Subprime Crisis Confirms Wisdom of Separating Banking and Commerce

Abstract

During the past three years, a highly-publicized controversy has raged over the question of whether Congress should prohibit acquisitions of industrial loan companies (ILCs) by commercial organizations. The controversy began when Wal-Mart and Home Depot filed applications to acquire ILCs. Those applications triggered strong opposition from a broad coalition that included the Federal Reserve Board (FRB), members of Congress, community banks, labor unions, retail stores, and community activists. From July 2006 to January 2008, the Federal Deposit Insurance Corporation (FDIC) imposed a moratorium on the processing of applications by commercial firms to acquire ILCs. In May 2007, the House of Representatives passed a bill (H.R. 698) that would prohibit further acquisitions of ILCs by commercial firms.

The Senate has not yet acted on legislation similar to H.R. 698 and is not likely to do so during 2008. Wal-Mart and Home Depot have withdrawn their applications, thereby removing the stimulus for much of the public opposition to commercially-owned ILCs. Senator Robert Bennett of Utah, the state with the largest number of ILCs, has strongly opposed any legislation restricting commercial ownership of ILCs. Congress' attention has also been diverted by the subprime lending crisis.

Despite the current legislative impasse, there are three important reasons why Congress should prohibit commercial firms from acquiring ILCs. First, commercial ownership of ILCs conflicts with the well-established U.S. policy of separating banking and commerce. Second, widespread commercial ownership of ILCs will create serious risks for the U.S. financial system and cause significant distortions in the broader economy. As indicated by the FRB's recent rescue of Bear Stearns, large commercial owners of ILCs are likely to receive significant federal subsidies by gaining access to the federal safety net for financial institutions. Such subsidies will encourage other commercial firms to acquire ILCs, thereby promoting extensive commercial-banking links that will increase the U.S. economy's vulnerability to systemic financial crises.

Third, no federal regulator currently has authority to exercise consolidated supervision over corporate owners of ILCs. The Bear Stearns rescue has shown that the FRB must be given consolidated supervisory powers over the parent company of any financial institution that has access to the FRB's liquidity support facilities. However, it would not be desirable to authorize either the FRB or the FDIC to supervise commercial firms that own ILCs. Consolidated supervision of commercial parent companies of ILCs would significantly increase the amount of governmental intrusion in the commercial sector of our economy, and it would cause financial markets to expect federal support for large commercial owners of ILCs. The subprime crisis confirms the need for Congress to close the ILC loophole in order to forestall even greater threats to the stability of our financial system and the broader economy.

Keywords: subprime lending crisis, separation of banking and commerce, deposit insurance, federal safety net, industrial loan companies, systemic risk

JEL Classification: E44, E53, G20, G21, G28, G38, K20, K22, K23, N20