1. Introduction.
  2. Misallocation Of Credit.
  3. Anti-Competitive Effects.
  4. Conglomeration And Its Adverse Impact On Economic Productivity.
  5. Bank Safety And Soundness.
  6. Increased Supervisory Burden.
  7. Excessive Political Influence.
  8. Arguments For Permitting Combinations Between Banks And Commercial Firms.
  9. The West German Experience.
  10. The Japanese Experience.
  11. Some Issues That Warrant Investigation By The U.S.Congress.


FOR MANY YEARS, a central tenant of financial structure policy in the United States has been the desirability of separating banking from the various commercial sectors of the economy -- i.e., industrial, commercial, and agricultural activities. This structural division between banking and commerce has been codified in the Bank Holding Company Act and several other federal banking laws which collectively prohibit commercial firms form acquiring or operating banks and conversely prohibit banks from engaging in commercial activities.

The U.S. has maintained this long-standing policy of separating banking and commerce out of concern that the mixing of banking and commercial activities would result in the misallocation of credit, extensive anti-competitive practices, and exposure of the federal safety net established for banking to a broad range of risks emanating from commercial sectors of the economy. Other concerns posed by the mixing of banking and commerce include overburdening the supervisory resources of the federal banking regulators, consumer privacy problems, and reduction of credit availability in local communities.

The Bush Administration, however, has recently proposed legislation that in the name of "financial modernization" and "international competitiveness" would eliminate the separation of banking and commerce. Specifically, the Treasury Department's recent study of the nation's financial system, Modernizing The Financial System (1991), concludes:

The time is right to permit broader combinations of banking and commerce. Commercial companies have been an important source of capital, strength, management expertise, and strategic direction for a broad range of non-banking companies as well as thrift institutions....

Finally, while it is true that few other countries permit exactly this form of affiliation, there are significant combinations of banking and comme rce in our most formidable trading partners, Germany and Japan.

More broadly, the proponents of ending the separation of banking and commerce claim that this structural change would bring new capital into the banking industry, permit bank holding companies to achieve better earnings diversification, and produce various operating economies.

In assessing this fundamental policy issue, it is important to draw a clear distinction between integration within the financial service sector -- notably, the combination of banking, securities, and insurance activities -- and the more radical restructuring of the economic landscape that would result from combinations between banks and commercial or industrial firms. Without question, financial service integration raises a number of important public policy concerns, especially conflicts of interest and broadened access to the federal safety net established for banking. Yet, the scope of these concerns is moderated by the circumstance that integration within the financial service sector involves only financial service activities and the core financial service activities -- banking, securities, and insurance -- are already subject to close regulation. By contrast, the mixing of banking and commerce threatens credit misallocation and anti-competitive practices throughout the entire economy and exposure of the banking safety net to a far more extensive set of risks.

The motivations of the corporations that seek to end the separation of banking and commerce are quite diverse. A number of major commercial firms would like to enter the commercial banking business. Some large securities and insurance firms with affiliates engaged in commercial activities wish to be able to enter the banking business -- if full integration of financial services is permitted -- without first divesting their commercial affiliates. Some banking institutions seek entry into certain commercial or industrial activities. Perhaps most important of all, a number of large banking organizations wish to terminate or substantially reduce the statutory authority of the Federal Reserve Board to regulate bank holding companies and their nonbank affiliates. Because the separation of banking and commerce has provided a key rational for the Federal Reserve Board's authority to regulate bank holding companies, if the policy of separation were abandoned, this would significantly weaken the justification for continued regulation of bank holding companies.

Ending the separation of banking and commerce in the United States would not only reshape the U.S. economy, it would also have far-reaching repercussions at the international level. According to a survey by the Federal Reserve Bank of New York, the majority of industrial nations separate banking and commerce either by statutory prohibition or

administrative policy. Yet, with the globalization of financial markets, permissive financial market policies adopted in a county as powerful as the United States will inexorably spread to other nations.

Some developing countries have permitted the combination of banking and commerce with unsatisfactory results. As the World Bank noted in its World Development Report 1989, which contains an extensive review of financial systems in developing countries:

In some countries the banks were owned by industrial groups. This reduced the access of outsiders to finance and concentrated a great deal of wealth and power in the hands of a few.

Before enacting any legislation that would permit the mixing of banking and commerce, the U.S. Congress should carefully weigh the likely adverse effects and benefits of such change. In conducting this review, the Congress should consider that the mixing of banking and commerce in many respects would constitute a classic example of economic externalities. Some large corporations that combine banking and commercial activities might improve their operational efficiency; but, at the same time, significant costs would in all likelihood be passed along to the economy as a whole in terms of (i) misallocation of credit, (ii) anti-competitive effects, (iii) exposure of the federal deposit insurance funds and taxpayers to greater risks, and (iv) additional supervisory burdens borne by federal banking or antitrust regulators. The externality concept applies because on the whole the large corporations that would benefit from combining banking and commercial activities would not bear the costs associated with this change in economic structure.

Further, proposals to end the separation of banking and commerce should not be characterized as "deregulation initiatives." In an economy in which banking and commerce were mixed, the banking and antitrust regulators would have to assume the vast new regulatory burden of monitoring and supervising complex relationships between banking activities and commercial activities conducted within the same firm or corporate conglomerate. Only if the proposed safeguards established to control such relationships are essentially a ruse designed to facilitate enactment of legislation ending the separation of banking and commerce -- but never intended to be vigorously enforced -- would the burden of regulation not increase. Ironically, the surest way to minimize the need for regulation and supervision is to maintain the separation of banking and commerce.

This report examines the adverse impacts and public benefits that are likely to result from ending the separation of banking and commerce in the United States. The report gives close attention to the inherent limitations of various safeguards that have been proposed as tools to curb the adverse impacts. The report also examines the West German and Japanese experience with economic systems that permit either direct ties (West Germany) or indirect ties (Japan) between banking and commerce. Finally, the report identifies a number of key issues that should be examined in-depth by Congress in the course of any legislative consideration of proposals to end the separation of banking and commerce.



Ending the separation of banking and commerce would permit the formation of links between the central credit institutions of the economy (commercial banks) and a vast array of commercial users of credit. The most obvious problem with linking banking and commercial activities is that it tends to undermine the independence and neutrality of banks as arbiters in the allocation of credit to the real sectors of the economy. When a bank extends credit to an affiliate or to customers or suppliers of an affiliate, the credit judgment is inevitably influenced by the affiliate relationship and the transaction cannot be considered truly arms-length or market-driven.

Even if there is an inclination on the part of the bank to avoid deviating from its normal underwriting standards, this is inherently difficult given the subjective nature of the risk assessment process which lies at the heart of credit decisions. This inherent subjectivity of credit evaluation is most pronounced in regard to business loans, where the credit decision requires judgment about a firm's future earnings prospects and the quality of its management.

Clearly, a bank with a commercial affiliate would face a variety of incentives and pressures to provide preferential credit to the affiliate. Moreover, a bank could also support an commercial affiliate in a far more subtle, but equally effective manner by extending preferential credit to the affiliate's suppliers and customers.

Distortion in the allocation of credit induced by bank affiliation with commercial firms can have a subtle but nonetheless substantial adverse effect on the overall productivity of the economy, as credit is distributed through preferential channels to commercial affiliates, their suppliers and customers rather than allocated on the basis of productive efficiency. Moreover, even if safeguards were to prohibit bank lending directly to commercial affiliates, the problem is not solved since the opportunities for preferential lending to the suppliers or customers of commercial affiliates are vast. Many commercial firms maintain a complex web of relationships with suppliers and customers and preferential access to credit would be a powerful and market-distorting weapon in building these relationships.

Preferential extensions of bank credit to support commercial activities would entail several different types of public injury: (i) misallocation of credit, (ii) anti-competitive effects, and (iii) threats to the financial soundness of banks. Misallocation of credit, which refers to the fact that preferential access distorts the allocative efficiency of the credit market, would be implicit in all types of preferential extensions of bank credit to commercial activities. Anti-competitive effects would also be present in most types of such preferential access to credit in the sense that the favored commercial affiliate would gain an unfair advantage over independent commercial competitors. Such competitive advantage may accrue to a commercial affiliate by virtue of the affiliate's direct access to preferential bank credit, the affiliate's enhanced market power over suppliers and customers who are afforded preferential access to bank credit, or in more unusual circumstances, the ability of the bank to effectively restrict access to bank credit for commercial firms that compete with the commercial affiliate. Finally, threats to the financial soundness of banking institutions would arise in the more extreme instances of preferential credit extension where prudent lending standards have been cast aside in the effort to support a commercial affiliate.

Banking regulators may be able to spot and curb severe deteriorations in credit standards that jeopardize bank soundness; but more subtle forms of credit misallocation can occur without threatening bank soundness, as long as the relaxation in credit standards for loans to commercial affiliates is kept within bounds. Given that the banking regulators are already overburdened with the task of controlling bank soundness, it is quite unrealistic to expect them to monitor and detect more subtle bias in the vast array of loans that banks would make to commercial affiliates, their suppliers and their customers if the mixing of banking and commerce were permitted.

The mixing of banking and commerce threatens economic injuries that have a far broader reach and potential for economic damage than the more narrow economic harms posed by integration within the financial service sector, such as conflicts of interest in the distribution of securities, use of insider information, and the tying of insurance products to credit. In large measure, this difference in potential harm stems from the fact that bank/commercial firm affiliations link financial intermediaries with ultimate end-users of credit, while financial integration merely combines different types of financial intermediaries. In an economy where depository institutions are broadly linked to end-users of credit, the potential for distortions in the flow of credit is enormous.

Recent experience with savings and loan investment in real estate equity and the extension of mortgage loans to such investments provides dramatic evidence of the dangers involved in mixing the credit extension function (banking) with the end-use of credit (commerce). Real estate equity investment is often labeled as a financial service activity, but in reality it is a high-risk, end-use of credit that should be classified as a commercial activity for purposes of financial structure policy.

Since the Bank Holding Company Act has prohibited affiliation between banks and commercial firms, it is not easy to use recent U.S. experience to empirically demonstrate the adverse effects of bank/commercial linkages. On the other hand, savings and loan holding companies -- at least those with a single S&L subsidiary --have not been subject to this prohibition and some have developed affiliations with a limited number of commercial firms. The gross misuse of Lincoln Savings and Loan Association by its parent, American Continential Corp., a real estate development firm, provides a graphic example of the dangers inherent in combining depository institutions with commercial firms.

