200 S. Drucker and M. Puri
difference in the probability of default is approximately the same as the difference in
default probability between investment-grade bonds and unrated bonds.
Puri (1994)also examines the long run default performance of bank-underwritten is-
sues. The author uses both the cumulative mortality rate and probit models to examine
the default performance of bonds. The cumulative mortality rate allows for an accu-
rate comparison of default probability by measuring default rates on bonds that have
been outstanding for equal periods of time, adjusted for calls, maturities, and previous
defaults.^11 Using a sample of industrial bond issues during the period January 1927
through September 1929,Puri (1994)finds that the cumulative mortality rate is signif-
icantly higher for non-bank underwritten issues than bank underwritten issues for 3,
5, and 7 years from the issue date.^12 These results are particularly strong in the non-
investment grade sample for all time periods. The results support the view that banks
were not exploiting conflicts of interest. While the mortality rate analysis is better than
an unconditional comparison of default rates, the probit model allows the researcher to
control for other important factors that might influence the probability of default. Con-
sistent with the mortality analysis, the results of the probit model strongly indicate that
commercial bank underwritings of industrial bonds and preferred stock defaulted less
often, and foreign government bonds defaulted with similar probability. Interestingly,
Puri (1994)finds that there was a selection bias in the Senate hearings that lead to the
Glass–Steagall Act. The two banks that bore the brunt of the investigation underwrote
securities that had a significantly higher default rates than that of other banks and were
not representative of bank underwriters in general.
Together, the ex ante pricing results and the long run performance studies paint a
convincing picture. Commercial bank-underwritten securities received higher prices.
Investors rationally paid higher prices because in the long run these securities performed
better than ex ante similar offerings. This suggests that conflicts of interest were not
dominant in bank-underwritings during the pre Glass–Steagall period.
3.2. The late 1980s and beyond
During the late 1980s and throughout the 1990s, commercial banks were gradually
allowed to re-enter underwriting markets. In 1987, the Federal Reserve permitted in-
dividual bank holding companies to establish Section 20 subsidiaries that could to a
limited extent engage in “bank ineligible” activities.^13 However, the subsidiaries had to
be separately capitalized and separated from the lending parent by information, finance,
(^11) SeeAltman (1989)for a formal definition and discussion.
(^12) The sample period for this study provides for a more uniform regulatory and economic environment, as
it starts after the passage of the McFadden Act, which legally allowed national banks to underwrite debt
securities, and ends before the stock market crash of October 1929.
(^13) Section 20 of the Glass–Steagall Act prevented commercial banks from affiliating with a company “en-
gaged principally” in the “issue, flotation, underwriting, public sale, or distribution at wholesale or retail or
through syndicate participation of stocks, bonds, debentures, notes or other securities”.