Banks Must Be Untied from an Outdated Law

Critics looking for new scapegoats in the corporate accounting affair have seized on allegations that some of America’s largest banks made loans to now-bankrupt companies solely to snag investment banking business. In some cases, they are said to have required companies to buy other services in order to gain loans.

If this happened, the banks violated a 1970 law that prohibits banks from tying non-banking services to the extension of credit in any form, even if the services are offered in a bundle at a discount. Moreover, the banks could have violated other provisions of banking law if they lent money at below market rates because they might have put the safety and soundness of their institutions at risk.

So far, the main federal regulators charged with enforcing the banking laws – the comptroller of the currency and the Federal Reserve Board – have found no evidence of this. But whether or not they do, there is a fundamental issue at stake. Why should banks be prohibited from tying loans to non-banking products? Other companies are not subject to such restrictions. If they were, customers would not be able to buy flat-rate telephone services from companies that “tie” local and long-distance charges together. Nor could they take advantage of low interest financing from motor companies’ finance arms when buying cars. And what about the bundling of “burgers, fries and a Coke” at McDonald’s?

In other industries, US law allows companies to bundle products and services, provided customers can buy competing products and services from other suppliers. In the language of antitrust, tying is generally unlawful only when a company offering a bundled package has “market power”. But in 1970, Congress imposed a tougher prohibition on tying by banks. It had two rationales. First, there was a presumption that banks exercise some kind of market power when considering req-uests for loans. The customer may not fully realise he or she has other choices if asked to buy another service along with the loan. Second, the government has an interest in banks’ safety and soundness because it insures their deposits up to Dollars 100,000 (Pounds 63,000) per account. If banks extend credit as a loss leader as part of a package of services, this objective is compromised.

But the financial world has changed radically since 1970. Consumer credit, whether in the form of 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 nationwide. Indeed, some of these large borrowers have been the ones initiating the tie – telling commercial and investment banks they will not give them investment banking business unless the banks give them credit. To top it off, entry into banking is now free of regulatory interference. This means banks have more difficulty dominating any local market, especially the big urban areas where most Americans live.

In such a world, the presumption that banks have “market power” is no longer correct. The time has come for the flat prohibition against bank tying of loans to be replaced by the standard application of antitrust laws. Of course, the law requiring banks to book their loans at arm’s-length market terms should remain in force, and perhaps be strengthened, to prevent banks from under-pricing their loans in order to land other business.

Too radical? Then the tying prohibition could be replaced by antitrust law only for the large, publicly held companies that already have issued, or want to issue, commercial paper – the best alternative to bank lending. Why should the borrowers not get the same benefits from banks that they can gain when buying other goods and services?

One potential objection to changing the tying law is the worry that banks would relax their guard in making loans, and thus run 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 can be prohibited (and already is largely against the law). Besides, banks got into much more lending trouble in the 1980s, when they were not affiliated with non-banking operations. Moreover, the big banks in particular are now much better capitalised, thanks in large measure to stiffer capital requirements in place since 1991. These would remain in force if the anti-tying law changed in the way suggested here.

Sometimes, in their momentary zeal to enforce a particular law, policymakers forget to ask the basic question of whether the law makes sense. In this case, it does not. It is time to free bank lending to let the market do what it is supposed to do. The forces of competition should be allowed to provide benefits to customers and any abuses can be policed through the antitrust and other banking laws.