Randall S. Kroszner
Published June 1, 2000 | June 2000 issue
A key issue raised but not resolved in the Gramm-Leach-Bliley Financial Modernization Act of 1999 concerns the relationship between banks and nonfinancial firms. This relationship can have a broad impact on the roles that banks play in the corporate governance system and the financing of enterprises. As I argue below, the Act involves a missed opportunity for strengthening banks' roles in these activities and eliminating an increasingly artificial distinction between banking and commerce.
The Act creates new financial holding companies (FHCs) that have much greater powers than traditional bank holding companies to engage in a wide range of financial services. Securities trading and underwriting, insurance and traditional commercial banking activities can now be combined in a single holding company. The old barriers from the Glass-Steagall Act and Bank Holding Company Act that fragmented financial services have been largely swept away so that the most efficient combination of financial services can be provided under one roof. The Act, however, does not authorize the same freedom for the FHCs with respect to their operation of or affiliation with nonfinancial enterprises.
While the Act expands the ability of banks to make equity investments in nonfinancial enterprises (so-called merchant banking investments), it includes a number of provisions designed to maintain a separation between banking and commerce. Prior to the Act, commercial banks could make limited merchant banking investments. The banks were permitted to own a maximum of 5 percent of the voting equity of a nonfinancial enterprises and no more than 25 percent of nonvoting equity. The Act eliminates such ownership and voting limits, so FHCs can now take a controlling interest in a nonfinancial enterprise. Two important conditions, however, are imposed on such investments.
First, merchant banking investments cannot be held indefinitely. The Act did not provide an explicit time limit and simply states that the investment can be "held for a period of time to enable the sale or disposition thereof on a reasonable basis consistent with the financial viability of the [investment]."
Second, the FHC cannot become actively involved in the entity in which it invests. In a turn of phrase that only a lawyer could love, the Act states that the FHC cannot "routinely manage or operate" the nonfinancial enterprise that it invests in except as may be required to obtain a reasonable return on investment upon sale or disposition.
The Fed and Treasury have the unenviable task of implementing these vague directives. The spirit of the law is to permit banks to expand their venture capital and private equity investments while not permitting them to participate too directly in the governance and day-to-day decisions of nonfinancial enterprises. The interim rule promulgated by the Fed and Treasury generally imposes a 10-year maximum holding period but allows 15 years in certain circumstances. Venture capital funds typically involve promises of dissolution after roughly 10 years, so this rule should permit banks to participate in venture capital funds.
Prior to the 1933 Glass-Steagall Act that separated commercial from investment banking, banks in the United States were becoming increasingly involved in securities activities. J. P. Morgan, while not holding a commercial bank charter, took long-term equity stakes for itself and its customers in many nonfinancial companies and often took an active role in the management of such companies by placing its partners on their boards. Recent research by Brad DeLong suggests that Morgan's men on the boards did add value to these enterprises.1
Fortunately, the interim rules permit the FHCs to place their executives on the boards of the nonfinancial enterprises in certain circumstances. As long as the FHC executives do not become officers or employees of the enterprise, the FHC will not be considered to be routinely operating or managing the nonfinancial enterprise. Also, more direct intervention, for example, taking control of the board and appointing new managers, is permitted in extraordinary circumstances, such as times of significant financial distress. Monitoring and judging when the FHCs cross the line to become too actively involved in management and what circumstances are sufficiently extraordinary to warrant more direct control, however, is not an easy task.
A rationale for imposing restrictions on bank involvement concerns conflicts of interest. When creditors such as banks are represented on corporate boards, they may face a conflict of interest. The board has a fiduciary obligation to the equity owners, but the interests of creditors and equity holders may diverge. Equity holders receive high returns if a high-risk, high-return project pays off and have limited downside risk due to limited liability, that is, they can lose only as much as they invested. Creditors, however, do not enjoy the upside of such a project since their return is limited to the agreed-upon interest rate and can lose their investment if the project does not pay off. Thus, creditors may evaluate projects differently than equity holders because they prefer that the enterprise maximize the probability of their repayment rather than maximize the expected return to shareholders.
One "solution" to the conflict is to have a creditor also take an equity stake. If a bank owns equity of a firm that borrows from it, for example, the bank will take account of the interests of both the shareholders and creditors. Equity ownership by banks, thus, can mitigate the conflicts by aligning its interests with those of equity holders. So-called mezzanine finance, in which equity and debt instruments are combined, is common in leveraged buyouts and in venture capital. Venture capitalists thus recognize and deal with potential conflicts by linking equity and debt. By allowing banks to hold equity stakes, the Gramm-Leach-Bliley Act provides a mechanism that undermines this rationale for imposing restrictions on banks' operation and management of nonfinancial enterprises.
In addition to the restrictions embodied in the Act, U.S. banks already face strong discouragements from active involvement in nonfinancial enterprises due to the legal doctrines of lender liability and equitable subordination.2 These doctrines are ways in which the U.S. legal system addresses the creditor-shareholder conflict during financial distress, which is when the divergence of interests is most severe. Banks, for example, might prefer to shut down a distressed enterprise to ensure loan repayment, while shareholders would prefer to continue operations of a troubled enterprise in the hope that it will turn around.
