A loophole in current law, however, permits any type of firm--including a commercial company or foreign bank--to acquire an FDIC-insured ILC chartered in a handful of states without becoming subject to the prudential framework that the Congress has established for the corporate owners of other full-service insured banks. Prior to the crisis, several large firms--including Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley, GMAC, and General Electric--took advantage of this opportunity by acquiring ILCs while avoiding consolidated supervision under the BHC Act.

The Federal Reserve has long supported closing this loophole, subject to appropriate "grandfather" provisions for the existing owners of ILCs. Such an approach would prevent additional firms from acquiring a full-service bank and escaping the consolidated supervision framework and activity restrictions that apply to bank holding companies. It also would require that all firms controlling an ILC, including a grandfathered firm, be subject to consolidated supervision.

We believe it is critical for Congress to consider and address the important public policy implications raised by the ILC exception, particularly in light of the dramatic recent growth and potential future expansion of banks operating under this special exception. If left unchecked, this recent and potential future growth of firms operating under the exception threatens to undermine the decisions that Congress has made concerning the separation of banking and commerce in the American economy and the proper supervisory framework for companies that own a federally insured bank. The ILC exception also creates an unlevel competitive playing field by allowing both financial and commercial firms to own an insured bank but avoid the prudential limitations, supervisory framework and restrictions on affiliations that apply to corporate owners of other insured banks.

I should briefly reiterate my concerns about the safety net for the creditors of the largest banks, as these concerns shape my views on the ILC issue. As I have noted before, I worry that some of these creditors believe they will be bailed out in the event of institutional insolvency because their bank is viewed as “too big to fail.”

But because I believe we should strive to limit protection for creditors of large banks, additional combinations of banks and nonbanking firms that potentially expand the safety net to cover activities not currently in scope are particularly troubling. As a matter of public policy, it would be far preferable from my perspective to take steps to limit the existing safety net.

The purchase of a bank by a commercial firm violates the separate of banking and commerce, and so I wouldn't advise allowing that. But if you do allow it, then it would be better to have consolidated supervision, which includes an overview of the financial condition of the parent - that is, the commercial firm - as well as of the ILC subsidiary.

The FDIC does not have the authority to supervise the corporate owners of ILCs and their affiliates in the same manner that bank holding companies and their nonbank affiliates are supervised under the BHC Act. The GAO recently concluded that, due to these differences in authority, exempt ILCs may pose more risk to the deposit insurance funds than banks operating in a bank holding company structure.

The general concern is that, if a commercial firm owns a bank, would there not be a possibility that the safety net would be inadvertently extended to the commercial firm? Would we be able to segregate the financial condition of the commercial firm from the bank? And would it be possible for not just the FDIC, but for any bank supervisor to adequately supervise not only the bank, but also the owning firm, to ensure that the safety and soundness rules were being met?

This is not a technical matter, nor a simple matter of fairness that affects only a small number of grandfathered companies.  There is no restriction that prevents grandfathered states from chartering new ILCs for corporations seeking banks, as they have continued to do since 1987.  Moreover, competitive pressures could encourage existing bank holding companies seeking commercial affiliations or to avoid prudential supervision to relocate their insured banks to grandfathered states that charter ILCs to take advantage of the ILC loophole.  Consequently, taking this step would alter the structure of banking in the United States and be contrary to two important national policies that Congress reaffirmed recently in the GLB Act: one prohibiting the mixing of banking and commerce, and the other establishing a federal prudential framework to assue that companies that own insured banks operate in a safe and sound manner.