By David Cho Washington Post Staff Writer
Tuesday, May 18, 2010; 11:51 AM

Goldman Sachs, Morgan Stanley and other big Wall Street firms were able for years to set up commercial banking businesses while avoiding the strict regulation this kind of activity usually entails.

But the law that made this practice possible has been preserved — despite opposition from the Obama administration — in the bill sponsored by Sen. Christopher J. Dodd (D-Conn.) remaking financial regulations and closing loopholes in oversight.

Critics say the provision has survived because the law helps create jobs in a few states with influential senators, including Senate Majority Leader Harry M. Reid (D-Nev.) and Sen. Robert F. Bennett (R-Utah), the second-highest-ranking Republican on the banking committee.

Retaining the law is among the concessions administration officials accepted as they pressed lawmakers to approve the far-reaching legislation. The White House and leading Democrats in the Senate have vowed to squash all carve-outs for special interests.

The law, which provides for what’s called an Industrial Loan Company charter, was initially designed so that commercial companies like Target could help their customers make purchases by offering them credit. The companies set up what were effectively in-house banks but were spared the stiff conditions typically applied to banks, for instance requirements that they set aside enough capital to cover potential losses and limits on how much they can borrow. Utah and Nevada attracted nearly all of these financing divisions by writing rules that are favorable to the companies.

Before long, big investment firms realized they too could establish commercial banking subsidiaries in these states and gain the advantages banks have, for instance deposit guarantees from the Federal Deposit Insurance Corp., without submitting to tougher regulation.

This opportunity was enormously profitable for big investment companies because it allowed them to raise funds cheaply. Bank customers typically accept very low interest rates if they can hold their money in FDIC-insured accounts. Banks then use that pool of deposits to make investments.

Between 1998 and 2008, Wall Street’s ILC subsidiaries saw their businesses grow exponentially. Merrill Lynch‘s ILC reached nearly $60 billion in assets, larger than the assets of all traditional ILCs combined. Four other investment banks established large ILC divisions, including Morgan Stanley, which had $38.5 billion in its ILC, and Goldman Sachs, which had $25.7 billion.

During the financial crisis, many of the parent companies ran into trouble, including virtually all of those associated with the largest ILCs.

Some, like Lehman Brothers and Merrill Lynch, later collapsed during the financial crisis or were taken over. Others, like Goldman Sachs and Morgan Stanley, still operate ILCs but no longer benefit as much because they submitted their entire business to stricter federal regulation to weather the financial storm.

“The ILC charter was disproportionately valuable precisely to the parent companies that were the most reckless,” said Raj Date, chief executive of the Cambridge Winter Center for Financial Institutions Policy, a nonprofit research group. “If you want a system with fewer crazily reckless participants, then you should eliminate all the special treats that you give to them. . . . The ILC charter, for Wall Street firms, was unambiguously one of those special loopholes.”

As written, the Senate bill preserves the ILC charter but puts a three-year moratorium on new approvals. It also asks the U.S. Government Accountability Office to study the issue further. The administration, in its version of the bill released last summer, had called for ILCs to be regulated the same as banks.

Although the bill does not require that, the administration has ensured that all companies whose failure would threaten the financial system could be brought under federal supervision.

Reid has said the ILC charter should be protected. Although many of the parent companies that set up ILCs ran into trouble during the crisis, Reid and other defenders said the financing divisions themselves remained healthy.

“While I appreciate some of the concerns raised by critics of the ILC charter, the evidence is overwhelming that these institutions have been managed in a safe and sound manner,” Reid wrote to the Senate Banking Committee last year.

Reid’s spokesman, Jim Manley, said that Bennett took the lead on the issue. “Senator Bennett was the one pushing this, but having said that, this is something Senator Reid has been following,” said Manley. “His whole goal here is to save jobs in Nevada.”

ILCs employ hundreds of people in Nevada and as many as 15,000 in Utah, lawmakers from those states say.

Sen. Bennett also noted that many of the ILC divisions remained healthy, even as the parent companies struggled.

“When Lehman brothers went down and had to sell its assets, the ILC was one of its crown jewels,” Bennett said in an interview. “The point is ILCs have extended credit in niche markets where credit was not available and they did it in a safe and sound manner and didn’t lose a dime of taxpayer money.”

But critics say these arguments miss the main problem with the ILC charter. Wall Street firms should not be able to exploit any loophole in the law, these critics urge.