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FDIC Banking Review
The Future of Banking in America
The Mixing of Banking and Commerce: Current Policy Issues
Christine E. Blair*
The issue of whether, or to what extent, banking and commerce should be allowed to mix is again the focus of a public policy debate. The issue often arises when criteria for permissible activities for a bank and its owners, subsidiaries, and affiliates are being discussed, as they are now. Although there is no hard evidence that combinations of banking and commerce are harmful, there is no evidence that they are beneficial, either. Nevertheless, developments in the foreign and domestic marketplaces suggest that combinations involving banking and commerce are becoming more common. Thus, the debate has been renewed.
The current debate centers on industrial loan companies (ILCs), also known as industrial banks. ILCs are state-chartered institutions that have banking powers, subject to certain restrictions on lending and deposit taking. ILCs are regulated by their state chartering authorities and, at the federal level, by the FDIC. The unique nature of the ILC charter has kept these institutions outside the purview of the Bank Holding Company Act (BHCA). As a result, the parent companies of ILCs include a diverse group of financial and commercial firms.1
Two pieces of legislation passed by the U.S. House of Representatives in 2003 have focused attention on whether ILCs should be considered equal to other insured depository institutions with regard to powers such as interstate banking and payment of interest on business checking accounts.2 Consumer groups and community bankers have responded to the proposed legislation by raising questions about its competitive effects. In particular, concerns focus on the possibility that commercial entities, which in certain states can enter banking by acquiring an ILC charter, could branch nationwide. For example, in 2002, Wal-Mart attempted to acquire an existing ILC in California. In response, the California legislature amended the state's law, thereby prohibiting a commercial entity from making such an acquisition, and Wal-Mart subsequently withdrew its notice. Other concerns focus on whether federally insured depository institutions, including insured ILCs, should be allowed to pay interest on business checking accounts; some people argue that if they were, the ILCs would have a competitive advantage over other insured depository institutions. Finally, fears have been expressed that the failure to prohibit such a mixing of banking and commerce could lead to a situation like that in Japan, where informal links between commercial firms and banks have raised safety-and-soundness concerns.
The Federal Reserve Board has expressed concern that expanding the powers of ILCs would weaken the legal barriers separating banking and commerce. The Board argues that there is a long-standing policy of separating banking and commerce and that the proposed expansion would undermine that policy. Although the FDIC has the authority to examine the parent of any ILC, the Federal Reserve Board argues that the absence of federal oversight of the owners of ILCs threatens the safety and soundness of the banking system.3
As the primary federal regulator of ILCs, the FDIC has expressed the view that these institutions pose no greater safety-and-soundness risk than do institutions with any other charter.4 Rather, the challenge facing bank regulators is to ensure that market innovation can take place while maintaining the public's confidence in the banking system. As FDIC Chairman Donald Powell has noted, regulators must guard "against the possibility that the regulatory system itself does not impair the vital process of innovation and change that is the lifeblood of the American marketplace."5
And so the stage is set and the debate over banking and commerce continues.6 The relevant questions are should banking and commerce should be allowed to mix, and if they mix, should the combination be regulated? This paper examines the arguments in terms of the public interest; reviews the evidence about an alleged long-standing principle of separation; explores the benefits of, and then the risks posed by, affiliations between banking and commerce; discusses firewalls and prudential supervision; spells out two approaches to regulating affiliations; and concludes with a summary and a discussion of policy implications.
Separation versus Affiliation: The Public Interest
There are generally two views on whether banking and commerce should be separated. The first view argues that a line of separation must be maintained because the risks of allowing banking and commerce to mix outweigh the possible benefits. The failure to maintain a separation of banking and commerce, especially in terms of ownership and control of banking organizations, could have potentially serious consequences, ranging from conflicts of interest and the lack of impartiality in the credit decision-making process to the unintended expansion of the financial safety net. To adequately protect the insured entity from such abuses (it is argued), the insured entities' corporate owners need to be subject to federal supervision and regulation.7 This viewpoint has been articulated over the years by (among others) the Federal Reserve Board, some members of Congress, and community bankers; many of these advocates of separation claim that their position is based on a long-standing principle of the separation of banking from commerce (this claim is examined in detail below).8
The other view argues that mandating a separation of banking and commerce prevents the benefits of affiliation from being realized and can result in an inefficient allocation of resources. Given adequate supervisory oversight of the insured entity, federal regulatory and supervisory authority over the corporate owners of the insured entity represents an unwarranted hampering of the market process that is neither necessary nor desirable. This view has been expressed by (among others) the FDIC, some members of Congress, and public policy groups.9 The FDIC has long argued that with certain safeguards in place to protect the bank and ensure the safety and soundness of the banking system, affiliations between banking and commerce should be permitted.
Although the current debate centers on the industrial loan charter, the underlying policy issueswhich have been debated for many yearscome down to whether the public interest is served when affiliations between banks and commercial entities are prohibited.
Testifying before Congress on financial services reform in 1987, the FDIC's then-chairman L. William Seidman argued that the public interest would be best served by a financial services industry that met four objectives: the financial system should be viable and competitive, the banking system should be operated in a safe and sound manner, customers should realize benefits from enhanced competition, and the system should be flexible enough to respond to technological change.10 Consistent with these objectives, the regulatory and supervisory structure of banking should be the simplest and least costly one available.
The question facing policy makers then wasand continues to bewhether these objectives can be met without restricting the ability of banks to choose the corporate structure that best suits their business needs. As Seidman noted: "The pivotal question . . . is: Can a bank be insulated from those who might misuse or abuse it? Is it possible to create a supervisory wall around banks that insulates them and makes them safe and sound, even from their owners, affiliates and subsidiaries?"11 If so, then the banking and commerce debate should focus on how affiliations should be regulated so that the public interest is met.
A Long-Standing Principle of Separation?
The literature on the issue of a long-standing principle of separating banking and commerce is extensive.12 This literature shows that the extent to which banking and commerce have mixed or have remained separate has been a function of the demands of the marketplace, the level of technology and the state of development of organizational and business structures. Recently, Haubrich and Santos (2003) dispel any notion that a separation of banking and commerce has been a long-standing principle in American banking history. They conclude that despite the regulations and prohibitions on certain activities and forms of control, extensive links between banking and commerce have existed and continue to exist and have often been facilitated by the use of arrangements very similar to those that have been prohibited by law.
