Arthur F. Burns Fellow Peter J. Wallison

The tragic fall of Bear Stearns will have effects across markets and across time. It will raise concerns about moral hazard, the activity of short sellers in a nervous market, and the government's role in forcing the parties to agree to a price that many will question.

But in the avalanche of commentary we can expect in the coming weeks, few are likely to note the significance of the collapse in relation to the controversy about commercial companies owning industrial loan companies.

Under the Gramm-Leach-Bliley Act of 1999, only financial institutions, including securities companies and insurers, can control or be affiliated with ordinary commercial banks. There is no such restriction, however, on the control of ILCs, even though they have many of the attributes of commercial banks, including federal deposit insurance.

For many years the Federal Deposit Insurance Corp. routinely approved applications--by retailers, auto manufacturers, and others--to acquire ILCs, although these companies would not be permitted under Gramm-Leach-Bliley to control ordinary commercial banks.

However, when Wal-Mart applied to acquire an ILC, a firestorm developed in the banking industry and Congress, and the agency imposed a moratorium on applications from commercial firms to give Congress time to impose Gramm-Leach-Bliley restrictions on ILCs.

That moratorium expired Jan. 31 without any action by Congress, and the FDIC is now legally bound to approve applications by any company, regardless of the nature of its activities.

When the moratorium was in effect, the agency held hearings, examined legislative history, and generally sought to determine whether any harm would come to an ILC because it was controlled by a commercial company. If the FDIC ever came to any conclusions, it has not made them public.

Nevertheless, after the end of the moratorium, Sheila Bair, the agency's chairman, urged Congress to enact legislation that would authorize it to continue prohibiting commercial companies from gaining control of ILCs.

In examining whether control by a commercial company would be harmful, the FDIC was asking the right question. Protecting the safety and soundness of banks has always included scrutiny of a bank's parent company.

The Federal Reserve has tried over the years to establish a policy that a parent company should be a source of strength for its subsidiary banks. It is doubtful this long-term effort reflects sound policy or law.

The ideal source of strength for a bank is not a banking or financial services holding company; it's an institution or company whose reasons for instability or financial weakness are not likely to be correlated with those of the bank itself. In that case, if the bank were weakened by events in the financial economy, the parent would not be affected and could provide support in the form of additional capital.

The sudden collapse of Bear Stearns, and the current weakness of many other securities companies and banks, calls into question whether it makes sense for the FDIC to ask for the same Gramm-Leach-Bliley restrictions to be imposed on ILCs.

As the law stands today, the agency is not limited in the kind of company it can approve as an ILC parent. If commercial companies were excluded, the agency would be limited to approving applications by companies in the one sector of the economy, in which risk and instability is highly correlated in time with risk and instability in the banking industry.

In this broad policy sense, the decision by Congress to restrict bank affiliations to financial institutions was ill advised. Not only are financial companies' weaknesses correlated in time with those of banks, but financial institutions are no better as bank parents or affiliates than commercial companies. All use bank credit and as parent companies raise the same questions about the extension of the bank safety net beyond the banking field.

As demonstrated by the Bear Stearns case, a financial intermediary such as a securities company can collapse in a matter of days if it loses the confidence of its counterparties and customers. This is because the intermediaries are highly dependent on short-term financing. Once the market begins to suspect such a company may be unable to meet its financial obligations, it is a goner.

None of these deficiencies is true of an ordinary commercial company such as a retailer. Even in today's economy, these companies have remained stable, because their credit arrangements are generally medium- or long-term and not collateralized by assets that can lose their value quickly.

Like anyone in a competitive market, commercial companies can encounter difficulties, but these are random and not correlated with the difficulties common to financial intermediaries in times of market turmoil. In these conditions, commercial companies can add capital and stability to a bank or ILC at a time when a financial parent cannot.

The Bear Stearns' collapse makes it clear that Congress made a serious error by limiting the control of banks to companies engaged in financial activities. There is no reason for the FDIC--which is responsible for protecting the Deposit Insurance Fund--to make the same mistake.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.