A Law That's Out of Date: Anti-Tying Restrictions On Banks

Since 1970, U.S. law has prohibited banks from tying their loans to other non-banking products, even if the bundle of services is offered at a discount to customers. The law has had two rationales: to prevent banks from exploiting an unequal bargaining position relative to their customers by forcing them to buy unwanted products or services, and to keep banks from lending out money at below market rates, putting themselves and the fund that insures that their deposits at risk.

Critics looking for new scapegoats in the Enron affair have seized upon allegations that some of the country's largest banks that loaned the company money did so because they were too eager to get Enron's investment banking business—going so far as to require the company to purchase the loans and other services. If that occurred, the banks violated a 1970 law that flatly prohibits banks from tying non-banking services to the extension of credit in any form, even if the two services are offered in a bundle at a discount to customers. Moreover, if the banks loaned money at below market rates in the process, they put the safety and soundness of their institutions at risk, violating other provisions of banking law.

Time will tell, of course, whether these and other similar allegations eventually prove to be supported by the facts. So far, however, the main federal regulators charged with enforcing the banking laws—the Comptroller of the Currency and the Federal Reserve Board—have found no substantiating evidence.

But whether they ultimately do or not, there is a more fundamental issue at stake. Why should banks even be prohibited from tying loans to non-banking products? Other firms aren't subject to this flat restriction. If they were, you wouldn't be able to buy flat rate telephone service from wireless companies that have "tied" local and long-distance service together at one bundled price. Or you wouldn't be able to take advantage of low-interest financing from the auto companies' finance arms when buying their cars. And what about those "bundles of burgers, fries and a coke" you can get at McDonald's now, but wouldn't be able to buy if there was a flat prohibition?

In all sectors of the economy outside the banking industry, firms can bundle products and services together as long as customers have effective choices to buy competing products and services from other suppliers. In the language of the antitrust laws, tying is unlawful only where the firm that forces you to buy the bundle has "market power." In all of the above examples, they clearly do not.

In 1970, Congress nonetheless imposed a much tougher prohibition on banks tying loans to other services, even if the bundle is offered more cheaply than the two products or services separately. There were two rationales. One was the presumption that banks indeed do exercise some kind of market power when considering a request for a loan. Customers may not fully realize they had other choices if told they need to buy another service along with the loan. A second rationale relates to the fact that government has a legitimate interest in the safety and soundness of banks because it insures their deposits up to $100,000 per account. If banks extend credit as a loss leader as part of a package of services, then this objective is compromised.

The financial world has changed radically, however, since 1970. Consumer credit, whether credit cards or mortgages, is now widely available from a dizzying array of providers. So is business credit, especially for large companies that can borrow from investors directly by issuing debt, as well as from a panoply of banks across the country. Indeed, some of these large borrowers have put the screws to both commercial and investment banks by making clear they won't give them any investment banking business unless they also give them credit.

In such a world, the presumption that banks have "market power" is simply no longer correct. The time has come, therefore, to repeal anti-tying restrictions and rely instead on the rules of the antitrust laws. Of course, the law requiring banks to book their loans at arms-length market terms should remain in force to prevent banks from under-pricing their loans in order to land other business.

Too radical, you might say? Then, initially replace the tying prohibition with an antitrust rule only for the large, publicly held companies that already have issued or want to issue commercial paper, the market's best alternative to bank lending. Why shouldn't these borrowers get the same benefits that they can get when purchasing other goods and services?

One predictable objection to changing the tying law is the claim that banks would relax their guard in making loans, creating a greater risk of loss, in an effort to land non-bank business from borrowers. But this is just a variation of under-pricing, which already is against the law. Besides, banks got into much more lending trouble in the 1980s when they were not affiliated with non-banking operations as they have been for over the last decade. Moreover, this time around the big banks in particular are much better capitalized, due in large measure to stiffer capital requirements that have been in place since 1991 and that would continue in force were the anti-tying law changed in the way suggested here.

Sometimes in the temporary zeal to enforce a particular law, policymakers forget to ask the basic question of whether the underlying law makes sense. In this case, it doesn't. It is time to free up bank lending to let the market and competition do the work it is supposed to do—let the force of competition deliver benefits to customers—and to police any abuses with the antitrust laws that apply everywhere else in the economy.


View the corresponding Joint Center for Regulatory Studies paper