Proponents of the regulatory state have seen very few causes for celebration in the past two years. Buried in the mountain of bad news was an underreported but alarming phenomenon: the entrance of tech giants into commercial banking. Recent reporting that Amazon and other tech companies are interested in entering the banking market should cause those concerned about market consolidation and stability to panic. More importantly, it should cause regulators to think long and hard before making any changes that would allow these companies to engage in commercial banking activities.
As one of the few entities that are allowed to create money, banks perform an essential public function. When a customer goes to a bank and enters into a legal loan agreement, the bank creates a demand deposit. Demand deposits are indistinguishable from government money and are included in any measure of the money supply. As a player in controlling the money supply, banks are also integral to a government’s monetary policy. In essence, governments and banks have a special relationship, with the government providing many benefits to banks. Banks earn seigniorage, have partially guaranteed liabilities, and in times of emergencies, have unlimited access to central bank liquidity.
In exchange for these advantages, banks submit to heavy regulation. One of the most important regulations in the United States is the Bank Holding Company Act (BHCA), which severely limited a bank’s ability to own commercial firms. In relevant part, BHCA bars commercial firms from owning banks or obtaining bank charters. The BHCA was made with both financial stability and fairness in mind – no non-bank firm can outcompete an entity with a government backstop, so a bank’s ability to compete must be tightly controlled.
This bar would have been absolute if not for Senator Jake Garn of Utah. As Chairman of the Senate Banking Committee during passage of the BHCA, Senator Garn, bent on protecting his state’s cottage industry, carved a loophole by writing an exemption to the BHCA proscription that allowed non-bank entities to obtain industrial loan charters (ILCs). The ILC exemption blurred the line between commercial and banking entities. ILCs allow commercial firms to establish industrial loan companies. Industrial loan companies, chartered on the state level, can take deposits and sell financial products. However, because these ILCs result in the creation bank-like entities, important safeguards exist to limit the reach of this loophole. ILCs are still largely regulated in the same way that banks are regulated. In addition, to prevent an advantage from accruing, ILCs are generally barred from financing their parent companies, some of which include companies as large as Target and General Motors.
Despite these safeguards, in the wake of the Great Financial Crisis of 2008 (GFC) legislators saw it fit to . Even after the moratorium ended in 2013, the ILC scene remained relatively dormant, until SoFi, a personal finance company, applied for an ILC in 2017. Soon after, Square, a financial services company, followed suit. For various reasons, SoFi has since withdrawn its application. There are reasons to think, however, that these applications are but a harbinger. In the past few months, officials and lobbyists from Apple, Amazon, PayPal, and Facebook have increased their meetings with federal banking regulators. According to certain sources, these meetings have been wide-ranging. Industry attorneys and commentators, however, suggest that these meetings show how much more involved tech giants are in offering financial services.
Federal regulators would be wise to tread carefully in this minefield. While ILCs may be mostly regulated in the same way as ordinary banks, they benefit from an important exemption: they are not regulated by the Federal Reserve for any contribution to systemic risk. For this, and other reasons, it is imperative that regulators not take the decision to charter new ILCs lightly.
There are those who believe ILCs are more likely to ameliorate rather than exacerbate systemic risk. Proponents of allowing new ILCs to form, including Acting Chairman of the Office of the Comptroller of Currency (OCC) Keith Noreika, believe the proliferation of ILCs would decrease risk in the banking system. Noreika suggests the current rules restricting bank’s ability to engage in commercial activities amounts to putting “all our eggs in one basket,” because a banking system comprised only of banking firms is less stable than a banking system comprised of a mixture of commercial firms with banking arms. The line of thinking applies standard economic theory to banking. A company that sells multiple products is less susceptible to shocks than a company that sells one product. In the event of a shock, these new conglomerates would be able to use their other lines of business to subsidize their banking arms.
