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.

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.

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.

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.....

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.

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.

2. MONITORING TRANSACTIONS
WITH AFFILIATES.

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.

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.

(B). DOMINANCE OVER CORPORATE FINANCIAL DECISIONS.

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.

(C). UNDERDEVELOPMENT OF EQUITY CAPITAL MARKETS.

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.

(D). CONFLICT OF INTEREST AND INSIDER INFORMATION.

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 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.

(E). BANK BAILOUTS OF COMMERCIAL FIRMS.

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.

(F). UNDUE POLITICAL INFLUENCE.

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."

3. INTERNATIONAL COMPETITIVENESS OF GERMAN FINANCIAL INSTITUTIONS.

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.

4. INSULATION FROM THE MARKET FOR CORPORATE CONTROL.

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.

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.

(C). BANK SUPPORT FOR CARTELIZATION OF THE COMMERCIAL SECTOR.

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."

5. INSULATION FROM THE MARKET
FOR CORPORATE CONTROL.

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.

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.

(B). TRANSACTIONS WITH BANK HOLDING COMPANY AFFILIATES.

(I) PREFERENTIAL LOANS.

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....

....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.

(II) LOANS TO CUSTOMERS AND SUPPLIERS OF AFFILIATES.

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.

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.

(III). RECIPROCAL CORRESPONDENT BALANCES AND INSIDER LOANS.

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.

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.

2. INDIRECT ACCESS TO THE PAYMENTS SYSTEM.

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.

3. CAPITAL ADEQUACY OF BANK HOLDING COMPANIES ENGAGED IN COMMERCIAL ACTIVITIES.

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.

4. REGULATION OF S&L LOANS TO AFFILIATES AND TO CUSTOMERS OF AFFILIATES OR SERVICE CORPORATIONS.

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....

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.

5. AFFILIATION BETWEEN BANKS AND TELECOMMUNICATIONS FIRMS.

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.

6. AUTO LENDING BY FINANCE COMPANY SUBSIDIARIES OF THE AUTO MANUFACTURERS.

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.

7. REVIEW OF THE WEST GERMAN EXPERIENCE: BANK CONTROL OVER COMMERCIAL FIRMS.

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.

8. REVIEW OF THE JAPANESE EXPERIENCE: CORPORATE GROUP CONTROL OVER BANKS AND COMMERCIAL FIRMS.

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.