Holding Company Affiliates and Operating Subsidiaries:
In considering financial modernization, two alternative organizational structures have been proposed. One would require that new activities such as securities or insurance underwriting be placed in a holding company affiliate. In order to own such an affiliate, the holding company would have to be well-capitalized. The other alternative would give banks the option of housing new activities in a bank operating subsidiary. This operating subsidiary would be subject to certain safeguards, including: application of the principles of Sections 23A and 23B of the Federal Reserve Act to transactions between a bank and its operating subsidiary; the requirement that the bank be well-capitalized; and the requirement that the bank's investment in the operating subsidiary be deducted from regulatory capital.
Safety-and-soundness issues arise in two situations: when the bank is healthy and the affiliate/subsidiary is financially troubled; and conversely, when the affiliate/subsidiary is healthy and the bank is financially troubled. Each is discussed below. We conclude that the affiliate and operating subsidiary structures offer similar protections when the bank is healthy and the affiliate or subsidiary is troubled, but that the operating subsidiary structure provides superior protection when the affiliate/subsidiary is healthy and it is the bank that is in financial trouble.
Bank Healthy - Affiliate/Subsidiary Troubled
There are a number of safety-and-soundness concerns that arise when a bank is financially strong but its affiliate or subsidiary is financially troubled. First, the bank might transfer funds to the subsidiary in an attempt to save its (or its parent's) investment. However, both the affiliate structure and the operating subsidiary structure provide the same limits on such exposure. In particular, the application of the principles of Sections 23A and 23B of the Federal Reserve Act to operating subsidiaries ensures that any extension of credit by a bank to its operating subsidiary would have the same limitations and safeguards as would apply to extensions of credit by the bank to its holding company affiliate. With respect to equity contributions, the bank might downstream capital to its subsidiary or it could upstream funds to its parent, which could then downstream the funds to the troubled affiliate. However, since the bank's investment in an operating subsidiary is deducted from regulatory capital and the bank would have to be well-capitalized under both the affiliate and operating subsidiary structures, equity transfers are limited to capital in excess of the well-capitalized threshold.
Of course, a bank might risk sanctions and illegally transfer funds to its affiliate or subsidiary in violation of Sections 23A and 23B, even though it would fall below the well-capitalized level. Such a transfer also might go undetected by regulators until it was too late. But, it is important to remember that banking organizations seek to maximize the return to their shareholders; thus, they have the same economic incentive to improperly transfer funds to an affiliate as to a subsidiary. In order for bank regulators to be able to detect improper capital transfers, bank regulators must have similar access to operating subsidiaries and holding company affiliates, and similar mechanisms could be used to monitor capital flows between a bank and its operating subsidiaries and between a bank and its parent or affiliates. In short, banks may occasionally break the rules, and for a short time go undetected, but neither their incentive nor their ability to do so is affected by organizational structure.
Another safety-and-soundness concern arises when an affiliate/subsidiary fails. Despite limited liability, theoretically, the corporate veil may be pierced to make the bank accountable for the liabilities of its affiliate or subsidiary. First, it is important to note that piercing of the corporate veil is very rare. Second, corporate veils can be pierced between a parent and a subsidiary and between affiliates. The critical issue is not organizational structure, but whether the bank controls and dominates its affiliate or subsidiary so that they are held out to the public or operated as integrated entities. Under both the affiliate and operating subsidiary structures, there are certain straightforward steps a bank would be required to take to ensure that its affiliate or subsidiary is in fact separate from the bank. These steps include having separate management and record keeping for the two corporations, and not having identical boards of directors. With some basic safeguards such as these, the legal separation of both subsidiaries and affiliates can be reasonably ensured.
A third safety-and-soundness concern that could arise from a troubled affiliate or subsidiary is contagion, or reputational risk. That is, despite the fact that the bank may be legally insulated from the financial troubles of its affiliate or subsidiary, the troubles of the affiliates/subsidiaries may extend to the bank because they could undermine public confidence in the organization as a whole. This risk is real, but it depends largely on public perception, not organizational structure. If regulators strictly enforce firewalls, there will be less contagion risk. If, on the other hand, regulators encourage banks to bail out troubled nonbank subsidiaries or affiliates, then contagion risk will be a larger problem for operating subsidiaries and affiliates alike.
Bank Troubled - Affiliate/Subsidiary Healthy
Safety-and-soundness considerations also arise when the affiliate/subsidiary is healthy and the bank is financially troubled. As noted earlier, banking organizations seek to maximize the return to shareholders. Thus, if a bank is in danger of failing, banking organizations have an incentive to shift resources from the bank to healthy nonbank affiliates. Since operating subsidiaries are an asset of the bank, no such incentive exists to shift resources out of a troubled bank into a healthy operating subsidiary. Of course, firewalls exist to protect the bank from an improper transfer of funds when a bank is near failure, and regulators monitor troubled banks very closely. Nonetheless, in the case of a troubled bank, there is less reason to be concerned with breaches in the firewalls between a bank and its subsidiary than between a bank and its affiliate.
A second safety-and-soundness consideration involves the support that the healthy affiliate or subsidiary gives to the bank, and hence, indirectly depositors and the insurance fund. Since, as noted above, an operating subsidiary is an asset of the bank, the earnings from or the proceeds of the sale of a subsidiary belong to the bank, and if a bank poses supervisory concerns, regulators can prevent those funds from being directed up to the holding company. In some cases such funds might prevent a bank from failing. If the bank does fail, earnings or sale proceeds before failure will lower the insurance losses of the FDIC. If the subsidiary has not been sold before failure, then the subsidiary becomes an asset of the receivership and directly serves to limit the losses of the insurance fund.
The Federal Reserve's "source-of-strength" doctrine provides some of the same support for banks from bank affiliates, but not as completely and not as well as outright ownership. First, the source-of-strength doctrine has never been fully litigated, and bank holding companies have occasionally successfully balked at meeting the Federal Reserve's demand for capital injections into their insured banks. Second, even when bank holding companies have injected capital into banks that subsequently failed, the FDIC has twice been sued to recover some of those funds. In the First Republic failure, the recovery of funds downstreamed to the bank was one of several issues in a suit eventually settled out of court. A suit by the Bank of New England Corporation trustee in bankruptcy to recover funds and assets downstreamed by the holding company into the bank before failure was settled on January 6, 1999, with the payment of $140 million by the FDIC, as receiver and in its corporate capacity, to the bankruptcy estate. Finally, despite the source-of-strength doctrine, once a bank fails, the depositors and the FDIC have no claim whatsoever on the nonbank assets of the holding company. This differs markedly from an operating subsidiary, which, as noted earlier, would become an asset of the receivership and whose full value would accrue to depositors and the FDIC.
The operating subsidiary structure and the holding company structure provide similar safety-and-soundness protection when the bank is sound and the affiliate/subsidiary is financially troubled. However, when it is the bank that is financially troubled but the affiliate/subsidiary is sound, the operating subsidiary structure has a definite safety-and-soundness advantage.