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Universal Banking, Conflicts of Interest and Firm Growth

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Abstract

This paper studies the relationship between universal banking and firm performance. With 40 developing and developed countries, I find that the overall effect of universal banking on firm growth is negative. This suggests that the negative effect of conflicts of interest dominates the positive effect of economies of scale and scope in universal banking. However, in countries with stronger protection of creditors’ rights and higher information efficiency, conflicts of interest are less likely and the negative relationship between universal banking and firm growth is significantly weaker.

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Notes

  1. In general, universal banking refers to banks conducting a wide range of businesses including security, real estate, insurance businesses and etc. In my paper, since I only focus on the ability of commercial banks to conduct security businesses, I use “universal banking” interchangeably with the combining of commercial banking and security businesses.

  2. This is kindly suggested by the anonymous referee.

  3. Besides security businesses, the Bank Regulation and Supervision database also provides information on regulations of banks engaging in insurance and real estate businesses and ownership of nonfinancial firms.

  4. ‘Unrestricted’ means a full range of activities in the given category can be conducted directly in the bank; ‘Permitted’ means a full range of activities can be conducted but all or some must be conducted in subsidiaries; ‘Restricted’ means less than a full range of activities can be conducted in the bank or subsidiaries; and ‘Prohibited’ means the activity cannot be conducted in either the bank or subsidiaries.

  5. These variables contain information about log of GDP per capita, GDP growth, inflation rate, institutional development, financial development, economic freedom from government intervention, and share of bank assets in government-owned banks.

  6. In the robustness check section, it is checked that this does not affect the results.

  7. For the results reported in this paper, growth rates greater than 300% or less than − 70% are considered as extreme. With this restriction, 1,450 observations are removed. Other criteria for removing outliers have also been tried and the same qualitative results are obtained.

  8. Value of sales is not included as a control because it is not reported for firms in East European countries. However, regressions that control for value of sales with East European countries removed give qualitatively similar results.

  9. The industry category left out is ‘Other’.

  10. I include one measure at a time.

  11. The paper covers more countries than in La Porta et al. (1998) and therefore can not use La Porta et al. (1998) as a complete guide in further classifying civil law countries.

  12. By the time the data was collected the Glass–Steagall Act had not been passed and thus the USA still had high restrictions on banks conducting security businesses.

  13. Note that the variable “Economic Freedom” actually measures the lack of economic freedom. Hence, the positive correlation coefficient actually indicates a negative relationship between security business restrictions and economic freedom.

  14. I thank the anonymous referee for pointing this out.

  15. Large firms attract more media attention than medium firms and it would be more difficult for universal banks to hide negative information about them.

  16. For instance, ‘Security’ is reduced from 3 to 2, which means the country used to allow only a limited range of security businesses be conducted by commercial banks but now permit a full range of security businesses to be conducted by subsidiaries of commercial banks.

  17. This number is calculated as 35.24 + ( − 34.11) ×0.6.

  18. I thank the anonymous referee for suggesting this measure and also pointing out the direction of finding other relevant variables to me.

  19. This is calculated as − 8.81 + 122.96 ×0.13.

  20. Countries in my sample considered as developed countries are Canada, France, Germany, Italy, Portugal, Spain, Sweden, UK, and USA.

  21. The results of these and the remaining robustness tests are available upon request.

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Authors and Affiliations

  1. Department of Economics WB201, Ball State University, Muncie, IN, 47306, USA

    Lili Xie

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  1. Lili Xie
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Correspondence to Lili Xie.

Additional information

This paper is adapted from Chapter II of my dissertation at the University of Illinois at Urbana–Champaign. I am especially indebted to my advisor, Charles Kahn, for continuous support and help. I am grateful to Murrilo Campbell, George Pennacchi, and Juha Seppala for valuable advice. I thank Robert DeYoung, Douglas Evanoff, Craig Furfine, Hesna Genay, Mitchell Petersen, Tara Rice, and Richard Rosen for helpful comments. I also benefited from comments of seminar participants at Ball State University, University of Illinois at Urbana–Champaign, Federal Reserve Bank of Chicago, 2006 SEA meeting, and 2007 MFA meeting. All remaining errors are mine.

Appendix

Appendix

Variable Explanations and Data Sources

  • Firm Level Variables (All from WBES (2000) of World Bank):

    • Sales Growth: average sales growth over the past three years as of the time of the survey.

    • General Credit Constraint: whether financing poses a problem for a firm’s growth and operation. This variable takes four values: 1 (no obstacle), 2 (minor obstacle), 3 (moderate obstacle), and 4 (major obstacle).

    • High Interest Rate: whether high interest rates pose a problem for a firm’s growth and operation. This variable also takes four values: 1 (no obstacle), 2 (minor obstacle), 3 (moderate obstacle), and 4 (major obstacle).

    • Export: whether the firm is an exporter.

    • Govern: whether the firm has government ownership.

    • Foreign: whether the firm has foreign ownership.

    • Small: whether the firm is a small firm (5–50 employees).

    • Manufacture: whether the firm is in the manufacturing industry.

    • Service: whether the firm is in the service industry.

    • Construction: whether the firm is in the construction industry.

    • Agriculture: whether the firm is in the agriculture industry.

    • Log of Competitors: logarithm of the number of competitors.

  • General Country Characteristics:

    • Inflation: average inflation rate over 1996–1999. From International Financial Statistics and World Economic Outlook.

    • GDP per capita: average GDP per capita over 1996–1999. From International Financial Statistics and World Economic Outlook.

    • GDP growth: real growth rate of GDP averaged over 1996–1999. From International Financial Statistics and World Economic Outlook.

