Regulatory Oversight of Industrial Loan Companies Likely To Increase: St. Louis Fed Analysis

ST. LOUIS — As non-financial companies like Home Depot and Wal-Mart attempt to get into banking by buying or chartering industrial loan companies (ILCs), the entire ILC industry will be subject to more regulation and greater supervisory oversight.

Economist Michelle Clark Neely offers that observation in the July issue of The Regional Economist, a quarterly publication of business and economic topics published by the Federal Reserve Bank of St. Louis. The publication is also available online at the St. Louis Fed's web site.

ILCs, also known as industrial banks, have been in existence for about 100 years. Initially, they were small, state-chartered institutions that made uncollateralized loans to low- and moderate-income workers who couldn't get loans from banks.

Most ILC owners are financial services firms, such as Merrill Lynch, Morgan Stanley and American Express, and many have great access to capital markets. About one-fourth of the ILCs, however, are owned by non-financial firms, and typically offer financial services that tend to directly support the products of their parent companies. For example, auto companies General Motors and Toyota own ILCs.

Neely said some of the scrutiny that ILCs have generated has to do with their explosive growth in the last few years. "Over the past two decades, the collective assets of these institutions have increased by more than 5,000 percent," she said.

Neely said that the reason that ILCs are drawing so much attention now has less to do with their size and scope and more to do with who owns them—or wants to. "The recent ILC applications by Home Depot and Wal-Mart," said Neely, "have renewed long-standing debates about the mixing of banking and commerce, the concentration of economic power and the proper role of federal banking supervisors."

Two important features of ILCs—permitted commercial ownership and a lack of consolidated federal supervision—set them apart from commercial banks and "it's those traits that have put the ILC industry in the spotlight, "said Neely.

She noted that the current debate about the ILC industry can be attributed to the banking ambitions of two of the country's largest retail firms: Home Depot and Wal-Mart.

In its 2005 ILC application, Wal-Mart stated that it would not engage in retail banking (accepting deposits from the public and making loans), but, rather, would focus on processing electronic checks and debit and credit-card payments. The retailer emphasized its intent is to eliminate the need for a third-party processor, thus saving money that could be passed on to Wal-Mart's customers via lower prices for its goods.

"To say these applications were controversial is an understatement," said Neely. Primarily because of threatened congressional action and renewal of an FDIC moratorium, Wal-Mart eventually withdrew its application, but Home Depot is still attempting to pursue its effort to buy EnerBank from CMS.

Neely said that critics of ILCs typically offer several arguments against commercial ownership:

• Letting non-financial firms own ILCs runs counter to a long-standing barrier in the United States between banking and commerce.
• Allowing large commercial firms into banking could create economic conglomerates and concentrate economic resources into the hands of a few.
• Some ILCs, unlike most other regulated financial institutions, are not subject to federal supervisory oversight, creating potential problems of safety and soundness and competitive issues.

To solve some of these problems, some policymakers and ILC critics have proposed that the FDIC be given consolidated supervisory powers over ILC parents, such as those employed by the Federal Reserve or the Office of Thrift Supervision.

At the same time, proponents of ILCs argue that the wall between banking and commerce is artificial anyway, and may do more harm than good when resources are not allocated efficiently. And, while about two dozen ILCs have failed in the past 20 years, backers emphasize that just two of those failures resulted in significant losses to the deposit insurance fund.

While Neely acknowledged that Wal-Mart's withdrawal of an application for an ILC has taken some of the heat out of the current firestorm, "it appears likely that the ILC industry will be subject to more regulation, both at the ILC and parent-company levels."

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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