Investment Banking and Commercial Banks

The commercial and investment banks had operated in their independent domains for a good part of the twentieth century. The former catered to individuals and businesses for their cash management, borrowing, and trade needs, while the latter provided capital mobilization, brokerage, initial public offerings, and investment management for public and private enterprises. Over last two decades, this distinction has blurred as the laws restricting banking activities have eased in most large western economies.

The separation of two banking activities was supposed to be in the public interest to increase the safety of the banking system and reduce risks. The separation laws (e.g. Glass–Steagall Act in the US) arose as the aftermath of Great Depression in the United States. The rationale being that if same entity is involved in lending and investing, this is a conflict of interest and makes the financial system unstable. The deposit mobilization institutions i.e. commercial banks, possess tremendous power and should not be allowed to speculate in securities market. These banks should be managed to limit the risk to depositors’ money.

With increasing number of mergers and acquisitions in 1980’s and 1990’s, the commercial banks grew larger and stronger. The essential repeal of Glass–Steagall Act in 1999, allowed the creation of megabanks or universal banks. The deregulated financial markets had blurred the distinction between loans and securities. The commercial banks were losing out to investment banks which are not strictly regulated and also to foreign banks where there were no restrictions. It was stipulated that Instead of separate banks, different subsidiaries could offer lending and investment services, thus avoiding conflict of interest. Securities are less risky than loans, more liquid, and more open to public scrutiny. Allowing commercial banks to deal in securities offered a mechanism to diversify their risks.

It has been argued that 2008 financial crisis was due to deregulation and blurring of distinction between commercial and investment banking. However, deregulation is only partly to blame. The issue is not enough regulation but rather the enforcement of existing regulations. The banks and other financial institutions overlooked their own time tested principles to determine credit worthiness of the borrowers and issued credit to anyone who needed it regardless of their ability to pay. The basic greed and earning profit from interest to generate money from money was the main cause.

In today’s interconnected world, consumers of financial products (individuals, businesses, and governments) have wide and easy access to providers. It would be a competitive disadvantage for banks not to offer the entire portfolio of financial products. Prudent regulation and monitoring should be emphasized and the same bank should be able to accept deposits, issue loans, and offer investment management services to individual and corporate customers.