metadata: authors: 0: author: Talley,Samuel H.
docna: 0: docna: Bank holding companies : a better structure
            for conducting universal banking?
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Social Policy,Legal Products,Banking Law,Judicial System Reform,Urban Housing and Land Settlements,Public Sector Economics,Urban Governance and Management,Urban Housing,Banks & Banking Reform,Financial Regulation & Supervision,Legal Reform,Financial Law,Legislation,Municipal Management and Reform,Regulatory Regimes,Public Finance Decentralization and
            Poverty Reduction,Law Finance and Growth,Financial Sector Policy
teratopic: Infrastructure Economics and Finance
abstracts: cdata!: Banking systems in many countries have
            become increasingly unstable in recent years.  At the same
            time, market forces have pushed banks to expand into a
            variety of universal banking activities without impairing
            the stability of the banking system.  The basic bank holding
            company proposal contains three major elements : first, any
            bank that wants to operate as a universal bank must first
            form a holding company and then conduct all riskier
            activities in holding company units rather than directly in
            the bank.  The bank would continue to engage in traditional
            banking activities that involve the usual level of risk;
            second, the government would develop laws and regulations
            designed as safeguards to insulate the bank from any
            financial problems that might occur in holding company
            affiliates of the bank; and lastly bank regulatory
            authorities would impose little or no supervision on holding
            company units.  The use of the bank holding company device
            to conduct universal banking activities can promise
            important public benefits including : 1) a sounder
            commercial banking system; 2) less banking regulation; and
            3) greater competitive equality between banking and
            nonbanking units.
repnme: repnme: Bank holding companies : a better structure
            for conducting universal banking?
display_title: Bank holding companies : a better
            structure for conducting universal banking
listing_relative_url: /research/1991/05/699965/bank-holding-companies-better-structure-conducting-universal-banking
topicv3: Banking Regulation m1326903 971,Bank Regulation and Supervision m1327225 317,Taxation m1327615 1121,Land and Housing m1327648 817,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Infrastructure Economics and Finance
origu: Policy, Research & Ect Affairs
no_of_pages: 29
author_keys: 0: author_key: 87672
model_extractions: **Policy, Research, and ExtenlAfar**

<!-- Start of picture text --> Financial Policy and Systems<br><!-- End of picture text --> WPS 663 This papera product of the Financial Policy and Systems Division, Country Economics Department- is part of a larger effort in PRE to explore ways to increase the soundness of banking systems. Copies are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Zena Seguis, room N9-005, extension 37665 (24 pages).

Banking systems in many countries have become increasingly unstable in recent years. At the sanie time, market forces have pushed banks to expand into a variety of universal banking activities, including some that appear to involve higher risks than traditional banking operadons.

Talley notes that these trends have prompted questions about whether restructuring banking organizations might permit them to pursue universal banking activities without impairing the stability of the banking system.

The basic bank holding company proposal contains three major elements:

* Any bank that wants to operate as a universal bank must first form a holding company and then conduct all riskier activities in holding company units rather than directly in the bank. The bank would continue to engage in traditional banking activities that involve the usual levels of risk.-

The government would develop laws and regulations designed as safeguards to insulate the bank from any financial problems that might occur in holding company affiliates of the bank.

* Bank regulatory authorities would impose little or no supervision on holding company units. Instead, the marketplace would discipline the financial affairs of these affiliates.

The use of the bank holding company device to conduct universal banking activities can promise important public benefits including: (1) a sounder commercial banking system, (2) less banking regulation, and (3) greater competitive equality between banking and nonbanking units.

One major objective of using holding companies to conduct banking activities is to preserve banking stability. The evidence is inconclusive on whether holding companies could achieve this goal.

The major risk is that policymakers may tend to assume that safeguards protecting b'ynks are invulnerable and allow holding companies to engage in risky activities they would never consider permitting banks to conduct. If holding companies encountered serious problems because of unduly high risks, banks rffiliated with them could experience serious damage as a result.

|The PRE Working Paper SeriPs disseminates the fidings of work under way in the Bank's Policy, Rcscarch, and Extemal Affairs Complex. An objectivc ofthcescries is to gcttheserHmdings out quickly, even if presentations arc less than fully polished. The rindings, interpretations, and conclusions in these papers do not necessarily repTcsent offrlcial Bank policy.

Produced by the PRE Dissemiination CentcT
# **Table of** Qnt&jjU

|I.|Introduotion|1|
|---|---|---|
|IS.|Universal Banklng|2|
|IIS.|The Basic Bank Holdlng Company Proposal|4|
|IV.|Alleged Advantages of the Proposal|5|
|V.|Challenges to the Alleged Advantages|6|
|VI.|EmpirLcal Evldence on Insulation|10|
|VIZ.|other Proposals<br>FaLl-Proof Bank Proposal<br>Fail-Proof Parent Proposal|13<br>14<br>18|
|VIII.|Conclusion|20|

The author wLshes to thank members of the Financlal Policy and Systems Divlslon, Country EconomLces Department, for helpful comments.
# r. INrRODUCTION

In recent yrv,rs, banking systems in many countries have been experiencing increasing insta&DLity. At the aame time, market forces have been pushing kanks to expand into various universal banking activities, some of which appear to involve greater _risks_ than traditional banking activities. The combination of theme two developments has raised the question whether it might be possible to regtructur banking organizations in order to permit them to pursue universal banking activities without impairing the stabillty of the banklng system.

