Free at last

A key tenet of President Obama's financial overhaul plan is to ensure that all federally chartered banking institutions play by the same rules. To accomplish that goal, the White House has proposed streamlining banking regulators and doing away with the federal thrift charter, which allows housing-focused depository institutions such as savings and loans and savings banks to operate with higher concentrations in residential lending than commercial banks can.

Under the Obama plan, eliminating the thrift charter would wipe out the special privileges that savings and loans enjoy, except for one. Thrifts have the unique ability to operate across state lines regardless of state laws limiting interstate branching. Now unimpeded branching power would be granted to every bank in the country.

It's a controversial proposal but one that would simplify the convoluted regime now in place. Interstate bank branching is governed by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which removed federal restrictions on interstate expansion of banks but gave the states a fair measure of authority to set terms for branching within their borders by the out-of-state banks. Since Riegle-Neal's enactment, the number of branches run by banks based in other states has soared from 62 to roughly 25,000. Branches run by out-of-state banks now account for 40% of domestic branches.

Despite the growth in interstate branching, Federal Reserve vice chairman Donald Kohn says the lingering limitations hurt customers, particularly in underserved markets. In 2005 congressional testimony, Kohn said more extensive branching would result in "better banking services for households and small businesses, lower interest rates on loans, and higher interest rates on deposits."

The law allowed states to forbid branching across their borders, but today all 50 states and the District of Columbia permit it. States, however, still may impose restrictions: They can prohibit partial acquisitions of individual branches, and they may forbid the banks from setting up new, or "de novo," branches from scratch. States also may set minimum age requirements on banks or branches being acquired and establish statewide deposit caps. Many states also imposed reciprocity rules that grant entry according to an expanding bank's home state rules. For instance, a state may chose to ban de novo interstate branching unless the expanding bank has its headquarters in a state that permits de novo entry.

According to a study by the Federal Reserve Bank of Chicago, 28 states prohibited de novo branching at the end of 2005. Also, 33 states maintained a statewide deposit cap.

Restrictions on interstate branching are seen as a way to protect small community banks from multistate bank holding companies, which have a huge competitive edge from their lower cost of funds. The Fed has long supported eliminating the interstate banking restrictions. But lobbying by community banks, which are much less likely than big banks to expand across state lines, killed a House-passed measure that would have put commercial banks on equal footing with thrifts.

John Ryan, executive vice president at the Conference of State Bank Supervisors, says state banking regulators support extending thrift-branching powers to commercial banks because the change would bring order to a convoluted system. He predicted small banks would benefit too, especially those based near a state border. "Community banks with markets that cross state lines would be better able to serve their customers," he says.

The Obama plan strikes a delicate bargain to win community bankers' acquiescence. The White House proposes to eliminate the charter for industrial loan companies, a specialized type of depository institution that nonfinancial companies have been allowed to own. Community bankers worry that Wal-Mart Stores Inc. and other big retailers will one day set up ILCs as a backdoor way to build a nationwide banking business. Facing a storm of political opposition, Wal-Mart in 2007 dropped an application to start an ILC. Ryan predicts eliminating ILCs, or at least forbidding them from branching, would keep community bankers on board with unfettered branching for commercial banks. n

Bill McConnell is Washington bureau chief for The Deal.