For example, certain charter types-including limitedpurpose consumer banks and ILCspermit a mixing of banking and commerce. These charter types do not fit the definition of a bank under the BHCA and technically are not banks; in certain states, they can be owned by commercial firms. These firms, in turn, are not subject to the BHCA and are not required to become bank holding companies.13
And there is other evidence of banks exercising control over commercial firms, and commercial firms exercising control over banks, through various means. Sometimes, as legal restrictions were placed on the mixing of banking and commerce, certain exceptions were made that allowed commercial firms to retain their affiliations with banks. Examples include the limited number of nonbank banks that were grandfathered by the Competitive Equality and Banking Act of 1987 (CEBA), and the unitary thrift holding companies that were grandfathered under the Gramm-Leach-Bliley Act of 1999 (GLB). Sometimes, the mixing has resulted from the equity investments of banks, including investments in small business investment companies, equity acquired in loan workouts and equity kickers, and merchant banking activities. Outside of chartered banking, captive finance companies of large commercial firms (e.g., GE Capital) also approximate a mixing of banking and commerce. Moreover, individuals are permitted to hold a controlling interest in both a bank and a nonbank commercial firm. For example, in the case of chain banking organizations, federal regulatory oversight does not extend to the owner.14
International comparisons of the treatment of banking and commerce are instructive. The U.S. practice of prohibiting affiliations between banking and commerce contrasts with the practice of most other industrialized countries, since in these countries linkages among banking and commercial entities in the form of ownership and control are common. Throughout Europe, where universal banking is common, and in Japan, where the keiretsu is a dominant business form, banking and commerce traditionally have had greater freedom to mix.15
U.S. banking is in fact characterized less by a tradition of being separate from commerce than by regulatory attempts to separate it from commerce. Since the banking crisis and economic depression of the 1930s, these attempts have focused on prohibiting affiliations between banking and commercial firmsthat is, on separating banking from commerce at the ownership level. In 1933, responding to the general belief that the nation's banking and economic problems had been caused by conflicts of interest between banks and their securities affiliates, Congress passed the Glass-Steagall Act, which prohibited affiliations between commercial and investment banking. Two decades later, in 1956, a general and long-standing distrust of large banking conglomerates combined with the increased merger activity of the 1940s and early 1950s led to the passage of the BHCA, which separated banking from commerce by restricting the activities of owners and affiliates of banks. The BHCA defined bank holding companies and established a framework for their regulation by the Federal Reserve. The restrictions on ownership and affiliation that are currently in effect stem from the BHCA and its subsequent amendments.
Throughout the remainder of the twentieth century, rapidly changing technology and the changing nature of banking led to increasing demands for the banking system to be restructured and given broader powers.16 At the same time, the regulatory line separating banking from commerce was being weakened as banks increasingly found ways to engage in a range of financial activities.17 And other financial services providers found ways to offer bank-like products to their customers, one example being the cash management account offered by securities firms. After repeated congressional attempts to address financial modernization, GLB was passed in 1999, effectively acknowledging and extending the degree to which banking organizations were permitted to engage in nonbank financial activities.18
In summary, banking has never been absolutely separate from commerce. Although the activities permitted to banks have always been subject to prohibition, restrictions on affiliations with nonbank firms are relatively recent. Moreover, despite the regulatory line prohibiting affiliations between banking and commercial firms, it is likely that the market will continue to move toward a greater blending of banking and commerce. The linkages that exist between banking and commerce outside of the current restrictions on ownership or activity can also be expected to continue.19 Thus, as has recently been noted, "It is perhaps better to replace the claim that banking has been separated from commerce in the United States with the observation that regulations have attempted to separate banking and commerce."20
The Potential Benefits of Affiliation
The potential benefits of mixing banking and commerce are well known and have been discussed in the economics literature.21 Among the potential benefits are operational efficienciescost and revenue synergiesincluding economies of scale, economies of scope, and informational efficiencies. Other potential benefits may result from greater product and geographic diversification, access to new sources of capital, and enhancement of the global competitiveness of U.S. banks.
Cost synergies can result from economies of scale (when increasing the scale of operations lowers the average costs of production) or from economies of scope (when costs of production are lowered by the production of products that share inputs). Finding empirical evidence for the existence of these economies in banking has proven to be difficult.22 However, the lack of demonstrable economies in banking does not imply a lack of cost complementarities between banking and other commercial activities. For example, the entrance of commercial firms into bank-like activities may be evidence of economies of scope. Technological innovations in recent years have made combinations of banking and commerce in the United States economically feasible and profitable. Changes in the cost structures of banks and commercial firms alike, which are the result of improvements in technology, also leave room for potential economics of scope.
Should economies of scope exist, they would provide one incentive for banks and commercial firms to seek mergers with one another. However, even though GLB has lessened the restrictions on affiliations among banks and securities and insurance firms, the limitations on bank activities and commercial affiliations have largely kept U.S. banks from availing themselves of the possible synergies.
A further incentive for affiliating may come from informational efficiencies.23 For example, banks could have an incentive to hold equity positions in commercial firms if doing so would make it easier for them to gain the information necessary for their role as intermediary. In addition, holding equity can limit the bank's exposure to moral hazard. Bank financing of start-up ventures, when an equity claim substitutes for collateral, is an example. The equity claim can provide the bank with information about, and the ability to exercise control over, the commercial firm. These informational incentives would probably result in bank ownership of commercial firms, but not commercial ownership of banks.
Other literature has focused on the implications of banks holding equity positions in borrowing firms. For example, Pozdena (1991) cites arguments in favor of lifting existing restrictions on commercial and bank affiliations, noting that the ability simultaneously to hold the equity of commercial firms and lend to them is important to the successful intermediation of risky credits. Santos (1999) examines the implicationsgiven deposit insuranceof equity stakes when funding is provided by a bank rather than a financier: mixed debt and equity are shown to control moral hazard. Haubrich and Santos (1999) argue that there is a liquidity synergy that gives banks an incentive to own a nonfinancial firm: by creating an internal market, merging with a nonfinancial firm increases the bank's efficiency in disposing of assets that back defaulted loans.
Other incentives for affiliations between banking and commercial firms include enhanced product and geographic diversification and greater access to capital.24 Affiliations could lead to the diversification of the combined organization's portfolio risk, although the effect is likely to differ among banks of different size. Large banks with overseas operations that are permitted equity investments would probably see a smaller effect from affiliations at home than would smaller banks with no overseas presence. Although access to new capital was thought to be a compelling argument for affiliation in the early 1990s, when the cost of capital to banks was high, the immediacy of the need disappeared with the decade-long banking recovery and with structural changes (such as interstate branching) that have facilitated mergers.25
Affiliations between banking and commercial firms can also enhance the global competitiveness of U.S. banks. As noted, many other countries do not place similar restrictions on the affiliation of banks with commercial entities, with the result that combinations of industrial, commercial and banking firms are common.26 It can be argued that this potential benefit was tacitly acknowledged by the provisions of GLB that allow financial holding companies to engage in limited merchant banking activities for investment purposes. As such, these provisions result in a mixing of banking and commerce that was heretofore prohibited to U.S. banks.27
Questions remain about the extent to which an incentive exists for banks and other firmsfinancial and nonfinancial aliketo affiliate. For example, large firms such as Sears Roebuck and Ford Motor Company took advantage of the unitary thrift charter during the 1980s, only to sell those thrifts subsequently. Krainer (2000) reports speculation that these firms may have wanted to capture tax losses at troubled thrifts rather than establish a long-term presence in banking. Another possible conclusion is that the combination of banking and commerce may be less attractive to commercial firms than some might expect.28
The Potential Risks of Affiliation
The potential risks from allowing banking and commerce to mix that are cited most often are the potential for conflicts of interest and for the misallocation of credit; the fear of, or aversion to, a concentration of powerfinancial or economicthat could lead to monopolies; and the potential for an expansion of the federal safety net, which could expose the taxpayer to losses. (A discussion of these risks and whether they justify a separation of banking and commerce is presented in this section. The following section expands on the ways of managing the risks.)