Even the savings and loan experience, however, provides only a limited test of the potential for credit misallocation that would occur if the separation of banking and commerce were ended. While some savings and loans have been linked to a limited set of commercial activities, savings and loans have had only limited involvement in commercial lending -- with the important exception of commercial real estate lending.

Some proponents of ending the separation of banking and commerce contend that preferential extensions of credit from banks to their commercial affiliates do not entail any public injury, but rather involve merely internal transfer price decisions within a holding company structure -- much in the way that the auto manufacturers seek to maximize their overall corporate profits by offering below-market-rate auto loans through finance company affiliates to car buyers. However, this view overlooks two unique features of banking institutions that distinguish them from captive finance companies -- (a) the pivotal role of banks in credit markets and their attendant obligation to serve as neutral arbiters of credit, and (b) the existence of federal deposit insurance and the federal safety net for banks, which provides unregulated, commercial firms with a subtle, but nonetheless significant incentive to shift financial risk to their bank affiliates. Thus, preferential extensions of credit by banks to their commercial affiliates cannot be dismissed as mere private, intra-corporate accounting decisions, but instead entail real public injury in terms of credit misallocation, anti-competitive effects, and threats to bank soundness.


While credit misallocation can occur in a number of different forms, it has a common purpose -- the use of credit as a strategic resource to promote the interest of a commercial affiliate. The distinguishing characteristic of credit misallocation is the provision of credit to an affiliate under conditions or terms that are not generally available to borrowers at large, thereby giving a competitive advantage to the commercial affiliate. The specific types of credit misallocation can be categorized as follows:


High-risk loans extended by S&Ls to their real estate development affiliates provide a classic example of relaxed underwriting standards. Continued access to credit during periods of monetary restraint or bank retrenchment -- such as that recently triggered by the Comptroller of the Currency's tightening of bank examination standards -- represents another form in which commercial affiliates could be given preferential access to credit.


The potential for distortions in the allocation of credit resulting from preferential bank lending to suppliers and customers of commercial affiliates is vast and virtually unmonitorable under any set of realistic assumptions concerning the supervisory resources of the banking or antitrust regulators. The use of credit as a tool to strengthen relationships between a commercial affiliate and its suppliers and customers would be particularly effective in the manufacturing sector where many firms depend on a complex network of both suppliers and customers. A case involving Sears provides a classic example of such "vertical" misallocation of credit. Prior to enactment of the 1970 Amendments to the Bank Holding Company Act, Sears controlled a commercial bank in the Chicago area. Federal Reserve Bank of Chicago examiners found that the bank had a heavy concentration of its commercial loans to firms that were Sears' suppliers, a pattern which they judged to be an unsound banking practice. After reviewing the matter, the Federal Reserve Bank advised Sears to relinquish control over the commercial bank.

Insight into the difficulties inherent in regulating transactions with affiliates can be gained by examining the current restrictions on bank transactions with non-bank affiliates. Sections 23A and 23B of the Federal Reserve Act cover not only bank loans to affiliates but also loans to third parties where any of the proceeds "are used for the benefit of, or transferred to" an affiliate. Interpreted expansively in a regulatory environment allowing the mixing of banking and commerce, this language could restrict certain types of commercial bank lending to suppliers or customers of commercial affiliates. For example, it could restrict loans to an affiliate's customers -- either consumers or businesses -- whenever any of the loan proceeds are to be used to purchase goods or services from the affiliate. However, it is questionable whether the Federal Reserve Board would have sufficient resources to monitor bank compliance with such an interpretation of Sections 23A and 23B in an environment involving extensive bank/commercial firm affiliations. Moreover, many loans made to an industrial affiliate's suppliers and corporate customers -- such as working capital loans or commercial real estate loans -- would escape even the broadest interpretation of Sections 23A and 23B.


For a commercial firm that is experiencing financial difficulties favorable access to credit from an affiliated bank would have tremendous importance. In fact, the ability to rely on the credit facilities of an affiliated bank in times of trouble may well be of much greater strategic importance to commercial firms than obtaining preferential access to credit under normal operating conditions. Experience in both Germany and Japan -- where ties between banks and commercial firms are extensive -- demonstrates that banks have a strong tendency to bail out troubled commercial affiliates.


Some commentators contend that even if Congress were to end the separation of banking and commerce the current restrictions on credit transactions with affiliates contained in Sections 23A and 23B of the Federal Reserve Act would prevent credit misallocation, unsound loans, and bailouts. Yet, these rules allow a bank to extend credit to a single affiliate in an amount equal to 10% of the bank's capital and up to 20% of the bank's capital to all affiliates in the aggregate. While these safeguards, if rigorously enforced, might restrain the more egregious depletions of bank capital, they would still give a large bank considerable leeway to engage in credit misallocation and more subtle bailouts. For example, under these rules Citibank, with its $7.6 billion equity capital base, would be in a position to extend emergency lines of credit totalling $1.5 billion to two or more troubled commercial affiliates.


When the Bank Holding Company Act was enacted by Congress the concern was voiced that if banks were allowed to have commercial affiliations, they might refuse to lend to competitors of their commercial affiliates. In metropolitan areas where many different banking organizations are engaged in commercial lending, it is unlikely that such a refusal-to-deal by one or two banks would be effective in restricting access to banking services by competitor commercial firms. However, in smaller, non-metro banking markets, which often have only one or two local banks engaged in commercial lending, the possibility of credit denial or imposition of onerous credit terms for commercial firms in competition with bank affiliates must be viewed as serious.

Moreover, even if banks were willing to extend credit to commercial firms in competition with their own affiliates, such a credit option may be more apparent than real. Many commercial firms would be extremely reluctant to maintain a credit relationship with and provide the required confidential business information to a bank with a commercial affiliate that was a direct competitor.


THE MOST FUNDAMENTAL OBJECTION to the linking of banking and commerce lies in its potential for unleashing a broad array of anti-competitive forces. In large part, misallocation of credit and anti-competitive effects are simply different terms that describe the same economic injury. This is readily apparent with respect to preferential access to credit for affiliates, their suppliers and their customers -- the crux of credit misallocation and, at the same time, a practice with obvious anti-competitive effects. However, analysis in terms of anti-competitive effects casts a somewhat broader net in assessing potential public injuries.

Competition analysis focuses more sharply on the underlying purposes for which credit can be used as a strategic business weapon. For example, granting suppliers of a commercial affiliate preferential access to credit would usually be seen as an advantage for the suppliers, but the threat to withdraw such preferential access also provides a means for the commercial affiliate to build market power vis-a-vis its suppliers.

Competition analysis also introduces concerns that lie beyond the scope of credit misallocation within the real sectors of the economy. In particular, commercial affiliates -- and to a lesser degree their suppliers and customers -- are likely to provide a captive banking market for an affiliated bank. If bank/commercial firm affiliations were to become extensive, then the ability of banks to lock in the banking business of a broad range of commercial affiliates would in all likelihood foreclose a substantial amount of competition in banking markets.

The exact nature of the anti-competitive effects resulting from any given bank/commercial firm affiliation will be greatly influenced by whether the bank or the commercial firm is the dominant partner or whether there exists a rough parity between the two. If the commercial firm is clearly dominant, then there is likely to be considerable emphasis on using the bank's resources to promote the strategic advantage of the commercial affiliate. If the bank is dominant, then there is likely to be more emphasis on tying the commercial affiliate and its suppliers and customers to the bank's financial services, although even in this case promotion of the business interests of the commercial affiliate is likely to remain an important goal.

The major anti-competitive effects of mixing banking and commerce can be categorized as follows:


Preferential access to credit in its manifold forms --unusually favorable loan terms, relaxed underwriting standards, implicit guarantees of bailout, and preferential access for suppliers and customers -- provides an unfair competitive advantage to affiliated commercial firms. Such preferential access to credit is not the result of any genuine economies of scope achieved by mixing banking and commerce; rather, it is based on the suspension of independent credit judgment and the transfer of risk from commercial activities to affiliated banks. Clogging the arteries of credit allocation with extensive self-dealing relationships is likely to have a significant anti-competitive impact on the overall performance of the economy.


The MIT Commission on Industrial Productivity (1989) has found that building cooperative relationships between manufacturing firms and their suppliers and customers is an essential step in improving the productivity of U.S. industry. However, the ability of a large commercial firm with a bank affiliate to link its suppliers and customers to preferential access to credit would greatly enhance the commercial firm's market power over its suppliers and customers and thereby encourage coercive rather than cooperative relationships.

A manufacturer with a bank affiliate that could offer suppliers or customers preferential access to credit would have an unjustified competitive advantage over manufacturers without bank affiliates when it comes to building vertical relationships. Moreover, once suppliers or customers have become hooked on preferential access to credit, the manufacturer's market power will be even greater, since many small and medium-sized business are reluctant to change banks. In short, the use of credit in this fashion as a strategic business weapon would distort commercial relationships in an extended production chain involving material and parts suppliers, primary manufactures, wholesale distributors, and retailers.

Preferential access to credit can also be used to encourage consumers to purchase the products of a commercial affiliate. The most dramatic example of this is provided by the finance company affiliates of the major U.S. auto manufacturers. These captive finance companies have made auto loans with rates as low as 2% and recouped this credit subsidy to borrowers by receiving "subvention" payments from the auto manufacturers and auto dealers. Imagine the objections that would have been raised if these subsidized loans had been extended by federally insured banks that were affiliates of the auto companies.

In general, the use of captive lenders to finance consumer purchases enables commercial firms to both create and take advantage of consumer confusion by presenting consumers with a complex array of options involving different trade-offs between purchase price and credit price. In the auto loan market, the use of cut-rate loans and "subvention" payments by captive finance companies has undermined the utility of the Truth-in-Lending Act and its annual percentage rate yardstick as a mechanism to facilitate comparison shopping for consumer credit.


As indicated above, in smaller banking markets affiliations between banks and commercial firms could result in denial of credit or at least obstructed access to credit for competitor commercial firms. On a broader economic scale, extensive links between banks and firms in a specific industry could lead to credit policies designed to reinforce barriers to entry and oligopolistic behavior within the industry. The Japanese banking system, which is interlocked with Japan's industrial sector, provides a good example of this anti-competitive potential.


Commercial banks in their capacity as lenders obtain confidential business information on a broad range of commercial firms. Whenever a commercial firm acquires control of a bank, it may via the acquired bank obtain access to this confidential information. If the acquired bank happens to have a loan relationship with a competitor of the acquiring commercial firm, then the acquirer may gain important confidential information concerning its competitor, an inherently unfair and anti-competitive situation. Although obtaining access to confidential information on competitors is not likely to provide the primary motivation for commercial firm acquisition of banks, such access would, nonetheless, be a serious, anti-competitive consequence.


