The Good and Bad of Bank Regulation: The Case of Industrial Banks

By | January 15, 2019

 Courtesy of James R. Barth and Yanfei Sun [1]

“Industrial banks” are financial institutions that are probably a mystery to most Americans. Although they may not be household names, industrial banks (IBs) have existed for more than a century. Indeed, they pre-date the establishment of the Federal Reserve in 1913. Their names are a nod to their original mission: lending to industrial workers who had difficulty obtaining credit elsewhere. Over time, IBs evolved by expanding their customer base and geographical reach. Today they are modern financial institutions that offer a wide variety of financial services.

If the term rings familiar, it’s likely because of a flurry of news coverage in 2005 when Wal-Mart filed an application to charter an industrial bank and applied for deposit insurance from the Federal Deposit Insurance Corporation (FDIC). Other commercial firms at the time (including BMW, Toyota, General Electric, and Harley-Davidson) already owned IBs, but Wal-Mart’s application aroused a wave of heated opposition. In response, the FDIC declared a six-month moratorium on new applications for IBs in July 2006 (which was later extended to January 2008) and held public hearings on the Wal-Mart proposal. Wal-Mart withdrew its IB application in March 2007, before the FDIC made its ruling, which defused the controversy.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) placed another moratorium that ended in July 2013, on approving federal deposit insurance for new IBs owned by commercial firms. It also required the Government Accountability Office (GAO) to assess the role and regulation of IBs, which are not banks under the Bank Holding Company Act (BHC Act) of 1956. Importantly, establishing or acquiring a financial institution that is not a bank under the BHC Act is the only way that a commercial company can own a depository institution eligible for federal deposit insurance. The GAO released its report in January 2012 and did not recommend repealing the federal rules allowing IB ownership by commercial firms.

Historical Overview

More than a century ago, IBs were established to provide loans to low and moderate-income industrial workers who had stable jobs but little access to bank credit. At the time, banks catered to businesses, while savings and loans focused on home loans. Mutual savings banks existed but were located in the New England states. This situation provided an opening for a new type of financial institution geared toward an underserved market. This market existed because loans were not typically extended to industrial workers at the time. Since these institutions chose to make industrial workers their primary customers, they became known as either “industrial loan companies” or “industrial banks.”

The IB industry has never been large in terms of its number of institutions or assets, and has always been dwarfed by the banking industry. In 1920, for example, there were 87 IBs with $31 million in assets—but in that same year, there were some 30,000 commercial banks holding nearly $50 billion in assets. In Q3 2018 there were only 25 IBs holding $246 billion in assets, as compared to 5,486 other FDIC-insured institutions holding $18 trillion in assets.[2] This striking imbalance helps explain why so few people are aware of the existence of IBs. More importantly, it indicates that the IB industry is not, nor has it ever been, a threat to the stability of the banking industry.

 In the early years of the IB industry, at least 40 states chartered IBs. As of Q3 2018, only six states still had active FDIC-insured IBs.[3] This situation is due to the Competitive Equality Banking Act (CEBA) of 1987, which specifies that only IBs chartered in states that had in effect, or under consideration, a statute requiring, or that would require, IBs to be FDIC-insured as of March 5, 1987, were exempt from the definition of a “bank” in the BHC Act. This means that only IBs chartered in “grandfathered” states, as determined by the Federal Reserve, are eligible for the IB exemption from the BHC Act. Until 2009, there were seven such states, but the last IB in Colorado became inactive that year. There are currently only six grandfathered states with depository IBs: California, Hawaii, Indiana, Minnesota, Nevada, and Utah.

Of the six states with Ibs, Utah dominates the market share, accounting for 60 percent of IBs and 96 percent of assets, as of Q3 2018. Nevada ranks second, with 16 percent of institutions and 3 percent of assets. The remaining four states collectively account for 24 percent of IBs and roughly 1 percent of assets. Utah and Nevada are by far the two most important states for the IB industry today.[4]

Throughout the industry’s history, most IBs were either stand-alone entities or subsidiaries of other financial firms. In 1988, however, General Motors acquired an IB charter. From this point forward, there have been two ownership models: IBs owned by financial firms; and IBs owned by commercial enterprises.

Financially-owned IBs have dominated commercially-owned IBs with respect to both the number of institutions and total assets. As of Q3 2018, there were 19 financially-owned IBs accounting for 94 percent of assets, and six commercially-owned IBs accounting for the remaining 6 percent. Utah accounts for 93 percent of the assets and roughly 96 percent of the commercially-owned IBs. These institutions, moreover, are owned by a variety of commercial parents, ranging from automobile companies to retailers to transportation companies to a motorcycle manufacturer.

