The total losses reported by banks and insurers during the financial crisis in 2007 were $1.1 trillion in the world. As the table below, there were sixteen universal banks contributed to those losses and account for more than half. However, there was only a quarter of them need government support which are Bank of America, Citigroup, Royal Bank of Scotland Group and UBS. In addition, no universal bank fails during the crisis.
There were many failures of different financial situations after the crisis. However, there is no empirical evidence shows that universal bank is the reason of failure contagion that affected the financial system in the current crisis.
For that reason, many economists had argued whether if universal banking is the reason for the contagion of banks failures. Vennet (2002) [1] provided evidence and concluded that specialized banks benefit from lower levels of efficiency compare to universal banks. Allen and Jagtiani (2000) and Mälkönen (2004) use portfolio simulations to argue that universal banks are more able to withstand an economic shock due to their diversification benefits. On the other hand, Boot and Schmeits (2000) argue that diversification in activities of universal banks may reduce the accuracy of price signals which will weaken market discipline.
Frontier Economics (2009) [2] has listed three main factors causing financial crisis. The most common one is the over-exposure to asset-backed securities, which were the main factor causing losses to investment banks and universal banks. The other two factors are over-exposure to end credit risk and over-reliance on wholesale funding, which cause losses to retail and commercial banks.
Figure below shows that, universal banks were not the most affected by the crisis and their losses were lower than investment or retail and commercial banks.
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Advantages
Since universal banks offer a wide range of financial services and stay dynamically available for business, they provide potential advantages for the stability of both the banking system and the real economy.
Financial efficiency benefits - reflecting the greater risk-diversification, which increases the overall stability of the financial system and reduced financial intermediation costs, which reduces agency problems and increased financial stability benefits that universal banks offer.
Universal banks increase the overall stability of the financial system as a result of risk-diversification. By offering a diversification of products, universal bank can use its costs for a wider range of activities to generate more profits. Therefore, it helps reduce risks and increase the stability of the financial system as well as reduces the costs of avoiding failure. In addition, since universal banks enjoy a greater risk-diversification, they enjoy lower funding cost which means that customers can enjoy lower costs of finance and other services.
Universal banks also reduce the agency problems by reducing the financial intermediation chain. Specialized banks usually have to rely on financial intermediations because they only have direct relationship with a few customers. For example, a mortgage bank does not have any relationship with other types of customer except mortgage customers. In contrast, since universal banks combine their different stages of banking activity as a whole, they have shortened the length of the financial intermediation chain. It helps universal banks reduce information asymmetries and transaction costs between end-suppliers and end-users of capital.
International trade and investment benefits
Before the emergence of universal banks, global financial transactions such as trade finance, trade insurance, foreign exchange and international payments are carried out by international banks. Without international banks, transaction costs of imports and exports would be high. As a result, a mass of universal banks enter the international market due to the demand of majority.
Universal banks also assist international investment and capital flows. They facilitate international capital markets, such as distributing securities in one country to help households, companies or governments raise capital in another country.
competition and innovation benefits
Universal banks usually tend to expand to new markets and provide new products thus increase competition among different financial institutions. If other institutions do not want to be lag behind, they have to create innovation with the best practice to keep pace with universal banks. Not only making contributions to competition and innovation, universal banks generate economic benefits. Customers now can easily reaching a wide range of products with low cost as well as other modern financial services. There are many studies has noted this, for example, Claessens (2009) [3] noted, "Making financial systems more open and contestable, i.e., having low barriers to entry and exit, has generally led to greater product differentiation, lower cost of financial intermediation, more access to financial services, and enhanced stability."
Problems
Universal banks are generally "too big to fail" and the governments will bail them out because if they fail, the costs would be so large. Therefore, they reckless of consequence and intend to commit with greater risks which create moral hazard and lead to the increasing of their risk and cost of failure. However, universal banks only increase moral hazard if they are failed in risk control, reflecting in weaker business control or management failures. Failing in risk control definitely leads to greater losses. For example, UBS experienced significant losses during the crisis because it was deficient in its risk management and control practices. Another problem is that when investment activities in a universal bank go bad, the losses are not only suffered by the investment bank but also the retail banking side.
One more problem of universal banking model is the conflicts of interest, which arise from information asymmetry. Benston (1996) [4] believed that conflicts of interest are the result of the combination of commercial banking and underwriting. As explained by Rich (1993), universal banks gather inside information of customer's securities that they underwrite and use that information to make inside profits on the sale of those securities.
Furthermore, universal banks also issuing securities and fooling debtors to fund bad loans. Because universal banks are underwriter, they provide untruthful information to potential customers and transfer credit risk to the public. Additionally, universal banks also provide false information on the paper offered to the public. Thus, they can persuade naive depositors to buy bad securities.
Conclusion
The recent financial crisis occurred because of many reasons such as macroeconomic conditions, market failures and ineffective risk control. In fact, there were no clearly evidence affirm that universal banking model is riskier than the others. In this crisis, different financial institutions have failed, not only universal banks. For example, German Landesbanks purchased lots of US subprime assets before the subprime crisis happened in 2007. Furthermore, Northern Rock (a specialized mortgage bank) or Lehman Brothers (an investment bank) also declared bankruptcy during the crisis. All those three banks mentioned are not universal banks. At that time, there are some problems with universal banks, for example Royal Bank of Scotland or UBS, but they were because of poor risk management.
In fact, almost universal banks survived the financial crisis without needing material government support. Therefore, the government should provide considerable support for retail, commercial and investment bank.