When commercial firms become affiliated with banks, they firms tend to withdraw from the market for banking services and to rely on their affiliated banks for key banking services. As a result, other banks are at serious disadvantage in competing for the banking business of these commercial firms. Thus, where bank/commercial firm affiliations are commonplace, there is considerable foreclosure of competition in banking markets. Such foreclosure of competition becomes even greater if the suppliers and customers of commercial firms are also tied to the services of affiliated banks. Overall, the underlying tendency is to weaken the role of market forces in commercial banking and increase reliance on negotiation within corporate networks.

West Germany illustrates dramatically how linkage between commercial firms and banks can significantly reduce competition in the corporate loan market. Although commercial firms in Germany are not formally affiliated with commercial banks via a holding company structure, the largest commercial banks, nonetheless, exercise substantial indirect control over a great many large commercial firms. The banks have achieved this control via a combination of direct stock holdings, proxy voting on behalf of individual investors, as well as director and officer interlocks.

Studies of the German banking system have found that the banks have used their position of control over commercial firms to influence the financial decisions of these firms. In particular, the commercial firms tend to use their "hausbank" for financial services, and there is a pattern of over-reliance on bank loans and underutilization of securities markets. This pattern of reliance on "hausbank" financing has inhibited competition in the German corporate banking market, made penetration by foreign banks extremely difficult, and produced high profits for the German banks.

In Japan, each of the large commercial banks is allied with its own group of commercial firms, bound together by cross holdings of stock and personnel ties dating back to the pre-World War II zaibatsu or industrial combines. These corporate groups, such as Mitsubishi and Mitsui, often extend vertically to encompass the suppliers and customers of their larger members and thus contain hundreds of firms. A Japanese bank usually serves as the "main" bank for the firms within its own corporate group. Like the German experience, these close links between Japanese banks and Japanese commercial firms have made it virtually impossible for foreign banks to penetrate the large commercial loan market in Japan.


COMBINATIONS BETWEEN BANKS and commercial firms would represent a classic form of conglomerate mergers, a pattern of business organization that has significantly weakened the productivity of the U.S. economy during the last several decades. For example, a 1987 study by Michael Porter of 33 large-scale mergers between 1950 and 1986 found that conglomerate mergers had by far the highest failure rate -- 74% of the conglomerate mergers reviewed ended in failure. Harvard Business Review (May-June 1987). Similarly, a 1987 study by McKinsey & Company found a high incidence of failure among corporate diversification programs undertaken over the 1972-1983 period and notes that the danger of failure is greatest for large-scale conglomerate acquisitions. More generally, a Brookings Institution sponsored study by F.M. Scherer and David Ravenscraft of 6,000 corporate mergers between 1950 and 1977 found that the adverse impact of mergers has made a significant contribution to the decline in U.S. productivity. Mergers, Sell-Offs, and Economic Efficiency (1987).

If bank/commercial firm affiliation were permitted, the most likely pattern of conglomeration would entail the take-over of commercial banks by large commercial firms. Commercial firms are more likely to be the acquirers rather than the targets because they have a much larger capital base than banking institutions. As of March 1989, the largest U.S. industrial firms had the following market-value equity capital: IBM - $66 billion; Exxon - $59 billion; General Electric - $40 billion; A.T.&T. - $34 billion. By contrast, the four largest U.S. banking companies had much smaller levels of market capitalization: Citicorp - $9 billion; J.P. Morgan - $7 billion; Security Pacific - #4 billion; BankAmerica - $ 4 billion. Among the top 100 U.S. corporations ranked by market capitalization, there were only two banking companies -- Citicorp and J.P. Morgan.

In recent years, many large manufacturing firms have been reluctant to reinvest their earnings in plant, equipment, and R&D in an effort to strengthen their future productivity, instead preferring to seek short-term gains through conglomerate acquisitions or, more passively, simply buying back their own stock. As the MIT Commission on Industrial Productivity recently found:

In industry after industry, we observed an unwillingness on the part of U.S. firms to forgo these short-term returns and, as in the consumer-electronics case, an associated tendency to diversify into activities that are more profitable in the short run..... we think that we have detected something approaching a systematic unwillingness or inability of U.S. companies to "stick to their knitting" and maintain technological leadership.....

A real danger posed by authorization of bank/commercial firm conglomeration is that by opening up a new merger option it is likely to reinforce the already unhealthy tendency of U.S. industry to focus on short-term profits at the expense of longer-term investment in production technology, worker training, and plant and equipment.

Of course, commercial firms would not always be the acquiring partner in bank/commercial firm mergers and some bank take-overs of commercial firms could be expected. However, given the lack of knowledge on the part of bank managers about the operation of industrial and commercial firms, such combinations would appear to fall squarely within the classic pattern of unsound conglomerate mergers. More generally, it is difficult to see how mergers between banks and commercial firms, irrespective of which type of firm is the acquirer, could capture substantial economies of scope, given the major differences in the production processes between banking and commercial activities.

Extensive acquisition of banking institutions by commercial firms may also have an adverse macroeconomic repercussions. To date, commercial firm forays into the financial service area have tended to emphasize credit cards and other forms of consumer credit -- e.g., the captive finance companies of the auto manufacturers, Sears' Discover credit card, and A.T.&T.'s Universal credit card. Obviously, commercial firms have a strong promotional interest in encouraging consumers to spend more, especially on their own products. Yet, restructuring the financial system in a way that encourages even greater use of consumer credit and more consumer consumption and therefore less savings would run directly contrary to the widely recognized need for the U.S. economy to increase its savings and investment rate.

Finally, elimination of the prohibition against bank/commercial firm affiliation is also likely to have an adverse effect on the investment horizon of the banking industry. Given the large pools of capital in the commercial sector that could be mobilized for the take-over of banks, removal of the acquisition barrier would subject banks with full force to the harsh winds of the market for corporate control. This would instill in bank managements a much greater focus on short-term earnings and maximizing P/E ratios in the interest of discouraging potential take-over offers. Yet, such fixation on the short term is likely to lead to a reduction in the supply of important banking services that provide longer-term benefits to local communities. Many banks provide important resources -- especially, technical assistance and credit packaging to promote economic and community development projects -- that in the long run work to strengthen their local communities and also indirectly benefit the banks. Thrusting banks into the market for corporate control is likely to undermine the willingness of bank managements to make such longer-term investments.


THE SUSPENSION OF INDEPENDENT CREDIT judgment that is inherent in the mixing of banking and commerce not only opens the door to credit misallocation and anti-competitive practices, it also raises major concerns about bank safety and soundness. Managements of bank/commercial conglomerates will have a strong incentive to use bank resources to aid commercial activities; and such assistance can be delivered in various forms that range from unconscious bias in credit underwriting, to explicit cross-subsidization, and ultimately to the bail-out of troubled commercial affiliates.

Strong impetus to the incentive to use bank resources to support commercial activities derives from the dynamics of federal deposit insurance. Federal deposit insurance shifts part of the risk of bank failure due to risky loans to the federal deposit insurance funds and ultimately to taxpayers; but, all of the benefits of success in risky banking endeavors accrue to the bank, its owners, and its affiliates. Thus, bank holding companies with commercial affiliates will have a powerful incentive to shift as much risk as possible from commercial subsidiaries, which are not covered by federal deposit insurance, to bank subsidiaries.


As discussed above, real estate equity investment is a high-risk commercial activity involving extensive end-use of credit and, thus, should be characterized as a commercial rather than a financial service activity. Real estate equity investment was a primary factor in the collapse of the S&L industry and this monumental financial debacle provides a clear warning of the dangers of mixing banking and commerce.

During the 1980s many S&Ls made real estate equity investments either directly or through their service corporation subsidiaries. Admittedly, these equity investments were lodged directly within S&L portfolios or S&L subsidiaries, rather than in S&L affiliates -- and the affiliate relationship is the organizational structure generally envisioned for combining banking and commercial activities. Nonetheless, the S&L experience with investment in real estate equity provides compelling evidence of the injurious conflicts of interest, misallocation of credit, and misuse of bank resources that can arise when commercial and banking activities are combined.

Research recently conducted by Essential Information shows that S&Ls which engaged in real estate equity investment activities, either directly or through service corporation subsidiaries, had a dramatically higher incidence of failure than S&Ls without such investments. This research analyzed the year-end 1987 call reports (financial statements) of all 3,172 federally-insured S&Ls. Each S&L's level of real estate investment was approximated by adding together its direct real estate equity investment and its service corporation investment. The call reports do not indicate the proportion of service corporation assets that were invested in real estate equity, but for the S&L industry as a whole almost one-half of aggregate service corporation assets were invested in real estate equity. The analysis then divided S&Ls into three classes: S&Ls with no real estate investment; S&Ls with real estate investment greater than zero but not above 3% of their total assets (modest real estate investment); and S&Ls with real estate investment greater than 3% of their total assets (heavy real estate investment).

The 656 S&Ls with tangible net worth less than zero at year-end 1987 were deemed to have failed for purposes of the analysis. In view of the severe economic recession in Texas and the high incidence of failure among Texas S&Ls, the analysis further divided the 3,172 S&Ls into two separate groups: 279 Texas S&Ls and 2893 non-Texas S&Ls.

Among Texas S&Ls, the failure rate rose from 23.9% for those with no real estate investment, to 54% for those with modest real estate investment, to 66.1% for those with heavy real estate investment. For non-Texas S&Ls, the failure rate rose from 8.6% for those with no real estate investment, to 19.1% for those with modest real estate investment, to 36.1% for those with heavy real estate investment.

The dramatic rise in the failure rate of S&Ls engaging in real estate investment suggests that this activity not only resulted in direct investment losses but, more importantly, had a corrosive influence on the lending decisions of the S&Ls. This hypothesis was tested by examining the interaction between high-risk lending, real estate investment, and tangible net worth. Two categories of high-risk loans employed were: (a) nonresidential mortgage loans --primarily commercial mortgage loans and land acquisition and development loans -- and (b) commercial construction loans.

The average tangible net worth of all 2893 non-Texas S&Ls was 3.00%. As one would expect, non-Texas S&Ls with high levels of nonresidential mortgage loans and also high levels of real estate investment had an average tangible net worth of -3.90%. Yet, non-Texas S&Ls with high levels of nonresidential mortgage loans but low levels of real estate investment had an average tangible net worth of 2.62%, virtually the same as the average for all non-Texas S&Ls.

