...Enforcement (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. This latter point is important given recent evidence that even healthy bank failures are followed by significant and permanent declines in real economic activity (Ashcraft 2005) Moreover, since the largest commercial banks in the United States are controlled by financial holding companies, which in turn own the largest investment banks, the equity that a parent holding company has invested in non-bank subsidiaries has important consequences for the real default risk of the affiliated banking subsidiaries and potential liability of the FDIC in the event of failure.

In the academic literature, there is only one existing empirical study of the link between BHC affiliation and distressed bank behavior (Gilbert 1991). While the author documents that problem banks affiliated with a multi-bank holding company (MBHC) are more likely to receive a capital injection than unaffiliated problem banks, he does not document any impact of affiliation on future bank outcomes, and does not distinguish between the impact of regulation and the natural operation of internal capital markets. (6) This latter interpretation of the data cannot be easily dismissed given a growing literature on internal capital markets in bank holding companies. Using a sample of approximately 300 publicly traded MBHCs before the aforementioned reforms of bank holding regulation (1986-89), another study (Houston, James, and Marcus 1997) demonstrates that bank subsidiary loan growth is more sensitive to the cash flows and capital position of the holding company than to the cash flows and capital position of the subsidiary. (7) More recent studies (Campello 2002, Ashcraft 2006) document evidence that banks associated with MBHCs have better access to the federal funds and large CD markets, implying that affiliated banks are better able to shield the effect of a monetary contraction on bank loan supply by replacing insured deposits with external funds.

This paper contributes to the literature by documenting that, since these two reforms of BHC regulation, banks affiliated with MBHCs are more likely to receive injections of capital when distressed, recover from financial distress more quickly, and are less likely to fail from distress in the next year. I document that the benefit of holding company affiliation comes through access to resources in other bank and non-bank subsidiaries, as well as greater access to external funds through access that the parent has to the public equity market. This paper attributes much of these benefits to changes in BHC regulation and not the market, as the measured benefit of MBHC affiliation has increased significantly relative to both one-bank BHC-affiliated and stand-alone banks since 1989. While there is evidence that distressed MBHC-affiliated banks recovered from distress more quickly before the strengthening of the source-of-strength doctrine, the measured benefit of MBHC affiliation since these reforms in preventing future distress has increased significantly. Moreover, while there was no link between resources in non-banking affiliates and future bank outcomes before these reforms, there is now a strong relationship between these resources and the probability of future bank distress.

The paper proceeds as follows. An overview of the data employed appears in Section 1. The linkage between MBHC affiliation and future financial distress is documented in Section 2. The impact of changes regulation on this linkage is measured in Section 3, and Section 4 concludes.

1. DATA

I use annual December data on the financial condition of all insured commercial banks and any affiliated BHCs over 1984-2004. Information on the income and balance sheets of banks is taken from the Call Reports of Income and Condition and matched to similar information about affiliated holding companies on both a consolidated and parent-only basis using the Y-9C and Y-9LP/SP reporting forms, respectively. This financial condition data are matched to historical supervisory exam (CAMEL) ratings of commercial banks. Each bank-year observation from the financial reports is matched to the most recent exam rating, which is available electronically for the full sample starting in 1987. Summary statistics are displayed in Table 1, broken out across five panels: bank income and condition in Panel A, measures of financial distress in Panel B, BHC resources in Panel C, capital injections in Panel D, and future bank outcomes in Panel E. In each line, the table reports the mean above the standard deviation and the number of observations with non-missing values. The first column reports summary statistics for the whole sample, while the last three columns report summary statistics on each of three subsamples: stand-alone banks, one-bank bank holding companies (OBHCs), and MBHCs.

Panel A describes the bank variables pulled from the Call Reports. Affiliation with any type of BHC in line 2 is identified using the regulatory high holder. Affiliation with a MBHC in line 1 is identified by counting the number of commercial banks with the same regulatory high holder. The data document that about 74% (30%) of the bank-years in the sample belong to affiliates of a BHC (MBHC). Relative to stand-alone banks, MBHC affiliates appear to be a little larger in line 3, have less in equity relative to assets in line 4, and lend more in line 8. Moreover, note that the mean of each variable for a MBHC-affiliated bank is typically much closer to the mean for an OBHC affiliate than a stand-alone bank (e.g., log assets in line 3, equity ratio in line 4, loans in line 8, and return on assets in line 10). This suggests that the former subsample might be a better control group for the MBHC sample.

Panel B documents four measures of financial distress: a CAMEL rating of 3, 4, or 5 in line 12; a CAMEL rating of 4 or 5 in line 13; a ratio of problem loans to equity capital greater than the 85th percentile of all bank-years in line 14; and a ratio of problem loans to equity capital greater than the 95th percentile of all bank-years in line 15. The broader measures indicate that about 15% of bank-years are associated with financial distress while the more narrow measures involve only 5%. Figure 1 documents the fraction of distressed banks over the sample for the broad measure in Panel A and narrow measure in Panel B. The figure illustrates that measures of similar scope seem to track each other quite closely over time. During the peak of the banking crisis in the 1987, one-third of the banking industry was distressed when using the broad measures, while about one-eighth was distressed under the narrow measures.

The first six lines of Panel C describe the amount of resources available to a parent holding company in...

NOTE: All illustrations and photos have been removed from this article.



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