Proponents of ILCs also argue that more ILCs would serve to encourage much needed competition in our heavily concentrated financial system. The past 30 years has seen an astonishing consolidation in the American financial sector. The resulting decrease in the number of banks and increase in the average size of banks has increased concerns about systemic risk. Perhaps most importantly, the consolidation has led to existence of “too big to fail” banks (“TBTF banks”) or “systemically important institutions” (or my preferred “systemically dangerous institutions”). These banks, according to conventional wisdom, must be kept solvent and liquid at all costs. This has repercussions beyond the market, impacting our legal and political structures. Federal prosecutors have cited the size and importance of these institutions when justifying decisions to forgo prosecution (so called “too big to jail”). To make matters worse, these financial leviathans hold extensive sway in our political system, through both political donations and lobbying. Of course, these institutions would wield their influence to crush any potential threats to their dominion, including traditionally-chartered FDIC banks. In order to compete, aspiring banking entrepreneurs need a new avenue for entry – a role that the ILC, which can act as bulwark against these financial heavyweights, can serve.
While it is possible that allowing commercial firms to get ILCs will introduce diversification into financial system, shrinking TBTF banks, resulting in both political and economic benefits, history shows us the opposite is also possible. Housing multiple important economic actors under one roof simply provides more reasons for government intervention. The example of General Motors (GM) during the GFC is illustrative. GM established an ILC, GMAC, that primarily offered auto and home financing. During the GFC, GMAC faced insolvency due to exposure to the mortgage markets. Because GMAC was integral to GM’s business and GM was integral to the American economy, the federal government stepped and bailed out GMAC through GM. It does not seem a stretch of the imagination that, considering the importance of, for example, Amazon to the American economy, the federal government would similarly have little choice but to keep Amazon afloat if Amazon chartered an ILC that faced similar insolvency.
The experience of the GFC shows that governments, in the crisis interregnum, should work to unwind and decrease connections between commercial and banking entities while also working to increasing the number of banks. ILCs may help facilitate the latter, but fail to address the former, equally important, problem. The current debate around ILCs is somewhat similar to debate that occurred two decades past around the repeal of the Glass-Steagall Act. In the late 1990s, there was a fierce debate about allowing traditional banks to enter other financial activities, such as securities underwriting and insurance. Previously, such conglomerates were unlawful under the Glass-Steagall Act. Proponents of tearing down this regulatory wall argued that doing so would increase financial stability through diversification. Again, the argument stated that an entity with multiple lines of business was more robust to market shocks than an entity with fewer businesses. The events of 2008 revealed the foolishness of these arguments. Instead of containing risk, allowing banks to have multiple lines of business spread the contagion from mortgage lenders to securities underwriters to insurers. Allowing large firms to diversify leads to concentration, which increases, rather than disperses, risk. Both theory and practice bear out this relationship.
Given what is at stake, the news that tech giants have taken a greater interest in talking to federal banking regulators is truly chilling. Aside from the systemic risk attendant to increased concentration in our financial system, imagine the effect that combining banking and tech might have on the tech industry. Large tech companies are already in the business of crushing competition. If they are given bank charters, this would all but put a nail in any future competitors. As large banks, these companies would benefit from much cheaper cost of capital. Financial markets will likely assume, as they do with the current TBTF banks, that these companies have implicit government backstops. Thus, we would expect that markets will lend to these institutions at much lower rates than their competitors. Under these market conditions, traditional tech competitors such as startups would be put at a debilitating disadvantage. As it stands, these tech giants have morphed the tech landscape into an industry characterized by consolidation. With even higher barriers to competition, fewer and fewer startups will begin with the purpose to compete but rather to become the latest high priced snack for these tech sharks.
The dangers of allowing large technology firms to engage in traditional banking outweigh any possible benefits. These new firms would negatively affect the economy and the political system. A combined technology and banking firm would only worsen systemic risk in the financial system by enabling further consolidation. It would also stifle innovation by giving established tech firms a greater advantage over startups. These economic risks may only be outweighed by the political risks. As it stands, the technology and banking industries are the largest industrial lobbyists. What power over the political process would a hybrid tech and banking firm wield? To avoid these risks, regulators should seriously scrutinize any attempts by these conglomerates to enter the commercial banking game.
Ocasha Musah is a Quorum Editor and a J.D. candidate, Class of 2018, at N.Y.U. School of Law.