Wall Street just can't seem to get out of its own way these days. Even as the scandal over the breakdown of the wall between research and investment banking continues to cast a dark cloud over large banks, another gathering storm threatens to further weaken their credibility.
This time it's the commercial lenders that stand accused. Regulators are looking into allegations that banks are making loans contingent upon the corporate borrower's ability to provide other fee-based business, such as cash-management services or investment banking. The illegal practice, known as "tying" or "pay to play," is said to be widespread among commercial banks.
The National Association of Securities Dealers launched an investigation into tying after it received complaints from corporate borrowers. Although NASD won't comment on the investigation, it did issue a notice warning member banks that tying arrangements are against the law. "NASD is concerned that the practice of tying commercial credit to investment banking is becoming increasingly widespread," it said.
According to the Association for Financial Professionals, tying is endemic. It surveyed 3,500 financial officers and found that 48 percent believed that "if they didn't award other business to short-term lenders, the amount of short-term credit would be reduced." And 39 percent said they didn't expect to get loans at all if they didn't award other business to lenders. "It's very much a real issue," says James Haddad, a member of the AFP's board of directors and vice president of finance at Cadence Design Systems Inc., a San Jose, Calif., software firm. "I've seen it throughout my career [in finance]. Every company sees it. Banks aren't bashful about letting you know they expect loans to bring in other business."
The treasurer of a Fortune 500 company who asked to remain anonymous agrees that tying has created headaches for corporate borrowers. (Most finance executives won't talk about the problem openly, for fear of damaging their banking relationships.) "It's nothing official — they don't ask you to sign anything," says the treasurer. "But it's understood that creditors are trusted to get their share of other banking business. That's just the way it is." The treasurer was forced to move the company's lock-box business to a new bank after the company secured a new line of credit with that bank, even though the finance executive preferred the existing one. The treasurer blames the practice on the low-interest-rate environment, explaining, "Banks don't want to lend money anymore."
The practice of tying could have grave consequences for the economic system, says Haddad. He says that plenty of large banks made big loans to companies based more on what fee-based business the loan could generate than on the creditworthiness of the borrower. That practice has already contributed to large losses in loans made to technology and telecom firms — losses that could affect the rates and terms of credit for companies at large. "Effectively, banks look at lending as a loss leader," says Haddad. But when they make bad loans to a company like WorldCom based on how much other business they can get, the backlash has an impact on all companies. "Everyone ends up paying higher fees and rates," he adds.
Rep. John Dingell (D-Mich.) is urging the Federal Reserve to crack down on tying. In a letter to Alan Greenspan, Dingell said he was "concerned about the implication of these practices on the health of the financial markets and on the availability of credit to U.S. corporations."
The prevalence of tying is largely a product of the consolidation of banks in the late 1990s, and of the repeal of the Glass-Steagall Act in 1999, which kept commercial banks out of the investment-banking business, says Dimitri Papadimitrious, president of the Levy Economics Institute at Bard College in New York. He doesn't think Glass-Steagall should be reinstated, but he does think regulators need to enforce existing laws, including those that prohibit tying. Says Papadimitrious: "I'm not so sanguine that regulators will do the due diligence on lenders until it reaches a crisis; then it's already too late."