The Mixing of Banking and Commerce
in the United States
When criteria for permissible activities for the bank, its direct subsidiaries or its affiliates are discussed, the broader issue of whether, or to what extent, banking and commerce should be allowed to mix often arises. To a degree but by no means completely, banking and commerce in United States economic history have been conducted separately, with "separately" meaning conducted by organizations whose activities were, or are, limited to either the banking or commercial field with no formal, legal affiliations outside that field. This partial separation of banking and commerce seems to have been largely voluntary and unplanned, a response to the then-existing demands of the marketplace, level of technology, and state of development of organizational and business structure. In recent decades, however, much of the separation has been mandated by government.
Lines of separation can be drawn on two levels, prohibiting the mixing of banking and commerce within a single entity and prohibiting the common ownership of banking and commercial firms. Restrictions on permissible activities generally have existed in some form throughout American banking history. Restrictions on common ownership of banking and commercial firms are more recent, stemming from the Bank Holding Company Act of 1956 and its subsequent amendments.
The remainder of this Appendix discusses the mixing of banking and commerce in the United States, dating from the granting of early bank charters to the current environment. Following a brief discussion of the historical evidence on the mixing of banking and commerce, contemporary examples are reviewed. These examples include: grandfathered bank holding companies; savings-and-loan holding companies; nonbank banks; limited-purpose consumer banks; captive finance companies; industrial loan companies; and foreign activities of U.S. banking organizations.
Evidence on a government-mandated separation of banking and commerce within a single entity is mixed. Many early American bank charters included prohibitions against engaging in manufacturing or speculative real-estate activities. An absolute prohibition on banks engaging in "commercial" activities does not appear to have existed, however. In fact, in earlier times both private and chartered banks engaged directly in commerce.
The practice of combining banking and commercial activities was common during the period that ran approximately from 1799 to 1838. Bank charters were granted by state legislatures and provided a general right to incorporate and engage in banking, although they generally did not articulate what was meant by the business of banking. The mixing of banking with some form of commerce often occurred. During this period, economic development was characterized by a rapid expansion of business and the concurrent need for credit. Corporations that were chartered to engage in some particular line of commerce, for example, agricultural, industrial or public-works interests, often also were given the authority to engage in a general banking business.
For example, the precursor to the Chase Manhattan Bank was chartered by the State of New York as the Bank of the Manhattan Company in 1799. The charter authorized the company to develop a water system for New York City and permitted the directors of the water company to use surplus capital in any way they saw fit, including the business of banking. The company subsequently engaged in the businesses of banking and life insurance and operated the water business throughout the nineteenth century.
As the states began to grant bank charters more freely, they also began to limit the nature of the banking business authorized by the charter. Early definitions of the "business of banking" reflected a recognition by the states that banks played an active role in the functioning of the economy and in serving business, but that some limits were necessary. Limits ultimately were included in the National Bank Act of 1864, which enumerated the powers granted to national banks as those that were "incidental to the business of banking." These limits did not pertain to affiliations.
During the last quarter of the nineteenth century and the first decades of the twentieth century, banks utilized a variety of corporate structures to affiliate with commercial enterprises, including voting trusts, the use of bank affiliates, and the establishment of bank holding companies. The best known voting trust involved linkages between J.P. Morgan and Company and a large number of commercial enterprises. Bank affiliates, in turn, had virtually unlimited authority to engage in activities that were prohibited to banks. Affiliates were chartered under the general business corporation laws of the states, and were owned and controlled by the stockholders of the banks. Bank affiliates were not subject to any examination. Further incentive to use affiliates came, in part, from state and national branching restrictions that had limited the ability of commercial banks to provide large-scale financing to industry.
The bank holding company - a corporate entity that owns or controls a bank - became an alternative corporate structure in the early 1900s as the states began to allow corporations to purchase the stock of another corporation. In the last half of the 1920s, the bank holding company became an increasingly popular form of corporate structure in which banking and commerce were allowed to mix. Bank holding companies held controlling interest in commercial banks and other financial institutions as well as business corporations. Unless the holding company also was a bank, the holding company was subject to little federal or state control.
