The state of California is facing an issue of tremendous importance to banking regulation in the United States. On Aug. 13 the Banking Committee of the State Assembly held a hearing on an application by Wal-Mart to buy Franklin Bank of California. For those unfamiliar with banking this may seem unremarkable, but this acquisition could set a precedent that has the potential to damage the banking system not only in California but across the country. So when the committee asked for my views on the proposed acquisition I readily agreed to provide them.
When I worked to pass legislation modernizing federal law on financial services, there was considerable discussion about the degree to which commercial businesses should be allowed to participate in banking. At the time, a number of commercial entities had a hand in banking through what was known as the unitary thrift exception.
This exception allowed commercial businesses to own one thrift or savings and loan. We closed that loophole as of March 4, 1999. Now the law is clear and consistent: If you want to own a bank, you need to be a bank holding company, and that means your business needs to be financial services - not commercial endeavors (including any nonfinancial business such as selling products at retail).
When we were debating the Gramm-Leach-Bliley Act, the view of the majority of my colleagues - as well as experts such as Alan Greenspan and Paul Volcker - was that banks and bank holding companies needed to have stricter oversight than commercial businesses to protect the safety and soundness of the banking system. At the time, I favored keeping the unitary thrift exception. Now, with the benefit of hindsight, it is better that I lost.
What changed my mind? In a word, Enron.
In truth, if it were only Enron, we could dismiss it as an anomaly. But we now know the list of large commercial businesses engaging in bad accounting and management practices is much longer than that. Given the financial problems that some commercial enterprises have been - and may still be - hiding, we need the separation of banking and commerce. We simply cannot have the same degree of confidence in the balance sheets of commercial businesses as we have in the financial strength of our banks. That is because our banks are very closely regulated.
Bank regulators help ensure that banks do not succumb to the temptation to overexpose themselves to financial risk. Regulators help ensure that banks maintain sufficient financial reserves. They also help ensure that banks fulfill their responsibilities for community investment and preserve the privacy of their customers.
The level of oversight of the solvency and other activities of our banks is unimaginable for commercial enterprises. Commercial businesses wouldn't know what to do with a team of bank examiners descending upon them. Most of them could not begin to meet the stringent standards for banks, bank holding companies, intersystem transactions, and the like. When commercial businesses own a bank, important protections are lost.
I am not saying that Wal-Mart is Enron. The mixing of banking and commerce, however, will create pressures that may be difficult for any company to ignore. If one business unit is not performing to expectations and a commercial business is given the potential to quietly address the issue through its own bank, it will be tough to resist tapping that potential. We should not create a situation that tempts corporate officers with that choice and expect them all to follow the law. In light of what we know about corporate America, we should set policy that minimizes the opportunities to choose the wrong path.
If a commercial business owns a bank, the influence that business may have on the bank's relationship with its other customers and potential customers is also a troubling issue. Many small businesses (and virtually every business is small compared to Wal-Mart) have limited access to the capital they need to operate or expand.
This is particularly true in the rural areas where most Wal-Marts are located. How can a bank deal fairly with competitors of its parent company? It seems unlikely that a local hardware store that wants to expand in order to better compete with Wal-Mart could get a loan from any bank owned by Wal-Mart.
A Wal-Mart bank acquisition could also threaten the health of community banks in California. Most community banks are owned or run by local citizens who have a real stake in their communities. Not only are these communities their homes, but the economic health of the community directly affects the health of the community bank. Community banks, most of which are in rural locations, are an important source of funds enabling local businesses to thrive.
Unlike many larger banks that may take deposits in one locality and lend in another, most community bank loans benefit the neighborhoods in which depositors live and work. The interdependence of community banks and their local customers is an integral part of the economic health of many communities, especially rural communities.
The precedent California may set is important to consider. Allowing Wal-Mart to buy a bank after we set a strict rule of separation between banking and commerce at the federal level will set a precedent for other businesses to do the same. Once that happens I am concerned that it will open the floodgates for other businesses to get into banking through the California loophole, and that sooner or later this will cause safety and soundness problems for our banking system. When that happens, it won't just be shareholders on the hook - it will take all of our tax dollars (through FDIC insurance) to fix it.