Similarly, non-Texas S&Ls with high levels of commercial construction loans and also high levels of real estate investment had an average net worth of -5.26%. By contrast, non-Texas S&Ls with high levels of commercial construction loans but low levels of real estate investment had a average tangible net worth of 3.27%, again roughly comparable to the average for all non-Texas S&Ls.

The data indicate quite forcefully that it was the combination of high-risk lending and real estate investment activities that proved to be so lethal to S&L safety and soundness. Somewhat surprisingly, high-risk lending by itself does not seem to have been a major factor in the erosion of S&L net worth.

A similar pattern of lethal interaction between real estate investment and high-risk lending prevailed among the 279 Texas S&Ls. The average tangible net worth of all 279 Texas S&Ls was -10.62%, reflecting the severity of the Texas economic downturn and the greater use of real estate investment powers by Texas S&Ls. Texas S&Ls with high levels of nonresidential mortgage loans and also high levels of real estate investment had an average tangible net worth of -13.41%. Yet, quite remarkably, Texas S&Ls with high levels of nonresidential mortgage loans but zero real estate investment had an average tangible net worth of 2.24%.

In a similar vein, Texas S&Ls with high levels of commercial construction loans and also high levels of real estate investment had an average tangible net worth of -17.95%. Yet, Texas S&Ls with high levels of commercial construction loans but zero real estate investment had a average tangible net worth of 5.64%.

The study demonstrates that combining banking and real estate equity investment -- a commercial activity that is both high-risk and a major end-user of credit -- has had an extremely adverse impact on the performance of depository institutions. Undoubtedly, the magnitude of this deleterious impact stems from a number of factors. The real estate investments themselves were often improvident. Unsound loans were extended to support the real estate investments -- in some instances, in violation of lending restrictions. Unsound loans were also extended to support real estate investments made by syndicates involving S&L insiders. Finally, and perhaps most important, the ability to combine banking and real estate investment activities served as a magnet that drew real estate developers to take over S&Ls and thus brought into the S&L industry new managements that were far more interested in real estate promotion than running S&Ls on a sound and sustainable basis.


Without question, restrictions on bank transactions with affiliates, such as Sections 23A and 23B of the Federal Reserve Act, if properly structured and rigorously enforced, could limit bank and deposit insurance fund exposure to risk-taking by commercial affiliates. Yet, even with this restraining effect, some exposure would remain. Thus, authorizing affiliations between banks and commercial firms would inevitably expose the federal safety net established for banks to some level of risk from a potentially broad range of commercial activities.

A number of factors contribute to this "irreducible" exposure of the federal safety net. First, in situations of dire financial distress, banks may well decide to violate legal restrictions on loans or other transactions with affiliates or subsidiaries. Witness Continential Illinois Bank's unlawful loan to assist its options trading subsidiary during the 1987 stock market crash. Second, indirect support for a commercial affiliate through high-risk loans to the affiliate's suppliers and customers will be extremely difficult to control by supervision and regulation.

Third, commercial firms affiliated with banks would have indirect access to the payments system and this would further increase the exposure of the federal safety net. A commercial affiliate in serious financial difficulty could readily prevail upon its bank affiliate to make large overdraft payments to third parties. Such large payments are speedily executed over the electronic payment networks, Fedwire or CHIPS. If the commercial affiliate were to fail to cover its overdraft with the bank by the end of the day, the bank itself could be thrown into an overdraft position vis-a-vis the payments system and if the bank's liquidity resources were limited, it might default on the payments system.


AFFILIATION BETWEEN BANKS and commercial firms would significantly increase the supervisory burden borne by the federal banking regulators. Commercial affiliates and commercial holding companies with bank subsidiaries would have to be subject to some degree of regulation in order to minimize the exposure of the federal safety net, as well as to curb credit misallocation and anti-competitive practices.


A key issue in the regulation of holding companies that control both banks and commercial firms will be the determination of whether the holding company and its various subsidiaries have adequate capital. Although discussions of capital adequacy often focus on the parent holding company, capital adequacy of holding companies is more properly measured on a consolidated basis --which in effect takes into consideration the adequacy of capital within each subsidiary. Thus, from a capital adequacy perspective, it doesn't matter whether commercial activities are conducted directly in the parent holding company or lodged in various subsidiaries of the holding company. In either case, the measurement of capital adequacy should be the same.

One of the principal reasons why it is important to regulate the capital adequacy of holding companies that control banks is to prevent the instability that often results from excessive leveraging. In recent years, corporate take-overs and leveraged buy-outs have suddenly and quite dramatically reduced equity capital levels at many commercial firms. By regulating the capital adequacy of bank holding companies, the Federal Reserve Board has prevented this destabilizing syndrome of high-leverage from afflicting the banking industry.

Removing the capital adequacy standards for bank holding companies -- in a sense, letting corporate raiders set capital levels -- would have a three-fold adverse effect. First, thinly capitalized holding companies would exert strong pressure on their subsidiary banks to upstream earnings. Second, the inherent instability of these parent companies would tend to undermine public confidence in their subsidiary banks. Third, eliminating capital adequacy regulation at the holding company level, especially in conjunction with permitting bank/commercial firm affiliations, would thrust banks with full force into the market for corporate control and ensnare them in the obsession with short-term profits.

Under the present banking structure, the primary rationale for regulating the capital adequacy of bank holding companies is that the failure of a bank holding company can have a number of adverse impacts on its subsidiary bank. Sudden failure by a holding company can undermine public confidence in a subsidiary bank and thereby lead to funding problems for the bank. A dramatic example of such contagion is provided by the recent collapse of Drexel Burnham Lambert. The bankruptcy of the Drexel's unregulated parent company caused a reluctance on the part of securities firms to deal with Drexel's registered broker-dealer subsidiary and led to the subsidiary's ultimate demise. As SEC Chairman Richard Breeden explained in recent testimony before the Senate Banking Committee:

The holding company's insolvency appears to have shattered the trust and confidence of the dealer and banking community in the subsidiary broker-dealer, even though it remained solvent with considerable excess liquid assets.

A subsidiary bank may also become operationally interdependent with its parent holding company or a commercial affiliate. For example, there may be extensive sharing of a data processing facilities. The potential for operational interdependence would appear to be substantial if banks were allowed to affiliate with communications firms. In such situations, failure of the holding company could cause serious problems for the bank.

A major reason for concern over the financial condition and capital adequacy of a bank holding company engaged in commercial activities is that when trouble occurs in a commercial activity the holding company management will have a strong incentive to use the resources of the subsidiary bank to provide assistance. Holding companies tend to be run as consolidated entities and it is natural for top management to use the resources of a strong bank subsidiary to prevent the failure of either the parent holding company itself or a commercial subsidiary. For example, the failure of a commercial subsidiary that has issued debt securities to the public could substantially increase future funding costs for the holding company and its surviving subsidiaries. The motivation to call on bank resources in times of crisis is certainly strong enough to encourage management to go to great length to circumvent -- or even directly violate -- regulatory restrictions designed to prevent the diversion of bank resources.

It is often asserted that the legal doctrine of corporate separateness will insulate bank subsidiaries from the liabilities of commercial affiliates or parent holding companies. While corporate separateness may effectively limit subsidiary bank liability to third parties -- such as public holders of securities issued by the holding company or its other subsidiaries -- the doctrine in no way constrains management from siphoning resources out of a bank subsidiary in order to aid a troubled commercial affiliate or the parent holding company itself.

The capital adequacy issues raised by bank/commercial firm affiliations are especially important because commercial firms are generally unregulated and free to set their own capital ratios, subject of course to market constraints. However, as evidenced by the many recent instances of excessive leveraging, such market restraint can be minimal. Thus, in an economy in which banking and commerce were mixed, proper regulation of capital adequacy would require the Federal Reserve Board to determine appropriate capital ratios for a potentially broad array of different types of commercial affiliates. This would entail a major extension of the Board's regulatory responsibilities.

Moreover, the supervisory burden inherent in regulating the capital adequacy of bank holding companies engaged in extensive commercial activities would be much greater than that involved in capital adequacy regulation of bank holding companies that are permitted to expand only into other types of financial service activities, namely securities and insurance activities. These financial service activities are already subject to prudential regulation -- including regulatory determination of capital ratios. Thus, an appropriate capital adequacy standard for a financial service holding company with separate bank, securities, and insurance subsidiaries could be derived readily by summing the pre-existing capital requirements of its individual subsidiaries.


A key regulatory responsibility in an economy in which banking and commerce are mixed would be to monitor bank transactions with commercial affiliates and the suppliers and customers of such affiliates. As discussed above, such transactions must be non-preferential in order to prevent credit misallocation, anti-competitive effects, and even safety and soundness problems. Yet, assigning to the Federal Reserve Board the duty to monitor a host of bank transactions with a broad range of commercial affiliates, their suppliers, and their customers would constitute a tremendous supervisory burden. Even if the task were simplified by prohibiting bank transactions directly with commercial affiliates, the burden of monitoring transactions with suppliers and customers would still be immense.

Moreover, it is not possible for a regulator to determine whether a credit transaction with a commercial affiliate is non-preferential and does not involve unusual risk without first obtaining a considerable amount of information on the financial condition of the borrower. This would entail extensive record keeping requirements.

The SEC's recent problems in handling the Drexel Burnham Lambert collapse illustrate the need for information on unregulated parents or affiliates of financial institutions. In his Senate testimony, Chairman Breeden stated:

The Commission did not have adequate information regarding the Drexel holding company and its unregulated affiliates. The absence of the information severely hindered the Commission in its monitoring of the regulated entities, especially our ability to know of the imminence of a liquidity crisis for the parent, and the corresponding risk that the broker-dealer's capital could be depleted in a desperate but fruitless attempt to pay the parent firm's unsecured creditors.


COMBINATIONS BETWEEN LARGE BANKS and large commercial firms raise the specter of excessive political power. Some observers see this as a false issue, arguing that there is little evidence to support the claim that large, conglomerate corporations exercise greater political influence than the trade associations that represent independent firms in segmented markets. However, two factors warrant special concern about the long-run political implications of conglomeration by banks and commercial firms.

First, it is likely that within the next 10 years integration of financial service firms will be authorized and that powerful bank/securities/insurance conglomerates will emerge. Such financial conglomerates would exercise considerable political influence in their own right and it would be politically unwise to permit them to interlock with powerful commercial firms.

Second, in West Germany, the Western industrial nation where affiliation between the banking sector and the industrial sector is most extensive, there is wide recognition among the academic community, antitrust agencies, and the major political parties that the large German banks wield undue political and economic influence. In fact, the political power of the large German banks has been strong enough to block all efforts to roll back the interlocks between banks and commercial firms. Thus, perhaps the greatest danger inherent in the formation of corporate structures that exercise excessive political influence is that they become politically untouchable.


