Ch. 5: Banks in Capital Markets 193
prospects than outsiders due to their screening and monitoring of loans. Compared with
investment banks, which do not generally acquire private information through lending
activities, commercial banks have lower costs of information production. This advan-
tage can allow commercial banks to gather more information about their clients and be
better certifiers of firm value than investment banks. Second, banks may achieve infor-
mational economies of scope by jointly delivering lending and underwriting services
and re-using the same client specific information for several purposes (see e.g.Benston,
1990; Saunders and Walter, 1994). As a result, informational economies of scope can
lower transaction costs and reduce the costs of intermediation.
However, the potential benefits of commercial banks as underwriters of public se-
curities can be limited by costs that can occur due to conflicts of interest from banks’
incentives to misuse their private information. A bank may privately know that a firm
has poor prospects but attempt to protect its own interests by certifying that the firm
is of high quality and underwriting public securities, with the hope that investors will
subscribe to the issue. The firm then can use the proceeds to pay down its bank loans at
the expense of outside investors. This activity benefits the bank in two ways—in addi-
tion to earning a fee on the security underwriting, the bank reduces its overall portfolio
exposure to default risk. A commercial bank that lends and underwrites may face other
conflicts of interest that it may attempt to exploit. For example, banks may issue loans
to third-party investors on the condition that these funds are used to support the price
of a new issuance of public securities. In this case, the supporting of the security price
through bank loans could send incorrect signals to investors and other new issuers re-
garding the true performance of the underwriter, making the bank appear to be a better
underwriter than in truth. As another example, the bank may attempt to “tie” the pro-
vision or pricing of credit to the firm’s use of the bank’s investment banking services.
By threatening to reduce the availability of credit or increase the cost of borrowing, the
client may then face costs from higher-priced or lower-quality services, with the bank
reaping the rewards.^3 Of course, conflicts of interest may be mitigated by the bank’s
concern for harming ongoing client relationships and its own reputation. It is likely
that short-term gains from exploiting these conflicts are offset in the long run by these
concerns, which can affect the ability of the bank to generate future business and profits.
Theoretical papers byKanatas and Qi (1998, 2003), Puri (1999), andRajan (2002)
contrast the benefits that can arise from certification and informational economies of
scope with the costs from conflicts of interest. These papers provide formal analyses of
allowing banks to extend their business beyond traditional lending activities, and these
studies produce some implications for the pricing of public securities, the firm’s choice
of underwriter, and the costs of financial intermediation.^4
(^3) SeeWalter (2004)for a thorough analysis of potential conflicts of interest in financial services firms.
(^4) In a slightly different vein,Boot and Thakor (1997a, 1997b)examine the impact of the choice between
universal and functionally separate banking, and argue that a financial system in its infancy will be bank
dominated.