IBs essentially operated like local consumer finance companies during their early years and thus were not deemed important competitors for banks. However, things started to change when the FDIC was established in 1934 in response to numerous bank runs and associated failures. The FDIC decided to insure the thrift certificates of 29 industrial banks that year and later added IBs to the ranks of insured financial institutions on a case-by-case basis. The Banking Act of 1935 also made IBs eligible for membership in the Federal Reserve. As a result, four IBs located in Illinois, Michigan, North Carolina, and Ohio were members as of 1940. Over time, more states began allowing IBs to offer both demand and time deposits. Then, with the passage of the Garn-St Germain Act in 1982, all deposit-taking IBs became eligible for federal deposit insurance.

Regulation

From the outset, IBs, being state-chartered financial institutions, have always been regulated by their chartering states. After the establishment of the FDIC, however, IBs that acquired FDIC insurance also came under the supervision of the FDIC. As a result, the FDIC has the authority to examine any affiliate of any insured depository institution, including the parent company. This authority applies to IBs so that the FDIC is able to determine the relationship between the IB and its parent as well as the effect of such a relationship on the IB. Moreover, state regulatory authorities in California, Nevada, and Utah have the authority to conduct examinations of both the parents and affiliates of IBs.

In addition, IBs are subject to Sections 23A and 23B of the Federal Reserve Act, which restricts transactions among IBs, affiliates, and parent companies. More specifically, IBs are prohibited from extending loans of any significance to their parent company or an affiliate, or from offering loans on preferential or non-market terms. Lastly, Utah and the FDIC require a majority of IB board members to be outside directors unaffiliated with the parent companies.

Banks did not seem very concerned about competition from IBs for a long time—not even in 1988 when the first commercial firm acquired an IB charter. Since then, a variety of commercial firms have acquired or formed IBs, including BMW, General Electric, Target, Pitney Bowes and Harley-Davidson, without generating controversy.

Wal-Mart Creates a Fire Storm

The banking industry began to focus on competition from IBs when the IBs owned by Merrill Lynch and Morgan Stanley began to grow dramatically by providing insured deposits to their customers. However, it was Wal-Mart’s attempt to enter the market that created a real storm.

Wal-Mart made its first move in this arena in 1999, when it tried to acquire a small savings and loan institution in Oklahoma. However, the Gramm-Leach-Bliley Act (GLB Act) of 1999, which prohibited the mixing of banking and commerce, took effect that year, and Wal-Mart missed the deadline for such an acquisition. In 2001, it then tried to partner with Toronto-Dominion Bank USA to buy a thrift institution, but the Office of Thrift Supervision (OTS), which was merged with the Office of the Comptroller of the Currency in July 2011, denied its application. A year later, Wal-Mart tried yet again to purchase an IB, this time in California, but the state quickly passed a law prohibiting such an acquisition.

In 2005, Wal-Mart filed an application with the Utah Department of Financial Institutions and the FDIC to establish a federally insured IB. However, the FDIC did not approve the application for deposit insurance. Instead, the FDIC placed a six-month moratorium on all industrial loan company applications in July 2006. In January 2007 the moratorium was extended by the FDIC for an additional year for IBs that would be owned by commercial companies. At the time of the moratorium, the FDIC acknowledged that commercially-owned IBs had not caused serious problems to date but pledged to closely monitor the existing ones.  Prior to the moratorium, the FDIC held two public hearings in April 2006 on Wal-Mart’s deposit insurance application. In response to its request for public comments, the FDIC received more than 12,600 comment letters, mostly opposing the approval of Wal-Mart’s request.

Many banks opposed Wal-Mart’s entry into this market, fearing that such a behemoth would use the IB to establish branches in all its stores throughout the country and eventually offer a full line of banking services. They were not placated by Wal-Mart’s statement that it only wanted to own such an institution to reduce the transaction costs it was incurring by paying banks to process credit card, debit card, and electronic check transactions in its stores. Wal-Mart eventually withdrew its application in March 2007, before the end of the moratorium and before any decision had been made by the FDIC. Interestingly, by 2007, California, Colorado, Illinois, Iowa, Kansas, Maine, Maryland, Missouri, Oklahoma, Texas, Wisconsin, Virginia, and Vermont had passed legislation restricting to various degrees the operation of IBs.