An important example of the use of the holding company structure during this period was the Transamerica Corporation. At its peak, the Transamerica Corporation held 100 percent ownership of many different holding companies. In 1930, these included holding companies for: bank stocks; stocks of securities corporations; general investments of stock-exchange securities; foreign holdings and investments; permanent commercial and industrial investments; stocks of joint-stock land banks; stocks of insurance companies; and stocks of mortgage companies. The holding companies, in turn, held both financial and commercial subsidiaries, including the Bank of Italy, the Bank of America, N.A., the Bank of America of California, Occidental Life Insurance Company, Pacific National Fire Insurance Company, and Consolidated Foundries. The holding company structure clearly allowed Transamerica to engage in a wide variety of activities, effectively mixing banking and commerce. Enactment of the Bank Holding Company Act of 1956, however, required Transamerica to restructure its operations substantially.
Restrictions on the Mixing of Banking and Commerce
The Bank Holding Company Act of 1956. The rapid growth of bank holding companies caused concern among federal banking regulators about the potential for concentration of credit in the banking industry. Harsh controls were forestalled in part by the Congress' concern about the extent to which it could legally exercise control over state-chartered corporations, especially in the face of evidence that bank holding companies played a positive role in the banking industry. But the concern eventually was overridden by the continued expansion of bank holding companies and the fear of monopolistic control in the banking industry.
The Banking Act of 1933 first defined bank holding companies and established the framework for their regulation. However, the restrictions on ownership and affiliation as they are known today are the product of the Bank Holding Company Act of 1956 and its subsequent 1966 and 1970 Amendments. The basis for the expansion of bank holding company regulations was the belief that it was necessary to prevent the monopolization of banking by holding companies and the formation of large banking-industrial complexes. With the passage of the 1970 Amendments, virtually all bank holding companies became subject to federal regulation, and statutory and regulatory controls were placed on the expansion of bank holding companies into other businesses. That is, a separation of banking from commerce was established in terms of restrictions on the activities of the owners and affiliates of banks.
Under the Bank Holding Company Act (BHCA) of 1956, a bank holding company was defined as a corporation owning at least 25 percent interest in two or more commercial banks, whether Federal Reserve members or not. Federal Reserve Board approval was required for the creation or expansion of bank holding companies; interstate acquisitions of banks were limited, and the right of states to limit bank holding company expansion was upheld. Ownership of shares in nonbank corporations, other than those of corporations engaged in approved bank-related activities, were prohibited. The 1956 Act also prohibited a bank holding company or its nonbank subsidiary from engaging in any nonbanking activity, except as otherwise provided in the BHCA. Bank holding companies were allowed to engage in certain activities. The Federal Reserve Board was given the authority to allow additional nonbanking activities other than those expressly permitted if they could be shown to be "of a financial, fiduciary, or insurance nature" and were "so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto."
Bank Holding Company Act Amendments. The BHCA was amended in 1966 and 1970. The 1966 Amendments primarily addressed problems in the 1956 Act. Standards for the evaluation of holding company applications were revised and exemptions from the BHCA provisions for investment companies and their affiliates, religious, charitable and educational institutions were eliminated. The 1966 Amendments also relaxed the 1956 Act by applying Section 23A of the Federal Reserve Act to transactions between sister subsidiary banks; the 1956 Act had prohibited virtually all normal banking transactions between these entities.
The 1970 Amendments were focused on the regulation of one-bank holding companies and the nonbank activities of bank holding companies. The rapid growth in the number and size of one-bank holding companies during the 1960s raised concern among bank regulators and led to demands from the Congress and independent banks for the inclusion of one-bank holding companies under the BHCA. The 1970 Amendments accordingly extended regulation under the BHCA to one-bank holding companies. As a result, Federal Reserve Board oversight was extended to virtually all bank holding companies.
