John Dingell

Congressman John D. Dingell, the indefatigable Democrat from Michigan, has embarked on a crusade against the practice of ‘tying’ – where banks use loans to secure further business. Saskia Scholtes reports

This August, the Federal Reserve fined the New York branch of West Landesbank, a German state bank, $3 million for demanding a role in bond underwriting business in return for extending loans. The settlement brought to the public’s attention a battle that has been under way for at least four years and is a personal bugbear of Congressman John D. Dingell, the Democratic Representative for Michigan.

Since the repeal of the Glass-Steagall Act in 1999, which dismantled the walls between banking, brokerage and insurance services, Congressman Dingell has repeatedly asked regulators to investigate the practice of banks tying loans to other more lucrative investment banking business.

Although previous probes by financial regulators have consistently cleared the commercial banks of ‘tying’ due to a lack of evidence to support such accusations, Dingell is convinced that these inquiries have not yet dug deep enough. And so, unfazed, he has commissioned yet another round of investigations, citing a wealth of new evidence that seems to contradict the regulators’ previous assessments.

Moreover, Wall Street and Washington are now different places. Enron’s collapse – and subsequent exposure of fraud – has reminded financial regulators that they are not just in the business of doing the right thing but much more importantly, being seen to do the right thing. The regulators’ embarrassment at being upstaged by New York attorney general Eliot Spitzer’s lead on exposing conflicts of interest in bank-provided equity research has left the regulators with a need to redeem themselves in the eyes of the public and their paymasters.

And so Dingell’s time may well have come: is Glass, Steagall and now Dingell possible?

‘Tying’ is now being investigated by a total of five US financial regulators. Along with the Fed, the Securities and Exchange Commission, the National Association of Securities Dealers, the General Accounting Office (GAO), and the Office of the Comptroller of the Currency are all involved.

Flouting the law
Tying bank loans to other business is illegal in the US under the Federal Reserve Act and the Bank Holding Company Act Amendments of 1970. But Congressman Dingell believes that regulators do not adequately enforce these two laws.

“I raised concerns about illegal tying at every opportunity throughout the years of Glass-Steagall debates in Congress,” says Dingell. “I was not at all comforted or satisfied with the assurances of the bankers and the bank regulators that the laws on the books were sufficient, or that the regulators were diligently policing for violations.”

According to Dingell, there are numerous examples of these laws being flouted. In July last year, he presented a 10-page document to the Federal Reserve, the Comptroller of the Currency and the GAO with clippings from the media demonstrating that banks regularly extend loans with strings attached – the phrase “we leverage off our balance sheet” features prominently.

And earlier this year, a survey of 3,562 corporate treasurers and financial officers by the Association of Financial Professionals suggested that the practice of tying commercial loans to other business is widespread, and has in fact become even more prevalent in the past year.

According to the survey, nearly 90% of responding companies with annual revenues greater than $1 billion reported that they are subject to some form of pressure from credit providers to award other business; and 48% of large companies indicated that they were denied credit, or had the terms of credit changed, after they chose not to award bond underwriting business to their commercial bank.

Dingell has also pointed to other evidence that infers the practice is rife. First is the frequently large difference between bank loan rates and the spreads on a company’s bonds; or the often greater difference between bank loan rates and the cost of insuring a borrower against default in the credit default swap market.

And second, is the rise of the commercial banks in the rankings for bond underwriting business since the repeal of Glass-Steagall. This according to Dingell, suggests that commercial banks are using their balance sheets in an attempt to squeeze the non-lending banks out of investment banking mandates.

The problem is that while it is illegal, Dingell says the law is still not being enforced. And what’s more, says Dingell, “the regulators didn’t get around to conducting targeted exams until after I asked for the GAO study last July”. Up until that point, the regulators had conducted investigations based solely on theoretical models for how credit should be priced and interviews with the bankers making the loans.

Dingell adds: “The Federal Reserve didn’t issue supervisory guidance until last month.” In an effort to clarify the situation, the Fed issued a new interpretation of the Bank Holding Company Act Amendments which stipulates that banks can provide their customers with a “meaningful option” to buy other bank services. But banks are not allowed to place conditions on the award of credit.

Dingell describes the situation as “piano-player regulation” – in other words, the regulators need to be spoon-fed evidence of malpractice before they act, leaving Dingell in a position of being forced to dictate the score. “First they write to me that ‘we have not identified illegal tying by banks’. But after sending them a complaint alleging such activity by WestLB, their response was effectively ‘oops, there is tying going on here’,” he says.

However, while the various regulators are set to report on their findings this fall, credit market participants argue that any charges of tying will be extremely difficult to prove, not least because the banks are very cognizant that they cannot be explicit about tying products.

Where conclusive evidence of tying is present, the matter is easily resolved. For example, the Fed fining WestLB $3million amidst allegations that in 2001 WestLB tied the availability or price of credit to its appointment as an underwriter for bond issues “by means of oral statements…, written and email correspondence…, draft and executed agreements and side letters with customers”. WestLB did not admit guilt and instead settled out of court.

