. The American economy was dominated by a relatively small number of financiers who forged constellations of investment and commercial banks, leading industrial firms, and railroads. Louis Brandeis, in his classic Other People’s Money, focused on investment banks as the centers of power during the period, but investment and commercial banks were not always easy to distinguish. Investment banks were permitted to hold deposits, and commercial banks were permitted to underwrite securities. Members of these alliances sat frequently on the boards of directors of multiple, nominally competing, financial institutions. George F. Baker, an ally of J. P. Morgan, sat on the boards of three banks and an insurance company.

Both German and Japanese banks developed later than those of the USA, beginning in the 1850s in Germany and the 1870s in Japan. By the beginning of the twentieth century, however, a handful of German and Japanese banks had become dominant actors in their respective economies, standing at the head of groups of companies, thus equaling or exceeding the power of American banks. The overwhelming power of the US banks began to ebb after 1912. The Clayton Act of 1914 outlawed director interlocks between competing firms, leading to a sharp decline in formal ties among the banks. The leading financiers of the period either died or retired, and although many transferred control to their sons or hand-picked successors, these second-generation leaders did not possess the power that their elders had enjoyed. Paradoxically, however, although US commercial banks suffered during the Great Depression, investment banks were more seriously affected.

A turning point was the Glass–Steagall Act of 1933, which forced commercial banks and investment banks to separate their activities. Commercial banks were prohibited from underwriting securities, and investment banks were required to give up their deposits, which had been their primary source of capital. This set the stage for what some observers argue was a resurgence of bank power in the post-World War II period.

Although World War II severely disrupted both nations’ economies, German and Japanese banks did not experience a similar decline in power. One reason for this is that, in Germany and Japan banks are permitted to hold equity in nonfinancial firms. Partly as a consequence of this, and partly because there was no equivalent to Glass–Steagall, banks in Germany and Japan have been considerably more involved than US banks in firm policy making. After World War II, the American occupational forces broke up the Japanese zaibatsu (business groups) but left the leading banks intact (Gerlach 1992). The German economy recovered quickly after the war and a small number of major banks remained dominant. Although most observers believe that German banks remain more powerful relative to industry than banks in the USA, there is now some controversy over how dominant their role is (Ziegler et al. 1985).

3. Capital Dependence And Bank Power

American commercial banking is stratified informally into national, regional, and local sectors. The national banks are led by a relatively small number of major money-center banks located primarily in New York but also in financial centers such as Chicago and San Francisco.

In recent years, as commercial banking has under-gone major changes (described below), banks in areas such as Charlotte, North Carolina have emerged as among the largest. The national money-center banks are typically the leaders of major lending operations for the largest nonfinancial corporations. Regional and local banks, which make up the vast majority of US commercial banks, focus primarily on lending to mid-sized and small businesses.

Although the early American commercial banks were involved in long-term lending, US commercial banks generally have specialized in short-term notes of less than one year. Insurance companies have focused on long-term private debt, while investment banks have focused on the placement of long-term public bonds. A study by Go (1999) has shown that American commercial banks became more heavily involved in term loans of 1 to 10 years during the 1930s. Even prior to that, some large banks were involved in bonds as well as loans of up to 5 years. Given commercial banks’ role as a source of corporate external financing, a number of scholars have assumed that their power over nonfinancial corporations was a function of the degree to which the latter were dependent on external financing. In their classic work, The Modern Corporation and Private Property, Berle and Means (1939) argued that the increasing profitability of large US corporations generally freed them from dependence on banks because firms were able to finance their investments with retained earnings. This view was accepted by the vast majority of social scientists into the early 1970s. The evidence for this argument was equivocal, however. A study by Lintner (1960) suggested that the use of external financing by American firms did not decline between 1925 and 1955. Stearns (1986) showed that the use of external debt financing by USA firms was at relatively low levels in the post-World War II period but that it began to increase around 1965, remaining relatively high into the early 1980s.

The evidence on the increasing use of external financing corresponded with a renewed focus on the power of commercial banks. This came from two sources. First, although unlike banks in Germany and Japan, US commercial banks had been prohibited from directly owning equity in other firms by the National Bank Act of 1863–4, in the post-World War II period they became increasingly active in managing corporate pension funds through their trust departments. As part of their fund management, banks invest in corporate stock, on which they have voting rights. A Congressional investigation in the 1960s led by Representative Wright Patman revealed individual bank trust department holdings of 5 percent or more in nearly 30 percent of the 500 largest USA industrial corporations. Despite some heavily publicized cases, it is unclear whether the banks actually used these holdings as leverage over corporate policy, as is believed to occur outside the USA, especially in Germany. Useem (1996), however, has suggested that institutional stockholders have become increasingly active in voicing their views to managers in recent years.

