Bradley K. Sabel*
One of the great outstanding issues in American finance, both generally
and in particular during the ongoing debate on repealing the Glass-Steagall
Act, is the separation of banking and commerce. Depending on how
one reads American history, it has been a legal tenet or historical
imperative throughout our history that American banks not be controlled
by commercial firms, and that banks themselves not control commercial
firms. While the reasons for the separation are worthy, our recent
history seems to bring into significant question the wisdom, if
not the practicality, of trying to preserve it.
The source of the concept that banking should be separate from
commerce is muddled, though the current rationale has force. The
present-day theory is that the credit function would be distorted
if a bank were owned by a particular business company or had significant
commercial investments. For example, a bank owned by General Motors
might be required by its owner to adopt a policy to make more loans
to buyers of GM automobiles than those who buy Fords, Chryslers,
Volvos and others. Or a bank that held a sizable stake in GM might
adopt such a policy on its own in order to strengthen GM and thereby
protect or enhance the value of the stake. Prohibiting GM from controlling
a bank, or a bank from owning GM stock, avoids this possibility
and thereby, so goes the theory, protects the objectivity of the
credit-granting process. This makes it more likely that small entrepreneurs
will obtain sufficient bank credit that they can grow to the point
at which they can compete with GM. The paradox of the separation
is that banking has been intertwined with commerce for as long as
banks have existed; indeed, lending to business companies and serving
their needs for payment services (through deposits and funds transfers)
and risk-reduction services (such as letters of credit) have been
the prime activities of banks historically.
The immediate problem with preserving the separation of banking
and commerce is that this issue is standing in the way of modernizing
the United States' financial structure. The debate on repealing
Glass-Steagall has metamorphosed into a wide-ranging reconsideration
of the Bank Holding Company Act, which implements the banking-commerce
separation. The reasons for the linkage of Glass-Steagall with banking-commerce
separation are quite understandable. Securities firms for decades
have been deeply involved in making investments in commercial firms,
usually new firms that are believed to have significant growth potential.
Those investments take the form of holdings of sizable percentages
of voting stock. Such holdings are not permissible for bank holding
companies, which are limited to five percent of any class of voting
stock of a nonbanking company. Any securities firm that decides
to acquire a bank becomes subject to the same limitation on such
holdings, totally apart from Glass-Steagall's restrictions. This
means that merchant banking investments would have to be severely
restricted, which many securities firms appear to believe would
extract a cost that would vitiate many of the benefits of controlling
a bank. Indeed, such holdings are an important part of capital formation
in this country. Providing the seed capital for a small private
company and nursing it along to the point at which it can be sold
to the public has been an extremely profitable line of business
for securities firms, and many private companies themselves would
not have the opportunity to grow without attracting such seed capital
at birth.
Preserving the banking-commerce separation will also pose a huge,
if not insuperable, barrier to financial reform on the more basic
level of politics. Apart from the value of merchant banking to securities
firms, the more significant political problem may be that the acquisition/consolidation
game would be slanted in favor of the banks in the event that Glass-Steagall
were repealed while retaining the banking-commerce barrier. Bank
holding companies have some flexibility in structuring holdings
in nonbanking companies in order to stay within the Bank Holding
Company Act's restrictions; for example, they can hold nonvoting
stock, as well as voting stock, in circumstances in which a large
part of the value of the company invested in can be captured. A
nonbank company, however, will not have this flexibility if it attempts
to acquire a bank holding company. This would give bank holding
companies an advantage over nonbanking companies if the shackles
of Glass-Steagall were finally removed. Nonbanking companies that
fear acquisition are generally unlikely to favor such a possibility;
many will want to be the acquiror rather than the acquiree.
Acknowledging the political realities, legislation currently under
consideration in Congress would permit a bank holding company to
make merchant banking investments to a limited extent. In addition
to merchant banking investments, the legislation would also permit
a limited amount of commercial involvement by bank holding companies,
which could engage in non-financial activities so long as no more
than 15 percent of their revenue comes from those activities. Conversely,
commercial companies would be allowed to control banks with less
than $500 million in assets so long as banking revenues are no more
than 15 percent of total revenue.