Organizationally, there are **three** alternative ways Ln which banking organizations can participate in universal banking activitles. First, they can conduct these activities directly in the bank. ThLs appears to be the arrangement that li most widely used. Second, they can conduct these activities in subsidiaries of the bank, an arrangement that appears to be increasing in use. Third, they can conduct these activities in bank holding companies (either in the parent company or in nonbank subsidlaries of the parent). To date, this organizational arrangement has not been wldely used, but is being increasingly discussed in banking and public policy circles.

Proponents of bank holding companies argue that conducting universal banking activities in holding company afflliates is clearly superior to conducting these activlties either dlrectly in the bank or in subsidiaries of the bank. These advantages include shielding the bank agaLnst the risks that universal banklng activLties may entail, **avoiding the** spread of bank-type regulation, and promoting a level playing field between bankLng and nonbanking competitors.

The objectLve of this paper is to evaluato the bank holdlng company device as a vehicle for conducting universal banking activittes. The paper identifies the major issues lnvolved, reviews the empirical evidence on the use of the
2 holding company iL acture, and discusses several proposals to make the use of the holding company device more effective from a public policy perspective.

The naper is divided into eight sections. Following this introductory section, the paper briefly reviews the pros and cons of universal banking. In the third section, the basic features of the bank holding company proposal are presented and explained. In the next two sections, the alleged advantages of the bank holding company proposal are presented, followed by various challenges to these alleged advantages. in the sixth section, the empirical evidence on the use of the holding company device for conducting universal banking activities is reviewed. Unfortunately, this empirical evidence is very limited because only one country, the United States, has expressly employed the holding company device on a wide scale to conduct universal banking activities. In the next section, two variants of the basic bank holding company proposal -- the fail-proof bank proposal and the fail-proof parent proposal -- are presented and evaluated. The major conclusions of the paper are presented in the final section.

# ST. UNIVERSAL BANKING

The term "universal banking" does not appear to have a precise definition. In general, however, the term implies that banking organizations have powers to engage in activities that go significantly beyond traditional banking activities. Tnese broader activltles mLght include lendlng and investlng that involve substantial term transformation, engaging in securities underwriting and dealing, and, in some countries, even holding equity positions in commercial and industrial companies.

As indicated earlier, there has been considerable controversy regarding the
3 morlts of universal bankLng.<sup>1</sup> The proponents of unLvereal banklng argut nt a thLs form of bankLng will promote economlc growth by maklng available much needed long-term flnancLng to comerce and Lndustry. UnLvereal banklng also will. promote efflcLency by allowlng '.Anks to achLeve economles of scale and scope. Moreover, unlversal bankLng will foster competitLon by opening up varlous areas of fLnance for entry by banks.

opponents of unlversal bankLng argue that lt will dLitort credlt allocatlon because of an Lncrease ln connected lendlng. Also, unlversal banking inevltably will lead to a greater concentratlon of economLc resources and polltlcal power. Further, unlvereal bankLng li bound to l*ad to confllcts of '&nterost -- for example, a bank underwrltlng securLtLes for a troubled fLrm where the proceeds of the Lssue would be used to pay off the bank's own loan to the company. FLnally, and perhaps most important, unlversal banklng could lnvolve banks engagLng in rlsky actlvitles that could jeopardLze the stabillty of the banklng system.

The dlfferen¢w of views regarding the merlts of unLversal banking is reflected ln several World Bank reports over the last decade or so. In the late 1970s, the Dank staff recommended the implementatlon of unLvereal banklng in the Phlilpplnes. Shortly thereafter, the staff turned around and argued agalnst unlversal banklng for Brasll and Mexlco.<sup>2</sup> The staff's apparent inconsistent approach may simply reflect Maxwell Fry's comment: "There li, therefore, no For a detalled review of the pros and cons of unLversal banklng, see Deena R. Khatkhate and Klaus-Walter Riechel, "Multipurpose Bankings Its Nature, Scope and Relevance for Less Developed CountrLes," InternatLonal Monetarv Fund Staff Zaprs, September 1980, pp. 478-516.

2 Millard Long, Revlew of Finanglal Sector _Work,_ World Bank, Flnancial Development Unlt, Industry Department, October 1983, p. 40.
4 universal **case** for or agaLnst **universal** banking." 3

# I,'". THS BASIC BANK HOLDING COMPANY PROPOSAL

The proposal to use bank holding companies to engage ln universal banking activitLes could take **various** forms. **The** form **used** ln thle part of the paper ia **the one** that **appears** most frequently ln pubiLc polLcy dLscussions. This proposal, which will be referred to as **the** kba bank holding company proposal, contains threo major elements.