ADVOCATES OF REPEAL of the current prohibition on affiliations between banks and commercial firms have advanced a number of arguments in support of their position. On the whole, these arguments do not stand up well under close scrutiny. Viewed in the most favorable light, they suggest only minimal public benefits from mixing banking and commerce. These minimal benefits appear to be heavily outweighed by the broad range of potential adverse effects discussed above.


Proponents of ending the separation of banking and commerce view the restriction on bank/commercial firm affiliation as a barrier to entry and in their eyes all barriers to entry ipso facto reduce competition. Yet, banking is already one of the more competitive sectors of the U.S. economy. Given the relative ease of chartering new banks and the elimination of geographic restrictions on banking activities, the barriers to entry in banking are minimal.

Moreover, commercial firms are likely to enter banking by acquiring larger banks rather than by de novo or toehold acquisition -- an entry mode that tends to reduce pro-competitive effects. Also, as discussed above, permitting commercial firms to freely acquire banks would subject banks to rigors and vagaries of the market for corporate control; and based on the experience of the commercial sector, the negative consequences of such change are likely to outweigh any theoretical benefits.


Economies of scope arise from the joint production of banking and other types of products or services. Yet, research economists within the Federal Reserve System have found little evidence to support the proposition that there are economies of scope in banking. Even within the broader financial service sector -- where the similarities between many banking, securities, and insurance products lend more plausibility to the claim for economies of scope -- the evidence is not very convincing. Witness the lack of success of Sears' much heralded one-stop financial service supermarkets or American Express's failures with Fireman's Fund Insurance Company and Shearson Lehman Hutton. With respect to affiliations between banking and most commercial activities, the possibilities for genuine economies of scope would appear to be even more limited.

There may be some service activities -- especially those involving information services or travel services -- that could be combined with banking to achieve economies of scope. In this case, the appropriate legislative approach would be to authorize bank holding companies to engage in these specific activities, rather than enact a blanket repeal of the separation of banking and commerce.


The claim is often made that conglomeration will strengthen a firm by enabling it to diversify it earnings stream. However, the poor performance of conglomerate mergers in the U.S. indicates that whatever hypothetical benefit may result from earnings diversification is far outweighed by diseconomies in management efficiency. Moreover, banks can achieve significant earnings diversification through geographic expansion and entry into other financial service activities. Thus, little in the way of risk-reducing diversification can be expected from allowing banks to combine with commercial firms, many of which are engaged in high-risk activities.


A popular argument for permitting bank/commercial firm affiliations is that the take-over of banks by large commercial firms would increase the level of capital in the banking industry. Unquestionably, most large commercial firms have much higher capital ratios than banks. Yet, this line of reasoning overlooks the fact that capital levels within the banking industry are set by regulation and few large banks maintain more than the minimum amount of capital. Commercial firms that acquire banks are not likely to maintain higher capital ratios at these banks than those required by regulation. Thus, such acquisitions are not likely to inject additional capital into the banking sector. Moreover, the experience of federal banking regulators in disposing of problem S&Ls suggests that commercial acquirers do not have much interest in weakly capitalized depository institutions.


It has also been suggested that the U.S. must permit the mixing of banking and commerce if our banking system is to remain internationally competitive. The implicit assumption is that such affiliations are commonplace in other industrialized countries. In fact, as the Federal Reserve Bank of New York has recently observed, among the Western industrialized nations "banking and commerce are generally kept apart."

In West Germany, the most notable exception to the general rule, there is widespread dissatisfaction with the interlocking between the banking and the commercial sectors. In Japan, the close association between banks and powerful industrial groups is an important factor in the cartelization of the Japanese economy and is viewed by the West as a restrictive trade practice.



Among the major Western industrialized nations, West Germany provides the leading example of close ties between commercial banks and commercial firms. The major West German commercial banks --particularly, Deutsche Bank, Dresdner Bank, and Commerzbank --exercise indirect control over a broad range of key commercial firms. Bank control is achieved by a combination of levers: direct holdings of stock; proxy voting on behalf of many individual investors who deposit their shares with the banks for safe-keeping; and extensive officer and director interlocks. In most situations, the shares voted as proxy for small investors are greater than the direct share holdings. This pattern results in an indirect form of control that stops short of outright ownership within a holding company structure. As a general rule, the German pattern of bank/commercial firm association involves bank control over commercial firms, rather than commercial firm control over banks.

The commercial sector control exercised by the German banks is concentrated on the larger German commercial firms. The banks, by combining their own direct holdings and their proxy votes, control on average 50% of the share voting rights of the 10 largest West German commercial firms and on average 36% of the voting rights of the 100 largest firms. For example, Deutsche Bank, Germany's largest bank, holds for its own account 28% of the shares of Daimler-Benz, the country's largest industrial firm; and the bank was instrumental in arranging the controversial merger between Daimler-Benz and Messerschmitt in 1989.

The extensive involvement of German banks in commercial firms is a consequence of the historical pattern of German industrialization. When Germany began its drive to industrialize late in the 19th Century, it lacked developed securities markets to provide equity capital and long-term debt for commercial enterprises. Instead, Germany relied on commercial banks to meet the financing needs of industrial firms. Thus, an emerging industrial firm would look to its "hausbank" for start-up equity and long-term credit, as well as the short-term loans more usually associated with commercial banking.

Another important outgrowth of the historical primacy of German banks in the area of corporate finance is that the German securities market, which has developed very slowly, is dominated by the large commercial banks. Today, the West German banks constitute for all practical purposes the West German securities industry and there are few independent securities firms. For example, Deutsche Bank dominates trading on West Germany's eight stock exchanges and is the lead underwriter for 40% of new equity issues. German banks have full securities powers -- brokerage, dealing, underwriting -- as well as authority to control commercial firms by holding their shares.


(a). Foreclosure of competition
in banking.

One of the most adverse effect of bank control over commercial firms is that it ties commercial firms to the banking services of their "hausbank" and thereby forecloses competition in banking markets. As the German Monopolies Commission noted in its First Biennial Report (1975):

Involvements of banks in companies in the non-banking sector distort competition between banks. Controlling interests are mainly used to obtain or secure preferential participation in the deposit business, financial transactions related to the export business, and in associations providing long-term credit and issuing shares for the company.

Given the ability to use corporate control to tie-in banking business, it is not surprising to find that Deutsche Bank, which among German banks has the most extensive network of control over commercial firms, has captured 21% of West Germany's huge trade financing market. Commenting on the consequences of the German banking structure, Dieter Wermuth, chief economist at Citibank in Frankfurt, observed in 1983:

It makes companies less free in shopping around for funds and keeps banks that may be cheaper from getting the business.

The contradiction between Citibank's lobbying position in the U.S. in favor of removing all restrictions on bank/commercial firm affiliations in the name of greater competition and the observations of its man on the scene in Frankfurt is striking.

The anti-competitive nature of the German banking structure has been confirmed by recent research that shows Germany to have one of the highest priced banking systems in Europe. For example, a 1988 Price Waterhouse study commissioned by the European Commission found that German banking prices were on average 33% in excess of the competitive price -- making them, along with Spanish banking prices, the highest in Europe. Further, Morgan Guarantee Trust has compared the spread between the inter-bank borrowing rate -- a reasonably competitive bank interest rate -- and the corporate prime lending rate for West Germany and the U.K.. The spread during the month of December averaged over the 1976-1988 period was 1.79% in Germany compared to only 0.09% in the U.K.


Control over commercial firms has enabled German banks to exercise considerable influence over the financial strategy decisions of these firms. Not surprisingly, German commercial firms have relied heavily on the type of financing most easily provided by banks -- short-term debt. As of 1987, German commercial firms relied on debt for 60% of their total debt and equity funding, and short-term debt represented 72% of their total debt. By contrast, U.S. commercial firms used debt for only 40% of their total funding, and short-term debt comprised only 35% of their total debt.


A major structural consequence of bank dominance over corporate financial decisions has been the retarded development of equity capital markets in the German economy. Although other factors have been at work, bank control or influence over commercial firms is one of the reasons why so comparatively few German firms have issued publicly traded equity securities. For example, in 1988 the gross national product of West Germany was $870 billion, compared to $760 billion for the U.K.. Yet, there were only 514 firms listed on the German stock exchanges, compared to 2135 on the London stock exchange.


The multiple roles of German banks as commercial lenders, major equity shareholders in commercial firms, and securities dealers create serious conflicts of interest. In their capacity as commercial lenders, the banks obtain extensive insider information on commercial firms, while their role as investors in equity securities and to some extent their function as securities dealers gives the banks a strong incentive to seek profit from this insider information.

A 1986 report of the Academic Advisory Council of the West German Finance Ministry expressed concern over this conflict as follows:

It is problematic to permit banks permanent participation in non-banks, because in their role as provider of credit, they have a clear advantage in information on the market for enterprises. As provider of credit they have access to information on assets and on profitability of firms and are in a position to use this knowledge for their own acquisitions of interests in those firms. In most Western industrial countries there are therefore limits to the participation of banks in non-banks. The Federal Republic should introduce such legal restrictions.

The German Monopolies Commission in its Second Biennial Report (1977) raised the same concern:

The gathering of information by banks on the economic situation of non-banks is a necessary lending policy tool. However, concern justifiably arises when banks use this information for the acquisition of stock.

Both the Academic Advisory Council and the Monopolies Commission have recommended that German banks be prohibited from holding more than 5% of the stock of any commercial firm. This restriction would parallel the current provision in the U.S. Bank Holding Company Act.


The extent to which the resources of German banks have been misused in efforts to bail out associated commercial firms has been constrained by the fact that banks generally control commercial firms rather than commercial firms controlling banks. Nonetheless, there is evidence of abuse of bank resources to protect associated commercial firms. For example, in 1983 the Schroder, Munchmeyer private bank failed as a result of its extreme concentration of high-risk loans to a group of firms closely associated with IBH Holding, a construction machinery firm. The Schroder, Munchmeyer bank held 7.5% of the stock of IBH Holding and also had a key management interlock with the firm.

The Schroder, Munchmeyer failure is particularly instructive because it demonstrates how easily a bank can circumvent restrictions on loans to affiliated or associated commercial firms. Most of the high-risk loans that caused Schroder, Munchmeyer to collapse were made to firms that had dealings with IBH Holding, rather than directly to the firm.