    • Economic Freedom: an overall measure of the absence of government coercion or constraint on the economy. It considers ten categories of institutional factors including (1) how easy or difficult it is to open and operate a business; (2) government’s direct use of scarce resources for its own purposes and government’s control over resources through ownership; (3) the fiscal burden a government imposes on its citizens through taxes; (4) the relative openness of a country’s banking and financial system; (5) the degree to which a country’s laws protect private property rights and the degree to which its government enforces those laws; (6) the level of corruption; (7) the extent a government allows the market to set wages and prices; (8) restrictions on foreign investment; (9) inflation; (10) tariff rate. From the Heritage Foundation. Averaged for 1996–1999.

  • Financial System Characteristics:

    • Security: a measure of regulatory restrictiveness in commercial banks engaging in the business of securities underwriting, brokering, dealing, and all aspects of the mutual fund industry. From World Bank Regulation and Supervision Database (2001). This variable takes the values of 1–4, with larger numbers representing greater restrictiveness:

      1. 1.

        Unrestricted indicates that a full range of activities in the given category can be conducted directly in the commercial bank.

      2. 2.

        Permitted indicates that a full range of activities can be conducted but all or some must be conducted in subsidiaries.

      3. 3.

        Restricted indicates that less than a full range of activities can be conducted in the bank or subsidiaries.

      4. 4.

        Prohibited indicates that the activity cannot be conducted in either the bank or subsidiaries.

    • Concen3: the share of the largest three banks in total banking assets. From World Bank Regulation and Supervision Database (2001).

    • Concen5: the percentage of deposits accounted for by the five largest banks. From World Bank Regulation and Supervision Database (2001).

    • Denied: the share of banking license applications rejected. From World Bank Regulation and Supervision Database (2001).

    • Foreign Bank Share: the share of assets in banks that are majority foreign owned. From World Bank Regulation and Supervision Database (2001).

    • State-owned Bank Share: the share of assets in banks that are majority state-owned. From World Bank Regulation and Supervision Database (2001).

    • Private Credit: Bank claims on the private sector as share of GDP averaged over 1996–1999. From International Financial Statistics and World Economic Outlook.

    • Market Capitalization: Stock market capitalization as share of GDP averaged over 1996–1999. From International Financial Statistics and World Economic Outlook.

    • Financial Development: Logarithm of the sum of Private Credit and Market Capitalization.

    • Financial Structure: Logarithm of the ratio of Private Credit to Market Capitalization.

  • Institutional and legal development measures:

    • Institution: average of six indicators measuring voice and accountability, political stability, regulatory quality, government effectiveness, control of corruption, and rule of law. Voice and accountability indicates the extent to which the citizens of a country can participate in the selection of governments and the independence of the media. Political stability measures the perception of the likelihood that the government in power will be destabilized or overthrown by uninstitutional and/or violent means. Government effectiveness measures perceptions of the quality of public service provision, the quality of the bureaucracy, the competence of civil servants, the independence of the civil service from political pressures and the credibility of the government’s commitment to policies. Rule of law measures the extent agents have confidence in and abide by the rules of the society. From Kaufmann et al. (1999).

    • Civil: whether the legal origin of a country is civil law or common law. From Reynolds and Flores (1996).

    • The following three variables consider securities laws regarding the issuance of new equity to the public.

    • Disclosure: an index of disclosure requirements in security issuing regarding the prospectus, the compensation of the issuer’s directors and key officers, the issuer’s equity ownership structure, the equity ownership of issuer’s shares by its directors and key officers, the issuer’s contracts outside the ordinary course of business, and transactions between the issuer and its directors, officers, and/or large shareholders. A higher value for this index indicates stricter requirements in information disclosure. From La Porta et al. (2006).

    • Liability: an index of liability standards for the security issuer and its directors, distributors, and accountants. A higher value for this index indicates that it is easier for investors to recover losses from the responsible party due to misleading information in prospectus or audited financial reports accompanying the prospectus. From La Porta et al. (2006).

    • Public Enforcement: the average of six indices: (1) supervisor characteristic index; (2) rule-making power index; (3) investigative powers index; (4) orders index; and (5) criminal index. The supervisor characteristic index is an index of the appointment, tenure, and composition of the supervisor of securities markets. The rule-making power index is an index of the power of the supervisor to issue regulations regarding primary offerings and listing rules on stock exchanges. The investigative index measures the power of the supervisor to command documents or subpoena the testimony of witnesses when investigating an violation of securities laws. The orders index aggregates stop and do orders that may be directed to the issuer, the distributor, or the accountant in case of a defective prospectus. The criminal index is an index of criminal sanctions applicable to the issuer’s directors and key officers, the distributor, or the accountant when the prospectus omits material information. The higher value the average of these six indices takes, the stronger the power of a public enforcer of securities laws is. From La Porta et al. (2006).

    • Credit Registry: a dummy variable indicating whether there is a private credit registry in a country. From Djankov et al. (2007).

    • Accounting Standards: the average percentage availability of seven groups of information in companies’ annual reports. The seven groups of information are general information, income statement, balance sheet, funds flow statement, accounting policies, stockholders’ information and supplementary information. From International Accounting and Auditing Trends (4th edition) published by the Center for International Financial Analysis and Research (CIFAR).

    • Stock Synchronization: a measure of the synchronization of stock price movements in a country. It is constructed as the average R 2 of firm level regressions of bi-weekly stock returns on market indexes in each country in 1995. From Morck et al. (2000).

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Xie, L. Universal Banking, Conflicts of Interest and Firm Growth. J Finan Serv Res 32, 177–202 (2007). https://doi.org/10.1007/s10693-007-0016-1

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