Banks and businesses have a symbiotic but occasionally fraught relationship. The great industrial enterprises of 100 plus years ago made substantial banks necessary and possible. They also imperiled the nation’s financial system during the Great Depression.

The immediate cause of the banking crisis of 1933-34 was Henry Ford’s refusal to bow to the Treasury Department’s demand that he convert his deposits in Detroit’s Union Guardian Trust Company (which the Ford family controlled) to capital so the bank remained solvent. Treasury Undersecretary Arthur Ballantine and Commerce Secretary Roy Chapin (an industrialist himself, who had run the Hudson auto company) traveled to Detroit, met with Ford and pleaded with him to adopt the plan Treasury formulated. They said if he did not relent he would destroy every bank in Michigan. Ford replied, if people had to endure a banking crisis, it would make them work harder, which would be good for them. Within days, deposit runs escalated at Union Guardian and other Detroit banks, then across Michigan and eventually nationwide. Within 48 hours of taking office, Franklin Roosevelt put the nation’s banks on holiday, where they stayed for 15 months.

Fast forward 22 years to 1956. Fearing the economic power of merged industrial and banking interests, and remembering the roots of the banking crisis of 1933-34, Congress passed the Bank Holding Company Act (the “Act”) to prevent such mergers. The Act set a low bar for what constituted control of a bank: ownership of 25% of a bank’s voting securities or the power to elect a majority of directors. Any party that acquired such control was legally deemed to be a bank holding company, subject to regulation as such by the Federal Reserve System. To industrialists, that was a fate worse than death.

In 1970, Congress added a third test, saying control existed when the Fed “determines after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank.” This addendum transformed “control” into a “facts and circumstances” test, further expanding the Fed’s power. The Fed also narrowed the zone of permitted investments by establishing rebuttable presumptions of control that kick in at 10% ownership of voting securities or, in limited circumstances, at 5%. As a Fed-imposed condition to making their investment, investor-owners of 5% or more of a bank’s voting securities are frequently required to sign “passivity commitments” agreeing not to take an active role in bank management or governance.

All these strictures served the purpose of requiring bank ownership to be widely distributed. They also put banks off limits to many of the nation’s most important sources of capital investment in the last 40 years—private equity firms, technology companies and the people who accumulated wealth in both those venues.

One can argue this arrangement serves the public interest by insulating banks from Henry Ford-like behavior and from predatory speculations of the sort that wrecked many industrial companies at the hands of the recently-pardoned Michael Milken and his brethren. But the arrangement also had unintended, and arguably undesirable, consequences.

1. Industry Consolidation. JPMorgan Chase, Citibank, Wells Fargo and Bank of America today operate as an oligopoly that controls two-thirds of the nation’s banking business. The industrial pillars that supported regional banks were wiped away in the late 20th Century. With them went most regional banks. Too, the Fed under Alan Greenspan venerated the efficiency they believed bank consolidation created and discounted the risks that came with it. So the concentrated economic power that Congress sought to prevent in 1956 came to pass anyway. The result has been a witch’s brew for all parties, as Wells Fargo’s recent history best demonstrates.

2. Capital Starvation. By number, community banks predominate—5,500 of them, more or less, across the nation. Many customers, including me, prefer to deal with them because of the personal nature of banking relationships one can develop. But the challenges of sustaining profitability, growing the business and replacing shareholders who grow old and desire liquidity make community banking one of the most difficult briefs to fill in the financial services business today. Public share ownership is not worth the expense. Private equity investment is unavailable due to the Fed’s restrictive definition of control. Technology continues to erode profitability. And competition from non-banks is ever present and growing.

3. Business Innovation. Sometimes innovation works well, or at least well enough, e.g.,PayPal. Other times innovation fails, e.g., NextBank, N.A., an Internet-only credit card bank that flamed out as PayPal took wing 20 years ago. The Fed’s control rules stifle innovation, or at least ensure it will be done predominantly by non-bank enterprises. The resulting risk to banks is competitive disadvantage compared to tech firms and more nimble non-bank financial firms.

In the face of these constraints, effective April 1, the Fed will modestly liberalize its control presumptions to make non-control investments in banks more feasible. The principal change is to create a matrix of progressively greater restrictions as the size of an investment rises from 5% to 25% of a bank’s equity capital. Intermediate breakpoints are 10% and 15%. For example, a company that owns 15% of a bank’s voting shares is presumed to control the bank if the company can appoint or elect the bank’s board chair or someone from the company is a “senior management official” of the bank. Below 15%, however, those restrictions do not apply.[1]

Some requirements are graduated. Thus, intercompany transactions between a bank and another company cannot represent 5% or more of the bank’s total annual revenues or expenses when 10% of the bank’s equity securities are owned by the company. At the 15% ownership level, 2% or more of annual revenues or expenses is the level at which control is presumed to exist.

These and other changes to the control standards are baby steps, to be sure. They represent a shift in the wind at the Fed and other regulatory agencies. Bankers and investors too must adjust their thinking and behavior rather than always doing what they have always done. The financial sector remains the foundation of our economy. It needs renewed strength from within, not just vendors bringing new products and services from outside boundaries the Fed sets.

[1] 12 C.F.R. § 225.32(f).