Fed Proposes Ban on Merchant Banking, a Practice With Little Risk – New York Times

Yet the question is whether this is a step too far. A business that has never substantially affected the soundness of banks is now threatened with extinction.

The proposed ban is another step back to the Glass-Steagall Act, the New Deal-era law that separated regular banking from investment banking and also limited the ability of banks to engage in merchant banking.

But there was never a complete prohibition even under Glass-Steagall. Investment banks like Goldman, which at the time were not chartered by the Fed as bank holding companies, could regularly engage in merchant banking, while commercial banks were allowed to engage in smaller merchant banking investments not exceeding 5 percent of their capital.

These limitations ended in 1999 with the Gramm-Leach-Bliley Act, which ended Glass-Steagall. This law specifically permitted merchant banking by bank holding companies. The removal of this stricture was uncontroversial at the time, as the debate was more focused on whether commercial banks could enter into investment banking and vice versa.

The reason at the time was that these activities did not substantially increase the risk of banks.

But then came the 2008 financial crisis, when the trading activities of investment banks played a part in the near collapse of the financial system. In the years since, banks have been on the defensive, as the Volcker Rule and other regulations have sought to limit their activities to plain-vanilla banking.

Nonetheless, the banking industry reacted to the latest regulatory move like a man seeing a headline in his morning paper and spitting out his coffee in shock.

“Bank holding companies,” a trade group said in response, “have successfully used the merchant banking authority granted to them by law to finance start-ups and growing companies, fueling jobs and economic growth.” This business has been done, it noted, “without any threat whatsoever to the safety and soundness of their affiliated banks or to the financial system at large.”

Randall D. Guynn, the head of the Davis Polk law firm’s financial institutions group, described the proposed ban as “a solution in search of a problem.”

The reason for the industry’s exasperation is easy to see. Merchant banking is simply the practice of buying operating companies. The risk to a bank holding company is twofold. First, the bank could lose its money — as with any investment. Or second, it could be held liable for the debts of that company.

The risk of losing the entire investment would appear to be the most problematic, but the Fed did not seem too troubled by this. This is in part a result of other regulations that limit the risk.

First, banks are penalized for these investments by having a charge applied to their allowable capital. Second, the bank must sell the investment within 10 years, a period that can be extended by application to 15 years. These investments are monitored heavily these days to ensure they are not unduly risky.

Merchant banking can be a profitable business. And it allows banks to take part in the business of their clients — getting to know them better and having more of a stake in their success.

This may be why Fed, in its release, relied on the legal technicality of potential liability to argue for a ban. The Fed stated that by investing in these companies, a bank increases the “risks of being legally liable for the operations of the portfolio company when a portfolio company is less likely to be able to satisfy the claims of creditors and tort claimants.”

This argument would be given an “F” by any professor of a basic corporation law class. Corporations are beings of limited liability — that is one of their key benefits. Courts will not hold shareholders liable for the debts or obligations of a corporate entity they own.

A court will sometimes order this shield pierced, but if the bank operates the company separately (as it usually does), this should never happen. Given this, the Fed’s report puts forth a contorted hypothesis that a bank could be liable if a company it owned experienced an “environmental” event like bankruptcy. But when has that ever happened?

Given the shaky justifications for this proposed ban — and the fact that Congress would need to enact it, making it unlikely to happen any time soon — perhaps another explanation is in order. It’s “bank-shaming.” In other words, no risk is worth taking and no investment is worth holding, and any bank that thinks otherwise will be publicly discredited.

So regulators are on the march, determined to rein in any activities that may not be core to banking, whether or not those activities make sense or the data supports them.

Indeed, in the Fed’s report, there was no data on whether merchant banking was profitable, whether banks were held liable for it or whether it was indeed risky. In fact, there was no data at all. Nor was there any consideration of the downsides to this ban, like the loss of an investor in growth businesses and smaller profits for banks, presumably meaning less credit.

The Fed may be right, but in a bank-shaming world, the downsides of eliminating risk for banks do not seem to matter much, nor does the data. We are in a world where regulators want no risk no matter the costs.

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