One of the great things about working at AEI is that I can offend everyone without losing my job. And recently I have managed to do something particularly difficult--to earn the opposition of both the small banks and the big ones at the same time.

Resident Fellow Peter J. Wallison

My criticism of the small banks arises out of my view that their opposition to Wal-Mart getting an ILC is purely and simply turf protection--an effort to avoid having to compete with a company that might actually offer consumers a better deal than they do.

When I was the General Counsel of the Treasury in the early 1980s, one of the major issues in bank regulation was whether it made sense to continue the separation of banking and commerce.

Those who answered no to this question at that point were generally representing banks. Banks wanted desperately to get into the insurance and securities businesses, and the separation policy was an obstacle to this.

On the other hand, the greatest supporters of the policy of separating banking and commerce were--you guessed it--securities and insurance companies--industries that didn’t want competition from banks.

Now that the Gramm-Leach-Bliley Act has permitted banks to affiliate with securities and insurance companies, there is a new set of cheerleaders for the separation of banking and commerce--the realtors, who are afraid that banks will be permitted to compete with them.

The banks were outraged by such a gross misuse of this old idea, until Wal-Mart came along and asked to join the banking business.

Now, the banks see all kinds of virtues in the separation of banking and commerce. Accordingly, the most rational way to think about the separation of banking and commerce is as a principle of convenience--useful only for the invidious purpose of protecting some industry from having to compete with another. Sometimes it’s cited by banks to protect themselves; at other times, it’s cited by other industries to protect themselves against the banks.

My view is that since the adoption of the Gramm-Leach-Bliley Act in 1999, the separation of banking and commerce has been a dead letter. It’s no longer a policy of Congress. It’s now a kind of slogan, completely empty of policy content.

Let me go through the reasoning for this proposition.

In order to be a policy, the separation principle must rest on some theory of economic harm--some way in which banks controlling or controlled by commercial firms is likely to cause harm to banks or to the economy at large.

Since we do not have a general principle against the affiliation of various kinds of firms--conglomerate mergers and acquisitions may not always be sensible, but they are not illegal--the separation principle must be based on the idea that there is some kind of specific harm that will come from permitting banks, in particular, to combine with other kinds of firms.

This harm has in fact been catalogued repeatedly for Congress by commentators as eminent as Paul Volcker and Henry Kaufman. In testimony to Congressional committees during the 1980s and 1990s, Mr. Volcker identified three separate dangers of permitting banks to affiliate with commercial firms:

• The bank with a commercial affiliate will lend preferentially to the affiliate, whether willingly or under duress from a commercial parent;
  
  
• The bank with a commercial affiliate will not lend to competitors of its commercial affiliate;
  
  
• Finally, if the bank’s commercial affiliates get into financial difficulty, the bank’s resources will be marshaled to bail them out.

What is the general principle of potential harm to banks or the economy generally that we can draw out of these concerns--a principle that might serve as a rationale for separating banking and commerce?

It can only be this: harm can come to banks, to competition, or to the economy generally, if banks--as the suppliers of credit--can be controlled by the users of credit.

If this is the rationale for the separation of banking and commerce, and if it is indeed national policy and not just an empty slogan, we should find that Congress has implemented it--has adopted legislation that is based on this principle.

But in fact we find the opposite. Congress has ignored the principle and has adopted legislation that runs directly counter to the idea that the users of credit should not control banks.

Exhibit A is the Gramm-Leach-Bliley Act of 1999, where we find that Congress paid no attention to these supposed economic harms.

Before the Act, banks could only be controlled by firms that were engaged in activities that were “closely related to banking.” Now, after adoption of the Act, it is permissible for banks to be controlled by securities firms and insurance companies.

In adopting the Act, Congress seemed to think that it was only making a slight change in the law relating to the permissible affiliations of banks, apparently because banks, securities firms and insurance companies are all engaged in what is loosely called “financial activities” and not in what might be called “commerce.”

But to test whether Congress actually supports the principle of separating banking and commerce, we must ask whether it makes any real difference whether the non-banking entities that are now permitted to control banks are “financial” rather than “commercial?”

Surely, the label we apply to a particular business activity--commercial or financial--can’t be the decisive point, so that if we call a business financial it can control a bank but if we call it commercial it can’t.

If, as we’ve seen, the underlying rationale for separating banking and commerce is to separate banks--as the suppliers of credit--from the users of credit, we must consider whether the controlling entities are or are not users of bank credit, no matter whether they are labeled “commercial” or “financial.”

