Now is a good time to remove the barriers to bank ownership of municipal debt, and thereby lower the cost to cities and states of rebuilding their infrastructures.
The benefits to government as well as banks are clear.
Cities and states face reduced federal funding despite an increased need for improvements in infrastructures.
At the same time, banks need solid, low-risk assets with a reasonable return. And banks not only have a natural interest in investing in their own communities, but also have a regulatory responsibility to do so.
Traditionally, banks were major investors in states and localities. Since the Tax Reform Act of 1986, however, banks have been excluded from the municipal bond and note market.
The only exception has been for small municipal issuers of general obligation debt, defined as entities issuing less than $10 million in a given calendar year.
Banks are allowed to deduct 80% of the cost of carrying new bonds issued by these small entities. Under these circumstances the banks have equal footing with other investors in taking advantage of the tax-exempt features of the debt.
This exception has served localities well, allowing local banks to support their towns - especially towns that might be too small for access to wider capital markets.
Moreover, the added competition from banks as buyers of municipal debt has another advantage.
Bonds issued by the smaller entities - so called bank-qualified bonds - typically are sold with interest rates about 25 basis points below those charged for similar issues that are not bank-qualified.
The same access to low-cost financing from interested banks should be available to all state and local governments.
A proposal before Congress is a step in the right direction and needs support.
A provision of Sen. Lloyd Bentsen's version of the urban aid bill would raise to $25 million, from $10 million, the defining limit for small issuers of general obligations. In other words, a municipality would be able to issue up to $25 million in bonds and notes in a year and still qualify as a "small issuer."
This proposal would help small and medium-size issuers by providing them better access to credit. It also would put local banks in a better position to help slightly larger local governments through the current difficult economic times.
It is expected that Senate debate on the urban aid bill will begin Tuesday. This bank deductibility provision needs to be supported vigorously.
A similar provision was previously attached to the energy bill, which is stalled in a conference committee.
An even better idea would be to allow banks to deduct the carrying cost of all public-purpose municipal securities. Banks' ability to hold municipals should not be constrained by the size of the issuer, but rather by the purpose of the debt.
Banks should be able to take advantage of the tax-exempt characteristics of any public purpose municipal debt.
And limiting investment to public-purpose borrowings would address one of the major concerns that was behind the 1986 tax law.
Broadening the deductibility exception to cover all public-purpose borrowings (usually general obligation bonds, but arguably any education, water, sewer, or transportation revenue bonds as well) would encourage much-needed investment, would lower state and local costs, and would not reduce federal revenue.
Big Savings for Localities
The presence of banks on the demand side of the municipal bond market would not only drive down the interest rate on municipal borrowings, it would also lower state and local issuance costs.
Banks are sophisticated buyers, experienced in making risk evaluations. They would purchase bonds without the expensive credit enhancements (insurance, foreign letters of credit, for example) that since 1986 have been increasingly required to make bonds attractive to less sophisticated investors.
In the case of a typical city bond, this could save hundreds of thousands of dollars in issuance fees.
Federal revenue would not be substantially affected by letting banks deduct the cost of carrying the debt of larger issuers, so long as the amount of municipal borrowing did not change just because more buyers were available.
If the banks do not earn the tax-exempt interest, some other taxpayer will.
Time for Action
The need for investment by states and cities is painfully apparent. Banks are a natural source of capital to rebuild the physical infrastructure and educational systems across the county.
Barriers to that capital can be removed by the timely passage of appropriate legislation.
Mr. Crozier is chairman and president of Baybanks Inc., Boston. Elizabeth Whitehead, senior vice president, helped in preparation of this article.