|Should the Walls
by Jim Surowiecki
NEW YORK, NY (June 26, 1997) -- For more than 60 years, U.S. banks
and U.S. commercial companies have played on two different ball fields. As
a result of legislation passed during the Great Depression, banks and
non-financial institutions have been prohibited from merging or acquiring
each other. Even if Bill Gates has helped provide every other service you've
needed in the last year, he hasn't been allowed to lend you money.
Soon enough, though, he may very well be able to, at least if legislation
currently making its way through the House of Representatives is passed.
Last Wednesday, the House Committee on Banking and Financial Services approved
a provision in a wide-ranging bank reform bill
that would allow commercial companies to acquire small banks. The amendment,
which passed by the slimmest of margins -- the vote was 25-23 -- was the
partner to an amendment passed the day before, which would allow banks to
generate up to 15% of their revenue from commercial activities. That provision
Under the terms of the measure, commercial companies would not be able to
engage in unlimited banking activity. They would be limited to acquiring
banks with assets of $500 million or less, and the gross revenues of the
banks would have to be 15% or less of the commercial company's gross revenue.
Nevertheless, the proposed legislation takes a crucial step toward dismantling
the walls between finance and commerce that were initially established as
a way of guaranteeing the stability of the U.S. banking system.
A crucial factor in the early years of the Great Depression, of course, was
the lack of faith in banks, which often prompted runs that forced institutions
to close. (Think, to take only the most obvious example, of the film It's
a Wonderful Life.) Franklin Delano Roosevelt's first major act as president
was his declaration of a bank holiday, a decision intended to give financial
institutions a chance to regroup. More substantively, the Banking Act of
1933 (Glass-Steagall Act) created the Federal Deposit Insurance Corporation
(FDIC) to provide bank deposit insurance to give consumers a sense of security
and avoid bank panics.
In exchange for its special status -- no other companies are able to guarantee
their creditors that the federal government will pay off any obligations
they can't meet -- the banking industry accepted limits on the kinds of business
it could do. Not only were they prohibited from strictly "commercial" activities
like retail and manufacturing, but they were also prohibited from running
brokerage or insurance operations.
In recent years, though, as the mantra of globalization has spread and as
ever more complicated financial instruments have been devised, banks have
pushed strongly for an end to these restrictions. In what has been termed
a quest for "financial services modernization," banks have sought the right
to merge with brokerage houses and insurance companies, or to engage in those
businesses on their own. The bill that just made it out of the Banking Committee,
in fact, had as its main focus the ability of banks to affiliate with securities
firms and insurance companies.
As a corollary, though, banks have also pushed for the right to acquire
commercial companies. In part, this is a practical matter. Since many securities
firms and insurance companies already have commercial holdings, any bank
that merged with a brokerage house would then own a portion of a commercial
company. At its root, though, the question is an ideological one: Should
there be regulatory limits on the kinds of business a bank can do?
Supporters of the proposed legislation insist that change is not merely necessary
but, as the sponsor of the original banking-commerce amendment Rep. Marge
Roukema(R-N.J.) puts it, "absolutely inevitable." The advent of global markets
and the speed with which financial transactions can now be performed, Roukema
argues, means that attempts to make rigid distinctions between banks and
other companies are doomed to fail. Certainly the evolution of the financial
services industry during the 1980s eroded much of the usefulness of those
Still, the simplest answer to the question, "Why are banks special?" is that
only banks enjoy the protection of the FDIC. And the potential intermingling
of banking and commerce raises the troubling specter of taxpayers' money
being used to bail out banks crippled by their underperforming commercial
businesses. Certainly the 15% restriction means that a bank's whole future
won't be tied up in whether consumers are buying tires this quarter, but
it would be not surprising if that 15% foothold gradually expands to the
point that we find ourselves responsible for the performance not only of
banks, but also of commercial companies.
More intriguingly, the new legislation may have a major impact on the way
credit is allocated, potentially in market-distorting ways. Rep. Doug Breuter,
a Republican from Nebraska who voted against the banking-commerce amendment,
argued that it would create conflicts of interest in lending, and that it
would prevent credit from flowing to "the most productive use." While we
can regard the idea that the market is always right with some skepticism,
it does seem worthwhile to ponder what happens when a bank's decisions about
lending are affected by considerations other than creditworthiness.
What's interesting about all this is that the new bill would move the United
States closer to the European and Japanese models, where large banks often
have huge stakes in commercial companies and play crucial roles in directing
industrial policy. While that system has the beneficial effect of allowing
corporations to adopt more long-term strategies, it has also tended to insulate
firms from competitive realities and to create iron triangles of bureaucracy.
Certainly the overinflation of the Nikkei stock market in the late 1980s
and early 1990s is impossible to understand without taking into account the
role of banks in propping up stock prices.
The irony, of course, is that these proposed changes arrive at a time when
the banking industry is enjoying unparalleled success and enormous stability.
Just last week, the FDIC announced that bank earnings in the first quarter
of 1997 were a record $14.5 billion, up from $13.7 billion in the previous
quarter and $12 billion a year ago, an annual increase of better than 16%.
The first quarter's annualized return on assets was 1.26%, the fourth-best
quarter in history. And, even more strikingly, non-interest income accounted
for 37% of bank operating revenues in the quarter. One might be forgiven
for asking, "If it ain't broke, why fix it?"
There's still a very good chance that the banking reform bill will not make
it out of the House, and similar legislation has yet to be considered by
the Senate. In the long run, though, the pull of conglomeration may prove
as irresistible as it has everywhere else, even though the real question
is whether an industry that enjoys special protection doesn't have, in the
end, special obligations.