In Focus: Evolution of an Issue: Tying Debate Turns to Loan Quality

By Barbara A. Rehm

WASHINGTON — Congressional concern over banks coaxing customers to buy multiple products is morphing into a debate over the impact that cut-rate loans are having on credit quality and the broader credit market.

Gone, or nearly so, are allegations that banks are breaking the law when they provide cheap loans to entice a customer to buy more products, particularly investment banking services. Either this "illegal tying" just is not happening, or it is too hard to prove given the complicated law and its long list of exemptions.

But the issue refuses to die, and lawmakers are now questioning whether the industry's moves to boost the profitability of customer relationships is undermining credit quality, artificially holding down the cost of credit, and whether bank competitors are being unfairly disadvantaged.

"The relationship between loans to a corporation that may or may not be subsidized by the promise of future, additional investment banking business … has the potential to alter credit markets, and it certainly can disguise the true cost of credit," Sen. Chuck Schumer said during a Feb. 5 Senate Banking Committee hearing.

"It may also price out many firms that cannot subsidize below-market loans through fees from other businesses."

That's what big pure-play investment banks such as Goldman, Sachs & Co. and Morgan Stanley have been arguing for years: banks are stealing their customers by underpricing loans. Commercial banks, the brokers charge, have an unfair advantage in that they can hold these loans on the books at original cost while brokerages must mark the credits to market every quarter. (Accounting rules figure banks hold loans as long-term assets while brokers do not — a differentiation that has blurred over the years as banks securitize more assets.)

The New York Democrat's comments came during a hearing on William Donaldson's nomination as chairman of the Securities and Exchange Commission — an agency that had not weighed in on this issue.

But Mr. Donaldson, who founded the brokerage firm Donaldson, Lufkin & Jenrette Inc., vowed the SEC would investigate, saying "making soft loans to get the more profitable business is an issue that rivals the use of research as the handmaiden of banking."

Making a cheap loan to get a customer's underwriting business has helped commercial banks make inroads on firms such as Goldman Sachs. But gaining market share has come at a cost to credit quality, said Sen. Schumer.

Since enactment of the Gramm-Leach-Bliley Act in 1999, Sen. Schumer said, "We've seen a lot of writedowns of loans that certainly were made alongside investment banking relationships … I'm thinking specifically of recent experiences of firms that have lost more loan value from recent large-scale bankruptcies than they ever made in investment banking fees."

At the Donaldson hearing, Senate Banking Chairman Richard Shelby, R-Ala., repeated his intention to hold a hearing on tying specifically and more generally on Gramm-Leach-Bliley, the financial reform law that made it easier for banks to offer both credit and securities products.

He may be able to use some ammunition from the General Accounting Office, which is investigating allegations of bank tying at the request of Rep. John D. Dingell. The Michigan Democrat resurrected interest in this topic last July with a letter to Federal Reserve Board Chairman Alan Greenspan and Comptroller of the Currency John D. Hawke Jr.

GAO sources said there is no deadline on their report, which is just now taking shape. But it is clear the investigative arm of Congress will be looking closely at how well the Fed and the OCC are enforcing the anti-tying provisions of the Bank Holding Company Act of 1970. (The agencies investigated this question in 1992 and turned up little; the GAO issued a report in 1997 that also found few instances of illegal tying.)

Federal banking regulators are not convinced there is a problem. They contend examiners are enforcing anti-tying laws, and there is no evidence that banks are underpricing loans to gain investment banking market share. Since banks are not illegally tying products, the regulators argue that there has been no impact on credit quality.

"The agencies have not found that commercial banks are manipulating the pricing of credit to build investment banking market share," Mr. Greenspan and Mr. Hawke wrote in an Aug. 13 letter to Rep. Dingell. "We have not identified illegal tying by banks and thus do not have evidence that such tying activity was a cause of recent losses."

In response to Rep. Dingell's letters, federal bank regulators did agree to review the big banks' internal tying policies, marketing programs, training materials, and internal compliance audits. Last week Mr. Hawke provided an update on that effort: "We haven't found anything that would raise a serious question, but our investigation is still ongoing."

But in a Feb. 6 speech to a group of lawyers, Mr. Hawke questioned the wisdom of deploying examiners to search for tying violations, and suggested aggrieved borrowers or competitors should sue banks.

"There is a question of resources here," he said. "Why not go to court and try to prove your case if you think you've been damaged?"

Mr. Hawke described the row between commercial and investment banks as a "clash of titans" who should be able to defend themselves without the government's help.

Commercial bankers are reluctant to stir this pot, but many say privately that they are not dictating terms to customers — it's the other way around.

Isaac Lustgarten, a partner with Arnold & Porter law firm in New York, echoed the private comments of many bankers.

"There is a legitimate flip-side to this," Mr. Lustgarten said. "Borrowers go to banks and say provide us both services. In return for one-stop shopping, we also want a lower price. They are saying, 'Reward us, the borrower, for coming to you and you alone.' "

Again privately, bank regulators agree with this assessment and few insiders expect any sort of regulatory crackdown. Even if the SEC wants to, sources said it lacks the authority.

"Donaldson doesn't have much he can do about it. He can't regulate those banks," said one lobbyist who counts commercial and investment banks among his clients. "At the end of the day, it's got to be Greenspan or Hawke, and that doesn't seem likely."

Whether the issue gains any traction in Congress may depend on the results of the GAO study.

"I don't think it will become an issue until and unless people begin to document that it is happening, in which case there will have to be some action," Rep. Barney Frank, the ranking Democrat on the House Financial Services Committee, said recently.

Still, Sen. Shelby's hearings into how well Gramm-Leach-Bliley is working could be another avenue for making changes in the ways banks are allowed to market credit products.

Corrected September 15, 2016 at 2:43PM: This post is part of a recurring series of classics from our archives. The story below appeared on Feb. 14, 2003, about the effects on credit quality of banks' persuading customers to buy multiple products, a practice known as "tying."