Breaching the Walls Between Banking & Commerce
By James R. Barth, R. Dan Brumbaugh Jr., and Glenn Yago
Reform efforts in Congress have provoked controversy. But eliminating the barriers between commerce and banking will promote competition and efficiency for U.S. banks.
Congress and the Clinton Administration are considering a number of proposals that would relax restrictions separating depository institutions from other types of companies. Most of these proposals would significantly ease, if not entirely eliminate, legal barriers separating banks, securities firms, and insurance companies. The issue generating the most conflict, how-ever, involves relaxing barriers between banks and commercial firms.
The intensity of this debate surfaced in March when House Banking Committee chairman James Leach said, "Mixing commerce and banking simply doesn't fit our kind of democracy."
To the contrary, we believe the current barriers between commerce and banking are indefensible. Boundaries erected by the Bank Holding Company Act of 1956 restrict competition and place the domestic regulatory structure at odds with the rest of the industrialized world. The United States stands virtually alone among developed countries in barring bank ownership of commercial firms and vice versa. Barred from pursuing the full range of opportunities available to foreign banks, domestic institutions are disavantaged in an increasingly international banking market.
Removing ownership barriers would spur domestic competition, promoting efficiency and lower prices for financial services. It would also open a potential new source of capital for banks acquired by commercial firms. And the threat of takeover generally would constitute a powerful force for ensuring that managers of both banks and commercial firms serve shareholder interests.
Critics see three major dangers. They argue that the apparent subsidy banks enjoy through their access to federally insured deposits and other government services could be transferred to any affiliated commercial firm, thereby creating competitive distortions in other industries and extending potential taxpayer loss exposure. Second, they cite potential conflicts of interest. Could a bank's safety and soundness be jeopardized by improper transactions between itself and affiliates engaged in commerce? Would the bank's credit decisions be impartial? Finally, they insist that mixing banking and commerce would lead to undue concentrations of economic and political power.
None of these arguments, in our view, stands up to close scrutiny. Most academics and regulators who have studied the subsidy question deem such a benefit, if it actually exists, to be relatively small, considering the cost of the attendant regulatory burden imposed on banks. In any case, eliminating the subsidy would eliminate the potential for spreading its benefits.
Conflicts of interest can be handled by firewalls and regulatory protections already in place. And concerns about the potentially excessive economic and political power that might be amassed in bank-commerce unions fade when examined in the light of international competition and the steady decline of banks' market share in U.S. financial intermediation.
Critics also ignore the pervasive mixture of banking and commerce already at work within the United States. For example, Ford Motor Co. and General Electric Co. provide a wide range of financial services--in Ford's case, constituting 63% of 1996 earnings. On another front, Internet technology and other forms of electronic commerce will progressively enable individuals and firms to operate outside traditional banking boudaries, obtaining credit, reaching savers and borrowers and making payments.
Expanding inter-industry ownership opportunities would surely enhance banks' ability to adapt to these market forces. U.S. chartered banks currently control less than 20% of the assets held by all domestic financial services firms, down from 50% in 1950. The industry's traditional lending and deposit-taking role continues to erode as other firms wrest away business by capitalizing on falling legal barriers, new technology and flourishing capital markets.
Banks are attempting to cope by cutting costs and enhancing revenues, often through mergers and acquisitions; increasing operations abroad; and expanding into fee-based businesses. Freer banking entry into commerce and vice versa would increase bankers' options for finding profitable business niches. It is truly ironic that restrictions said to serve banks' interests actually retard their ability to adapt to market changes.
Out Of Step
Current U.S. law does allow an individual to own a controlling interest in both banking and commercial firms. But two factors prevent banks and commercial firms from acquiring or being acquired by each other. The first is the prohibition on banks owning stock in commercial firms. Second, the Bank Holding Company Act defines any firm that controls a bank as a bank holding company, which in turn is prohibited from controlling any non-bank firm, except one engaged in activities "closely related to banking." The definition of that phrase, established by the Federal Reserve, encompasses such a narrow range of non-banking activities so as to effectively preclude the mixing of banking and commerce.
By contrast, democratic countries such as Austria, Switzerland, the United Kingdom, France, the Netherlands, Finland, Germany, Ireland and Greece allow completely unrestricted bank ownership of commercial firms and vice versa. Denmark, Portugal, Luxembourg, Belgium, and Spain allow the mixing of banking and commerce with some restrictions. All of these countries are part of the European Union, whose banking directives allow a bank to invest up to 15% of its capital in a single commercial firm, with a maximum limit of 60% of the bank's capital invested in different commercial firms. Moreover, the directives place no restriction on commercial firms' ownership of banks.