A second possible source of bank power was corporations’ increased use of external financing. Mintz and Schwartz (1985) have argued that, given its value as a generalized resource, banks’ control over capital has given them a broad ‘hegemony’ within the larger business community. Although they are rarely actively involved in company decision making, Mintz and Schwartz suggest that the banks are able to make broad policy decisions about the allocation of capital within the economy. As their evidentiary base, Mintz and Schwartz describe several examples of bank intervention in the affairs of nonfinancial firms. In addition, they show that the major commercial banks were the most central firms in the networks of director interlocks that span the leading US firms, a finding that has been replicated repeatedly across studies and over time (Mizruchi 1996). One could argue that the use of external financing does not ensure automatically that firms are dependent on banks. On the contrary, borrowing contains both tax benefits and, when interest rates are low, cost benefits. A study by Mizruchi and Stearns (1994) shows, however, that even when controlling for the cost of capital, when retained earnings are high, borrowing tends to decline, and vice versa. This suggests, consistent with the arguments of a number of economists, organizational scholars, and sociologists, that firms will tend to avoid borrowing from banks if they have sufficient amounts of cash.

It is important to note that these same phenomena— reliance on external financing, ability to vote stock, and centrality in corporate interlock networks—have been used to suggest the power of financial institutions in the German and Japanese contexts. Gerlach (1992) argues that although Japanese firms became better able to finance investments with retained earnings in the postwar period, they remain heavily dependent on banks. Zysman (1983) suggests that German banks’ control over virtually all sources of external financing, loans, bonds, and equity, along with their high direct equity holdings and willingness to use them gives them a high degree of leverage.

4. Major Recent Changes In Commercial Banking

Mintz and Schwartz’s argument seemed to fit the German and Japanese cases quite well, but it was intended to apply to the USA. Although its applicability to the American case was always controversial, the argument was consistent with a considerable amount of evidence. Bank involvement in institutional stock-holding had increased significantly since the 1950s, nonfinancial corporations’ use of external financing had increased since the mid-1960s, and banks remained the most central firms in the corporate network from the early 1900s into the 1980s. Beginning in the early 1980s, however, a series of events occurred that altered the nature of commercial banking radically. Rapid changes in technology and the regulatory environment led corporations to reduce their reliance on banks for capital, as firms turned increasingly to direct borrowing through the issue of commercial paper. By 1994 the value of outstanding commercial paper in the USA equaled that of outstanding debt to commercial banks.

Meanwhile, the proliferation of alternative sources of savings and investment such as mutual, pension, and money market funds led individuals to reduce their deposits in commercial banks. In response to these losses, the largest commercial banks turned increasingly to high-risk lending, leading to several major bank failures and near-failures in the late 1980s and early 1990s. Both the number of commercial banks and the proportion of corporate debt acquired from commercial banks declined by one-third between 1979 and 1994 (Davis and Mizruchi 1999, p. 220). Large commercial banks responded to the loss of their traditional franchise by shifting their focus away from lending (especially domestic lending, which was no longer profitable) and toward financial services such as capital market services, foreign currency exchange, and derivatives. They also participated increasingly in securities underwriting, as legislation and lax enforcement slowly chipped away at the Glass–Steagall provisions. The largest commercial banks came increasingly to resemble investment banks. Bank profits, which had declined sharply in the late 1980s and early 1990s, rebounded by the mid-1990s. Both of these changes in bank strategies have had the effect of altering the social role of commercial banks within the American business community. As Davis and Mizruchi (1999) document, the largest banks reduced substantially the number of executives of major corporations appointed to their boards, thus losing their place at the center of the interlock network.

Two major developments of the late 1990s raise questions about the future of commercial banks as distinct entities. In April 1998, Citibank, the largest US commercial bank, announced a merger with Travelers Insurance, whose units included the in-vestment firm of Salomon Smith Barney. This new megafinancial firm, called Citigroup, became the first corporation since Glass–Steagall openly to blend commercial and investment banking as well as in-surance underwriting. In October 1999, the US Congress and the Clinton Administration reached an agreement and repealed the Glass–Steagall Act. The new legislation will allow financial corporations to offer a full range of services, from traditional lending to public stock offerings (New York Times October 23, 1999, A1, B4).

5. The Future Of Commercial Banking

Given the tidal wave of changes occurring in the financial world at the the beginning of the twenty-first century, it is difficult to know whether commercial banks will continue to exist. Both the efficiency and control benefits of combining financial services under a single roof suggest that US commercial banks will move toward mergers with investment banks and other financial institutions, making them more like the ‘universal banks’ that exist in Germany and other countries. Of special interest to social scientists will be the extent to which these combinations lead to a resurgence in the power of US financial institutions. Regardless of the level of bank power from the beginning of the twentieth century to the early 1980s, it is undeniable that commercial banks became significantly less influential during the 1980s and 1990s. The effect of this anticipated integration of financial corporations on relations between financial and non-financial corporations will be an interesting process to observe.


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