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Lessons from history III: Banking separation (1/3) The Other Separation: the separation of Banking and Commerce in the United States

A good way to put the separation of investment and commercial banks into perspective is to come back to the arguments that led to a much older separation whose distinctive feature is to have survived the wave of deregulation of the 1990s: the separation of banking and commerce in the United States.

In the aftermaths the 2008 crisis, many people, including Finance Watch, have been advocating reform of the EU banking structure. One of the key measures would be the separation of commercial and investment banks. In the debate, people tend to forget that the idea of limiting the way banks lend and controlling the risky assets in which they invest is nearly as old as banks themselves. Because banks control substantial assets, “as early as 1374, governmental regulation prohibited banks from trading in certain speculative commodities” [Symons, 1971].

Protecting the real economy

Architects of the American banking system, among whom Alexander Hamilton (1757-1804) played a key role, took Britain as a model. They believed that banks should be separate from commerce, which today we would call the real economy, or Main Street. However, in the late 18th century, there were no banking laws. So financial institutions were regulated through charters of incorporation: banks needed charters to be allowed to operate and regulatory provisions were introduced into individual charters granted by state or national authorities.

In the 19th century, as industrial capitalism was really taking off, financial regulation was already centered on two principles. “The first principle delimiting the scope of all bank activities is the promotion of safety, soundness, and the absence of substantial risk, both to deposited funds and the monetary system. A second, correlative principle, particularly delimiting the bank activities of credit granting and credit exchange, is economic neutrality in the allocation of economic resources” [Symons, 1971]. In other words, banks should be sound, and they should not threaten competition in the real economy.

Separating banking from commerce

In 1863, the National Banking Act was adopted at the federal level. The Act is very similar to the Free Banking Act, which was adopted by the State of New York in 1838. Both acts provided that banks were only allowed to carry on ‘the business of banking’, defined essentially as “deposit taking, credit granting, and credit exchange” [Symons, 1971]. The aim was to prohibit banks from entering commercial ventures, which were perceived as too risky.

A major consequence of the separation of banking and commerce was the prohibition on holding stocks. Indeed, holding stocks means owning companies, and banks were not allowed to own commercial firms. So in 1852, in Talmage v. Pell, a court annulled a purchase of bonds because banks “purchased these bonds, as they might have purchased a cargo of cotton, to send to market, to be sold at the risk of the vendor, for the highest price that could be obtained”. This resulted in a consistent prohibition against dealing in stocks. This is the way through which the separation of banking and commerce gave birth to the separation of retail and investment banking. And this explains partly why the latter happened in the United States in 1933 (see article about the Glass-Steagall Act).

Throughout the 19th century, case law became more nuanced. Judges started to distinguish licit from illicit holding of stocks. Taking stock as passive collateral and later realizing a profit by resale was permitted, whereas taking stock primarily to operate or control a business was prohibited. By the time of the 1929 crash, this whole legal system collapsed because banks had, on an enourmous scale, created affiliates that were not regulated and could therefore deal in stocks. These structures were at the heart of the stock market crash that led to the Great Depression.

These events prompted a clamp down on the speculative behavior felt to be responsible for the crash, and in particular on financial speculation. So the United States put in place a regulatory form and regime which restricted bank activities and in particular might be though to have restricted them to commercial banking activities. Even in the post-war period this mind-set persisted: in 1956, Congress adopted the Bank Holding Company Act which prohibits banks from holding non-banks and vice-versa.

Recent deregulation

However the last 25 years have seen enormous changes in banking and in finance, most especially de-regulation has led to massive growth in financial activity. In 1999, the Gramm-Leach-Bliley Act repealed the Glass-Steagall sections of the 1933 Banking Act which separated commercial and investment banks in the US.

But despite intense lobbying arguing that diversification would make banks sounder**, the 1999 Act did not put an end to the separation of banking and commerce. As a result, US banks may deal in stocks, but they may not control commercial companies.

Wal-Mart, a fortunate decision

In 2005, in the middle of the pre-2008 euphoria on financial markets, Wal-Mart sparked a national debate in the United States when it applied to the Federal Deposit Insurance Corporation to acquire its own Industrial Loan Company (see below for more background on the FDIC and ILCs***). ILCs are the only remaining exception to the separation of banking and commerce.

Overwhelmed by the stakes and the intensity of Wal-Mart’s lobbying, the FDIC imposed a one-year moratorium on all acquisitions of ILCs by commercial firms and turned to Congress to determine whether such acquisitions should be prohibited. Both Wal-Mart and the world economy should be grateful to the FDIC for that decision, which prevented the credit bubble from being fed by the immense market power of the biggest retailer in the world. That decision, based on the 18th century principle that banking and commerce should be separate, looks wise in the aftermath of the 2008 crash, as it did in the aftermath of the 1929 crash and as it did to the founders of America’s banking laws.

Fabien Hassan

The next article, Banking separation (2/3), will deal with the Glass-Steagall Act, and explain how America decided to separate investment and commercial banks.

References:

  • SYMONS JR, Edward L. Business of Banking in Historical Perspective. Geo. Wash. L. Rev., 1982, vol. 51, p. 676.
  • WILMARTH JR, Arthur E. Wal-Mart and the separation of banking and commerce. Conn. L. Rev., 2006, vol. 39, p. 1539.

Notes:

* The argument that banks should be diversified was widespread among economists lobbying for Wal-Mart to operate its own bank. Yet, this goes against the very basics of finance. In principle, diversification should not be at the level of the industrial company, but at the level of the portfolio of assets: don’t make umbrellas and ice-creams if there are no economies of scale, just let investors buy stocks from two different companies The very role of financial markets is to manage such industrial risks and this explains why diversified holding companies are always traded at a discount on financial markets.

***

FDIC

The FDIC is “an independent agency created by the Congress to maintain stability and public confidence in the nation’s financial system by insuring deposits” (http://www.fdic.gov). It was the major measure introduced by Roosevelt in the famous Banking Act of 1933, which was designed after the 1929 crash to prevent financial crises in the future.

ILCs

“Industrial loan companies and industrial banks (collectively, ILCs) are FDIC-supervised financial institutions whose distinct features include the fact that they can be owned by commercial firms that are not regulated by a federal banking agency” (http://www.fdic.gov). They usually issue small loans to consumers or/and workers of the industrial company itself.

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