So if the separation of banking and commerce has any reality as a national policy, and is not just a slogan that is used to protect one industry from competition by another, we should find--in terms of the underlying rationale for the separation--that there is something that actually distinguishes securities firms from, say, retailers like Wal-Mart.

But that is not what we find. In fact, we find that there are no differences between securities firms and retailers like Wal-Mart that are relevant to the rationale underlying the separation of banking and commerce.

Are securities firms users of credit?

Certainly.

In fact, they are among the most credit-dependent firms in the economy, since they carry their securities portfolios--their inventories--almost entirely with bank credit.

Are they users of credit in the same sense that, say, retailers like Wal-Mart are users of credit?

Again, certainly.

Just to be sure we have this right, let’s test it against Paul Volcker’s three reasons for separating banking and commerce.

In doing this, I am assuming--as Mr. Volcker must have assumed--that there are no laws or regulations on bank conduct, or that they will be ignored. In fact, there are very strict laws and regulations against the three dangers that Mr. Volcker cites, and if bank managers violate these rules they subject themselves to personal liability for fines of up to $1 million per day.

But--because we must--let’s assume with Mr. Volcker that bank managers will ignore these penalties…

Could a bank that is controlled by or under common control with a securities firm be required to lend preferentially to that firm?

Of course.

Is the same thing true of a bank controlled by or under common control with a retailer--say, Wal-Mart? Yes.

Might a bank that is controlled by or under common control with a securities firm refuse to lend to competitors of that firm? Of course .

Is the same true of a bank controlled by or under common control with a retailer?

Again, yes.

And finally, if the securities firm that controls or is under common control with a bank got into financial difficulties, could its affiliated bank, as Mr. Volcker suggests, be importuned to make funds available to bail it out?

Of course.

And would the same thing be true in the case of the retailer. Again, yes.

So is there any difference--from the standpoint of the harms that the separation of banking and commerce is intended to prevent--between a bank affiliating with a securities firm and the same bank affiliating with a retailer like Wal-Mart?

It seems obvious that the answer is no.

If this is true, what is left of the rationale for separating banking and commerce?

The answer has to be--nothing.

If every abuse or potential abuse that is supposed to provide the underlying rationale for the separation of banking and commerce could occur if banks are affiliated with securities firms--which Congress permitted in the GLB Act--what basis could there be for not permitting affiliations with retailers? Or for that matter with automobile manufacturers, oil companies or software developers?

The answer, it seems, is that there is no rational basis for the distinction; it is completely arbitrary.

Thus, by opening the door to affiliations between the suppliers of credit--banks--and the users of credit--securities firms--Congress affirmed that it no longer believed that affiliations between banks and the users of credit represent a danger to banks, to competition, or to the economy generally.

Under these circumstances, the separation of banking and commerce must be on its way out. If it’s not supported by a comprehensible rationale, as I said at the outset, it’s nothing more than a slogan--or maybe even a superstition.

And in a world where we go out fearlessly on Friday the 13th, walk under ladders, and ignore black cats, that’s not a very solid foundation for its survival.

So, if Congress no longer believes that there is any reason to separate banks from the users of credit, and if there’s no difference between securities firms any other users of credit, why did Congress adopt the Gramm-Leach-Bliley Act, which allows banks to be controlled by securities firms and not by retailers like Wal-Mart?

The answer is that Congress wanted to preserve the power of the Federal Reserve Board over the banking industry.

It happens that in today’s world the Fed no longer regulates many important banks. Most of the largest banks have become national banks, regulated by the Comptroller of the Currency.

The Fed’s only real authority over the banking system, then, comes from its regulation of companies that control banks--known as bank holding companies.

In effect, the Gramm-Leach-Bliley Act expanded the activities of bank holding companies to securities and insurance and other financial activities, and authorized the Fed to draw the line between financial activities and others. This power to declare new activities permissible for companies affiliated with banks will continue the Fed’s control of banks by continuing its control of their holding companies.

So when the question arises whether Wal-Mart should be able to control a bank-like entity such as a Utah Industrial Loan Company, it should not be considered in the context of some supposed “principle” about separating banking and commerce--but only whether it makes sense to continue to support the Fed’s authority over the banking system.

And when we realize that allowing Wal-Mart and others to compete with banks would bring great benefits to consumers--especially to those consumers who could benefit from the lower costs Wal-Mart provides--preserving the Fed’s turf and protecting the banking industry from tough competition--looks a lot less attractive.

