Here’s what both sides in banking-and-commerce debate get wrong

The interest of tech firms in offering banking services has opened a familiar line of criticism from opponents of what has been a very successful type of bank charter. They say industrial banks like those allowed in Utah could enable both retailers like Walmart and tech giants like Amazon and Microsoft to control the banking system through what these critics assert are rampant conflicts of interest.

On the flip side of the coin, other commentators — more friendly toward the IB charter — say the policy precedent supports weakening restrictions on nonbank parent companies owning banks.

But both sides describe the current industrial bank sector, its governing rules and the intent of the charter inaccurately.

Federally insured IBs have existed since 1982 and have consistently been the best-capitalized and most profitable group of banks in the nation. That is not because they have unfair advantages or unlimited growth potential.

George Frey/BLOOMBERG NEWS

True, IBs are one of the last types of charters that can be owned by a commercial parent that does not have to become a bank holding company. What critics get wrong is believing that this enables limitless loans and other types of transactions between a commercial giant and its bank subsidiary.

Not only do IBs face restrictions on the kind of deposit accounts they can offer, but Sections 23A and 23B of the Federal Reserve Act, and Regulation W, prohibit a federally insured bank from making loans directly to an affiliate or directly to someone to buy stuff from an affiliate. Therefore, statements like those in a recent BankThink article by George Washington University professor Arthur Wilmarth — that IBs “are captive lenders for their … parents” that make “loans to promote the sale of their parents' goods and services” — are erroneous.

For example, let’s say Amazon owned an industrial bank. It could not issue credit cards for customers to use to buy stuff from Amazon, except in limited and largely irrelevant circumstances. A more typical route is for Amazon to partner with a third-party bank to issue credit cards in its name, which Amazon and most other retailers do now.

The limited circumstances where an industrial bank can lend to affiliates include if the receivables are collateralized dollar for dollar by a cash deposit in the bank. Another exemption applies if the IB is lending to third parties and the parent or affiliate buys the receivables without recourse on a daily basis. An IB can also make loans up to a small percentage of assets if the credit is oversecured by other kinds of collateral. These exemptions eliminate any risk to the bank and any opportunity to use deposits to fund the loans.

Another route which a retailer could take is to apply for a limited-purpose credit card bank, which is the only other charter besides IBs that can be owned by a commercial parent. Such credit card banks have been used by retailers to issue cards to customers. But that is about all those banks can do, which is why that charter is not desirable.

Meanwhile, commentators such as the American Enterprise Institute’s Peter Wallison come at the issue from a different perspective. Wallison argued on this blog that the pathways opened up between banks and financial nonbanks by the Gramm-Leach-Bliley Act make it hard to justify the separation of bank and nonfinancial entities. He said policymakers should remove the remaining limits on retailers owning banks, and vice versa.

But Wallison’s argument overlooks the success of the IB as a narrow-purpose institution. Due to the legal limitations, most IBs can only offer specialized products that compete with other banks in very limited ways.

A good example is the IB owned by one of the largest chains of truck stops in the nation. Truckers are one of the most underbanked professions. In the past, many long-haul truckers, especially the owner-operators, lived on cash they could bring with them on each trip. The truck stop company organized an IB that can provide basic banking services at the truck stop.

IBs owned by auto manufacturers are another good example. Section 23A does not allow a bank to make an auto loan if the bank's parent or affiliate finances the selling dealer's inventory. The rule is to follow the money. Under what is known as the "attribution rule," a bank cannot make a loan if the money flows ultimately to an affiliate of the bank.

Even when an IB can make auto loans to buyers at a dealer that gets its floor financing from a different bank, the IB cannot discount the rate to encourage sales of vehicles made by an affiliate unless the affiliate compensates the bank for the lost interest. Section 23B says a bank cannot do something that is detrimental to the bank for the benefit of an affiliate. The test is, "Would the bank do X if it were not dealing with an affiliate?" If it would not, then it cannot.

Conversely, the parent also can't offer discounts on cars if the customer borrows from the IB without violating the anti-tying laws. For these reasons, many auto company-owned IBs do not make auto loans. They provide loans to independent dealers to build or remodel their buildings or offer credit cards to car owners.

Under current law, a retailer cannot own a full-service bank of any size. A retailer’s IB cannot offer checking accounts, severely constraining its ability to build a customer base.

Most IBs are organized by a company that sees opportunities to offer financial services to underserved or loyal customers — complementary products meant to deepen customer relationships. They do not represent any kind of threat to the banking system.

A smaller number of IBs are standalone banks owned by a company with other subsidiaries. A good example is the two banks that until recently were owned by General Electric. One made commercial loans for things like fast food franchises and equipment leases (not of GE equipment). The other bank made consumer loans to finance sales at retailers. Other than dividends paid by the banks to their parent, neither institution had any other connection to GE.

IBs owned by commercial companies enjoy two main benefits. One is a much higher level of support for the bank. A diversified parent has separate assets that it can use to supply capital and liquidity to the bank if needed. This largely accounts for the fact that over the past 30-plus years, IBs have consistently been among the best-capitalized and most profitable banks in the nation. The other benefit is an ability to recognize opportunities to serve financial services customers that other banks may not see. The long-haul truckers are a good example. This expands, not threatens, the banking system.