In Defense of the Bank Holding Company
To paraphrase misquotations of Samuel Clemens with respect to reports of his death, the reports of the impending death of the bank holding company (BHC) are greatly exaggerated. As a participant in the organization of approximately 100 BHCs beginning in the holding company boom years of the early 1980's through the current period, the recent announcements by two large banking organizations to consolidate their bank holding companies into the subsidiary bank charter caused me to reflect on why BHCs came to be in the first place.
The chief disadvantage of a BHC, especially for national banks and state non-member banks, is the addition of another federal regulator, the Board of Governors of the Federal Reserve System and more specifically the local Federal Reserve Bank (collectively, the "FRB"), to the organization's regulatory mix. The FRB requires certain annual, semi-annual, and quarterly reports to be filed by the BHC, as well as annual inspections. For large complex BHCs, and even some large non-complex BHCs, the applicable FRB has seemingly injected itself into the subsidiary bank operations to a much larger degree than with small non-complex holding companies. A second disadvantage of a BHC is that accounting is more complex because it is done on a consolidated basis. Third, for publicly traded BHCs, the primary securities regulator is the Securities and Exchange Commission, while publicly traded banks report to their primary federal regulators which have divisions to oversee securities filings. However, issuance of bank securities is exempt from the Securities Act of 1933, and issuance of securities by a bank will avoid a registration fee with the SEC. Finally, an operational disadvantage is the applicability of both the qualitative and quantitative limitations of Sections 23A and B of the Federal Reserve Act and Regulation W thereunder to transactions between a BHC and its bank subsidiary.
Despite the foregoing negatives attendant to maintenance of a BHC, advantages continue to far outweigh the negatives, particularly for smaller BHCs and even some large BHCs. The purposes of the BHC are (1) to diversify activities, (2) to serve as a source of strength and capital for a subsidiary bank, and (3) to provide liquidity and a market for BHC common stock. Regulation Y, governing BHCs, allows a BHC to enter into a number of activities which are so "closely related to banking or managing or controlling banks to be a proper incidence thereto," listing well over 20 approved activities. Financial holding companies have a broader range of non-banking activities that are "financial in nature or incidental to a financial activity." In addition, a BHC may invest in the equity of a business as long as the investment does not represent more than 5 percent common equity ownership of the target. Many smaller BHCs have used these activities to create additional lines of income for the holding company to reduce dividend pressure on the bank. For large BHCs, it is essential to be a financial holding company to engage in certain financial activities such as ownership of a broker/dealer that engages in underwriting activities or formation of a captive insurance company, a new trend among activities. Although theoretically these latter two activities could be conducted by bank subsidiaries, the prudential bank regulators have essentially foreclosed approval of such activities. Thus, a bank without a holding company would be estopped from engaged in owning a broker/dealer engaging in underwriting activities or forming a captive insurance company to underwrite deductibles and other uninsured risks of the organization.
Although Basel III has made capital instruments substantially uniform between banks and BHCs, many BHCs have utilized unsecured debt, whether in the form of debentures or lines of credit, to fund expansion and growth or to manage cash flow. In doing so, the holding company has served as a source of capital strength for the subsidiary bank. During the Great Recession, a number of our BHC clients purchased substandard assets from the bank subsidiary, thereby maintaining classified asset ratios at the bank within acceptable levels. This was also done under the authority of the BHC to serve as a source of capital strength to the bank. Elimination of the BHC would preclude such opportunities for a banking organization without a holding company.
Finally, the primary obligation of a board of directors is to maximize shareholder value. A frequent tool for large publicly held banking organizations is a share repurchase offer or program used when the market price of the stock is felt to be undervalued. Redemption of capital through repurchase of shares by a BHC is a fairly routine matter, but such a repurchase of bank stock is much more complex from a regulatory standpoint. Stock repurchase programs benefit selling shareholders by providing a market for sale and benefit remaining shareholders, in theory, by increasing shareholder value. For smaller bank holding companies, shareholders are provided liquidity through such repurchases as well as through loans collateralized by BHC stock at the subsidiary bank since the bank holding company stock is eligible as collateral, subject to limits of Sections 23A and B and Regulation W. Shareholders of banks do not have this option of borrowing from the bank collateralized by bank stock and would borrow from a competitor in order to use the bank stock as collateral. Thus, the ability to provide shareholder liquidity is important to both large publicly traded BHCs and smaller BHCs, though the means may be different.
Against these advantages, if the goal is to eliminate a federal regulator, it may be simpler to convert the bank to a member bank, making the federal regulator of the bank and BHC the same. For publicly traded companies, it remains to be seen what the effect of shifting from being an SEC filing company to a bank regulator filing company will be. A board must find reduction of the number of federal regulators and/or avoidance of SEC registration to be compelling reasons to discard the advantages of a BHC.