Of the 19 non-overlapping countries of the Group of Ten and EU, only five--the U.S., Japan, Canada, Sweden and Italy--significantly restrict the mixing of banking and commerce. Even within this group, Japanese, Canadian, Swedish and Italian banks may own shares in commercial firms up to certain limits. Overall, banks in countries that allow banking/commerce combinations hold 73% of the world's banking assets.
By prohibiting ownership of commercial firms by banks, the U.S. is more restrictive than any other G-10 or EU country. Yes, U.S. bank holding companies may own up to 5% of the voting shares of any commercial firm, and the Federal Reserve has allowed investments up to 25% in non-voting shares. But such ownership must be non-controlling and passive, respectively. These restrictions leave the U.S. out of step with the world's other wealthy democracies in terms of allowable integration of banking and commerce.
Archaic Definitions
People tend to think of the U.S. restrictions as being part of a long tradition. Actually, they date back only to 1956, when the Bank Holding Company Act was implemented. For most of our history, mixing banking and commerce was not considered antithetical to democracy.
Nor are the current prohibitions and restrictions applied uniformly among the different types of federally insured depositories in the United States. Reflecting the ad hoc nature of U.S. banking regulation, unitary savings and loan holding companies may be commercial firms and engage in any activity. There is no evidence that this greater ownership flexibility contributed to the savings and loan crisis of the 1980s and early '90s.
Because the current debate centers on depositories that fit the legal definition of a bank, it is important to distinguish between legal definitions and the functional workings of financial firms when analyzing the issue of mixing banking and commerce. The legal definition of a bank, established by the One Bank Holding Company Act of 1970, includes firms that make commercial loans and accept demand deposits. Since then, the definition has been expanded to include those two activities conducted by a depository insured by the Bank Insurance Fund of the Federal Deposit Insurance Corp.
This definition led to some hairsplitting in order to accommodate what in the 1970s became known as "nonbank banks." Initially, these firms were legally defined banks that were acquired by other financial and non-financial firms. Non-bank firms could own banks as long as the banks made commercial loans but did not offer demand deposits, or vice versa. Since the average legally defined bank today has only about 15% of its assets in commercial loans and 15% in demand deposits, the distinction between a legally defined bank and a non-bank bank can be relatively small.
Nor is the "leakage" of allowable mixtures of banking and commerce limited to the purchases of wealthy individuals, unitary savings and loan companies, and non-bank banks. Many non-banking firms provide commercial loans or close substitutes. Many of these same firms provide payment instruments that may increasingly substitute for demand deposits. They offer checking accounts, for example, or issue credit and debit cards. The development of electronic commerce, including "smart cards" and on-line transactions, promises to further erode the relative importance of demand deposits.
Many traditional distinctions already seem archaic. Is the relationship between the Ford Motor Co. and cars or General Electric Co. and electricity the same as in earlier years? In fact, these companies have evolved partly into bank-like businesses that are meaningful substitutes for banks. Ford's 1996 annual report, for example, offered a postage-free insert that could be used to establish a Ford money market account. In the same report, Ford noted that only 37% of its $4.4 billion of net income came from automotive operations; financial services operations provided the remaining 63%. General Electric, with 39% of its $7.3 billion of earnings derived from capital services operations, offers a wide range of financial services to third parties, but states that few of the services are directly related to its manufacturing operations.
Such examples reveal how the current Congressional debate about mixing banking and commerce takes place within an artificial and static context, divorced from contemporary and future functional relationships.
The Subsidy Question
Critics of mixing banking and commerce fall back on three basic arguments. One involves the subsidy banks are reputed to receive through their access to federally insured deposits and other government services. They fear that such a subsidy could be passed on to an affiliated commercial firm, which would then enjoy unfair benefits within its particular industry.
The potential sources of subsidy are deposit insurance, intra-day overdrafts by banks using the Fedwire payments system, and access to discount window loans. Whether a net subsidy from these "safety net" services actually exists, however, depends on whether the gross subsidy value of the services exceeds the costs associated with the pervasive and expensive regulation of banks. The Federal Financial Institutions Examination Council has pegged the annual cost of this regulatory burden at about $9 billion.
