18 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
processing and collecting loans, and in pooling risks and thus helping individual
savers diversify, that is, “not putting all their financial eggs in one basket.” Further, a
system of specialized intermediaries can enable savings to do more than just draw
interest. For example, individuals can put money into banks and get both interest
income and a convenient way of making payments (checking), or put money into
life insurance companies and get both interest income and protection for their
beneficiaries.
In the United States and other developed nations, a set of specialized, highly effi-
cient financial intermediaries has evolved. The situation is changing rapidly, however,
and different types of institutions are performing services that were formerly reserved
for others, causing institutional distinctions to become blurred. Still, there is a degree
of institutional identity, and here are the major classes of intermediaries:
1.Commercial banks,the traditional “department stores of finance,” serve a wide
variety of savers and borrowers. Historically, commercial banks were the major in-
stitutions that handled checking accounts and through which the Federal Reserve
System expanded or contracted the money supply. Today, however, several other
institutions also provide checking services and significantly influence the money
supply. Conversely, commercial banks are providing an ever-widening range of ser-
vices, including stock brokerage services and insurance.
Note that commercial banks are quite different from investment banks. Com-
mercial banks lend money, whereas investment banks help companies raise capital
from other parties. Prior to 1933, commercial banks offered investment banking
services, but the Glass-Steagall Act, which was passed in 1933, prohibited commer-
cial banks from engaging in investment banking. Thus, the Morgan Bank was bro-
ken up into two separate organizations, one of which became the Morgan Guar-
anty Trust Company, a commercial bank, while the other became Morgan Stanley,
a major investment banking house. Note also that Japanese and European banks
can offer both commercial and investment banking services. This hindered U.S.
banks in global competition, so in 1999 Congress basically repealed the Glass-
Steagall Act. Then, U.S. commercial and investment banks began merging with
one another, creating such giants as Citigroup and J.P. Morgan Chase.
2.Savings and loan associations (S&Ls), which have traditionally served individual
savers and residential and commercial mortgage borrowers, take the funds of many
small savers and then lend this money to home buyers and other types of borrow-
ers. Because the savers obtain a degree of liquidity that would be absent if they
made the mortgage loans directly, perhaps the most significant economic function
of the S&Ls is to “create liquidity” which would otherwise be lacking. Also, the
S&Ls have more expertise in analyzing credit, setting up loans, and making collec-
tions than individual savers, so S&Ls can reduce the costs of processing loans,
thereby increasing the availability of real estate loans. Finally, the S&Ls hold large,
diversified portfolios of loans and other assets and thus spread risks in a manner
that would be impossible if small savers were making mortgage loans directly. Be-
cause of these factors, savers benefit by being able to invest in more liquid, better
managed, and less risky assets, whereas borrowers benefit by being able to obtain
more capital, and at a lower cost, than would otherwise be possible.
In the 1980s, the S&L industry experienced severe problems when (1) short-
term interest rates paid on savings accounts rose well above the returns being
earned on the existing mortgages held by S&Ls and (2) commercial real estate suf-
fered a severe slump, resulting in high mortgage default rates. Together, these
events forced many S&Ls to either merge with stronger institutions or close
their doors.
16 An Overview of Corporate Finance and the Financial Environment
