To approve or not to approve, that is the question. Wal-Mart's (NYSE: WMT ) recent application to form an industrial loan corporation (ILC) has caused such a stir that the Federal Deposit Insurance Corporation (FDIC), the regulatory body that insures deposits from bank defaults, effectively decided not to decide for six months, which helped it buy time to try to figure out what the heck it's going to do. Let's take a look at some of the key facts and issues.
Do you see what ILC?
An ILC charter basically allows a non-bank to set up a banking subsidiary to provide banking services, such as credit cards and consumer loans. Most ILCs are either financial service institutions, such as Merrill Lynch or Goldman Sachs, or industrial companies that use ILCs to finance customers' purchases of their products, such as General Motors' (NYSE: GM ) auto loans. Despite all the commotion about ILCs, they are still minuscule in stature, with 61 approved ILCs holding roughly $140 billion in assets and around $100 billion in deposits. This is around 3% of the $3 trillion in FDIC-insured deposits and less than 2% of the $9 trillion in U.S. banking assets.
If ILCs are such small fry, why are so many people up in arms about Wal-Mart's ILC application? For starters, the name Wal-Mart evokes images of a Leviathan capable of devouring all who dare stand in its way. Wal-Mart has made mincemeat of entire industries, taking huge chunks of market share in groceries, toys, dog food, and music. Wal-Mart's nearly $340 billion in annual sales dwarfs its closest competitors, such as Target (NYSE: TGT ) , at $57 billion, and Costco (Nasdaq: COST ) , at $60 billion.
Wal-Mart has done an arguably horrible job of public relations, and has painted a big red target (no, not that Target) on its back for competitors, unions, and activists. I'd say I'm relatively neutral about Wal-Mart. I like low prices, but the allegations of worker exploitation and low pay make me uneasy. However, I believe facts and emotions should be separated when dealing with the ILC issues and allegations. Here are some arguments:
1. ILCs lack adequate supervisory regulation.
Due to the Bank Holding Company Act (BHCA), banks operate under Federal Reserve jurisdiction and are subject to strict regulations regarding capital adequacy, loans to affiliates, and other rules and restrictions. Although ILC banks are subject to the same FDIC oversight as regular banks, the parents of the ILC (such as Wal-Mart) are exempt from the BHCA and thus not subject to the same regulatory standards as banks. A key argument for rejecting ILC applications is that ILCs introduce added risk due to less supervision of parent companies. I tend to agree with the idea that ILCs and banks alike should be subject to the same rules. I'll give this round to ILC opponents.
2. Banking and commerce shouldn't mix.
Many believe that the mingling of banking and commerce can lead to incestuous relationships that threaten to pervert the nation's flow of capital. If a bank owned a commercial subsidiary, it could lend to the subsidiary at preferential interest rates and refrain from making loans to competitors of the subsidiary. Banks are supposed to be impartial lenders, and ownership of commercial subsidiaries would corrupt lending integrity. Likewise, ILC opponents argue that a powerful company such as Wal-Mart could force suppliers to bank with it. Although I doubt Wal-Mart would be able to coerce suppliers into becoming banking customers, I do agree that unbiased lending practices need to be preserved at all costs, and regulations should address these concerns. Additionally, as banks argue to keep commercial companies from doing banking by banning ILCs altogether, those same banks push to gain access to commercial real estate brokerage and development, which would effectively blur the lines between users and providers of credit.
3. ILCs' operational risk threatens FDIC solvency and increases systematic risk.
If an ILC's commercial operations were to go bust, the ILC parent could raid the bank subsidiary of its deposits to stay afloat. As a result, the FDIC, which insures deposits, would be left holding the bag. ILC opponents love to make statements to the effect of, "Thank goodness Enron and WorldCom weren't ILCs." Although on the surface this seems to be a strong argument, after some thought it appears shallow and meant to instill fear rather than rationality.
After all, Enron and WorldCom funded their operations from capital markets and banks. After these companies went under, someone was left holding the bag, and in this case it was equity and debt holders -- including banks. Because none of these banks went bankrupt from bad Enron loans, none of them had to have the FDIC bail them out. Instead, the banks took the hit and the stock went down, which hurt the bank stockholders. If Enron had had an ILC, the FDIC would've taken the hit. In other words, risk is neither created nor destroyed by ILCs. Instead, the formation of an ILC merely transfers the primary risk to the FDIC from other capital providers, many of which are FDIC-insured banks.
Furthermore, I do not subscribe to the theory that ILCs add operational risk. I'd feel more comfortable knowing that my bank's parent is selling Gillette razors and Tide detergent rather than heavily leveraged credit default swaps and derivatives based on two times the Federal Funds rate minus the cube root of six-month Libor -- many banks operate internal hedge funds that deal with esoteric investment strategies.
Until next time.
Tomorrow I'll look at perhaps the most visible argument against the ILC -- that Wal-Mart could monopolize the banking industry -- and wrap up with some final thoughts. Stay tuned!
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