More generally, German banks routinely rescue commercial firms with which they have close relationships. In a recent example, Deutsche Bank pumped $225 million into Kloeckner & Company, Germany's largest trading firm, when it was on the verge of bankruptcy in 1988. Where a bank has been involved in the business decisions of a failing firm, such bailouts are motivated at least in part by a desire on the part of the bank to protect its reputation.

Often, the rescue is accomplished by an injection of equity capital from the hausbank, rather than additional lending. For example, in the Kloeckner rescue, Deutsche Bank took a controlling equity position in the giant trading firm. In these situations, the hausbank is likely to believe that it can best protect its exposure by gambling that a turnaround can be achieved. Obviously, a key element in such bank rescues is the ability of German banks to take equity positions in commercial firms. If a bank could only attempt a bailout by extending additional loans, it would not be able to profit from a successful turnaround. Finally, it is worth noting that some of the bailouts engineered by German banks have been strongly criticized as being unfair to the rights of minority shareholders in the rescued firms.


The far-reaching economic power wielded by the large West German banks by virtue of their domination over corporate finance and their control or strong influence over a broad segment of commercial firms translates into tremendous political influence for the banks. This political power has been strong enough to ward-off all legislative efforts to reduce bank share holdings in commercial firms, even though such reform has been consistently supported by the government antitrust agencies, the Ministry of Finance, the academic community, and most political leaders. Further, the German Bankers Association has successfully opposed the establishment in West Germany of a commercial paper market and money market mutual funds -- financial innovations that would have enabled savers to earn market rates and commercial firms to borrow at market rates.

Deutsche Bank was instrumental in encouraging the recent merger between Daimler-Benz and Messerschmitt. The merger was opposed by West Germany's Cartel Office; but the commercial firms and their powerful bank ally had sufficient political muscle to overcome this opposition and obtain government approval for the merger.

Far more important, as German reunification begins to take place Deutsche Bank and the larger West German commercial firms have been lobbying for a policy that would allow them to take over intact the large banking and industrial state-owned monopolies in East Germany. For example, in April 1990, Deutsche Bank announced that it had successfully reached a joint venture agreement with the newly formed commercial banking subsidiary of East Germany's central bank. Under the terms of the agreement, Deutsche Bank will in effect obtain control over roughly one-third of the existing banking offices in East Germany. Reflecting growing public concern on both sides of the border, the Federation of German Middle-Sized Industry, which represents over 40,000 West German firms, recently characterized the emerging trend toward large-scale take-overs as "a catastrophe for competition."


Large banks in the U.S. often claim that they cannot compete effectively at the international level unless they are granted much broader powers by Congress. These U.S. banks often point to the large German banks -- especially, their full securities and commercial investment powers -- as the appropriate model for international competitiveness.

If German banks were, in fact, powerful competitors in international banking markets, one would naturally expect West Germany to be a net exporter of financial services. This expectation is strongly reinforced by the fact that the West German economy is the world's largest exporter of goods and services and has a large trade surplus. Quite remarkably, a recent analysis by two economists, Alfred Steinherr of the European Investment Bank and Christian Huveneers of the Catholic University of Louvanne in Belgium, has found that for 1987 West Germany was the world's largest importer of financial services. This suggests strongly that the German "universal" banking system so envied by U.S. bankers has not been a very effective competitor at the international level.


Notwithstanding its anti-competitive effects, there is one major advantage that the German banking structure has given to the West German economy. Because the major banks control a large proportion of the shares of West Germany's larger commercial firms, these firms have been shielded from the threat of hostile take-overs. This insulation from the market for corporate control has provided West German firms with a business environment that is relatively conducive to focusing on long-term investment. Thus, one could argue that the German banking system, despite its anti-competitive aspects, is more supportive of a productive economy than the U.S. banking system. However, the appropriate course of action for the U.S. is not to mimic the German banking structure with all its anti-competitive features, but rather to find more direct antidotes to the excessive churning of corporate assets spawned by the hyper-active market for corporate control.



Benefiting from Japan's strong economic growth rate, large trade surplus, and sheltered domestic banking market, the large Japanese commercial banks have become the dominant international banking organizations. As of year-end 1988, the world's 10 largest banking organizations were Japanese commercial banks or trust banks.

In Japan, large banks are linked to large commercial firms through mutual control mechanisms that differ greatly from the traditional patterns of corporate affiliation and control found in the United States and Western Europe. Typically, a large Japanese bank will be a key member in a group of large corporations known as a keiretsu. The other members of a keiretsu are generally large commercial firms, although other financial institutions, such as insurance companies, may be included. For example, Mitsubishi, Japan's most powerful keiretsu, includes Mitsubishi Bank (the world's 4th largest bank), Mitsubishi Trust & Banking (the world's 10th largest bank) and a broad range of commercial firms involved in activities as diverse as steel, petrochemicals, rockets, ship building, cameras, beer, and real estate interests which include ownership of most of Tokyo's central business district.

Other major keiretsu are Mitsui, which includes Mitsui Bank (the world's 9th largest bank) and Mitsui Trust & Banking (the world's 16th largest bank); Sumitomo, which includes Sumitomo Bank (the world's 2nd largest bank) and Sumitomo Trust & Banking (the world's 13th largest bank); Sanwa, which includes Sanwa Bank (the world's 5th largest bank); and Dai-ichi Kangyo Bank, which is itself the world's largest bank; and Industrial Bank of Japan, itself the world's 6th largest bank. In total, these six powerful corporate groups contain 9 of the world's 16 largest banking organizations.

The major keiretsu are the direct descendants of the zaibatsu, the powerful industrial holding companies that dominated the Japanese economy prior to World War II. The zaibatsu were officially broken up by antitrust laws imposed by the U.S. occupation administration. In particular, the Anti-Monopoly Law, which still remains on the books, prohibited holding companies. However, Japan's leading keiretsu of today are in essence a reconstitution of the former zaibatsu in a form that relies on collective control rather than a holding company structure.

Each member of a major keiretsu holds a small share of the stock of the other members with the net result being that the keiretsu members as a group hold a controlling interest in the stock of each member firm. This collective control system is reinforced by extensive director and officer interlocks between the members and weekly meetings of top level officials that plan group strategy, including technology sharing and joint ventures among members. In recent years, the large keiretsu have become more closely knit, reflecting the common goal of Japanese industry to control domestic markets and be an aggressive competitor in international markets. The large keiretsu are corporate collectives that have proven themselves to be more effective international competitors than large U.S. conglomerates, where ownership and control are concentrated within holding company structures that are by an ironic twist of history more akin to the original zaibatsu model.

The large Japanese banks do not dominate associated commercial firms in the manner of the large German banks. In fact, Japanese antitrust law prohibits a bank from owning more than 5% of the shares of a commercial firm. Nonetheless, Japanese banks are key members of their keiretsu. During the early post-World War II period, Japanese industry was heavily dependent on bank loans to finance capital investment. In more recent years, the emergence of the Japanese stock market as one of the world's leading financial centers and high corporate earnings have provided Japanese commercial firms with alternative sources of funds. However, a large bank within a keiretsu still provides important commercial loan services to its fellow members. Equally important, a large bank will generally assume the leading role in coordinating the group strategy of the keiretsu. In fact, the large banks have to some extent replaced the zaibatsu holding company as the key coordinating mechanism of the keiretsu.

Implicit in the keiretsu relationship is the obligation of member firms to provide mutual support and to do as much business as possible with each other. Thus, the member bank will serve as the lead bank for the other members and stands ready to provide financial support if a member commercial firm encounters financial difficulty.

The concept of mutual support can also work to the advantage of a troubled bank. Some insight into the implicit obligation of the large commercial firms within a keiretsu to support their member bank is provided by the way in which Moody's Investors Service reacted to the recent sharp decline in the Tokyo stock market. Japanese banks hold large portfolios of corporate stock and the tremendous appreciation in the value of these holdings represents a major share of the banks' capital base. Thus, the 25% drop in stock prices during the January-April 1990 period raised concern about the capital adequacy of Japanese banks. However, Moody's recently cited the ability of the larger banks to obtain support from the commercial firms within their keiretsu as a reason for not downgrading the banks' outstanding securities. Moody's pointed out that much of the loan exposure of the largest banks is to commercial, industrial and real estate firms within their own keiretsu and argued that the keiretsu as a group would absorb any substantial losses on these loans.


While the large keiretsu represent a unique form of conglomeration, there is also a substantial level of vertical integration or vertical association within the Japanese economy. Each major industrial firm maintains a complex network of suppliers and customers that consists of hundreds of individual firms. Relationships with these firms tend to be long-term and often involve exclusive dealing. For example, many retail stores are affiliated with a particular commercial firm and sell only the products of that firm. The upshot is that the economic power of the large keiretsu extends not only horizontally by means of conglomeration, but also vertically through close relationships with hundreds of suppliers and customers.


The Japanese banking system is comprised of 12 giant city banks, which emphasize large-scale corporate lending and are generally linked to one of the major keiretsu, and a broad spectrum of smaller banks that focus more on lending to medium and small-sized businesses. Among the second category are 64 regional banks and 68 small business banks (sogo banks), as well as 455 mutual, small business banks (shinkin banks).

As discussed above, the control structure of the large keiretsu results in close association between large commercial firms and large banks. Yet, even outside the large keiretsu, Japanese commercial firms generally maintain a close and continuing relationship with a particular bank, which is referred to as their "main bank." In part, the continued strength of these relationships may simply reflect traditional Japanese business practices. It is possible, however, that the strong vertical relationships within the Japanese economy may play a role in tying medium-sized and even smaller businesses to particular banks. For example, medium-size firms that are suppliers to a large industrial member of a major keiretsu may be "encouraged" to use a smaller bank that has a close relationship with the keiretsu. The question of whether the keiretsu control structure extends vertically to determine the selection of main banks by medium and even small-sized businesses warrants further research.



Like German bank control over commercial firms, close association between Japanese banks and commercial firms within the keiretsu control structure tends to tie commercial firms to the services of their main bank and thereby forecloses competition in banking markets. Indeed, the underlying obligation of commercial firms within a keiretsu to do as much business as possible with their keiretsu bank is inconsistent with the workings of openly competitive banking markets.

Research confirms the assumption that the informal control exercised by keiretsu group structures tends to tie commercial firms to their keiretsu bank for key banking services. For example, a recent study of the banking relationships maintained by 668 of the larger commercial and industrial firms listed on the Tokyo stock exchange found that over the 1978-83 period only 11% of these firms changed their main bank. Moreover, the firms that did change their main bank tended to shift from a lesser bank to one of the six largest keiretsu banks -- Dai-Ichi Kangyo, Mitsubishi, Sanwa, Sumitomo, Fuji, and Industrial Bank of Japan. Interestingly, the study also found the stability of the main bank relationship or "tie-in" to be increasing when examined over a longer time period running from 1962 to 1983.