Changing Restrictions on the Mixing of Banking and Commerce

The opposition by some banks to IBs has largely focused on commercial ownership. Given such opposition, it is instructive to note that throughout most of U.S. history, commercial firms could own any type of banking institution, be it a commercial bank, savings and loan association, or an industrial loan company. As far back as 1799, the state of New York allowed Aaron Burr to use surplus capital in a water company that he owned to establish a bank—which ultimately became JPMorgan Chase. During the Great Depression, moreover, the federal government asked Henry Ford to convert a portion of his car company’s deposits at Manufacturers National Bank of Detroit into stock to prevent its collapse. He refused, but his son Edsel subsequently recapitalized the bank with his own funds. General Motors, for its part, injected capital into the National Bank of Detroit to save it from insolvency during this turbulent period.

The BHC Act, however, started to change ownership flexibility by prohibiting commercial firms from owning more than one bank. The first federal law restricting ownership of a bank, it prohibited any entity directly or indirectly engaged in any activity other than banking from owning more than one bank. In 1970, the BHC Act was amended to bar commercial firms from owning even one bank.

The story does not end here, however, because commercial firms could still own savings and loans. However, around the same time, the Savings and Loan Holding Company Act of 1967 imposed restrictions on commercial firm ownership of this type of banking institution, too. Similar to the BHC Act, the act prohibited the commercial ownership of multiple savings and loans through the establishment of multi-thrift holding companies.

Despite these legislative attempts to block commercial firms’ entry into banking, the door was not entirely closed, since the BHC Act defined a bank to be a financial institution that offered demand deposits and made commercial loans. Based on this definition, a commercial firm could acquire a bank but then cease to offer either demand deposits or commercial loans. This indeed happened; and such federally insured depository institutions became known as “nonbank banks.” By the mid-1980s, firms such as General Electric, Textron, ITT, Gulf & Western, John Hancock, Prudential Bache, American Express, Merrill Lynch, Dreyfus, Household, Beneficial, Sears Roebuck, J.C. Penney, McMahan Valley Stores, Bankers Trust Corp., Bank of Boston Corp., and others had established nonbank banks. In response, Congress passed the Competitive Equality Banking Act (CEBA), which grandfathered existing nonbank banks (but limited their growth) and prohibited the formation of new nonbank banks by expanding the definition of a bank to include any deposit

The other track that a commercial firm could take to gain entry into banking was to become a unitary thrift holding company that only owned a single savings and loan. However, there was a prohibition on commercial ownership of multiple thrift holding companies. As a result, there were far more unitary thrift holding companies controlling many more savings and loans than multiple thrift holding companies until the GLB Act further blocked entry by prohibiting commercial firms from ownership of unitary thrift holding companies. It did, however, grandfather existing companies.

Legislative actions taken by the federal government over the past 50 years have steadily and consistently blocked entry into banking by commercial firms. Commercial firms after 1987 and before 1999 had only two choices: become a unitary thrift holding company or own an IB. If a commercial firm became a unitary thrift holding company, however, its subsidiary was subject to the Qualified Thrift Lender Test, which meant the savings and loan institution had to hold a relatively high percentage of its loan portfolio in housing-related assets. It should not be surprising, then, that not all commercial firms would consider this option desirable. Some, therefore, like General Motors, decided to acquire an IB.

By 1999, there was only one remaining point of entry: the acquisition or formation of an industrial bank. As previously noted, there are currently six commercially owned and 19 financially owned IBs. The six commercially owned institutions now account for 6 percent of the total assets of the IB industry—and this segment could presumably account for even more, now that the moratorium on newly chartered commercially-owned IBs has been lifted.

Is the IB Model a Safe and Sound One?

The concern over commercial firms owning banking institutions presents some striking contradictions. After all, Bill Gates can own a bank, but Microsoft cannot. Members of the Walton family, moreover, do own a commercial bank, but Wal-Mart cannot. The company did, however, operate a full-service bank in Mexico until it was sold in 2014 and can own banks in most of the foreign jurisdictions in which it operates. It seems rather paradoxical that an individual can own a bank and a company, and yet that company itself cannot own a bank.

Furthermore, the United States is out of step with most countries around the world. According to World Bank data, only four of 142 countries surveyed prohibit the ownership of banks by commercial firms. Most importantly, this restricts the ability of the U.S. banking industry to draw upon the substantial equity of commercial firms. With options for enlarging its capital base narrowed, the U.S. banking industry will find it more challenging to remain a major player in the increasingly competitive global arena.