To protect against manipulation of the firm for the benefit of senior creditors, such as banks, at the expense of junior creditors and equity holders, these legal doctrines permit a bank to be sued if it "overreaches" its role as a creditor to exercise management control that results in harm to other claimants. Under equitable subordination, a bank that is found to have been active in management and acted "inequitably" prior to an enterprise's bankruptcy can lose its senior status in claims against the bankrupt enterprise. In addition, such a bank faces liability for losses to other claimants. The courts can and occasionally do go further and require the bank to pay punitive damages in lender liability cases. Unfortunately, these doctrines may go too far and have a chilling effect on beneficial bank involvement. There is no clear definition of what constitutes active "inequitable" or manipulative conduct. Prudent policies of refusing to "throw good money after bad" in not renewing a loan to a distressed firm often come under attack. If a bank has an executive or representative on the board of an enterprise, the bank is subject to "higher scrutiny" in such lawsuits. In an important recent case, a bank that was a major lender to an enterprise and had its own executives on the board was seen as crossing the line to trigger lender liability.3
Given this legal environment, the restrictions on banks from the "routine operation or management" of a nonfinancial firm in which banks invest seems redundant. It should also be noted that equitable subordination and lender liability are rarely found in other countries. The United Kingdom, Germany and Japan, for example, do not have such doctrines. In these countries, banks typically have broad leeway to intervene in an enterprise's affairs and restructure its operations and financing without threat of legal action by the equity holders.
The development of these legal doctrines in the mid-20th century in the United States may have been in part a response to the restrictions on bankers from owning equity and thereby being unable to mitigate the potential conflict through a combination of ownership and lending. Given that the Gramm-Leach-Bliley Act relaxes such ownership restrictions, it may be time to take another look at the relevance of these legal doctrines.
Another important issue that arises when banks are permitted to own equity in nonfinancial enterprises concerns risk and the stability of the financial system. The interim rules impose a 50 percent capital charge on all merchant banking investments and impose limits on the amount of funds that an institution may invest in such activities. Since the Fed and Treasury have little experience with supervising such activities, it is understandable that the regulators would move cautiously. It is important that the existing bank safety net not be expanded with this Act, and maintaining high capital standards for financial institutions is crucial to avoiding moral hazard problems. Risks associated with different types of merchant banking investments, however, vary widely, so allowing for some risk-rating of the capital charge would be sensible. Observing what levels of capital are held by competing nonbank financial organizations, such as GE Capital, would also provide valuable guidelines for assessing appropriate capital levels.
Also, it is unclear how risky merchant banking investments will be relative to other banking activities. Although this cannot be resolved definitively, we can look to the past and to other countries for clues. As noted above, prior to the Glass-Steagall Act, J. P. Morgan was one of the leading financial institutions engaged in merchant banking activities and it was a pillar of stability. In Germany, where banks have long been able to engage in the full range of financial service and merchant banking, the banking system has been quite stable.
As technology progresses, the regulators will face increasing challenges to distinguish between nonfinancial and financial investments and activities, thereby making capital regulation and the regulation of the FHC's relationship with supposed nonfinancial enterprises problematic. Many e-cash-style enterprises are not banks and are unlikely to become FHCs but hope to offer many banking and transactions services that compete directly with traditional banks in FHCs. Many retailers, auction sites, Internet portals, telecommunications firms and software makers might wish to offer banking and financing services to customers but might not wish to or be able to transform themselves into FHCs.
The Gramm-Leach-Bliley Act eliminated a means through which nonfinancial enterprises could acquire thrifts and provide banking services through a unitary thrift holding company structure. Wal-Mart, for example, had an application pending to become a unitary that would have allowed it to offer banking services in each of its stores. The Act bars new unitaries from forming and prevents the banking operations of an existing unitary from being sold to any entity except a banking or financial company.
Combined with the regulations on the nonfinancial investments and activities of an FHC, an opportunity was lost for greater experimentation that would allow commercial enterprises to offer banking and financial services seamlessly combined with, but incidental to, their main activity. By raising obstacles to these types of innovations, the Act may slow the blurring of the banking-commerce distinction, but it is an issue that will persist and provide challenges to the regulators and the marketplace for many years to come.
For more on Gramm-Leach-Bliley, see the March 2000 issue of The Region devoted to financial modernization.
Randall S. Kroszner
Randall Kroszner is professor of economics at the University of Chicago's Graduate School of Business and associate director of the George J. Stigler Center for the Study of the Economy and the State. During 1999-2000, he is the John M. Olin Fellow in Law and Economics at the University of Chicago Law School. Kroszner has served as an economist on the President's Council of Economic Advisers and has been a consultant to the International Monetary Fund, the World Bank, the Inter-American Development Bank, the Fed's Board of Governors and several Reserve banks.
Kroszner received his doctorate in economics from Harvard University and graduated from Brown University.
1 DeLong, J. Bradford. "Did Morgan's Men Add Value?" In Peter Temin, ed., Inside the Business Enterprise: Historical Perspectives on the Use of Information. Chicago: University of Chicago Press, 1991, pp. 205-249.
2 Kroszner, Randall S. and Philip E. Strahan, "Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability," National Bureau of Economic Research Working Paper #7319, Cambridge, MA, revised March 2000.
3 State National Bank of El Paso v. Farah Mfg. Co., Inc., 678 S.W. 2d 661, Tex. Ct. App. 1984.