Consider this simple question: Why does the government restrict the ability of pension funds, mutual funds and other kinds of institutional investors to invest in most banks? Banks are an industry in which "capital is king." Institutional investors control most of the world's capital. Their interests do not inherently conflict with banks'. So why put barriers between them?

These capital barriers are part of the Bank Holding Company Act, which prohibits a controlling investor in a bank from investing in anything else. In the real world, this has more of an impact on banking than every other aspect of holding company regulation.

It doesn't affect the largest banks, because the barriers apply only to controlling shareholders. Institutional investors usually have internal guidelines on both the maximum and minimum size of investments. If an investor's minimum would exceed 10% of a bank's equity, it cannot invest in the bank and hold a portfolio of diversified investments. For the largest bank holding companies, an investment of billions of dollars may not get close to the control threshold. As a result, institutional investors hold 45% of the shares of Citigroup, 71% of the shares of JPMorgan Chase, 43% of Bank of America, 65% of Wells Fargo and 59% of U.S. Bancorp.

So if it is OK for large banks to have institutional investors, why not smaller banks? Community banks can often rely on individual investors, but midsize banks usually need more capital than individuals can provide, and these banks have been squeezed the most for capital over the past several years. It is hard to see why this is not a wholly arbitrary policy.

The ostensible purpose of these restrictions is to block the formation of financial conglomerates. But the Bank Holding Company Act actually has the opposite effect. It blocks the free flow of capital to all but the largest banks, so they have grown the most. A fair number of new community banks have also been formed, but they rely more on individual investors. Banks in between have declined dramatically. Without artificial capital barriers, banks would play a much larger role in the credit markets, and if they'd had such a role the current economic downturn would have been less severe.

The overall effect is evidenced by the decline of banks as providers of credit in the past 50 years. At the end of World War II, traditional banks provided almost 60% of all the credit in the United States. Today that number is 20%. That did not happen because demand for credit has dropped or banks are less stable or cost-effective providers of credit. Recent events have proven the contrary. The drop-off is mostly due to options presented to investors by the securitization markets. In the simplest terms, one reason the securitization markets flourished is that they had unlimited access to capital, while banks suffered because they did not have such access.

This has especially affected midsize businesses. It was less of a problem when the securitization markets could support specialized nonbank lenders, but those lenders largely seized up along with their source of funding. Now midsize companies are desperate for credit. Forming new banks would be the best way to meet those needs. For investors, it presents a once-in-a-century opportunity to invest in new lenders, but a high level of interest in doing that is blocked by capital barriers and regulatory paralysis. Eliminating those barriers would result in the formation of many new banks and help solve the credit crisis.

Is there any other justification for these capital barriers that outweighs their impact on the banking industry? I have been involved in bank regulation for over 25 years, and I am convinced there is not. Bank holding companies are not stronger or safer than diversified holding companies. The Bank Holding Company Act's restrictions make holding companies inherently weak. Typically their only significant asset is the bank they own. If that bank gets in trouble, the holding company usually has little ability to supply new capital and is a helpless bystander as its bank collapses.

In comparison, a strong diversified holding company is able to provide a level of support to a subsidiary bank that would be unimaginable for most traditional banks. I have seen many instances where a nontraditional bank obtained significant amounts of new capital with a simple phone call. The 20-year record of industrial banks shows beyond any reasonable doubt that capital is usually not an issue for a bank with the kind of large diversified parent prohibited by the Bank Holding Company Act.

Regrettably, the Obama administration's blueprint for regulatory reform moves in the wrong direction. Due to the Fed's influence, the Obama plan would reinforce capital barriers and perpetuate the trend to larger banks and less stable sources of credit. A better policy would encourage the formation of more banks. If banks had remained the primary providers of credit, current regulations would have controlled much of the excess risk that caused the meltdown of the securitization markets and the near-collapse of the economy. But growth of banks can only be accomplished with large amounts of new capital, and institutional investors are the only feasible source for those funds. That cannot happen while capital barriers remain, so taxpayers have been forced to step in instead. What is now a burden for the taxpayer is an opportunity many investors would eagerly undertake, if only they could.

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