But evidence that alludes to tying – such as the interest on loans being less than on bonds – is problematic. One bond originator at a universal bank argues: “There are too many variables in the pricing of debt to make this kind of comparison. Currencies, maturities and covenant packages and their various combinations will each have different prices associated with them in the bond market, and then again in the loan market.” Furthermore, there are many different types of loan, all of which will require a different pricing structure.

Nor does the comparison hold true for credit default swaps, largely because the ability to deliver on a credit default swap will often differ substantially from the conditions placed on the loan, and there will often be many different bond or loan issues that can be delivered on the default swap contract. Hence the difference in pricing.

Another piece of Dingell evidence that market participants debunk is the rise of the commercial banks in the bookrunner league tables for bond issues. Universal banks argue that companies value liquidity. And as a result the universal banks stand to be rewarded with business as companies look to reinforce their lending relationships. Simon Harris, bank consultant at financial services consultancy Mercer Oliver Wyman, says that relationship banking, as its name implies, involves the cooperation of two parties. “Companies are well aware that the banks make very little profit on their lending business. So very often companies use ancillary business as a carrot to secure their lines of credit.”

But if companies, as well as the banks, can stand to gain from the packaging together of bank products, then who really gets hurt? Many market participants argue that the embargo on tying bank products together is just a relic from the days of the Great Depression, when the Glass-Steagall Act was implemented to prevent the banks from being too powerful. But for Dingell, tying is “a matter of serious concern with implications for the stability of the financial markets”.

First, the assertion that corporates are as much to blame for tying as the banks is somewhat disproved by the AFP’s survey of corporate treasurers, which exposes the role the banks play in coercion. Jim Kaitz, CEO and president of the AFP, says: “The evidence that this practice [of tying] was more prevalent among companies with over a billion dollars in revenue was somewhat counter-intuitive.”

Second, Dingell believes that tying is inherently damaging. Not least, the stability of the entire market is threatened by the commercial banks’ ability to use their lending operations to expand into areas of business that traditionally belonged to the investment banks, giving “a dwindling group of major commercial banks more leverage than ever,” says Dingell.

He adds: “Underpricing loans in order to win underwriting business can hurt credit markets by eroding credit quality and artificially holding down the cost of credit by not appropriately reflecting risk. Using loans as loss leaders puts the safety and soundness of the financial system at risk, and at the end of that daisy chain are the taxpayers.”

There is the danger that the commercial banks could extend increasingly large lines of credit to dubious companies in order to harvest more and more investment banking fees. According to Dingell, the result is that “it is more difficult for higher-quality, investment-grade companies to get all the capital they want.” And so companies may be forced into making sub-optimal choices when awarding investment banking mandates, which can mean bad news for the company and bad news for their bondholders.

The flip side
Unsurprisingly, not all observers of the market agree. Numerous academic articles and legal memoranda refuting Dingell’s arguments have been produced. These point out that allegation that the commercial banks are using loans to expand their market share in investment banking assumes that the banks are taking advantage of a lack of competition in the lending market to win business elsewhere. But, according to such papers, the loan market is anything but lacking in competition, not least because of the number of new entrants to the market, including the investment banks.

Another of Dingell’s concerns that the banks may extend large loans to dubious companies to win investment banking fees is contested as highly theoretical. On the one hand, it is pointed out that the banks should have the risk management systems to prevent concentration of bad credit risks; on the other hand, it is pointed out that in Europe, where tying is common, accepted, and not illegal, such activity does not appear to take place.

The charge that tying forces companies to make sub-optimal decisions when awarding investment banking mandates is denied because corporate treasurers do not – or should not – make decisions that would actively damage the company’s financial health.

However, many of these persuasive papers have been sponsored or commissioned by the American Bankers Association, an industry body representing America’s regional and national banks, which may not be entirely even-handed in its approach to the issue.

For his part, Dingell is uncompromisingly cynical about the suggestion that banks can be expected to act in the best interests of all their customers. But he is also somewhat removed from the situation itself. This could be both a blessing and a burden – allowing him the luxury of objectivity while depriving him of the finer nuances of the market.

So while Dingell is convinced that lending is riddled with conflicted interests that create instability, he may also be a man who is too principled to appreciate the benefits of pragmatism. At the same time, the universal banks are convinced there is no wrongdoing and no need for any change but they may be too close to problems to notice them.

While a post-Enron world has made legislators and regulators more prone to knee-jerk reactions, Dingell could not be accused of following suit. Congress’s longest-serving member has proven with his tireless quest to stamp out tying that he is neither suggesting rash changes nor is he about to give up.

“Before we can come up with a solution [to tying] we will need to study the GAO findings and recommendations and the proposed Federal Reserve rule change and guidance. Once we do that we can then make decisions about next steps, including what the most effective solutions would be,” he says. The question of whether he is right or not is another matter entirely.