Multinational Monitor

This article, and the sidebar examining the German experience with bank-commercial firm conglomerates, are based on "The Separation of Banking and Commerce," a 1991 Essential Information report.

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, abandoning the policy of separation would significantly weaken the justification for continued regulation of bank holding companies.

Some large corporations that combine banking and commercial activities might conceivably 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 misallocation of credit, anti-competitive effects, exposure of the federal deposit insurance funds and taxpayers to greater risks, and economic inefficiency due to conglomeration.

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. 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.

Parcelling out credit

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. Linking banking and commercial activities tends to undermine the independence and neutrality of banks as arbiters in the allocation of credit to the real sectors of the economy.

A bank with a commercial affiliate would face a variety of incentives and pressures to allocate credit so as to benefit its commercial affiliates.

Specific types of credit misallocation might include:

Loans to commercial affiliates with favorable terms, relaxed underwriting standards or preferential access.
Preferential lending to suppliers and customers of commercial affiliates. 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 made a heavy concentration of its commercial loans to firms that were Sears' suppliers, a pattern which they judged to be an unsound banking practice.
Bailout of commercial affiliates experiencing financial difficulties.
Denial of credit to competitors of commercial affiliates. In metropolitan areas with many commercial lenders, it is unlikely that a refusal to deal with competitors of banks' commercial affiliates by one or two banks would effectively restrict 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, there is a real possibility of credit denial or imposition of onerous credit terms for commercial firms in competition with bank affiliates.

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.

Preferential extensions of bank credit to support commercial activities would injure the public in a variety of ways. First, it would distort the allocative efficiency of the credit market. Second, preferential access to credit would provide the favored commercial affiliate with an unfair advantage over independent commercial competitors. Finally, in extreme instances where prudent lending standards have been cast aside in the effort to support a commercial affiliate, banks' financial soundness might be threatened.

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). The gross misuse of Lincoln Savings and Loan Association by its parent, American Continental 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. Savings and loans have had only limited involvement in commercial lending, with the important exception of commercial real estate lending.

Anti-competitive effects

The linking of banking and commerce could potentially unleash 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. For example, preferential access to credit for bank affiliates, their suppliers and their customers is the crux of credit misallocation and, at the same time, a practice with obvious anti-competitive effects. However, the two perspectives offer different views on the nature of the potential public injuries.

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, there is likely to be more emphasis on tying the commercial affiliate and its suppliers and customers to the bank's financial services.

The major anti-competitive effects of mixing banking and commerce include:

Preferential access to credit. 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.
Greater market power over suppliers and customers. 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.

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 below-market rates and recouped this credit subsidy to borrowers by receiving "subvention" payments from the auto manufacturers and auto dealers.

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 tool to facilitate comparison shopping for consumer credit.

Denial of credit to competitors. 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.
Access to confidential information on commercial competitors. 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 obtain access to this confidential information, including confidential information concerning competitors.
Foreclosure of competition in banking. When commercial firms become affiliated with banks, they 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. These banks may be further disadvantaged if the suppliers and customers of commercial firms are also tied to the services of affiliated banks.

The economic costs of conglomeration

If bank/commercial firm affiliation were permitted, the most likely pattern of conglomeration would entail the takeover 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.

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, they have sought short-term gains through conglomerate acquisitions or by buying back their own stock.

Opening up a new merger option 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.

Extensive acquisition of banking institutions by commercial firms may also have 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 the auto manufacturers' finance companies, Sears' Discover credit card and AT&T's Universal credit card.

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 runs the risk of exacerbating the consumer debt boom.

Commercial firms would not always be the acquiring partner in bank/commercial firm mergers and some bank takeovers 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, there is no reason to believe such combinations would enhance efficiency.

Elimination of the prohibition against bank/commercial firm affiliation is also likely to shorten the investment horizon of the banking industry. Exposing banks to the harsh winds of the market for corporate control would instill in bank managements a much greater focus on short-term earnings and share price, as they seek to discourage potential takeover offers. 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.

Not so safe and sound

The suspension of independent credit judgment associated with the mixing of banking and commerce 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, even at the risk of endangering bank structural soundness. Such assistance can be delivered in various forms that range from unconscious bias in credit underwriting, to explicit cross-subsidization, and ultimately to the bailout of troubled commercial affiliates.