Conflicts of Interest
Denying Credit to the Affiliate's Competitors. Does a bank with a commercial affiliate have an incentive to deny credit to its affiliate's competitors? From an economic perspective, given a competitive market for loans, a bank that unreasonably prefers its own affiliates is likely to suffer diminished earnings. When alternative sources of funds are readily available, the competitor will receive its funding elsewhere, but the bank will lose the profit it would have made on the loan. By denying loans to an affiliate's competitors, the profits of the consolidated banking organization will be lower than they would have been otherwise. However, such an incentive could exist if markets were not competitive, or if the affiliation yielded informational synergies so that the bank had a cost advantage over its competitors. In either case, the bank would have an incentive to deny credit to its affiliate's competitors.31 The question then becomes how to counteract the bank's incentive, which is discussed below.
Preferentially Funding the Affiliate. A situation in which the bank could choose to lend preferentially to its commercial affiliates, whether willingly or under duress, could arise because of the bank's access to lower-cost funds as a by-product of federal deposit insurance. This argument for separation, too, fails to hold in a competitive market for bank loans. Again, the nonaffiliated customer will be able to obtain loans from other providers at a competitive rate, and the bank's decision not to lend to its affiliate's competitors at competitive rates will result in lower profits. Moreover, this potential conflict has been addressed by Sections 23A and 23B of the Federal Reserve Act, which restrict the amount and terms under which banks can lend to their affiliates.32
Tying Loans to Purchases of the Affiliate's Products. Tying loans to other business has the potential to harm the corporate customer or the bank. Tie-in arrangements are illegal under antitrust laws for all businesses, but Congress made it much easier to prove a tying arrangement when a bank was involved. The BHCA eliminates the need for the plaintiff to establish the economic power of the bank and the specific anticompetitive effects of the tie-in arrangement, as would be required under the general antitrust laws.33 Section 106(b) of the BHCA prohibits anticompetitive tying practices: banks are prohibited from requiring customers to obtain nontraditional banking services or products in return for loans or a discounted banking service. This provision also precludes a bank from tying its banking services or products to the requirement that the customer not obtain some product or service from a competitor of the bank or its affiliates. Section 23B of the Federal Reserve Act, which requires transactions between affiliates to be at arm's length and on market terms, also serves to prohibit certain tying arrangements.
Tying is legally permissible in certain circumstances.34 For example, a bank may restrict the availability or vary the price of a loan on the condition that the customer also obtain a traditional bank product from the bank or an affiliate.35 Tying violations generally involve the tying of loans with securities or insurance services or products. However, restrictions on tying can be avoided. For example, there is no violation if the loan is booked through a nonbank affiliate or parent holding company. Tying prohibitions do not apply to investment banks or to U.S. banks' business with non-U.S. companies. Moreover, tying is permitted when the transaction is requested by the customer rather than initiated by the bank.36
The federal banking regulators have recently addressed the incidence and effect of illegal tying. In August 2003, the Federal Reserve Board issued a proposed regulation that would define the terms under which banks can legally engage in tying. The Office of the Comptroller of the Currency (OCC) also reported on the extent to which illegal tying poses concerns. Both agencies concluded that illegal tying was not a widespread problem among U.S. banks and that banks generally had adequate procedures to comply with antitying restrictions. In October 2003, the U.S. General Accounting Office released a study on the incidence of illegal tying and concluded that the extent of such tying is minimal and does not pose significant problems.37
Other Potential Conflicts of Interest. Another potential conflict of interest is to use inside information to benefit the bank at the expense of a nonbank affiliate or an investor. The bank has access to private information as part of its commercial lending and trust activities, and typically the privacy of such information is achieved through the use of firewalls between respective departments of the bank. This conflict can also arise between the bank and its investment banking affiliates. For example, if a corporate customer of the bank were in financial distress and, in turn, the bank's loans to that firm were in jeopardy, the bank's parent would have an incentive to underwrite bonds for the firm through its securities affiliatebonds that could then be used to pay off the troubled bank loans. Or the parent could use the securities affiliate to underwrite high-risk issues and could use the bank to extend loans to preferred customers. (Again, current law addresses these possibilities by establishing firewalls that prohibit the sharing of inside information between a bank and its affiliate.)
Other conflicts can arise from the bank's dual role as marketer of services and impartial investment advisor. Recent studies have found evidence of conflicts between promoting services and giving disinterested financial advice.38 Most recently, significant conflicts between the bank's role in promoting the securities it underwrites and its role in providing disinterested financial advice have been identified and addressed. In April 2003, the nation's biggest investment firms agreed to pay a record $1.4 billion to settle charges brought by the Securities and Exchange Commission, state prosecutors, and market regulators. The firms were charged with fraud in issuing recommendations for the securities of firms they knew were in trouble, in order to acquire investment banking business. In addition to significant fines, the settlement requires the following: a clear separation of securities research from investment banking; the provision of competing, independent research for investors at no cost; better disclosure of stock rankings; and a ban on the practice of allotting initial public offering shares to favored clients.39
* * *
On examination, the principal potential conflicts that are offered as a rationale for separating banking and commerce seem unlikely to pose significant risks to the safety and soundness of the bank or to the federal safety net. Firewallsincluding the restrictions on the transactions between a bank and its affiliate imposed by Sections 23A and 23B of the Federal Reserve Act, the BHCA Section 106 restrictions on tying, and Federal Reserve Regulation O (which restricts transactions with insiders)are in place to mitigate the incentives underlying the potential conflicts.40 And market-oriented solutionsfor example, competition in the markets for banking productscan also play a role in mitigating those incentives. If markets were not competitive, competition could be increased through the elimination of barriers to entry. Or if affiliation provided an informational advantage, banks without affiliates could achieve the same result, as they have done through leasing arrangements with grocery chains and other commercial firms. In short (and the point is elaborated on below), most conflict situations affecting banks can be controlled through the supervisory process and enforcement of the appropriate firewalls and need not pose excessive risk to banks or the banking system.
