Don't ban but expand them

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By Coleman Drake and John Berlau

In proposing his new financial regulations this summer, President Obama pledged to get tough on the big Wall Street banks whose risky practices are blamed for causing the financial crisis.

But strangely, the firms punished most in the president's plan are "Main Street" companies a world away from high finance, such as Target Corp., Toyota Motor Corp. and Harley-Davidson. Mr. Obama's "white paper" on regulation proposes to force these companies and others to sell off their limited banking operations called industrial loan companies (ILCs).

This action could contract credit and put a severe crimp on any economic recovery. Not only should ILCs not be banned, but they should also be expanded. Allowing new ILCs to form would help revive the economy and could save American taxpayers a great deal of cash by removing the necessity to bail out large banks.

An industrial loan company is a limited-purpose bank that can be owned by a nonfinancial firm. ILCs perform a variety of functions, such as lending to consumers and small businesses, leasing and real estate, credit cards, and providing other financial services related to their parent corporations. They have served both as an alternative and a supplement to traditional banks for small businesses and consumers.

Unfortunately, this option isn't widely available. ILCs are only recognized in a handful of states. Of those states, Utah has the vast majority of them. Presently, the ILC business in Utah alone is worth at least $168 billion. Nationwide, ILCs were worth $177 billion as of 2007.

After pushback from Target and other firms, politicians are now promising to grandfather existing ILCs. On Aug. 4, Federal Reserve Board Gov. Daniel K. Tarullo, echoing the statement of House Financial Services Committee Chairman Barney Frank, said the Fed no longer wishes to eliminate existing ILCs. Regrettably, however, both Mr. Tarullo and Mr. Frank still are opposed to expanding these institutions.

But the United States simply must allow new ILCs, because they are a surefire way to increase liquidity in an economy where credit is difficult to find. "Rather than bail out the traditional banks as though finance would disappear absent their existence, let the countless nontraditional financial firms grab market share from the financial institutions that failed," explains economist John Tamny, editor of RealClearMarkets.com.

But the proposals by Mr. Frank and the Obama administration would make ILC expansion impossible. The timing for this could not be worse for Congress to act on this recommendation. If a small business lender goes under, as press reports indicate it still could, many firms will lose financing options, leading to many more jobs being lost.

But if Wal-Mart Stores Inc., Home Depot Inc., Ford Motor Co. and Warren Buffett's Berkshire Hathaway Inc. were allowed to form ILCs, as they have expressed interest in doing, these powerhouses could pump billions of dollars of credit into the economy by distributing loans. Increased liquidity would mean a quicker recovery. Allowing businesses to set up more ILCs would create more jobs and could make U.S. firms more competitive. This not only sounds like a no-lose situation -- it is.

But some powerful financial firms may lose market share, and they have been vigorously campaigning against ILCs. Numerous banks and credit-card companies have a vested interest in restricting ILC charters. By keeping barriers to entry up against ILCs, banks can reduce the number of competitors in their industry. Credit-card companies would stand to lose fees they charge on businesses if more firms could set up their own banks.

But if the aim of new regulation is to help consumers, Mr. Frank and Mr. Obama should realize consumers have a considerable amount to lose from destruction of ILCs. Retailers with ILCs that do not have to pay as many fees to banks would be able to charge less for their goods. If the ILC ban is allowed to stand, the consumer could be the biggest loser of a plan that has the ostensible purpose of protecting them.

Critics claim ILCs are riskier than other banks, but ILCs did not worsen the credit crisis. As Chris Stinebert, head of the American Financial Services Association, recently noted in the House Financial Services Committee, "While over 52 community banks have failed already in 2009, industrial banks have been the best capitalized and most profitable banks in the nation."

Through their stable history going back many decades, ILCs have had a very small stake in mortgage-backed securities. As a result, they were much less prone to the mortgage meltdown than other banks. Still, the government remains intent on punishing institutions that could potentially assist in economic recovery if only allowed to do so.

Big banks are only too big to fail when they lack competitors able to step in and take their place. ILCs would help fill this void if the government would simply let them.

Coleman Drake is a research associate at the Competitive Enterprise Institute. John Berlau is director of CEI's Center for Investors and Entrepreneurs.