The 1970 Amendments also revised the standards that defined permissible nonbank activities. Under Section 4(c)(8), the Federal Reserve Board, through the use of regulation, interpretation, or individual decisions, has ruled on the permissibility of numerous nonbank activities. A bank holding company or its nonbank subsidiary may engage in a nonbanking activity, including a securities activity, only if the Federal Reserve Board determines that (1) the activity is "closely related to banking" and (2) the provision of the activity would likely result in public benefits that outweigh possible adverse effects. The Federal Reserve Board also was given authority to differentiate between applications to engage in an activity through a de novo subsidiary or acquisition of an existing firm. Anti-tying provisions that prohibit a banking company from tying an extension of credit or any other bank service to the use of the services of nonbank subsidiaries of the holding company were incorporated through Section 106 of the BHCA under the 1970 Amendments.
Most of the nonbanking activities that have been approved by the Federal Reserve Board for bank holding companies under Section 4(c)(8) also have been permitted for national banks as "incidental to banking" under the Office of the Comptroller of the Currency's Interpretive Letters. Over the past few years the Federal Reserve Board has issued a large number of Section 4(c)(8) decisions, most of which relate to investment and merchant banking activities. As a result, the original intent of Glass-Steagall to separate commercial from investment banking has been blunted.
Banking and Commerce in the Financial Services Industry
Grandfathered Bank Holding Companies. As a result of the 1970 Amendments to the BHCA, a number of commercial firms that owned banks found that they would subsequently be regarded as bank holding companies. The 1970 Amendments, however, provided exemptions for these companies if they met certain criteria. Ultimately, the Federal Reserve Board granted hardship exemptions to 12 companies. Although most of the banks have since been sold to other banks, a few continue to be owned by commercial firms.
Savings-and-Loan Holding Companies. Corporate owners of thrifts are savings-and-loan holding companies. In 1967, the Congress placed restrictions on the activities of multiple savings-and-loan holding companies, effectively prohibiting them from engaging in commercial activities. No such restrictions were placed on the non-thrift activities of unitary savings-and-loan holding companies - companies that owned a single savings-and-loan association. In 1987, the Congress extended to some multiple savings-and-loan holding companies (those thrift subsidiaries that were acquired in qualifying supervisory transactions involving failed or failing institutions and were consummated under federal regulatory oversight) the benefit of unrestricted activities enjoyed by unitary savings-and-loan holding companies. The Congress, however, also imposed the requirement that to continue to be free from prohibitions on non-thrift activities, unitary and otherwise qualifying multiple savings-and-loan holding companies must have their thrift subsidiaries meet the qualified thrift lender (QTL) test.
Nonbank Banks. Before the enactment of the Competitive Equality Banking Act of 1987 (CEBA), the BHCA defined "bank" as an institution that both took demand deposits and made commercial loans. An organization that did one or the other, but not both, was not a bank under the BHCA. Such an organization with a bank charter came to be called a "nonbank bank," and in the early and mid-1980s the possibilities of nonbank banks attracted considerable attention. Bank holding companies saw nonbank banks as a way to expand across state lines and seek favorable usury limits without running afoul of the interstate banking restrictions of the BHCA. Commercial firms and nonbanking financial firms saw nonbank banks as an avenue into the banking business without running afoul of the nonbanking restrictions of the BHCA.
In CEBA, the Congress closed the so-called "nonbank bank loophole" by broadening the definition of "bank" in the BHCA to cover any institution that either met the then-existing definition or was insured by the FDIC. Both types of owners of nonbank banks received some grandfathering protection, however. For the type of owner that might mix banking and commerce - the owner that was not a bank holding company - grandfather rights would be lost if the company otherwise became a bank holding company or if the nonbank bank did one or more of the following: (1) began to engage in activities in which it was not lawfully engaged on March 5, 1987; (2) offered or marketed products or services of affiliates that were not permitted for bank holding companies, or permitted its products or services to be offered or marketed by affiliates whose activities were broader than those permitted for bank holding companies; (3) permitted any overdraft on behalf of an affiliate or incurred any overdraft in its account at a Federal Reserve Bank on behalf of an affiliate; or (4) increased its assets by more than 7 percent in any one 12-month period. The fourth restriction was repealed by Section 2304 of the Economic Growth and Paperwork Reduction Act of 1996.
Limited-Purpose Consumer Banks. The Comptroller of the Currency is authorized to grant national bank charters that operate under certain restrictions, such as a prohibition on commercial lending. Numerous large retail companies have acquired such charters to provide credit for their customers. The owners of these banks do not fall under the Bank Holding Company Act. Several states also charter such limited-purpose banks.