Additional evidence that the keiretsu structure creates a "sheltered" banking market for a member bank can be seen by examining the commercial loan portfolios of the large Japanese banks that are members of the most extensive keiretsus. As of 1983, 51% of Mitsubishi Bank's commercial loans to large Japanese commercial firms were made to firms that were members of the Mitsubishi keiretsu; 59% of such loans for Mitsui Bank were to members of the Mitsui keiretsu. The comparable percentage for Sumitomo Bank was 45% and for Sanwa Bank the percentage was 41%. Given the growing tendency of commercial banks worldwide to spread large commercial loans across many bank via syndication, these relatively high percentages for loans to keiretsu associates are quite dramatic.

Although large loans to major Japanese corporations are increasingly syndicated to a number of participating banks -- as they are in the U.S. -- the keiretsu bank normally retains the key role and most profitable position of loan syndicator. Another remunerative banking service generally captured by keiretsu banks is the guaranty of bonds issued by large Japanese firms in foreign markets.

The linkages between Japan banks and commercial firms erect a subtle but effective structural barrier to foreign banks seeking to compete in Japanese banking markets. At the same time, these linkages give the larger Japanese banks favorable access to the expanding banking business of foreign subsidiaries of Japanese commercial firms. At present, foreign banks operating in Japan control only about 4% of total Japanese banking assets. By way of contrast, as of year-end 1989, foreign banks in the United States controlled 22.6% of U.S. banking assets and Japanese banks alone accounted for 12% of U.S. banking assets. Most remarkably, Japanese banks by year-end 1989 had managed to capture 17% of the total U.S. corporate loan market -- a market share that was undoubtedly bolstered by loans to U.S.-based subsidiaries of Japanese commercial firms.

This subtle structural barrier to international competition in banking has its primary impact on competition in commercial loan markets. As the Federal Reserve Bank of New York observed in a recent study of the Japanese banking system:

...close ties between Japanese corporations and Japanese banks make it difficult for foreign banks to compete in corporate lending markets.


It is commonplace for Japanese main banks to rescue troubled commercial borrowers. Within the keiretsu structure, the duty of the member bank to aid a distressed commercial member is implicit in the mutual support concept. At least among the large keiretsu banks, such support often involves large infusions of new loans at favorable interest rates.


The close association between Japanese banks and commercial firms has played a major role in the cartelization of the Japanese economy. The economic power of the large keiretsu derives from their far-reaching conglomerate activities, extensive vertical networks, access to financing, technology sharing, and joint venturing. This economic power is clearly enhanced by the presence of giant banks at their hubs engaged in key financing, planning, coordinating, and restructuring functions. Bank/commercial firm association, keiretsu conglomeration, and vertical integration are all key elements in an economic structure that is protectionist vis-a-vis foreign entry and facilitates the cartelization of domestic markets.

When this economic structure of reciprocal and hierarchial relationships fails to constrain price competition in domestic markets, the banks can take direct action to enforce cartel discipline. For example, in 1984 a domestic Japanese oil distributer sought to challenge the vertically integrated oil import/distribution system by purchasing oil directly on the international market. Karel van Wolferen reports in The Enigma of Japanese Power (1989) that Japanese banks responded to this threat to the oil distribution cartel by withdrawing access to credit for the renegade distributor.

The high productivity of Japanese industry and its competitive strength at the international level often obscures -- at least from a U.S. perspective -- the cartelization of domestic markets that has weakened the bargaining position of Japanese small business and imposed high prices on Japanese consumers. A study of comparative price levels in the U.S. and Japan conducted jointly by the governments of the two countries in early 1990 found that prices in Japan were on average 70% higher than in the U.S..

Recently, the Washington Post reported a good illustration of the price-fixing that follows from cartelization of domestic Japanese markets. In March, 1990 Japan's four major breweries in perfect synchronization raised the retail price of a standard 22 ounce bottle of beer from 300 yen to 320 yen ($3.15). In the far more price competitive U.S. beer market, the comparable retail price for 24 ounces of bottled beer -- two 12 ounce bottles -- is roughly $1.20.

The Japanese public views U.S. economic shortcomings -- weak management, poorly trained workers, inadequate household savings, and irresponsible macroeconomic policies -- as the root cause of the large U.S. trade deficit with Japan. Notwithstanding this underlying scorn for U.S. economic shortcomings, a growing number of Japanese consumers are beginning to recognize that the protectionist and cartelized structure of their economy has forced them to pay excessive prices. A recent survey of 10,000 Japanese consumers undertaken by Nihon Keizai Shimbun, Japan's largest financial newspaper, found that 43% of Japanese consumers believed that opening Japan's domestic markets to greater competition would be "for the Japanese people's own benefit and for the improvement of quality of life."


Like the German pattern of bank control over large commercial firms, the Japanese keiretsu structure has insulated large Japanese commercial firms from the market for corporate control. As a general rule, the combined share holdings of all the members of a keiretsu give the keiretsu as a group majority control of the stock of each of its members. This collective control shields each member from the threat of hostile take-overs. Undoubtedly, the keiretsu structure and the resulting insulation from the market for corporate control have been a primary reason why the Japanese economy has so successfully focused on long-term investment and avoided the excessive churning of corporate assets that has weakened the U.S. economy. In the long run, however, other means than cartelization should be relied upon to maintain the desired focus on productive investment.


AS PART OF ANY LEGISLATIVE CONSIDERATION of proposals to end the separation of banking and commerce, the U.S. Congress should conduct an in-depth examination of the following issues.


As discussed above, permitting bank/commercial firm affiliations would greatly expand the universe of credit transactions that would have to be monitored by banking regulators in order to prevent credit extensions on preferential terms. Even under a regulatory regime that prohibited credit transactions directly with commercial affiliates, loans to suppliers or customers of commercial affiliates would still provide a broad avenue for preferential lending. Conceivably, credit transactions with suppliers and customers of commercial affiliates could also be prohibited; but enforcement of such a prohibition would itself be a substantial regulatory chore.

The regulatory task involved in monitoring and adequately controlling credit extensions by banks to commercial affiliates entails major new regulatory responsibilities. To assess the magnitude and practicality of this task, the Congress should examine the regulatory experience to date in monitoring and controlling credit extensions where there are concerns about preferential lending that are analogous to those posed by bank/commercial firm affiliations.


Section 22(h)(3) of the Federal Reserve Act requires that bank loans to insiders must be:

.... made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and [may] not involve more than the normal risk of repayment or present other unfavorable features.

This statutory provision defines "bank insiders" to include any director, officer, 10% stockholder, or any company controlled by any such person.

The Congress should examine federal banking agency implementation of this safeguard against preferential lending. Specifically, the Congress should review the standards and procedures used by the agencies to determine whether loans pass muster under this statutory test.

Important questions to be answered include the following. Are the agencies concerned with misallocation of credit per se or do they seek only to prevent preferential lending that poses a clear threat to bank safety and soundness? What are the costs to the agencies and indirectly to the banks of monitoring insider loans? How effective have the agencies been in preventing credit misallocation and bank losses stemming from insider loans? Given the prevalence of insider loans as a key factor contributing to bank failures, serious questions arise as to the agencies' ability to prevent preferential lending and unsound loans in situations where conflicts of interest or external pressures impinge on the credit judgment process.



Section 23B of the Federal Reserve Act requires that bank loans to non-bank affiliates must have terms and credit standards:

....that are substantially the same, or at least as favorable to such bank .... as those prevailing at the time for comparable transactions with or involving other nonaffiliated companies....

Further, the Federal Reserve Board's orders authorizing bank holding companies to establish securities subsidiaries require that any bank loan to a corporation which has issued securities underwritten by the bank's securities affiliate must be on:

....terms and conditions that are substantially the same as those prevailing at the time for comparable transactions with issuers whose securities are not underwritten or dealt in by the underwriting subsidiary.

The Congress should review the procedures employed by the Federal Reserve Board and the other bank regulators to implement these prohibitions against preferential lending and then assess the cost and effectiveness of these procedures.


While Section 23B of the Federal Reserve Act prohibits preferential lending to affiliates, Sections 23A of that act places an aggregate ceiling on loans to affiliates. These two important provisions apply not only to loans made directly to an affiliate, but also to loans to third parties:

....if any of the proceeds of the transaction are used for the benefit of, or transferred to, such affiliate.

Further, the Federal Reserve Board's orders authorizing securities subsidiaries for bank holding companies prohibit a bank from extending credit to any person for the purpose of (i) purchasing a security that is being underwritten by the bank's securities affiliate or (ii) purchasing from the bank's securities affiliate any security in which the securities affiliate makes a market.

These regulations require major supervisory efforts to monitor or prohibit credit extensions to customers of affiliates. The Congress should examine closely the procedures used by the Federal Reserve Board to implement these provisions and then assess their cost and effectiveness.

A key issue for review is how broadly the Federal Reserve Board has construed the language in Sections 23A and 23B that restricts credit extensions which "benefit" an affiliate. Under a broad interpretation, many different types of credit that strengthen the overall financial position of a customer or a supplier of an affiliate could be viewed as indirectly benefitting the affiliate, even though none of the loan proceeds were transferred directly to the affiliate. By contrast, a narrow interpretation covering only loans where there is a direct transfer of the loan proceeds to an affiliate would provide banks with broad latitude to structure credit extensions to customers and suppliers of affiliates in ways that bypass the restrictions of 23A and 23B.

Current law limits the non-bank subsidiaries of bank holding companies to various financial service activities and, with the exception of selling securities to the public, the marketing of these financial services is generally not facilitated by collateral extensions of credit to customers or suppliers. Consequently, the Federal Reserve Board may have had only limited occasion to decide which types of credit extensions to customers or suppliers of affiliates fall within the purview of the "for the benefit" rule. However, if bank/commercial firm affiliations were permitted, the issue of supervising loans to customers and suppliers of affiliates would have to be addressed in a comprehensive fashion. Thus, the Federal Reserve Board's current interpretations provide an important precedent.


Section 106(b)(2) of the Bank Holding Company Act prohibits a bank from extending loans to insiders of a second bank that maintains a correspondent deposit balance with the first bank unless:

....such extension of credit is made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.

The purpose of this regulation is to prevent the misuse of bank resources and breach of fiduciary duty that occur when a bank insider directs his bank to place an excessively large or low-yield correspondent balance with another bank and as a quid pro quo the other bank makes a preferential loan to the insider. Here again, federal banking agency experience in implementing a prohibition against preferential lending will shed light on the supervisory burden that would arise if bank/commercial firm affiliations were permitted. Hence, the cost and efficacy of this prohibition on preferential lending should be reviewed by Congress.

