June 25, 2009
The End of ILCs?
Posted by Mehrsa Baradaran

Thanks Gordon for letting me be part of your blog community for a short time.

As part of the Obama administration’s regulatory reform proposal, Industrial Loan Companies (ILCs) are once again on the chopping block. ILCs are banks that are uniquely exempt from the Bank Holding Company Act (BHCA), which means that any corporation can own an ILC and bypass Federal Reserve supervision of the parent company. The administration states:  “The loophole for [ILCs] creates an unwarranted gap in the separation of banking and commerce and creates a supervisory 'blind spot' because Federal Reserve supervision does not extend to the [ILC] holding company.” The appeal of ILCs lies in this loophole, obviously, and so does the criticism.

The exemption of ILCs from the BHCA has survived many rounds of banking regulations starting in the 1950’s with the BHCA itself and stretching through the 1990s. Opponents want to shut down this exception because they say that it violates the US banking tradition of separating commerce from banking—corporations should not own banks and vice versa. The assumption being that when commerce and banking mix, conflicts of interest arise and the conglomerate effect leads to vulnerability. Opponents also argue that ILCs are destabilized by their parent corporation and that the FDIC insurance fund becomes vulnerable to “unregulated” holding company problems.

ILCs gained national attention—or scorn, more accurately—when Wal-Mart applied for one in 2005. Before that, ILCs were operating efficiently for decades out of the public eye. The attacks came from all sides, but at its core, the fight was fueled by the fear of Wal-Mart entering the banking fray and competing with the nation’s small banks in a way that only Wal-Mart can compete. The fears were legitimate, but most of the attacks were not.

Wal-Mart eventually backed down from the angry mobs and withdrew their application for an ILC and the hubbub over the charter died down, which is why I was surprised to see it last week in President Obama’s proposal for regulatory reform. HR 698, which was the result of the Wal-Mart debacle and that would close the ILC exception, passed easily through the House in May 2007 and has been stalled in the Senate Banking committee for almost a year. Most industry experts did not expect it to get out of committee intact because Senator Bennett, one of the ranking members of the committee, is from Utah, the state that charters the most ILCs in the country. It’s hard to predict how strongly the administration will push the issue, but ILCs are not likely to go down without a fight.

In my paper, I argue against the presumption that the separation of commerce and banking is a reality or an ideal. Banking and commerce were mixed at the beginning of banking and they continue to mix despite extensive regulation forbidding it. In fact, the mixing creates a more stable financial system by allowing businesses and banks to diversify. When toxic assets are held by, insured by, and sold by the same players, the toppling of a system is not difficult. Banks typically collapse overnight as opposed to commercial firms, like GM for example, that usually have long slides toward bankruptcy. Why not let a commercial firm’s long-term debt structure benefit a bank’s short-term cycle? International comparisons suggest that mixing of banking and commerce results in a more stable banking system.

ILCs are no less stable than any other banks. In fact, they have been surprisingly resilient in comparison to other unaffiliated banks during this recession. In my paper, I outline the advantages ILCs have to traditional banks, such as instant access to capital. One of the Utah ILC regulators told me that when one ILC encountered a credit freeze and needed $130 million, all they had to do was pick up the phone and call their commercial holding company and the money was wired to them the next day. Traditional banks have been sunk by a lot less than $130 million resulting in losses to investors and to the FDIC.

Now that we are rethinking banking generally, we should also reconsider assumed premises of banking, such as the separation of commerce and banking. Instead of shutting down the ILC charter, we could perhaps use it as a successful model for bank stabilization.

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