The 2008 financial crisis caused financial institutions on Wall Street to hold trillions of dollars of near-worthless investments. Some critics argue that the repeal of the Glass Steagall Act of 1933 played a big role in accelerating the financial crisis.
The Glass Steagall Act separated investment banking from commercial banking. Banks that offered commercial loans to non-financial institutions were not allowed to also provide underwriting services to the same institutions, or cross-selling.
The repeal of this act in 1999 is still highly debated, and many researchers are trying to understand how firms can benefit from a bank’s cross-selling activities.
Barbara Su is one such researcher. As an assistant professor of accounting at the Fox School, Su examines how banks’ cross-selling activities can influence the financial reporting quality of a non-financial institution.
“My research was based on my PhD dissertation,” says Su. “I was interested in looking at scenarios where banks provided multiple services to one corporate client.”
Her research, published in the Review of Accounting Studies, finds that cross-selling by banks promotes increased transparency of financial reporting by borrowing firms. Cross-selling was also associated with an improvement in the debt contracting value of accounting information at borrowing firms.
“If a company needs financing through bank loans, it can either (1) use underwriting and lending services provided by two different banks, or (2) ask the same bank to act as both the lender and the underwriter which is also known as cross-selling,” explains Su.
By acting as underwriters, banks assume the financial risk of a company for a fee. To fully understand how cross-selling affects financial reporting quality, Su compared firms that used two separate banks for lending and underwriting services and firms that used one bank for both these services.
Her research concluded that financial reporting quality in firms that used a bank’s cross-selling services increased.
Su explains, “When a bank engages in cross-selling by both underwriting and lending, they are providing multiple services to a firm and therefore have more interaction and information about a firm’s financial condition.”
Her research further attributes this increase in financial reporting to two main effects: the incentive effect and the information effect. Since banks are assuming a greater risk by providing multiple services, they have more incentive to monitor a firm’s financial reporting (incentive effect). Cross-selling enables information sharing within a bank’s department, giving banks deeper insight into the borrower’s underlying economics (information effect).
“If a firm is going to withhold bad news about its finances or deviate from accurate financial reporting, the banks will find out about it,” says Su. “Underwriting means that a bank has skin in the game, and they don’t want to be involved with a firm that is about to go bankrupt.”
Although her research provides evidence that there is a benefit for banks to provide multiple services to one client, Su warns against extrapolation. She cannot definitely say that it is beneficial for banks to engage in cross-selling.
“Given the limited data I work with, I can only provide limited evidence of the association my research draws,” clarifies Su.
Nevertheless, Su’s research is especially important for regulatory authorities because of the debate around the reinstatement of the Glass Steagall Act. Since the act was repealed, banks are allowed to engage in cross-selling. Su’s research provides evidence of improved financial reporting due to banks engaging in cross-selling.
So, besides regulatory authorities, this research should also be of great interest to firms who are seeking financing and banks that engage in cross-selling.
“Firms that need financing will need to show a higher level of financial reporting quality,” says Su. “This is not a bad thing because firms enjoy a lowered rate of interest if they choose the same bank to finance and underwrite their loans.”