Federal deposit insurance would encourage bank managers to use bank resources to support commercial activities. 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. 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 -- with taxpayers forced to pay the bill in event of bank failure.

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.

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, according to an Essential Information analysis of the year-end 1987 financial statements of all 3,172 federally insured S&Ls.

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

Political power play

The final danger posed by combinations between large banks and large commercial firms is the specter of excessive political power. A General-Motors-Citibank merger, or similar mergers, would create economic behemoths with political influence matched in U.S. history perhaps only by J.P. Morgan's money trust. That political power would, at the least, make it difficult to curb the potential economic abuses and dangers associated with bank-commercial firm mergers. More generally, it would constitute a gigantic impediment to policymaking in the public, rather than the corporate, interest.

Jonathan Brown is is director of financial research for Essential Information.

THE GERMAN COSTS OF CONCENTRATION

Among the major Western industrialized nations, Germany provides the leading example of close ties between commercial banks and commercial firms. The major 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 German banks' commercial sector control is concentrated among the larger German commercial firms. The banks, by combining their own direct holdings and their proxy votes, control on average 50 percent of the share voting rights of the 10 largest West German commercial firms and on average 36 percent of the voting rights of the 100 largest firms. For example, Deutsche Bank, Germany's largest bank, holds for its own account a substantial portion 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.

Higher prices, less competition, distorted economics

German bank control over commercial firms ties commercial firms to the banking services of their "hausbank" and thereby forecloses competition in banking markets.

The "involvemen[t] of banks in companies in the non-banking sector distort competition between banks," the German Monopolies Commission noted in its 1975 First Biennial Report. "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."

Exercising its control over commercial corporations to tie in banking business, Deutsche Bank -- which among German banks has the most extensive network of control over commercial firms -- has captured an enormous share of Germany's huge trade-financing market.

Dieter Wermuth, Citibank's chief economist in Frankfurt, observed in 1983 that the German bank control over corporations "makes companies less free in shopping around for funds and keeps banks that may be cheaper from getting the business."

Germany's concentrated banking structure has created one of the highest priced banking systems in Europe. A 1988 Price Waterhouse study commissioned by the European Commission found that German banking prices were, along with those in Spain, the highest in Europe. On average, the study found, German consumers pay 33 percent more in bank charges than the European average.

A Morgan Guarantee Trust study of the period 1976 to 1988 found that corporate borrowers suffered also. The corporate prime rate was 1.79 percent above the effective bank interest rate, while the comparable figure in the United Kingdom was .09 percent.

The controlling position of German banks in corporate structures has had numerous other adverse consequences:

German banks exercise considerable influence over the financial strategy decisions of commercial firms. German commercial firms have relied heavily on the type of financing that is most easily provided by banks short-term debt. As of 1987, German commercial corporations relied on debt for 60 percent of their total debt and equity funding, and short-term debt represented 72 percent of their total debt. By contrast, U.S. commercial firms at the time used debt for only 40 percent of their total funding, and short-term debt comprised only 35 percent of their total debt.

Equity capital markets in the German economy have historically been underdeveloped. 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 historically 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 United Kingdom. Yet, there were only 514 firms listed on the German stock exchanges, compared to 2,135 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.

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 percent 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. German banks routinely rescue commercial firms with which they have close relationships. Deutsche Bank pumped $225 million into Kloeckner & Company, Germany's largest trading firm, when it was on the verge of bankruptcy in 1988, for example. 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.

The far-reaching economic power wielded by the large 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. 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. The German Bankers Association has successfully opposed the establishment in 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 1989 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.

Notwithstanding its anti-competitive effects, the German banking structure has given the German economy one major advantage. The major banks' control of a large proportion of the shares of Germany's larger commercial firms has shielded them from the threat of hostile takeovers.

However, if U.S. policymakers are concerned about the economic effects of merger and acquisition activity -- and there is little evidence they are -- they should find more direct antidotes to the excessive churning of corporate assets spawned by the hyper-active market for corporate control. Mimicking the German banking structure with all its anti-competitive features would bring too high costs.

- J.B

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