Concentration of Economic Power within Banking
The conventional antitrust argument for separating banking and commerce has been that banks with monopoly power will attempt to expand into nonbanking businesses to extract monopoly profits and engage in price discrimination. In practice, however, it is not likely that conglomerate integrationthe combination of banks and nonbanks under a holding companywould result in monopoly rents because when markets for bank loans are competitive, it is difficult for the bank to extend market power from banking to nonbanking lines of business. Refusing to lend to the competitors of its nonbank affiliates or granting credit to its affiliates and their customers on favorable terms (as discussed above under conflicts of interest) serves only to reduce bank income. Attempts by the bank to engage in predatory pricing, by cross-subsidizing the operations of its affiliate, would work only if there were considerable barriers to entry. To the extent that banking markets are competitive, this antitrust argument for separating banking and commerce fails. Banking markets became increasingly competitive during the 1970s and 1980s; thus, the likelihood that banks would be able to extract monopoly rents was reduced. Although consolidation in banking has increased over the past decade, interstate banking and a competitive market for small banks continue to make it unlikely that monopoly power will spread from banking to nonbanking business.
The existence of limited economies of scope in banking makes it unlikely that banks and commercial firms would affiliate to the extent needed to produce an economic concentration.42 When Congress, in GLB, permitted combinations of large banks with large securities and insurance firms, it seemed to acknowledge that the potential for monopoly power is of less concern today and does not provide a rationale for separating banking and commerce.43
The second goal mentioned abovediscouraging the growth of large entitiesseems equally to be based on a straw man. A fear and distrust of banksespecially large money-center bankshas long been a hallmark of U.S. political history and probably contributed to the idea that the separation of banking and commerce was necessary to prevent the growth of large conglomerates.44 The net-public-benefits test of the BHCA instructs the Federal Reserve Board to consider, among other criteria, whether an "undue concentration of resources" would result when making its decisions regarding permissible activities for bank holding companies.45 Over the years, the Federal Reserve Board has relied on this criteria as the basis for denying applications under Section 4(c)(8) of the BHCA when major bank holding companies have applied for approval to undertake a joint venture with a substantial enterprise.46 Again, in light of GLB provisions mentioned above, this seems unlikely to be a justification for separating banking and commerce today.
And from the viewpoint of many community bankers, maintenance of a diversified economic system with a robust small- and middle-market business sector could be threatened by affiliations between banks and commercial firms.47 The primary concern of these bankers is that if a large commercial entity with monopoly power, as Wal-Mart is often perceived to be, were allowed to enter banking, it would use its monopoly power to displace its banking competitors. However, the argument could also be made that a large commercial banknot just a large commercial entitycould similarly displace its banking competitors in any given market. To the extent that there are few barriers to entry in that market, the argument that either a Wal-Mart or a large commercial bank would be able to exert monopoly power is weakened. Saunders (, 239), notes that "there is no reason to expect, a priori, that the competitive behavior of the banking industry would be eroded by eliminating the commerce-banking separation. Indeed, it may be that such a policy could have a pro-competitive effect, as the number of potential entrants and potential competitors expands."
Thus, although the fear of monopoly power in banking has deep roots, it is not a sufficient reason to prohibit affiliations between banks and commercial firms.48 Certainly concentrations of economic and political power, regardless of their source, are likely to continue to raise concerns and warrant the attention of policy makers. These concerns have traditionally been (and are best) addressed by Congress.
Walter (2003) expands on the circumstances under which the shifting of losses among the bank and its affiliates is likely to threaten the solvency of the insured bank and thus potentially threaten the deposit insurance funds and the taxpayer. One set of circumstances involves shifting losses among the parent's affiliates to protect the reputation of the firm; the other involves shifting losses to take advantage of limited liability.51
Under the first set of circumstances, the parent company would have an incentive to shift losses from one subsidiary to another to prevent negative information from reaching analysts and the market. For example, when the capital of the bank is greater than that of the nonbank affiliateso that a loss shift would harm the bank but not cause it to failthere is an incentive to shift losses to the bank, where they may go undetected and the reputation of the parent would be preserved. The reputation would be spared partly because the balance sheet of the bank might be more opaque than that of the nonbank affiliate.
Under the second set of circumstances, the shifting of losses from a more-capitalized affiliate to a less-capitalized affiliate would allow the parent to minimize its losses by taking advantage of limited liability. For example, if a nonbank affiliate incurred a loss that was larger than the capital or net worth of the bank, shifting that loss to the bank would cause the bank to fail. However, the loss to the parent would be limited to its capital investment in the failing bank. In fact, however, this shift could have a negative effect on the parent's reputation and is therefore less likely to occur than one might expect.
Because the creditors of the nonbank affiliate and the parent are more likely to exert market discipline than are the creditors of the bank, loss shifts either for reputation or for purposes of limited liability are more likely to be directed to the banka potential that raises safety-and-soundness concerns. The undesirable effects of shifting losses from nonbank affiliates to the bank can range from causing the bank minimal harm to causing its failure.
If the bank's creditors are aware of the potential for loss shifts, they should demand higher interest rates when they perceive a higher risk of such shifts. However, mispriced deposit insurance makes it less likely that the creditors of the bank will impose discipline by demanding higher interest rates. Thus, it is more likely that losses will be shifted to the bank.52 And it is precisely because these loss-shifting transactions raise safety-and-soundness concerns and potentially threaten the safety net that they have been made illegal under existing law. In particular, the firewall restrictions contained in Section 23A and Section 23B of the Federal Reserve Act require that transactions between an insured bank and its nonbank affiliates, including its parent, are on market-related, arms-length terms. Applicable to all insured depository institutions, they are intended to ensure that the loss shifting described above does not threaten the solvency of the insured bank.
Unchecked, these transactions and the resultant safety-net concerns would raise doubts about permitting banks to affiliate with nonbank entities, whether financial or commercial in nature. However, if regulatory discipline is imposed by the enforcement of firewalls and the prudential supervision of the insured entity, the potential harm to the deposit insurance funds and the safety net can be contained.
Managing the Risks: Firewalls and Prudential Supervision
The primary means of controlling abuse and ensuring the safety and soundness of the banking system is through the supervisory process. The goal is to balance the need for maintaining the safety and soundness of the banking system with banks' need to pursue activities and affiliations by which they can increase their profits, attract capital, and enhance their competitiveness.
The previous section mentioned several firewall restrictions: those contained in Sections 23A and 23B of the Federal Reserve Act, those contained in Section 106 of the BHCA, and the Federal Reserve Board's Regulation O. Sections 23A and 23B ensure that transactions between an insured bank and its nonbank affiliates, including its parent holding company, are on market-related, arm's-length terms. Applicable to all insured depository institutions, these restrictions are intended to ensure that the loss shifting described above does not threaten the solvency of the insured bank. Similarly, Section 106 protects from harm that may result from illegal tying. And Regulation O governs the transactions between insiders and the bank.
