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Should the Walls Come Down?
by Jim Surowiecki (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 (H.R. 10) 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 passed handily.

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 distinctions.

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.

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