Related Organizations
Financial Support
The "source of strength" doctrine is a fundamental and long-standing principle underlying the FRB’s supervision and regulation of BHCs. [21] In return for pledging to support its subsidiary bank, a BHC is allowed to acquire an institution that can issue federally insured deposits. In serving as a source of strength for its subsidiary banks, a BHC should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial distress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. (See 12 CFR 225.4(a)(1).)
Consistent with the FRB’s "source of strength" doctrine, a BHC structure can provide subsidiary banks with strong financial support because of the holding company’s ability to shift funds to the bank, if needed, from other entities in the consolidated organization. The financial support can take the form of capital (equity or debt) or the funding of loans and investments. In general, the lower the BHC’s leverage, the less likely the BHC will be to require cash flow from the banks to service its debt, and the more likely it will be to be able to serve as a source of financial strength to its bank subsidiaries.
When the financial condition of the parent company is tenuous, the parent may exert pressures on the subsidiary bank. To service its debt or provide support to other nonbank subsidiaries, the parent company may pressure a subsidiary bank to:
Pay excessive dividends.
Pay excessive management fees or other fees to affiliates.
Purchase inadequate or unnecessary services from affiliates.
Invest in high-risk assets to increase asset yields.
Purchase the parent’s or other affiliate’s lower quality assets, or trade its high-quality assets for such assets.
Make improper tax payments or unfavorably alter its tax situation.
Such activities are unsafe and unsound. The dividend policies of a national bank should be consistent with its capacity to pay and should not be based solely on the needs of shareholders or related organizations.
Debt service requirements of a holding company or other related organization may not be imposed upon or allocated to a national bank through management or other fees unless the fees represent reasonable reimbursement for goods and services that meet the legitimate needs of the bank. Generally, fees that are established solely to meet a shareholder or related organization’s need for funds and that exceed the value of goods and services received will be cited as an unsafe and unsound banking practice. Such fees may also violate section 23B. Such activity dissipates profits and capital and disserves the financial interests of minority shareholders. Examiners should ensure that the fees being paid represent reasonable reimbursement for goods and services received.
Even when a holding company’s structure is financially sound, the holding company’s practice of selling long-term debt and passing the proceeds down to its bank subsidiary in the form of equity capital still may present problems. Although such a practice, frequently referred to as "double leveraging," increases the subsidiary bank’s equity capital, the holding company must usually service its debts out of dividends from the subsidiary. If the subsidiary bank encounters an earnings problem, it may not be able to pay sufficient dividends to the holding company.
Another problem may develop when the holding company sells commercial paper and funds its subsidiary’s loans with the proceeds. If the maturities of the commercial paper sold and the loans bought are not matched, and if the volume of such funding is large in relation to the subsidiary’s overall operations, the practice may cause a liquidity problem.
A holding company may weaken a subsidiary bank by requiring it to maintain compensating balances to support holding company debt. In such a scenario, a holding company (or a nonbank subsidiary of a holding company) has a loan outstanding with a nonaffiliated bank. As a condition of granting the loan, the nonaffiliated bank requires the holding company’s subsidiary bank to provide a compensating balance. Such a transaction should be cited as an unsafe and unsound banking practice when the holding company provides insufficient compensation to its subsidiary bank for the use of the funds. When the subsidiary bank receives adequate compensation, the transaction need not be criticized (unless the arrangement has other unfavorable aspects, such as a requirement that the bank place deposits in excess of what would normally support holding company borrowings).
Federal Reserve Inspection Reports will provide financial and operational information on the activities and soundness of the holding company.
21.
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