Other safeguards that must be in place to adequately protect the insured entity are the requirements that the bank's investment in any operating subsidiary be deducted from regulatory capital, that the bank be well capitalized following that deduction, and that the corporate separateness of the bank be protected. To achieve adequate separation, the insured entity should be financially separatethat is, it must be separately funded and have no commingled assets, and all transactions with affiliates must be at arm's length. The insured entity must also be perceived by the market to be operated separately and to be legally separatethat is, to be not responsible for the liabilities of its affiliates.53
During periodic safety-and-soundness examinations, banks are examined for compliance with regulatory standards, including firewalls. As the primary federal regulator, the FDIC examines state-chartered nonmember banks; the OCC examines national banks; the Office of Thrift Supervision (OTS) examines thrift institutions; and the Federal Reserve examines state-chartered member banks. As noted earlier, the Federal Reserve also has authority to examine bank holding companies and financial holding companies. Off-site monitoring by banking regulators provides a check on the institution between examinations.
In the 1990s, regulators began to develop risk-focused supervision for those banks that are determined to be large and complex. Risk-focused supervision assesses a number of risks in each of the bank's major business lines. Because the risk profiles of large and complex banks may change rapidly, supervisors monitor risks on an ongoing basis so as to be better able to allocate supervisory resources to the areas that pose the greatest risk.54
In combination, prudential supervision and the enforcement of regulatory standards and firewalls can provide sufficient protection for the bank and help ensure the safety and soundness of the banking system.55 That is, these regulatory tools must be effective enough to ensure that the risk to the insurance funds is minimal, and flexible enough to allow institutions to explore the opportunities presented by affiliations with nonbank entities. The intended effect of firewalls is that the soundness of the bank not be jeopardized by an obligation to bail out an affiliate. Restrictions on the quantity and quality of transactions between the bank and its affiliates allow some synergies to be realized while minimizing the possibility that the insured bank will be harmed.56
The result is that the existing firewalls may not be fail-safe. Firewalls are acknowledged to work well during normal times, but they are criticized for being less effective in extremis, when they may be needed most.57 (Moreover, no firewalls have been tested since GLB made expanded affiliation possible.) And although impenetrable firewalls can be constructed, they may not be desirable. For example, as enacted in 1956, Section 6 of the BHCA achieved the complete isolation of banks within a holding company by effectively prohibiting transactions between affiliated banks, but the 1966 amendments to the BHCA repealed the prohibition.58
Two Regulatory Models
How then should affiliations be handled? Although separating banking from commerce would prevent the risks described above, it would do so in a heavy-handed way and would prevent the economically preferred market-based outcome from being realized. As Walter (2003) noted, "Maintaining a wall separating banking and commerce at best addresses a symptom of an uncompetitive market rather than the lack of competition itself."59
The alternative to prohibiting affiliations between banking and commercial firms is to regulate the affiliations so that potential harm to the safety net is contained. There are two regulatory models or long-term strategies for accomplishing the objective. In this context, the two models are distinguished by the extent to which the entire enterprise, including the parent of the insured entity, is subject to federal oversight. The first model reflects the view that federal oversight of the banking organization from the top downthat is, from the parent down to its subsidiaries, both bank and nonbankis necessary if the safety net is to be protected. The second model reflects the view that regulatory scrutiny can be accomplished from the bank or insured entity up: adequate safeguards will make it possible to protect the insured entity from the risks and conflicts that arise from affiliations without the need for explicit oversight of the parent.
The Top-Down Approach to Regulating the Banking Organization
Proponents of the top-down model argue that it maintains a separation of banking from commerce by limiting the ability of banks and banking organizations to own, or be owned by, nonfinancial or commercial firms. This limitation is achieved in three ways. First, affiliations among financial services providers are permitted only under the organizational structure of the financial holding company, which is subject to federal oversight (including functional regulation of certain nonbank affiliates and umbrella supervision of the entire organization by the Federal Reserve). Second, the Federal Reserve (in conjunction with the Secretary of the Treasury), has effective control over the determination of permissible activities for financial holding companiesthus, over banking and commerce.61 Finally, by eliminating the unitary thrift holding company charter, GLB precludes further commercial ownership of thrifts. But questions have been raised as to whether GLB maintains or undermines the separation of banking and commerce (see below).
Oversight of the Banking Organization. Traditionally, those who argue that affiliations between banking and commerce should be prohibited believe that the reliance on firewalls and prudential supervision alone is not sufficient to protect the insured entity.62 These advocates of separation question whether firewalls can be strong enough to prevent unacceptable levels of risk from harming the insured entity, yet flexible enough to permit the economic advantages of affiliation to be realized. They also question the ability of firewalls to ensure the corporate separateness of the insured entity.63 Accordingly, supervision of the insured entity and enforcement of firewalls to protect it from the risks posed by affiliation must be supplemented by consolidated or umbrella supervision of the entire banking organization.64
As noted above, bank holding companies became subject to consolidated supervision by the Federal Reserve under the BHCA. Under consolidated supervision, separate units of a holding company are supervised as one entity. The consolidated supervisor has direct oversight of the parent and its subsidiaries so that the relationship between nonbank affiliates and the insured entity can be controlled. Under GLB, the Federal Reserve received the power to be the umbrella supervisor of the financial holding company and in that capacity has various authorities.65 But for the purposes of umbrella supervision, functionally regulated nonbank affiliates are not treated as banks, and the Federal Reserve is directed to rely primarily on the information provided by the nonbank affiliates' functional regulators.66
Consolidated supervision has been criticized on several counts. Some of the critics have noted that it can be viewed as a "vote of no confidence in firewalls."67 If firewalls can effectively protect the insured entity, consolidated supervision is unnecessary. The argument is also made that consolidated supervision signals the market that regulators expect affiliates to be managed as integrated entities. As a result, ensuring effective separation of the insured entity from the risks posed by its affiliates may become harder as supervisors are more likely to focus on the integrated entity rather than the insured depository institution. Moreover (the argument goes), the requirements of consolidated supervision reduce the flexibility of bank or financial holding companies to adapt to a rapidly changing financial environment and to best meet the needs of their customers.68 The view that consolidated supervision need not extend to the owners of banks was clearly articulated by the interagency study issued in 1991 by the U.S. Treasury, which made broad recommendations for modernizing the financial services industry.69 The Treasury study noted that beyond certain necessary safeguards designed to ensure that the safety net was not extended beyond the bank, cumbersome bank-like regulation was not necessary for the financial services holding company that was then being proposed.70 The study argued that "it is practically infeasible for a bank supervisor to effectively regulate a complex and diverse range of businesses. Bank regulation should be concentrated on the bank, not on protecting a diversified [financial services holding company] that should be subject to normal market discipline."71 The study noted that consolidated regulation of the holding company ran the risk of being viewed as implicit government backing of holding companies, increasing the taxpayer's exposure and potentially expanding the safety net beyond the insured entity. The study also noted that full holding company regulation would deter nonbanking firms from investing in banks because potential investors would deem too high the price of having bank supervisors regulate all nonbanking activities. Moreover, the study noted that none of the hypothetical problems of combining banking and commerce was evident among commercial companies that owned depository institutions at that time, notably unitary thrifts, nonbank banks, and industrial loan companies.72
