Universal banking under bilateral information asymmetry

Abstract

The Gramm–Leach–Bliley (GLB) Act of 1999 repealed many provisions of the Glass–Steagall Act that curtailed competition between banks and commercial firms. Significantly, however, the GLB Act did not repeal the constraint on banks from owning equity in commercial firms (universal banking). Should banks be allowed to hold equity in corporate borrowers? If allowed, would banks optimally choose to do so? Despite its relevance from a policy perspective, there are surprisingly few theoretical analyses of this issue of universal banking. We develop a model in which the bank's advisory role as an inside shareholder hinges on its equity stake. The optimal capital structure and the bank's and entrepreneur's equity stakes are endogenously determined in a world with potential double-sided moral hazard. In certain scenarios, the bank may prefer not to hold any equity. Our analysis indicates that allowing optimal bank equity participation may foster improved corporate performance. This benefit of universal banking should be considered in policy debates.