Academic journal article Journal of Money, Credit & Banking

Are Bank Holding Companies a Source of Strength to Their Banking Subsidiaries?

Academic journal article Journal of Money, Credit & Banking

Are Bank Holding Companies a Source of Strength to Their Banking Subsidiaries?

Article excerpt

IN RESPONSE TO THE BANKING CRISIS of the late 1980s, Congress enacted two important reforms of bank holding company (BHC) regulation. The cross-guarantee authority granted to the Federal Deposit Insurance Corporation (FDIC) in 1989 through the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) permits the insurer to shift any expected losses associated with the failure of a banking subsidiary onto the capital of non-failing affiliate banks. (1) While the banking industry has challenged this authority in the courts as a taking of private property without just compensation, the cross-guarantee provision has been upheld on at least two separate occasions. (2) This "use it or lose it" approach to bank capital has arguably aligned the incentives of a parent holding company with those of bank regulators when deciding when and how much to support a troubled banking subsidiary before it fails with resources from another banking subsidiary. In 1991, Congress also clarified the authority of the Board of Governors of the Federal Reserve under its "source-of-strength" doctrine through the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The Federal Reserve had asserted since 1987 that the failure by a parent to act as a source-of-strength to a troubled subsidiary when resources were available would be "an unsafe and unsound banking practice" and subject to enforcement actions. However, this policy was challenged aggressively in the courts on the grounds that the Board had overstepped its regulatory authority. In FDICIA, Congress clarified that the BHC regulator does have the authority to force a parent company to guarantee the performance of a troubled banking affiliate as part of a capital restoration plan, but it ultimately limited the liability of the parent to 5% of the problem bank's assets. While the Federal Reserve could not compel a parent to use resources in a regulated non-banking subsidiary when such an action would have a "material adverse effect" on that subsidiary's condition, the Board was given the authority to order a parent to raise funds by divesting the non-banking subsidiary. (3) This later provision increases the leverage that the Federal Reserve has in convincing a parent holding company to use resources in non-banking affiliates. Together, these two reforms of BHC regulation constitute a significant strengthening of the legal backbone behind the source-of-strength doctrine.

After more than a decade of regulation, legislation, and litigation, it seems natural to ask, what has been accomplished? On the one hand, the observed resistance by the banking industry in the courts suggests that regulators are forcing bank holding companies to do something that they otherwise would not be willing to do. On the other hand, the source-of-strength doctrine is essentially a capital requirement, and academic research has struggled to find any impact of tougher bank capital requirements on bank behavior despite similar industry opposition. (4) The aim of this paper is to resolve these issues by documenting the impact of BHC affiliation on the future outcomes of distressed banks, and to measure how the impact of affiliation has changed since these two reforms of BHC regulation.

Why should we care? The banking industry has argued that the cross-guarantee authority of the FDIC makes the source-of-strength doctrine irrelevant, but this might not be the case for at least two reasons. (5) First, the FDIC does not have the authority to use capital invested in the non-banking subsidiaries of a BHC in order to defray the expected costs of bank failure. In contrast, the source-of-strength doctrine demands that a BHC use the resources in both banking and non-banking subsidiaries to support a distressed subsidiary bank. Second, the FDIC cannot exercise its authority until the subsidiary bank has already failed. In contrast, the source-of-strength doctrine involves the transfer of capital to a distressed subsidiary to prevent failure. …

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