Similarly, the GLB requirement that financial firms submit to umbrella oversight through the financial holding company structure may deter these firms' entry into banking. Although GLB's functional regulation provisions appear initially to shield nonbank firms, the Federal Reserve's authority and powers remain extensive, and from the viewpoint of these firms, GLB has restricted the incentives of the marketplace.73 A further deterrent may be the Federal Reserve's source-of-strength doctrine, which requires a holding company to provide financial assistance to its troubled subsidiary banks. Although the doctrine was restricted by the Fifth Circuit Court of Appeals in a case in which the Federal Reserve ordered a holding company to inject capital into a failing bank, under current regulation the source-of-strength doctrine remains the Federal Reserve's policy.74 By making investments in bank equities less attractive, the policy could have the effect of raising the organization's cost of capital. And because the policy is directed primarily at the corporate owners of banks, it would lead to the differential treatment of individual owners, for presumably they would not be held to the standard.75
Determination of Permissible Activities. Under GLB, the Federal Reserve plays the dominant role in determining permissible activities for the financial holding company and its subsidiaries. Beyond an initial set of permissible activities, GLB authorizes the Federal Reserve Board, in conjunction with the Secretary of the Treasury, to determine additional permissible activitiesthose that are financial in nature or incidental to such financial activities. The Federal Reserve alone is authorized to determine the set of activities that are complementary to financial activities, as long as they do not pose a substantial risk to the safety and soundness of the insured entity or the financial system.
The dynamics of expanding the list of permissible activities are different under GLB than under the BHCA. Under GLB the test is "financial in nature or incidental to," and unlike the "closely related to" standard of the BHCA, there is no net-public-benefits test. Once defined as permissible, an activity is open to financial holding companies and financial subsidiaries with only a post-entry notification to the Federal Reserve required. As a result, subsequent competitive evaluations are not possible. And, as noted earlier, GLB also directs the Federal Reserve to permit an unspecified set of commercial activities defined as complementary, and permits financial holding companies to engage in merchant banking.76
Through the provisions for determining what activities are financial, incidental, or complementaryand are thus permissible for financial holding companiesGLB has shifted the line of separation: instead of drawing it between banking and commerce, GLB has drawn it between finance and commerce. On this basis, some argue that GLB effectively undermined the policy rationale for separating banking and commerce.77 Moreover, the process of defining what is financial yet not commercial considerably weakens the congressional intent to maintain a separation of banking and commerce. The line becomes adjustable in response to changes in markets and technology, as determined primarily by the Federal Reserve. The result is a blurring of the distinctions between banking, finance and commerce, and without operational limits to expansion, GLB suggests a slow but accelerating integration of banking and commerce.78
But it is hard to argue that the potential risks posed by affiliations between securities firms and banks are less risky than those posed by affiliations between banks and other nonbank or commercial entities. For example, with regard to the use of credit or the benefits to be gained from affiliation with a bank, the activities of a securities firm do not differ significantly from those of a commercial firm.79 If it is imperative to keep banking separate from commerce, it should be no less important to separate banking from securities activities. By permitting affiliations among banking, securities, and insurance, GLB tacitly acknowledges that the safety-and-soundness risks posed by these affiliations are manageable. This acknowledgment makes it hard to defend the principle of separation.
Elimination of the Unitary Thrift Holding Company Charter. GLB placed new restrictions on the ability of banking and commerce to mix. Specifically, it ended the ability of commercial firms to own a single thrift in a unitary thrift holding company, although existing holding companies were grandfathered.80
Supervised by the OTS, unitary thrift holding companies are subject to prudential supervision and firewall restrictions81 and have long operated without raising safety-and-soundness concerns. For example, thrifts that were part of diversified holding companies were not significant sources of losses during the savings and loan crisis of the 1980s.82 Nor have they been recipients of a significant number of enforcement actions.83 In addition, thrifts in unitary thrift holding companies have tended to outperform other thrifts because of the greater diversification of their revenue streams, loan and asset portfolios, and funding sources. The mixing of banking and commerce conducted in the unitary thrift holding company has not been shown to pose undue risk to the safety net.84 Despite this, those opposed to the mixing of banking and commerce consider it unsuitable for a diversified holding company to own a single thrift.85
The enactment of GLB restrictions on diversified holding company ownership of thrifts closed a long-standing avenue through which banking and commerce have successfully mixed. Like ILCs, unitary thrift holding companies operated outside of the bank holding company structure and outside of supervision by the Federal Reserve. When GLB eliminated this corporate structure, it narrowed the options available for mixing banking and commerce.
The Bank-Up Approach to Regulation: Protection of the Insured Entity
By focusing on the bank itself rather than attempting to oversee the entire banking organization, bank supervisors should be able to defend adequately against any tendency by the owners of the bank to aid their nonbank affiliates. To do this, the banking supervisor requires certain powers, including the authority to monitor compliance on both sides of all transactions between the insured entity and its affiliates (including its parent), the authority to require that the insured entity and its affiliates report such transactions, andin the case of nonbank affiliatesthe authority to require that financial statements or other relevant information be made available to the primary bank regulator.87
As the primary regulator of state-chartered, nonmember banks and as the deposit insurer, the FDIC has various powers that allow it to ensure the safety and soundness of the insured entity and, by extension, to ensure the safety of the deposit insurance funds. When the FDIC is the primary federal regulatorfor example, for ILCsthe necessary protections can be provided without consolidated oversight of the insured entity's owners. Among the powers the FDIC has are the authority to examine both sides of transactions between the bank and its affiliates and to examine the bank and any affiliate, including the parent, as may be necessary to determine not only the relationship between the insured entity and the affiliate but also the effect of such relationship on the insured entity. When the parent is subject to the reporting requirements of another regulatory body (e.g., the Securities and Exchange Commission or a state insurance commissioner), the FDIC has agreements in place to share information with that regulator.88 Moreover, in examining any insured depository institution, the FDIC has the authority to examine any affiliate of the insured entity, including its parent company, as may be necessary to determine the relationship between the insured entity and the affiliate, and the effect of the relationship on both of them.89
The regulation and supervision of ILCs illustrate how the bank-up model can effectively protect the insured entity and the insurance funds without subjecting the entire organization to consolidated or umbrella supervision.90 The state of Utah, as home to approximately one-half of all ILCs and more than 80 percent of industry assets, provides a case in point.