Top government officials disagree among themselves about whether there is a subsidy. Federal Reserve chairman Alan Greenspan has testified in the affirmative. But Comptroller of the Currency Eugene A. Ludwig states, "no net subsidy exists." FDIC chairman Ricki Helfer has said, "If a net subsidy exists, it is very small." The Shadow Financial Regulatory Committee, a group of economists and attorneys outside the bank regulatory agencies, has concluded the net subsidy is "probably not particularly large."
Some effort should be made to answer the question once and for all. If a net subsidy is found to exist, it should be eliminated. Once eliminated, the danger of the subsidy spreading to non-bank affiliates would also be eliminated. In the absence of a precise measurement of the net subsidy, the issue remains: is the mere possibility that one exists sufficient to prevent any mixture of banking and commerce?
Discussion of shifting the benefits of a potential subsidy to non-bank affiliates raises the issue of the reliability of firewalls and their ability to ensure impartial credit decisions. Firewall protection already exists at the bank holding companies operating regulator-approved subsidiaries engaging in activities closely related to banking. Indeed, firewall protections are prevalent throughout banking, requiring arms' length transactions with insiders, affiliates, and subsidiaries. No loan to a related entity can exceed 10% of bank capital, for example, and all loans to related entities cannot exceed 20% of bank capital. In addition, all such loans must be collateralized. Finally, these kinds of transactions are examined and supervised closely by regulators.
Given the limited scope of the proposed mixing of banking and commerce and the types of lending limitations and regulatory scrutiny that already exist, the danger that banks could engage in significant improper lending or transfer of funds is almost certainly minor. As for lending to competitors of a bank's affiliated commercial business, U.S. chartered banks now provide less than 20% of all credit extended by all financial firms in the U.S. Even if existing protections designed to assure arms' length transactions were to fail, the potential damage is small.
Another concern is whether the so-called "too big to fail" doctrine would be applied not only to larger banks but also to large commercial firms affiliated with banks. Under all existing proposals, bank and non-bank holding companies or affiliates would have to be separately capitalized. As with current bank holding company and affiliate relationships, the new relationships would be closely monitored by examiners and supervisors. Under these circumstances, it seems unreasonable to argue that the too-big-to-fail protection would be conveyed to a non-bank holding company or affiliate. Experience in the S&L debacle suggests that large non-bank holding companies will go to great lengths to protect the capital of their "bank" subsidiaries.
Political Considerations
A final issue is whether inappropriate concentrations of economic and political power will emerge from the mixing of commerce and banking. The proposed combinations conceivably open the door to only one minor abuse of economic power--so-called "tying" agreements, in which the bank might say to the customer, "If you want a loan, you must buy our non-bank product," or vice versa. But the conditions under which such tying arrangements can occur are rare, and antitrust authorities have a long history of dealing with them effectively. Other than tying, combinations of banking and commerce are not anti-competitive because, by definition, the affiliates operate in separate markets.
A number of factors suggest that the capability and intent of banking and commerce combinations to affect domestic politics has declined. Banks themselves are individually and collectively less politically powerful today than they were before 1956, when they had fewer domestic non-bank competitors and the domestic market could be separated from the international one. Today, large banks and large non-bank firms are increasingly focused overseas, where 95% of the world's population resides producing 75% of its gross domestic product. Citicorp, for example, does business in over 90 countries, which contribute half its revenue. Half of Intel's revenue also came from abroad last year.
Competition, both domestically and internationally, will only intensify under the spur of technological change. Given these conditions, fears of inappropriate economic and political power arising from the proposed combinations of banking and commerce seem unjustified. Indeed, prolonging obsolete regulatory restrictions will hamper U.S. banking competitiveness and restrict capital flows.
Restrictions on mixing banking and commerce leave the United States in the position of a general still fighting the last war--not only out of step with most other developed countries, but also with the obvious economic direction of our time. We live in an era of increasingly competitive financial markets, which bring more and more innovative financial services produced by more and different types of firms to larger numbers of people around the globe at lower prices. That the U.S. finds itself mired in a debate about whether to allow firms even the opportunity to mix banking and commerce borders on the farcical.
Mr. Barth is Lowder Eminent Scholar in Finance at Auburn University, Louisiana. Mr. Brumbaugh is an economist based in Menlo Park, Calif. Mr. Yago is director of capital studies at the Milken Institute in Santa Monica, Calif.