INTRODUCTION

As observed in recent years, systemic financial crises, especially those associated with a currency collapse, can be fast-moving events resulting in wealth destruction, crippling the financial system and magnifying economic decline. The channels of collapse are numerous. What starts as a moderate recession can become a steep decline in economic activity as financial losses generate large exchange rate movements and bank collapses. Exchange rate depreciation damages the net worth of those who have borrowed in foreign currency. Furthermore, a trend of depreciation raises nominal interest rates on loans, and also adversely affects the relative price movements for producers of nontradables. As borrowers' ability to repay declines, bank net worth is destroyed. Additional bank losses may result from banks' direct exposure to interest rate and exchange rate risk.

In the frictionless world of neoclassical economics, the distribution of wealth has no effect on the allocation of investment capital. But in the real world, the wealth of borrowers and banks plays an important allocative role in financial markets. Destruction of the net worth of borrowers, especially a fall in the value of real estate and other assets relied on for bank collateral, and of banks can cause a collapse of the loan market (Keynes 1931, Fisher 1933, and Bernanke 1983).

Declines in banks' net worth, which can result in bank failures, reduce or eliminate banks' abilities to supply loans.

Introduction

From the mid-1930s through the 1970s the fundamental institutional and regulatory features of the U.S. banking system were taken for granted as permanent and mainly beneficial by most policymakers and economists. Various aspects of the regulatory system (particularly reserve requirements and deposit interest rate ceilings) were blamed for inefficiencies in capital market allocation by banks and often were seen as an impetus for financial innovations in and outside of banking: for example, NOW accounts, and the growth of credit unions and money market mutual funds. But much of the regulatory structure was seen as benign or beneficial. Studies of economies of scale in banking seemed to indicate that unit banking restrictions had little economic impact on bank efficiency. The stability of the commercial banking system seemed to have been ensured by the regulatory “safety net,” including federal and state deposit insurance program that removed depositors' incentives to run on their banks in response to adverse economic news, and by regulations on bank operations – notably, the separation of commercial and investment banking, justified in 1933 as a means to prevent dishonest or reckless practices by banks.

In retrospect, the faith in the post-Depression regulated system's ability to deliver bank stability is understandable given the unusual calm of the period from 1934 to 1980. Systemic banking panics or waves of bank failures had become a distant memory, easily attributable to a primitive state of affairs prior to the supposed rationalization of banking brought by the Depression-era reform.

Introduction

The American financial system has been an outlier internationally in virtually every important respect for the past century. It has been the most geographically fragmented and the most susceptible to financial crises (Calomiris and Gorton 1991; Calomiris 1993). It has been among the most restrictive of combinations of financial services within intermediaries, although in recent years some of these restrictions have begun to be relaxed (Kaufman and Mote 1989, 1990). The American system has also been the most persistently innovative financial system in the world. Often, important innovations have been induced by regulatory restrictions that raised the cost of finance under preexisting financial technology.

These observations are commonplace. Other unusual aspects of American financial history have received less attention, including the relative lack of bank involvement in industrial finance, the heavy reliance on corporate bonds as a means of finance, the high costs of securities underwriting, and the high cost of capital in American industry.

The main goal of this paper is to weave these peculiar features of the American system into a single interpretive tapestry. The central argument of the paper is that regulatory limitations on the scale and scope of banking in America hampered financial coordination and substantially increased the cost of capital for industrialization, particularly in the period of the growth of large-scale industrial enterprises prior to World War I. This may seem a strange claim in light of American growth and financial innovativeness.

American corporate banking has undergone enormous change over the past two decades. That change reflects a combination of long-run competitive pressures and short-run performance problems that led U.S. banks and their regulators to a new American version of global universal banking. From the perspective of the scale and scope of banks, these changes represent a convergence of U.S. banks to international norms in banking. At the same time, the U.S. version of universal banking entails novel linkages between banks and financial markets in the pursuit of enhancing bank-customer relationships. These new linkages give universal banking a new complexity and richness which banks outside the United States will increasingly imitate.

6.1 Introduction

The last decade has witnessed significant convergence in the practice and regulation of banking across countries, and the United States has done more than its share of changing. Differences remain in structure, powers, and regulation across countries. Nevertheless, banking has become much more uniform internationally, and there is a good chance that current changes being contemplated in Europe, the United States, Japan, and Latin America will reinforce the trend toward convergence.

More important than any single similarity in law, regulation, or practice is the common trend in banking “philosophy.” I will argue that global competition in financial services should be credited with producing regulatory, practical, and philosophical convergence, and with making bankers and regulators more willing to learn from each other's experiences.

The United States – uncharacteristically – has been a prime example of this convergence process.

The last two decades have witnessed dramatic bank deregulation in the United States. Of particular importance at the national level have been the relaxation of geographical and activity limitations on bank holding companies, achieved in the 1980s and early 1990s, respectively, by congressional action and new regulatory interpretations of existing law. In the last several years, both the Federal Reserve Board and the Comptroller of the Currency further enhanced the flexibility of bank operations by reducing limits on bank activities, and in 1999 Congress passed landmark legislation to repeal outright the separation of commercial and investment banking imposed by the Banking Act of 1933, and to expand bank powers in other directions (notably into insurance products).

Although deregulation has been dramatic, it is worth noting that it has sparked little controversy, or even surprise, among scholars of banking or banking history. No prominent banking historians or economists have defended unit (single-office) banking or the historical restrictions on bank activities in underwriting or insurance (in contrast, disagreement arises over the extent to which, and the manner in which, noncommercial firms should be permitted to own banks, and vice versa).

The lack of controversy in the face of such dramatic changes reflects a remarkable degree of agreement among banking scholars – supported by an extensive body of research – that historic limitations on U.S. banks' locations and activities are inefficient.

In this chapter I address three questions about universal banking. First, what is universal banking? Second, why might universal banking be an effective organizational structure for a banking system, particularly in a newly industrializing economy? Third, what is the evidence supporting or contradicting the view that universal banking reduces corporate financing costs for a newly industrializing economy?

I define universal banking as a banking system made up of large-scale banks that operate extensive networks of branches, provide many different services, hold several claims on firms (including equity and debt), and participate directly in the corporate governance of the firms that rely on the banks as sources of funding or as securities underwriters. That is an encompassing and therefore narrow definition of universal banking. But it suits my purposes. I will examine the pre–World War I universal banking system in Germany – which satisfies my narrow definition – and explore the synergies among the different elements in my definition.

To answer the question of whether universal banking reduces corporate financing costs, I will contrast the cost of financing industrialization in the United States and in Germany during the second industrial revolution (roughly 1870–1913). This period is important to examine for two reasons. First, the second industrial revolution involved large-scale production and distribution activities (emphasized by Chandler 1977), which brought a new challenge to financial markets – the rapid financing of very large minimumefficient- scale industries. Because large-scale production is typical of modern industrial practice, I think that the lessons from the second industrial revolution are broadly applicable to contemporary developing countries.