In August 2018, we reviewed economies of scale – the concept that larger companies can sometimes scale up their production and benefit from production efficiencies, thus reducing costs with savings that ultimately can be passed along to consumers. In this post, we consider the benefits related to economies of scope – when a business is diversified and able to offer multiple products or services, again, reducing costs with savings that ultimately can be passed along to consumers.
The issue of economies of scope is particularly timely as some policymakers have suggested re-imposing the prohibition on banking and securities activities under one umbrella company that was previously in place under the Glass-Steagall Act. But studying the lessons learned from economies of scope, it is clear that such a move would be a significant mistake that could lead to higher costs for companies and consumers, thus negatively impacting the broader economy.
Economies of Scope: Lending and Underwriting
Banning banking and securities activities within the same umbrella company would prevent a business from receiving loans and having its equity and debt offerings underwritten by the same firm. Just as retail consumers benefit from purchasing a variety of goods from a single retailer (think Amazon or Walmart), companies can also benefit from obtaining a range of financial services from a single firm. In particular, many companies obtain loans and have their debt and equity offerings underwritten by a single firm. More specifically, a securities firm – or “underwriter” – will offer or “issue” the company’s securities (stocks or bonds) for sale to the general public. At the same time, a bank affiliated with the securities firm will offer the company a bank loan to meet other financing needs. As discussed below, the company benefits from obtaining both underwriting and lending services from the same firm.
Researchers at Columbia University and Duke University in 2005 found that an increasing number of corporations obtain loans and have their securities offerings underwritten by the same firm. By 2001 (the last year of their sample), these researchers found that more than 20 percent of all underwriters of equity offerings were also providing loans to the companies issuing equity. These loans addressed other financing needs, such as the need for working capital. More recent research from the Federal Reserve in 2018 indicates that this trend has continued. These researchers found that, between 2011 and 2016, roughly 40 percent of all underwriters of corporate bond offerings also provided loans to the companies that were issuing debt securities.
So why is it important for businesses to have the opportunity to obtain both loans and underwriting services from the same firm? Researchers find that companies are charged lower fees when they obtain both financial products from a single firm. This is a classic example of “economies of scope.” Economies of scope occurs whenever a firm can produce two related goods at a cost that is lower than if each good was produced separately. As an example, a single reporter at a media company can write a news story that appears in print and online, conduct a video interview with a source that can be used in a story on the same topic airing on its television station, and promote the story via the reporter’s social media handles. The fact that a single reporter creates content for four different outlets – print, TV, internet, and social media – reduces the total cost of production and makes it possible to offer these media services at lower costs to subscribers and others buying the media products.
In the context of lending and underwriting, the researchers suggest that banks and securities firms collect and make use of the same information to provide underwriting services and make loans. Because the information only has to be obtained once and two financial services are produced, it is produced more efficiently by a single firm rather than having two separate firms (i.e., a securities firm and a bank) acquire the same information twice.
Both the researchers at Columbia and Duke and the Federal Reserve researchers find that the resulting savings are significant. Importantly, they find that these savings accrue largely to non-investment grade companies. Non-investment grade companies are typically younger firms with less of a track record for which acquiring information and data is more difficult and costlier. Accordingly, it is sensible that these companies would reap the biggest savings from economies of scope in the acquisition of information. As shown in Figure 1, the 2005 study found that a non-investment grade issuer of securities that was also receiving a loan saved $358,000 on the issuance of $200 million in securities. The 2018 study by Federal Reserve researchers also found significant savings from bundling lending and underwriting services. More specifically, and as shown in Figure 1, they found that a non-investment grade issuer would save $603,000 on a $200 million bond offering if it was also receiving a loan in addition to underwriting services. Both studies attribute this finding to economies of scope in the production of financial services. Firms that can share important, hard-to-acquire, company information can provide multiple financial services to a company at lower cost than if the business had to procure each financial service from an independent firm.
Sources: Drucker, Steven and Puri, Manju. “On the Benefits of Concurrent Lending and Underwriting.” The Journal of Finance, Vol. LX, No. 6. December 2005 https://faculty.fuqua.duke.edu/~mpuri/papers/concurrent_lending_JF.pdf; and Anenberg, Elliot, Maggie Church, Serafin Grundl, and You Suk Kim (2018). “On the Benefits of Universal Banks: Concurrent Lending and Corporate Bond Underwriting,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 5, 2018, https://doi.org/10.17016/2380-7172.2143.
Finally, it should be noted that these benefits relate to the observable costs associated with acquiring loans and issuing securities. Other benefits that are harder to measure include the efficiencies associated with “one-stop banking.” Just as many busy families benefit from saving time and energy by purchasing a range of goods from a single retailer such as Amazon or Walmart, so too can companies benefit by obtaining a range of financial services from a single firm. Doing so allows these companies to invest more time and energy into doing those things that make them a success.
Recently, some policymakers have suggested re-imposing the Glass-Steagall Act. To be clear, and as described in a BPI blog post, the Glass-Steagall Act had two fundamental prohibitions. First, banks were prohibited from engaging in securities activities (such as underwriting equity IPOs) and securities firms were prohibited from taking deposits. Second, conducting commercial and investment banking activities within the same umbrella company was banned due to restrictions on affiliations between banks and securities firms. The first of these prohibitions is still in effect today. Banks are not allowed to engage in securities activities and securities dealers are not allowed to take deposits. The second prohibition was repealed in 1999 by the Gramm-Leach-Bliley Act. As a result, financial umbrella companies are allowed to operate both banks and securities firms. In particular, all Forum members operate both deposit-taking banks and securities firms. If Glass Steagall’s second prohibition were re-imposed today, Forum members would not be permitted to offer their customers both banking and securities services under a single roof.
So why does it matter if companies are allowed to obtain multiple financial services from a single firm rather than separate and independent firms? As we have seen, the bundling of financial services offers opportunities for economies of scope that result in lower costs and fees for companies. Some of the savings from these lower costs and fees can then be passed onto consumers. As a result, financial regulation can have a real-world impact on people who spend most of their time managing their busy lives and wondering whether or not it is time to re-order more laundry detergent from Walmart or Amazon!
Empirical research convincingly shows that allowing financial firms the flexibility to offer both banking and underwriting services to companies results in significant cost savings. Given that Glass Steagall’s primary prohibition banning banks from conducting securities activities (and vice versa) is in place, it is not clear what goal would be achieved by restricting financial firms from offering a diversified set of financial services to their customers. Rather, such a policy would restrict choice and raise costs without any clear or convincing benefit.