A well publicized case suggests that vigorous implementation of this prohibition entails substantial supervisory costs. During the Carter Administration, charges were made that OMB Director Bert Lance, in his former capacity as an executive officer of two small Georgia banks, had placed very profitable correspondent balances at Manufacturers Hanover Trust, First National Bank of Chicago, Chemical Bank, and Citizens and Southern National Bank in return for receiving preferential personal loans from these banks. Former staff of the Comptroller of the Currency have indicated that the agency spent as much as one-half million dollars in the effort to determine whether these loans were tied to the correspondent balances and were on preferential terms.


A commercial firm on the verge of failure could easily be tempted to direct its bank affiliate to make large overdraft payments on its behalf to third party creditors. Such overdrafts -- essentially involuntary extensions of credit to the failing firm -- could impose large losses on the affiliated bank and, if the affiliated bank could not cover the overdrafts, also on the Fedwire or the CHIPS payment system.

To protect affiliated banks and the payment system from such abuse, the banking regulators or the banks operating the payments system would have to devise procedures to monitor the financial condition of commercial firms affiliated with banks. The Congress should assess the likely effectiveness and cost of such monitoring procedures.


The Congress should examine the additional supervisory burdens that would arise if the Federal Reserve Board were required to regulate the capital adequacy of bank holding companies engaged in extensive commercial activities. Capital adequacy for firms with a holding company structure should be measured on a consolidated basis, rather than for the parent company only. In effect, this requires that each subsidiary or separate activity should have a level of capital commensurate with its level of risk -- a view of capital adequacy known as the building block approach.

In establishing risk-based capital requirements for bank holding companies, the Federal Reserve Board appears to have side-stepped the building block approach and instead set a uniform capital requirement for all bank holding companies irrespective of their particular mix of banking and non-banking activities. This uniform approach, which in effect imposes the same capital standard on non-banking subsidiaries as bank subsidiaries, may be satisfactory under the present legislative scheme which confines non-banking subsidiaries to financial service activities that are essentially the same as or very similar to the activities conducted within bank subsidiaries. However, if bank holding companies were permitted to engage in commercial activities, then the uniform approach would no longer be workable and the Federal Reserve Board would have to determine appropriate capital ratios for a broad range of commercial activities. Setting capital ratios for commercial activities would raise a host of practical implementation problems, require new reporting requirements, and represent a major expansion of the Federal Reserve Board's supervisory responsibilities.


The concerns about preferential lending and misuse of bank resources raised by the mixing of banking and commerce have to some extent been present, albeit more narrowly framed, in S&L mortgage dealings with their affiliates and the customers of their affiliates or service corporations. The Federal Home Loan Bank Board's (FHLBB) experience in handling these issues provides useful insight into the supervisory problems that might arise in the broader context of bank/commercial firm affiliations.

Prior to enactment of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) in 1989, S&L mortgage lending to affiliates and their customers was governed by Title IV of the National Housing Act. Under Section 408(d) of that act, S&L transactions with affiliates, including mortgage loans, had to receive prior approval from the FHLBB and before authorizing such transactions the FHLBB had to find that they "would not be detrimental to the interests of savings account holders ....or to the insurance risk of [FSLIC]."

Section 408(d) of the National Housing Act and the FHLBB's implementing regulation (12 C.F.R 584.3) also addressed the issue of S&L mortgage loans to customers of their affiliates or service corporations. These provisions prohibited S&Ls from making mortgage loans to third parties for the purpose of purchasing real estate from affiliates. However, an S&L could make a mortgage loan to a third party to purchase real estate from a service corporation controlled by the S&L if:

....the credit terms are not preferential and conform to the institution's normal lending guidelines....

The Congress should examine the FHLBB's experience in administering these provisions. Key issues to be reviewed are (i) the criteria employed by the FHLBB to determine whether loans were "detrimental" or "preferential", (ii) the extent to which such loans played a role in S&L failures, and (iii) the overall cost and effectiveness of these regulatory safeguards.

Interestingly, the FIRREA legislation of 1989 repealed Title IV of the National Housing Act and substituted a new set of safeguards in place of those described above. Under the new statute, S&L transactions with affiliates are generally subject to Sections 23A and 23B of the Federal Reserve Act, but transactions with affiliates engaged in activities not permissible for bank holding companies, such as real estate investment, are entirely prohibited. It is not yet clear whether the regulators will interpret the new statutory provisions as prohibiting S&L mortgage loans to customers of affiliates or merely subjecting such loans to the standards of Sections 23A and 23B. Nor has it been decided whether to keep in place the regulation requiring that S&L mortgage loans to customers of their service corporations must be non-preferential.


In view of the remarkable level of innovation in information and communications technology and the fact that banking is essentially an information processing business, bank combinations with telecommunications firms are one type of bank/commercial firm affiliation that might actually result in economies of scope.

Although bank/telecommunications affiliations are currently prohibited by the Bank Holding Company Act and also by legal restrictions on the activities of telephone companies, the regional Bell companies and the major long-distance phone companies are pushing hard to enter the financial service and financial transaction processing businesses. For example, A.T.&T. in conjunction with Universal Bank of Columbus, Georgia recently introduced a general-purpose credit card that is affiliated with both Visa and Mastercard. Sprint Communications, a major A.T.&T. rival, introduced a Visa credit card in late 1987. The regional Bells are seeking judicial authorization to expand into a broad range of information-based services that could include credit cards, financial information processing, and even commercial lending. Ultimately, both banks and telecommunications companies may see cross-affiliation as the most effective way to promote home banking.

However, combinations between banks and telecommunications companies pose a number of unique problems that are distinct from the general concerns raised by bank/commercial affiliations. Given the quasi-monopoly status of the regional Bell companies and the common carrier status of A.T.&T.'s long-distance service, phone company combinations with banks would raise a number of key antitrust issues. Would a phone company with a bank affiliate be in a position to give the bank preferential access to common carrier telecommunications networks? Interestingly, A.T.&T. is giving customers who pay for long-distance calls with the new A.T.&T. Universal credit card a 10% discount off regular calling-card rates. Moreover, phone companies possess vast amounts of confidential information on both consumer and corporate customers which could give them major advantages in the marketing of financial services. The Congress should examine the various antitrust and privacy issues raised by bank/telecommunications company combinations.


A major example of affiliation between financial firms and commercial firms involves the large volume of auto financing provided by the finance company subsidiaries of the major auto manufacturers. During the 1980s, the auto manufactures provided deep interest rate subsidies on auto loans -- loan rates as low as 2% -- by means of large "subvention" payments to either their finance company subsidiaries or auto dealers. Although the aggressive use of captive finance companies by the auto manufacturers as a tool to market autos has not posed safety and soundness problems -- since federally-insured depository institutions have not been involved -- it does raises a number of important issues about the workings of credit markets. The Congress should review this experience to determine what implications it holds for the broader issue of bank/commercial firm affiliations.

Some evidence suggests that auto company use of credit to promote auto sales has resulted in an overall deterioration of credit standards in the auto loan market, affecting auto loans made by banks as well as captive finance companies. In recent years, auto loans with five year terms have become commonplace; yet, such auto financing entails considerable risk since on average the borrower with a five year loan has no equity in the financed auto until the 37th month after purchase. For example, in 1988 68% of the auto loans and leases made by GMAC had five year terms and in 1989 the percentage was 58%.

The American Bankers Association (ABA) recently reported that the delinquency rate on auto loans held by commercial banks had risen from 1.64% in 1984 to 2.7% in 1989 -- a 65% increase. The ABA survey also reported that the delinquency rate on banks' indirect auto loans -- loans made through auto dealers -- was 47% higher than the delinquency rate on auto loans made directly by the banks. According to the Consumer Bankers Association, intense competitive pressures in the auto loan market have forced banks to resort to indirect lending, which now accounts for 78% of auto loans made by banks.

Aggressive use of credit as a marketing tool by auto manufacturers has definitely complicated the purchase decision for auto buyers. The common option of cash rebate or subsidized financing means that consumers must not only assess the value of the auto but also compare the implicit trade-off between lower purchase price versus subsidized credit. Moreover, in the case of an auto purchase with subsidized credit, neither the subvention payment nor the cash rebate foregone -- factors which indirectly raise the purchase price -- are considered part of the finance charge in determining the annual percentage rate on the cut-rate auto loan. Thus, the introduction of subsidized credit has undermined the utility of the Truth-In-Lending Act as a mechanism for comparison credit shopping. Undoubtedly, the net effect of such confusion has been to impose higher costs on less sophisticated consumers.


In West Germany, large commercial banks exercise substantial control over a broad range of major commercial firms. The Congress should examine the impact of these bank/commercial firm control relationships on the performance of the West German financial system and real-sector economy.

A key task of this review should be to assess the extent to which bank control over commercial firms has blunted competition in West German banking markets and created an informal barrier to entry in corporate banking for foreign banks. A closely related issue involves the question of whether the large banks exercise undue influence over the financial decisions of West Germany's commercial firms. Another important issue to be examined centers on the conflicts of interest inherent in combining commercial lending, full securities powers, and major corporate equity holdings within the same financial institutions.

An additional issue that warrants review is the extent to which German banks bail out troubled commercial firms with which they are closely associated. Finally, the Congress should look at the question of whether the far-reaching economic power of the large West German banks enables them to wield undue political influence.


In Japan, banks maintain close associations with groups of commercial firms. In particular, the largest commercial banks are leading members of the giant corporate groups that dominate the economy. This corporate structure has been criticized as anti-competitive by U.S. trade negotiators in the ongoing Structural Impediment Initiative trade discussions with Japan. The Congress should examine the impact of bank/commercial firm associations on the performance of the Japanese banking system and, more broadly, the Japanese economy.

Like the review of bank/commercial firm relationships in West Germany, a key goal of this review should be to assess the extent to which bank/commercial firm ties in Japan have foreclosed competition in Japanese banking markets and served as a barrier to entry by foreign banks. Another important issue for review is the exact nature of a bank's obligation to bail out associated commercial firms.

Further, the Congress should examine the role played by bank/commercial firm associations in the cartelization of the Japan's domestic commercial markets. A key antitrust issue involves assessing the extent to which the coordinating and planning functions performed by the large banks for their corporate groups strengthen the domestic market power of these groups. Another important issue is to determine the circumstances under which the banks will use credit as a weapon to reinforce a cartel structure.


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