Until the 1920s, private investment firms dominated the underwriting process. Because they lacked the economic clout of commercial banks, however, the advantage shifted immediately once commercial banks decided to aggressively pursue underwriting activities. Banks did so once the remaining legal limitations on underwriting activities were eliminated.
Commercial banks entered the underwriting business with a number of advantages. Commercial banks in the principal money centers had long-standing relationships with large corporations. They also had an existing base of clients already using their services for financial matters. The existence of a network of branches facilitated sales at little additional cost. Banks were thus able to develop a strong and immediate presence in the retail distribution market.
By the time of the Great Depression, commercial banks threatened to monopolize the industry. In a relatively brief time, eight commercial banks -- Guaranty Trust, National City (Citibank), Chase, Bankers Trust, Equitable Trust, Continental Illinois, First National Bank of Boston, and Union Bank of Detroit -- had a significant amount of underwriting business. These and other commercial banks accounted for more than half of all underwriting business.
Domination by the commercial banks ended only because of direct intervention by Congress. During the Depression, Congress concluded that the involvement of banks in securities activities was at least partially responsible for the nation's economic collapse. In response it enacted the Glass-Steagall, which, among other things, prohibited banks from dealing in, underwriting, and purchasing securities for their own accounts. The law further prohibited commercial banks from affiliating with firms engaged in underwriting activities. Securities firms, in turn, were prohibited from accepting deposits. The net effect was a separation of commercial and investment banking.
This development disrupted existing banking relationships. Companies that were accustomed to having all of their financial needs met by a single firm were compelled to find new sources of funding. The result was vigorous competition among new and existing firms for a share of the business.
Moreover, by requiring divestiture or dissolution of the securities subsidiaries of some of the country's largest commercial banks, Glass-Steagall essentially ensured the creation of a class of investment banking firms with considerable skill, prominence, and access to the highest levels of corporate America. First Boston arose from the securities division of the First National Bank of Boston; Morgan Stanley from the remnants of J.P. Morgan; and Brown Harriman & Co. from National City Co. Formed from established banks, these new firms enjoyed instant name recognition and credibility. During the post-war period, they became the principal advisors to corporate America in regard to its capital needs.
As a result, banks and securities firms pursued different roles in the capital markets. Banks preferred arm's length relationships based on the provision of short-term funding. Securities firms, specifically investment banks, became the primary providers of long-term capital to American corporations.
Absent Glass Steagall, therefore, the United States was in the process of becoming bank dominated. Only with a legal separation in the two categories of financial institutions did this process stop. Once Glass Steagall was implemented, an independent and powerful set of investment banking firms developed. At the same time, the US developed vibrant and deep securities markets.
For more on this topic, see Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets.