Bank loophole for Wall Street remains in financial regulation bill

Sen. Christopher J. Dodd (D-Conn.), left, and Senate Majority Leader Harry M. Reid (D-Nev.) talk about financial regulation.
Sen. Christopher J. Dodd (D-Conn.), left, and Senate Majority Leader Harry M. Reid (D-Nev.) talk about financial regulation. (Charles Dharapak/associated Press)

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By David Cho
Wednesday, May 19, 2010

Goldman Sachs, Morgan Stanley and other big Wall Street firms have been able for years to set up commercial banking businesses while avoiding the strict regulation this activity typically entails.

The law that made this practice possible has been preserved -- despite opposition from the Obama administration -- in the bill sponsored by Sen. Christopher J. Dodd (D-Conn.) remaking financial regulations and closing loopholes in oversight.

Critics say it survived because the law has helped create jobs in a few states -- those with influential senators such as Senate Majority Leader Harry M. Reid (D-Nev.) and Sen. Robert F. Bennett (R-Utah), the second-highest-ranking Republican on the banking committee.

Retaining the law is among the concessions administration officials accepted as they pressed lawmakers to approve the far-reaching legislation. The White House and leading Democrats in the Senate have vowed to quash carve-outs for special interests.

The law, which provides for what's called an "industrial loan company" (ILC) charter, was initially designed so that commercial companies such as Target could help their customers make purchases by offering them credit. The companies set up what were effectively in-house banks but were spared the stiff conditions typically applied to banks, such as requirements that they set aside enough capital to cover potential losses and limits on how much they can borrow. Utah and Nevada attracted nearly all of the financing divisions by writing rules favorable to the companies.

Before long, big investment firms realized that they, too, could establish commercial banking subsidiaries in those states and gain the advantages banks have, such as deposit guarantees from the Federal Deposit Insurance Corp., without submitting to tougher regulation.

The opportunity was enormously profitable for big investment companies because it allowed them to raise funds cheaply. Bank customers typically accept very low interest rates if they can hold their money in FDIC-insured accounts. Banks then use that pool of deposits to make investments.

Between 1998 and 2008, Wall Street ILC subsidiaries saw their businesses grow exponentially. Merrill Lynch's ILC reached nearly $60 billion in assets, more than all traditional ILCs combined. Four other investment banks established large ILC divisions, including Morgan Stanley with $38.5 billion and Goldman Sachs with $25.7 billion.

During the financial crisis, many parent companies, virtually all of those associated with the largest ILCs, ran into trouble.

Some, such as Lehman Brothers and Merrill Lynch, collapsed or were taken over. Others, such as Goldman Sachs and Morgan Stanley, still operate ILCs but no longer benefit as much because they submitted their entire business to stricter federal regulation to weather the financial storm.

"The ILC charter was disproportionately valuable precisely to the parent companies that were the most reckless," said Raj Date, chief executive of the Cambridge Winter Center for Financial Institutions Policy, a nonprofit research group. "If you want a system with fewer crazily reckless participants, then you should eliminate all the special treats that you give to them. . . . The ILC charter for Wall Street firms was unambiguously one of those special loopholes."

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