ILCs became eligible for federal deposit insurance under the Garn-St Germain Act of 1982. In 1987, the Competitive Equality Banking Act expressly exempted ILCs from the BHCA and from oversight of the parent organization by the Federal Reserve.91 GLB did not repeal this exemption. Generally ILCs are authorized to engage in traditional financial activities that are available to all charter types. They may make all kinds of consumer and commercial loans and may accept federally insured deposits, but not demand deposits if total assets exceed $100 million. They may be original issuers of Visa or MasterCard credit and debit cards and may fund their operations with Federal Home Loan Bank borrowings. If an ILC is organized as a limited-purpose or credit-card institution, its products and services are limited to those specified by its charter.
ILCs are subject to the same regulatory and supervisory oversight (including the laws and regulations pertaining to bank safety and soundness and consumer protection) as chartered banks. They are subject to the same or higher capital requirements and the same regulations affecting transactions between the insured entity (the ILC) and its parent and affiliates. However, because of the ILC exemption from the BHCA, the activities and powers permitted under the ILC charter are restricted less than those under other charters. Given its flexibility, the ILC charter has been an attractive choice for companies that are not permitted to, or choose not to, become subject to the restrictions of the BHCA. As a result, it is not surprising that the parent companies of ILCs include a diverse group of financial and, where permitted, commercial firms.
The example of the ILCs offers one answer to the question of whether a bank regulated at the bank level can be insulated and isolated from the parent company's improprieties. G. Edward Leary, commissioner of the Utah Department of Financial Institutions, is among those who have argued that it can, noting that the contrary case has not been made. Leary argues that the collaboration between Utah and the FDIC has resulted in the effective regulation and supervision of the state's ILCs and serves as a working example of how well the bank-up approach can work.92
By Leary's admission, the supervision of ILCs is an evolving regulatory dynamic in the sense that the regulations must evolve to meet the changes in the industry. This responsive evolution is most visible in the approval orders for de novo ILCs, which contain many of the prudential safeguards under which the ILC will operate for the life of its charter. Among the safeguards for Utah's ILCs are requirements designed to maintain the autonomy of the board of directors and management and their independence from the parent company. To achieve autonomy and independence, the ILC's management must act in the best interest of the ILC; must maintain accurate and reliable accounting records on-siterecords on which to base its decisions; must retain authority to set policy and make decisions for credit underwriting; must ensure that all transactions with the affiliate or parent corporation are at arm's length; and must have sufficient personnel and resources to carry out its decisions.93 The state of Utah requires that the parent company register with the Utah Department of Financial Institutions and be subject to the department's jurisdiction and examination authority. As noted above, even though the FDIC is not designated the umbrella supervisor of ILCs, it does have the authority to examine the parent company of the ILC to determine the relationship between the parent and the ILC and the effect of that relationship on the ILC. That is, it has the authority to "supervise the organization" from the bank up.
Because ILCs are ably and effectively regulated and supervised from the bank upboth at state and federal levelsit is argued that they pose no greater safety-and-soundness risk than other charter types. Troubles in ILCs have not stemmed from issues pertaining to permissible activities or commercial affiliations or from the regulatory structure under which they operate, but from faulty strategic or tactical decisions.94 In short, the ILC charter does not represent an inappropriate mixing of banking and commerce. It is important that the ILC charter should not be seen as a loophole, but as a viable charter type and supervisory option.
The Example of Conseco. The bankruptcy of the corporate owner of an ILCConseco Inc.but not of the ILC itself illustrates how the bank-up approach can effectively protect the insured entity without there being a BHC-like regulation of the parent organization. Conseco Inc. was originally incorporated in 1979 as Security National of Indiana Corp. After several years of raising capital, it began selling insurance in 1982. Security National of Indiana changed its name to Conseco Inc. in 1984, after its 1983 merger with Consolidated National Life Insurance Company. Conseco Inc. expanded its operations throughout the 1980s and 1990s by acquiring other insurance operations in the life, health, and property and casualty areas.95 Conseco Inc. was primarily an insurance company until its 1998 acquisition of Green Tree Financial Services. A diversified financial company, Green Tree Financial Services was one of the largest manufactured-housing lenders in the United States.96 Upon acquisition, it was renamed Conseco Finance Corporation. Included in the acquisition were two insured depository charters held by Green Tree Financial Servicesa small credit-card bank chartered in South Dakota97 and an ILC chartered in Utah. Both of these institutions were primarily involved in issuing and servicing private-label credit cards, although the ILC also made some home improvement loans. The ILCGreen Tree Capital Bankwas chartered in 1997 and changed its name to Conseco Bank in 1998 after the acquisition. Conseco Bank was operated profitably in every year except the year of its inception, and grew its equity capital from its initial $10 million in 1997 to just over $300 million in 2003. Over the same period, its assets ballooned from $10 million to $3 billion.
Conseco Bank was supervised by both the Utah Department of Financial Institutions and the FDIC. Despite the financial troubles of its parent and the parent's subsequent bankruptcy (filed on December 18, 2002), Conseco Bank's corporate firewalls and the regulatory supervision provided by Utah and the FDIC proved adequate in ensuring the bank's safety and soundness. In fact, $323 million of the $1.04 billion dollars received in the bankruptcy sale of Conseco Finance was in payment for the insured ILCConseco Bank, renamed Mill Creek Bankwhich was purchased by GE Capital.98 As a testament to the Conseco Bank's financial health at the time of sale, the $323 million was equal to the book value of the bank at year-end 2002.99 Thus, the case of Conseco serves as an example of the ability of the bank-up approach to ensure that the safety and soundness of the bank is preserved.
This section discusses whether umbrella oversight of the parent company is necessary and explores how the debate about banking and commerce is affected by the increased complexity of banking organizations and how important it is for the banking system to have regulatory alternatives.
A Need for Umbrella Oversight of the Parent?
The purpose of umbrella oversight is to protect the insured entity from the risks posed by its affiliates. Over the years, varying opinions on the need for umbrella oversight have been expressed. From the perspective of the Federal Reserve, umbrella oversight provides the necessary framework that allows the risks associated with an organization's consolidated activities to be monitored and restrained. Umbrella oversight protects the insured entities in the organization and, in turn, the safety net. It also makes financial crises and risk to the financial system easier to prevent.100
Walter (2003) reached the conclusion that mixing banking and commerce need not be prohibited but argues that umbrella oversight of the entire organization is necessary. He notes that umbrella oversight is intended to mimic the types of limitations that private creditors would impose on risky affiliations.101 When uninsured creditors are aware of increased riskiness on the part of their debtor, they demand compensation for the added risk. In the face of increased risk taking by a nonbank affiliate, supervisors would similarly impose restrictions or other penalties to compensate for the added risk posed by the affiliate. For example, the supervisor could reduce the bank's supervisory rating or impose restrictions on transactions with the bank's affiliates. In doing so, the supervisor would be mimicking the monitoring behavior of the private creditor in the absence of deposit insurance and a federal safety net. In Walter's model, supervision of the entire banking organization is performed by the Federal Reserve in a top-down model.
