Beware the return of the ILC
Recent remarks by acting Comptroller of the Currency Keith Noreika and the industrial bank application submitted by Social Finance have raised significant policy questions about the mixing of banking and commerce, really for the first time since Walmart's and Home Depot's failed banking bids prior to the financial crisis.
Events of the past decade demonstrate that further removing the firewalls between banking and commercial and industrial businesses would be a huge mistake for our financial system and our broader economy.
Noreika suggested last month that the Trump administration could be receptive to proposals for combining banking and commerce. “It's not the best thing to put all your eggs in one basket,” he said.
SoFi’s application, meanwhile, indicates that there may be greater interest in the last viable type of FDIC-insured bank charter still legally available to commercial firms. To be sure, the fintech-powered marketplace lender is not a commercial entity like Walmart. As a financial services provider, SoFi could apply for a mainstream bank holding company license. But SoFi’s industrial bank bid could be seen as a stalking horse, potentially opening the door for more companies — including commercial and industrial firms — that want banking powers. In addition, we should question the wisdom of granting SoFi an FDIC-insured banking license without requiring SoFI to accept regulation by the Federal Reserve as a bank holding company, as other financial owners of banks must do.
These developments should worry both bankers and policymakers.
The Glass-Steagall Act of 1933 and the Bank Holding Company Act of 1956 (BHCA) sought to shield our banking system, and its FDIC-insured deposits, from disruptions in the financial markets and the general economy. Likewise, when policymakers provided government backing to banks prior to the late 1990s, this separation, rightly, stood in the way of extending aid to nonfinancial entities.
Federal authorities therefore were not in the position of having to support either the capital markets or commercial firms when they bailed out large failing banks (such as Continental Illinois and Bank of New England) during the 1980s and early 1990s. In 1990, federal authorities allowed Drexel Burnham, a large securities firm, to fail because it did not present a serious threat to our banking system.
However, federal regulators gradually opened loopholes in Glass-Steagall and BHCA, and in 1999 the Gramm-Leach-Bliley Act removed the walls separating banks from the financial markets. Allowing banks to enter the capital markets spurred the creation of huge financial conglomerates like Citigroup, Bank of America, JPMorgan Chase and Wachovia. All four of those institutions (and especially the first two) received massive amounts of federal assistance during the financial crisis.
During the crisis, federal officials protected the entire span of our financial markets, including securities firms and insurance companies, in order to stabilize our banking system. After the disastrous collapse of Lehman Brothers, federal agencies decided that they could not allow any more securities firms or insurance companies to fail without threatening the survival of our largest banks. Thus, after we combined banks with the capital markets, we were forced to extend the federal safety net for banks so that it embraced the complete scope of our financial markets.
If we remove the remaining barriers that separate banks from commercial and industrial firms, we will likely see the creation of many new kinds of banking-industrial conglomerates. Commercially owned "nonbank banks" existed for several decades — using a legal exception from the BHCA — until that exception was closed in a 1987 law. The 1987 law, however, left open a loophole for “industrial loan companies” that could be owned by nonfinancial parents, receive deposit insurance and operate as a full-service bank for consumers. (Only a select number of states, however, allow the ILC charter.)
The ILC loophole permitted dozens of car manufacturers and other commercial and industrial firms to open or acquire FDIC-insured institutions. The controversy over Walmart’s 2006 application — stoked by fears among community banks and local retailers about the competitive advantages Walmart would enjoy with an FDIC-insured banking charter — brought new ILC charter activity to a halt. The FDIC delayed action on pending ILC applications, followed by temporary freezes on new ILC bids imposed by the agency and Congress.
But the last moratorium expired in 2013, and the SoFi application could unleash a new wave of attempts by commercial, industrial and financial firms to acquire and charter FDIC-insured industrial banks.
The recent financial crisis gave us clear warnings about the systemic risks posed by banking-industrial combinations. GMAC, a financing unit of General Motors offering car loans and mortgages, largely operated as an ILC leading up to the crisis. It subsequently became a bank holding company and received over $17 billion in bailout funds from the Troubled Asset Relief Program. (GMAC eventually rebranded itself as Ally Financial.) During the crisis, General Electric’s ILC was similarly the recipient of tens of billions of dollars in debt guarantees from the FDIC.
Many existing industrial banks are captive lenders for their commercial and industrial parents. They provide loans to promote the sale of their parents' goods and services. They are not, and could never be, objective and impartial providers of credit. If we allow commercial and industrial firms to acquire more captive banks, the result will be an increasingly skewed allocation of credit across our economy.
Banking-industrial combinations would also create unfair competitive advantages for large commercial and industrial firms that can afford the costs of acquiring and operating banks. FDIC-insured deposits are the cheapest source of private-sector funding available. In addition, creditors will expect that large banking-industrial conglomerates will benefit from "too big to fail" treatment during the next financial crisis, as GE and GMAC did last time.
Meanwhile, many analysts have expressed concern about the growing market power of our five largest technology companies (Amazon, Apple, Facebook, Google and Microsoft) and their potential interest in offering banking services. If we allow our technology giants to acquire banks, we will increase their market dominance and create additional barriers to entry by new technology startups.
Supporters of mixing banking and commerce say such combinations are economically beneficial because they foster business diversification — not putting “all your eggs in one basket,” as Noreika put it. In fact, concerns about the "too big to fail" status of large conglomerates are the strongest reason for not combining banking with commerce. If we permit the formation of new banking-industrial conglomerates, we will be putting more of our eggs into very few baskets, and federal regulators will be under great pressure to protect those baskets during future financial and economic disruptions.
That outcome will be very bad for competition and even worse for systemic risk. Based on our experiences during the last financial crisis, we should know that such a course of action will almost certainly impose huge costs on consumers and taxpayers.