Those who have cautioned against allowing commercial firms to own IBs, or banks more generally, frequently focus on the systemic risks posed by such entities. They also raise questions about oversight and the potential for parent companies to use their IBs for anti-competitive practices. However, the regulation that is already in place appears to be adequate to address these concerns.

While the sheer size of some of the corporations that might wish to enter this market has been a flashpoint in the debate, the Dodd-Frank Act also provides a means to limit the growth of any company that might pose a systemic risk to the economy. And in times of systemic crisis, commercial firms do not gain direct access to the federal safety net (meaning FDIC insurance and access to the Federal Reserve discount window) merely by owning an IB.

Given the range of concerns that have been expressed about this little-known corner of the banking industry, it is essential to understand exactly how IBs are regulated. IBs have more restrictions on the types of deposits they are able to offer, though otherwise, both are subject to similar restrictions and oversight. More generally, both IBs and their parent companies are subject to bank regulations and regulatory oversight. They are examined and required to provide reports and other information specified by the regulators. The regulators can issue cease and desist orders, orders of prohibition, and civil money penalties to the parent company and every affiliate that has transactions with the bank or otherwise influences its operations, all individuals serving as officers or representatives of an affiliate, outside auditors, consultants and legal counsel, and anyone else that qualifies as an “institution-affiliated party” as defined in the Federal Deposit Insurance Act. These powers are comparable to the Federal Reserve’s authority over bank holding companies and financial holding companies.

Moreover, parent firms can serve as an important source of governance over their IBs. Commercial firms like BMW and Toyota clearly do not wish to have their brands damaged by inappropriate behavior on the part of their subsidiary IBs, given their overriding dependency on the products produced by the parents.

Unlike some of the IBs, the bank subsidiaries of bank holding companies are generally vital to the overall enterprise. Indeed, for most bank holding companies, as the financial performance of the bank goes, so goes the parent. This is not the case for commercial firms like BMW and Toyota that own IBs.

Conclusion

Financially-owned IBs are in many respects quite similar to other banking institutions. Since their parents are financial firms, they could become financial holding companies by converting their IBs to commercial banks. In this sense, there appears to be nothing particularly unique about financially-owned IBs as compared to commercial banks. However, both financially- and commercially-owned IBs are state-chartered rather than federally chartered, which is not the case for all commercial banks.

Apart from that difference, it is largely the fact that some IBs are owned by commercial firms that is truly unique today. The parents of these IBs cannot convert their IBs to commercial banks, and at the same time, themselves become financial holding companies. The only way for these commercial firms to currently own a banking institution is to continue owning their IBs.

Many of the diversified companies desiring to enter the IB industry have the expertise, resources, capital, and perhaps even established credit business to contribute to a bank, both during the start-up phase and over time. As the U.S. Treasury Department (1991) pointed out, “the development of these broadly diversified firms has often proven beneficial to the economy at large, and financial markets in particular. Most important has been the ability and willingness of such firms to strengthen the capital positions of their financial services subsidiaries. … The stability brought to the financial markets in this way is a net benefit to the economy overall.” The parents of commercially owned IBs, moreover, are now subject to serve as sources of strength due to the Dodd-Frank Act.

During the most recent financial crisis, IBs provided credit when other financial institutions were unable or unwilling to do so (due to a lack of liquidity or capital). If the IB industry is allowed to grow, it may be able to tap into new sources of capital from companies that are otherwise prohibited from owning a bank by the BHC Act. The total net worth of U.S. non-financial corporate businesses was $25 trillion as of Q3 2018.[5] If even a small percentage of this capital were invested in IBs, it could contribute to an expansion in the availability of credit, a development that could have wider ramifications for U.S. economic growth.

U.S. financial institutions now compete in a global marketplace. The vast majority of countries around the world allow the mixing of banking and commerce, leaving the United States out of step with international norms. This suggests that legislators, regulators, and other officials should be careful not to put U.S. financial institutions at a competitive disadvantage.

 

[1] For a more detailed discussion of this topic, see “A New Look at the Performance of Industrial Loan Corporations” by James R. Barth and Yanfei Sun, Utah Center for Financial Services, David Eccles School of Business, University of Utah, January 2018.

[2] See FDIC website, https://www5.fdic.gov/sdi/main.asp?formname=customddownload.

[3] Ibid.

[4] Ibid.

[5] See Federal Reserve Bank of St. Louis website, https://fred.stlouisfed.org/series/TNWMVBSNNCB.

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