These restrictions on bank ownership by commercial companies are
probably unworkable. Revenue percentage limitations are generally
difficult to comply with, especially for an entire organization,
because of fluctuations in revenues from various types of activities
over time. Size limitations always pose the problem, in a perverse
sense, of the company subject to the limitation being successful
and thereby growing beyond it. In both cases, the main problem is
that the limits themselves are artificial; they are not related
to any business rationale. Over time, the pressures on the limits
will face no principled opposition, since there was no principle
for the particular revenue or size limit in the first place. This
means that the hard issue should be addressed: Do we continue to
need banking to be separated from commerce?
There are several general reasons cited in favor of the banking-commerce
separation. One is that it prevents the creation and maintenance
of commercial-financial conglomerates of great size and economic
power; the German system, and the pre-war Japanese zaibatsu, are
the usual examples of this. Another one, described above, is that
it prevent banks from being swayed by their ownership by or of commercial
firms when making decisions on loans to other commercial firms.
A third is that it cushions the impact on banks of recession or
depression in the commercial world. The Federal Reserve appears
to cling tenaciously to the vitality of the third reason and to
suggest the importance of the second, while populists generally
hold to the first reason.
There are several reasons to question the continued vitality of
these reasons. Concerns about size seem almost quaint today. The
Chase, Chemical and Manufacturers Hanover organizations combined
into one within the space of five years, and the combined organization
is now the largest bank in the country. Similar consolidation is
taking place in the securities and insurance industries. However,
even those combinations are creating organizations that are relatively
small in the global arena, where truly massive organizations dominate
the global banking and securities markets. The American public's
response to consolidation has been muted. All this may mean that
the historical fear of bigness in the banking industry has faded
away.
The second concern might appear more vital, especially when organizations
trumpet the benefits of synergies among their components. However,
it may be questioned whether banking and financial services in reality
provide the types of benefits that commercial firms seem to desire.
Several such experiments of the last two decades seem to show that
it is much more difficult to profit from those benefits than might
appear. If commercial firms cannot do so, then any concerns about
a significant amount of acquisition may be overblown. On a more
basic level it may be questioned whether concerns about distortions
in the granting of credit are a significant threat. Commercial firms
for decades have been permitted to own one thrift institution without
being subject to the banking-commerce divide. Ford, Sears and other
major commercial firms have done so over the years, to varying degrees
of success. And one can validly wonder whether the fear about distorted
bank lending is a historical holdover, dating from the days before
Federal regulation of the securities markets, when the United States
capital markets did not have the transparency of operation that
exists today. The capital and money markets provide a far greater
scope of activity for seekers of credit than did the financial markets
of 60 years ago.
The major problem with permitting the intermingling of banking
and commerce would be the design of a regulatory system to accommodate
it. Currently the Federal Reserve has general supervisory authority
over a bank holding company and all of its nonbank subsidiaries
and regulates capital levels and permissible business activities,
with the general purpose of assuring that the holding company does
not get into such financial difficulty that it poses a threat to
the bank. When a bank holding company is restricted to financial
activities, the system makes some sense; the Federal Reserve is
familiar with most such businesses and can discern the general financial
outlook for the organization. With a significant non-financial component
to the organization, this system becomes problematic. The simplest
alternative may be to focus on the financial condition of the bank
rather than that of the holding company. This approach would, of
course, put pressure on the statutory safeguards against abuse of
the bank's credit facilities by the rest of the organization. This
has been addressed by the various reform proposals in a variety
of ways, none of which has attracted consensus.
Even though it appears that loosening the constraints on the separation
of banking and commerce may be workable, and may be necessary in
order to get the modernization that is long overdue, such a change
would be a major, if not radical, departure from the recent history
of the American financial system. Developing the consensus that
such a change requires will need a thorough consideration of the
pro's and con's of separation commercial firms from banks.
*Bradley Sabel is a partner at Shearman & Sterling, concentrating
on bank regulatory matters. After graduating from the Cornell Law
School in 1975, he joined the Federal Reserve Bank of New York,
where he served for eighteen years, eventually as Vice President
and Counsel.
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