So now you understand why the ICBA had a long piece in one of its newsletters last spring referring to a place called “Wallison World.” It was a rather long screed, so I’ll just quote a few lines:

If Peter Wallison had his way we would all live in an Orwellian economic world where monopoly means diversity; free enterprise means monopoly; and no consumer choice means endless consumer choices. In the Wallison world, Darwinism is taken to new extremes where not only do smaller enterprises not survive, they are ruthlessly crushed under gigantic economic engines that sweep aside any and all competing firms.

It continued in that vein for a while, so much so that my assistant commented that it made Bob Bork’s America sound like Disneyland.

But wait. I might have gotten back into ICBA’s good graces with my views on Basel II, which--while meeting with approval from the ICBA--will annoy the large “internationally active” banks.

The ICBA opposes Basel II as much as Citigroup and JP Morgan Chase embrace it.

On this issue, I’m with the ICBA and the FDIC, which believe that at the very least, if Basel II is implemented, it should be accompanied by a leverage ratio.

I support a leverage ratio because I believe--along with my colleagues on the Shadow Financial Regulatory Committee--that Basel II is not ready for prime time.

The purpose of Basel II, like the purpose of Basel I, is to work into the capital-setting process some element of the risks particular banks are actually taking.

This has to be done for banks because the government backing they receive impairs the market discipline that would otherwise set the appropriate capital level for a particular bank.

But saying that Basel II was intended to bring risk-sensitivity into setting capital requirements does not mean that this can actually be done. The fact is that we know very little about how to replicate the real world with formulas or models.

Let me give you a couple of examples.

Just this year, OMB’s forecast of the budget deficit missed the mark by $172 billion. The forecast was for a deficit of $420. The actual deficit was $248 billion.

Now, generations of economists have been refining and re-refining the models that predict the effect of tax policy changes on government revenues. Yet, as shown this year, the model of the economy that they use is grossly deficient.

In addition, a test was run on the Basel II formulas, and was found to reduce the capital requirements of the 26 banks that participated by a median of 26%

Worse than this was the fact that when the banks developed the risk-weights that they dropped into the Basel II formulas, their assessments of the risks of the same portfolio of mortgages was widely divergent, suggesting that they didn’t have a handle on the this fundamental issue. If the banks don’t have a good idea of the risks they are taking, the whole idea of Basel II is undermined.

Since Basel II has some regulatory momentum, and is being pushed by the country’s largest banks, it is possible that it might be adopted.

Accordingly, because of its deficiencies, I think we need a leverage ratio as a fail-safe device to protect the economy and banking system against the failure of one or more large banks that would not be carrying sufficient capital as a result of the Basel II formulas.

But if it’s a good idea to bring risk sensitivity into the setting of bank capital requirements, is there any way to do it?

I believe there is, and that is to use a special form of subordinated debt, an idea proposed by the Shadow Financial Regulatory Committee in 2000.

If we recall that the reason the government has to be involved in setting bank capital--unlike any other industry--is that the government is perceived to be backing banks and this impairs and reduces the market discipline that sets capital levels for all other industries, the most effective way to set bank capital requirements is to restore market discipline.

The way to do this most effectively would be to create a class of bank creditors who cannot “run” in the event that a bank’s capital begins to weaken, and cannot be bailed out by any government agency under any circumstances

Such a class can be created by requiring banks to issue a form of sub debt that will qualify as Tier 1 capital as long as it has a remaining maturity of at least one year and represents at least 2% of the bank’s assets.

The holders of this debt would be highly sensitive to changes in bank capital and bank risk, and this sensitivity would be reflected in the yield on the sub debt. If this yield rises, it would signal the supervisors that the market perceives the risks of a particular bank as increasing--another way of saying that the capital level is too low to give these debtholders comfort.

An increase in the yield on sub debt could also be worked into the Prompt Corrective Action formulas, so that the supervisor would have to take some steps if the yield on a bank’s debt went to junk levels.

It seems to me that this approach makes a great deal more sense than trying to model bank risk through probabilistic formulas and models that are unlikely for many years--if ever--fully to replicate the risks of the real world.

So, now in Wallison World the little folks would be crushed under the heels of the big guys, but the big guys would also be harassed by nervous creditors.

Bob Bork’s America was surely no worse.

Peter J. Wallison is a resident fellow at AEI.