Others have expressed the view that umbrella supervision of the entire organization is neither necessary nor warranted.102 If commercial firms that choose to enter the banking business were subjected to umbrella supervision, growing amounts of economic activity would be brought into a regulatory framework that was designed to administer the nation's financial safety net. Instead, federal oversight could be focused on containing the risks posed by such mixing of banking and commercethe risk that losses would be shifted to the insured entity and, in turn, to the deposit insurerthrough the use of firewalls and prudential supervision directed at the insured entity. Confining regulatory oversight to the bank can achieve effective regulation of the insured entity without unwarranted regulatory intrusion into the marketplace.
As noted above, experience has shown that the bank-up model, with proper safeguards, can work. In the bank-up regulatory model, supervision is performed by the primary regulator, which stands in the place or performs the role of the uninsured creditor. Importantly, regulatory discipline can be exerted to protect the safety net without the parent organization and the bank's nonbank affiliates being subjected to federal supervisory oversight. Under these conditions, regardless of holding company affiliation or size, banks should be entitled to choose the corporate structure that best suits their business needs.
Separation and the Increased Complexity of Banking Organizations
How does the greater complexity of financial organizations affect the debate about banking and commerce? Given the increased complexity, what (if anything) is needed to ensure that the risks posed by the mixing of banking and commerce can be contained within a framework of regulatory choice? Are current regulations sufficient? Or can they be improved?
Before GLB was passed, nonbank affiliates were generally quite a bit smaller and less complex than their bank affiliate. As a result, the incentives for the parent to shift losses to the bank affiliate in order to take advantage of limited liability were lessened. Today, under a financial holding company, banks are able to affiliate with securities and insurance firms that are likely to be as large as, if not larger than, the bank itself. The result is often an organization that is both large and complex, and is likely operated as an integrated entity that manages risk across business lines, rather than within legal entities. Thus, the likelihood may be greater that these large and complex financial organizations may attempt to shift losses to the bank and the insurance funds for limited-liability purposes.104
As financial organizations increasingly rely on risk-control strategies that view the activities of the organization in toto, it is all the more important that regulators have the ability to assess the risk posed to the insured entity.105 The framework of umbrella oversight in intended to provide the necessary transparency regarding the activities, practices, and inter-company dealings that affect the distribution of risk across the financial holding company, and to serve as a supplement to supervision by legal entity in that case. However, some have argued that the necessary degree of oversight or monitoring might be better determined by the degree of complexity within the organization, rather than solely on the basis of affiliation.106 For example, organizations that combine banking and finance, where business lines are managed at the holding company level, might warrant more of such oversight than organizations that combine banking and commerce, where the insured entity is clearly separate.
Outside the financial holding company structure, however, the transparency necessary to properly assess risk and protect the insured entity should be accomplished without requiring the organization (parent and affiliates) to be subject to a top-down form of umbrella supervision. Rather, any monitoring should be the responsibility of the functional regulator, and policy makers should consider whether additional powers may be required to ensure sufficient transparency.107 A clear benefit of this approach is that the nonbank economic activity associated with the mixing of banking and commerce would continue to be driven by the market rather than by regulation.
The Importance of Regulatory Alternatives
It is important that there be more than one approach to the regulation and supervision of banks. A key attribute of the dual banking system is the insured entity's ability to choose the supervisory structure under which it operates: the ability to choose contributes to a competition in excellence among bank regulators. Through its role as primary regulator of state-chartered nonmember banks and ILCs, the FDIC provides the bank-up regulatory alternative for organizations and individuals that choose not to be regulated by the Federal Reserve under a holding company structure. Thus, this model offers greater flexibility for corporate enterprise, while managing the risks posed by a mixing of banking and commerce. Without this alternative regulatory structure, the ability of the market to meet the demands of consumers could be severely restricted.
Does the mixing of banking and commerce constitute good public policy? The evidence suggests that the answer is a qualified yes: with adequate safeguards in place, the careful mixing of banking and commerce can yield benefits without excessive risk. Because the main potential risk of mixing banking and commercethe shifting of losses that may threaten the insured institution and the safety netcan be contained through the use of adequate safeguards and firewalls, the separation of banking and commerce does not appear to be justified.
Furthermore, there is no evidence of a long-term separation of banking from commerce in U.S. banking history. Certainly the activities permitted to banks have always been subject to prohibition, but affiliations with nonbank firms have not been prohibited until relatively recently. Nevertheless, the current prohibitions on corporate ownership of banks have been justified on the grounds that banking and commerce have always been separate.
Despite the current prohibitions, the current regulatory structure makes it possible for banking and commerce to continue mixing in many ways. In addition, the current trend in the market place is toward more combinations of banking and commerce. As FDIC Chairman Powell recently noted, "This trend is nothing more than the natural outgrowth of dynamics that have been under way in banking and bank regulation over the last two decades."108 The issue facing policy makers is how these combinations of banking and commerce will be regulated. Specifically, will increasing amounts of commercial activity be subject to umbrella supervision, or will the insured entity be the focus of supervision?
Is umbrella oversight of the entire organization necessary? The evidence suggests that the answer is a qualified no. Given the important role that regulatory choice has played and continues to play in the U.S. banking industry, there should be no need either to reconcile or to choose between the two approaches to regulating banking organizations. Each approach performs its role within the current regulatory system. Given the increased complexity of many banking and financial organizations, it is important that the risks to the insurance funds and the safety net are understood and that firewalls remain effective. In particular, there may be a role for added information sharing and disclosure within the current regulatory structure. Importantly, that added oversight could be performed under either the top-down or the bank-up regulatory model. Regulators and policy makers should consider what additional powers, if any, are needed to be able to effectively ensure corporate separateness of the insured entity, while also ensuring regulatory choice about how the banking enterprise is regulated.
* * *
*The author is a senior financial economist in the Division of Insurance and Research at the Federal Deposit Insurance Corporation. The author would like to thank Christine Bradley, Valentine (Missy) Craig, and Rose Kushmeider for insightful comments and careful review of earlier drafts, and Steven McGinnis for research assistance. Thanks also go to those individuals from the FDIC's Division of Supervision and Consumer Protection who provided valuable comments.
Barth, James R., Gerard Caprio, Jr., and Ross Levine. 2000. Banking Systems around the Globe: Do Regulation and Ownership Affect Performance and Stability? Working Paper No. 2325. World Bank.
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