Captive Finance Companies. Finance companies compete with banks in extending credit to businesses and consumers, in some instances making the same types of loans. And although finance companies do not take deposits from the general public, their funding is in many respects similar to bank funding. Both rely to a considerable degree on what might be called purchased funds: bonds and commercial paper for finance companies, and large-denomination certificates of deposit for banks.
Where finance companies provide an approximation of the mixing of banking and commerce is in the so-called captive finance companies. These institutions are owned by commercial firms, usually manufacturing and distribution firms. Captive finance companies originated from efforts by manufacturers to promote sales of their products by offering convenient access to credit. Some captives have expanded beyond these beginnings, however, to lend to other businesses and to perform such investment banking functions as financing mergers and participating in leverage buyouts. General Electric's GE Capital is the primary example of a captive that pursued new opportunities beyond its parent's business.
The experience of captive finance companies might have some relevancy to the banking and commerce debate. Although their primary purpose might be to promote the sales of their parents' products, captive finance companies appear generally to have been operated as profit centers. They do not appear to have been used to inflate sales by exploiting access to underpriced funds. One fear about mixing banking and commerce is that the banking side of the organization would be used to subsidize in some fashion the commerce side. Such a subsidization does not appear to have occurred with captive finance companies. For example, the expansion of GE Capital Services to activities beyond the financing of sales of its parent's products demonstrates the power of the profit motive and suggests that attempting to operate a captive without regard to its profitability might be difficult.
Industrial Loan Companies. Also known as industrial banks, industrial loan companies are state-chartered entities that have broad banking powers, subject to certain lending and deposit restrictions. Industrial loan companies may be owned by commercial firms without falling under the BHCA. Under the Garn-St Germain Depository Institutions Act of 1982, industrial loan companies that are regulated in a manner similar to commercial banks can apply for federal deposit insurance. Located primarily in the Midwest and West, the owners of these institutions include finance companies, oil companies, and securities companies. Industrial loan companies also often are owned by companies that operate credit-card banks in other states. In 1997, Utah lifted a ten-year moratorium on the issuance of new industrial loan company charters. Advantages of the Utah charter include the ability to make commercial loans, and the ability to "export" their interest rates beyond their state boundaries regardless of interest-rate caps elsewhere. There are no restrictions on ownership in the Utah industrial loan company charter.
Foreign Activities. Under Subpart A of the Federal Reserve Board's Regulation K, U.S. banking organizations can invest in a somewhat wider range of activities outside the United States than within. The foreign activities of Federal Reserve member banks, Edge Act corporations, and bank holding companies - the vast majority of the components of the U.S. banking industry that conduct foreign activities - are covered by Subpart A.
Generally, foreign activities must be of a banking or financial nature, although the list of permissible activities in Regulation K is broader than the list in Regulation Y of permissible domestic activities for bank holding companies. Among the activities in Regulation K are: general insurance agency and brokerage; underwriting life, annuity, pension fund-related, and other types of actuarially-predictable insurance; operating a travel agency provided the agency is operated in connection with financial services; and subject to certain limits, underwriting, distributing, and dealing in equity securities.
Regulation K also permits some degree of investment in activities beyond those of a banking or financial nature. The Regulation recognizes three categories of ownership, control, or investment by a U.S. banking organization: (1) subsidiary - ownership or control of more than 50 percent of the voting shares; (2) joint venture - ownership or control of 20 to 50 percent of the voting shares; and (3) portfolio investment - ownership or control of less than 20 percent of the voting shares. In a subsidiary acquired as a going concern, existing activities that are not otherwise permissible may account for not more than 5 percent of either consolidated assets or revenues of the acquired organization. For a joint venture, not more than 10 percent of consolidated assets or revenues may be attributed to activities not on the list of permissible activities. Portfolio investments in organizations engaged in activities not permissible may not exceed: (1) 40 percent of the total equity of the invested-in organization; or (2) 25 percent of the investor's Tier 1 capital if the investor is a bank holding company or 100 percent of Tier 1 capital for any other investor.