FLrst, any bank that wants to operate **an** a universal bank would be required to form a holding company and then conduct all rLskLer activitLes ln holding company units, rather thsn directly ln the bank. **These riskler activities** could be conducted either ln the holdLng company ltself, or In nonbank subuidLarLes of the parent company. The bank would contlnue to engage ln tradltlonal banklng actlvltLes that lnvolve bankable" rilks.

Second, the government would develop laws and regulatLons deslgned to inoulate the bank from any flntncLal problems that might occur ln holdLng company affiliates of the bank. At a mLnimum, these firewall* provisions would include: (i) strict quantitative limLtations on bank loans or other extensions of credit to holdlng company affilLates, as well as tlght limits on bank purchases of securLtLes or other assets from these aftflliate.l (11) requirements that all bank transactLons wlth affiliates be on "market terms" -- that ls, on terms and condltlons that are substantLally the same as those on bank transactLons wlth nonaffLliated partLes; and (L11) provisions that would prevent the holdlng company from extractLng excesslve dlvLdends from **the** bank that would unduly ' Maxwell **J.** Pry, Money. Interest and Rankina in Zoo=ic Develonment (Baltimore, **Nd.g** John HopkLns UnLversLty **Press,** 1988), p. 283.
5 deplete the bank's capital.

Third, holding company units wnuld be subject to little or no supervision by bank regulatory authorities.4 Instead, the financial affairs of these affiliates would be disciplined largely or entirely b. the marketplace. The rationale for not subjecting holding company affiliates ..o bank-type regulatLon is that it is not needed if the bank can be effectively insulated from holding company financir.l problems.

# IV. ALLEGED ADVANTAGES OF THE PROPOSAL

Proponents of the _basic_ bank holding company proposal argue that the proposal would produce substantial public bonefits. Most important, the proposal would allow the public to derive the benefits of universal banking without placing the stablilty of the banking system in jeopardy. _Th*_ bank holding company proposal also would minimize the spread of bank-t%ype regulation. By conducting rLsky universal banking actlvities in holding company affiliates, it would not be necessary to subject these activitLes to bank-typ regulation because the bank is protected by flrewall. By contrest, if these risky activitLes were conducted directly in the bank, or even subs.4-aries of the bank, these activities almost surely would be subject to bank-typ roqulation. As a result, the movement to universal banking probably would result over time in the spread of bank-type regulation throughout much of the financial system. Moreover, it would tend to result in regulatory duplication Ln those flnancLal industries (such **as** securitLes and insurance) that **are** probably already subject Holding company affiliates participating ln certaLn nonbanking activities might be subject to regulation by other government **agencies.** For example, if an afflilate **eng*ges** in securities underwriting and deallng, this actLvlty might be **supervised** by a **securities** regulatory authority.
6 to regulation by "functional" regulator.

Another advantage of the bank holding company prorosal is that it would place banking and nonbanking competLtors on a level playlng fleld. Flrst, both banking and nonbanking rLvals would be subject to essentially the same amount of regulation. By contrast, if universal banking actlvities were conducted directly in the bank, or in subeidLarius of the banks, the bank would be subject to banktype regulation, whereas Lts nonbanking rivals wouldn't. Second, the bank holdinq company proposal would promote competltlve equality ln the funding of universal banking actlvitles. If these activities were condupted direftly ln the bank, banks would tend to have a lower cost of funds because banks are protected by the government through such devices as deposit lneurance and access to a lender of last resort. Under the bank holdlng company proposal, however, activities would have to be conducted in holding company affillates. These affiliates would have to do their own funding in the m£rketplave or, alternatively, if funded by the bank, would be .equired to pay market rates. Consequently, holding company affiliates could not gaLn a funding advantage over thelr nonbank rivals.

# V. CHALLENGES TO THE ALLEGED ADVANTAGES

On first view, the baesc bank holding company proposal seems to represent an extremely attractive way to allow banking organliations to engage ln unlvereal banklng. The proposal holds out the promise that universal bankLng can be conducted wlthout jeopardLzing banklng stability or sprertiUng bank-type regulation throughout the financlal sector, and also would place banking and nonbanklng competitors on a level playLng field.

However, these alleged advantages of **the** bank holding company
**7**

proposal have been subject to s*rious challenges. The most Lmportant of these challengas Le that lt may not be possLble to insulate banks from holdLng company problems. f **the** flrewalls develop cracks, most of the alleged advantages of the proposal would dLiappear. There are thr-- ways that holdLng company problems mlght spill over onto banks.

flrst, lf a holdLng company affliLatu fails, credLtors of the affillate might successfully **sue** the bank to honor **the** debts of lts afflILate. Such a court rullng li referred to as "pLercLng the corporate veil" and effectlvely nullifies **the** technlcal legal separatlon of affillated corporatLons.

The wllingness of courts to plerce the corporate veLl could vary conslderably from country to country, depanding on the laws of the varlous countrLes and how courts have chosen to interpret these laws over tlme. What can be said, however, is that courts in many countrles have been willing to pLerce the corporate vell under certaLn cLrcumstances. In partlcular, courts have permLtted piercing ln cases where the business a.efaLre of affillates have been extensively commLngled, the affiliates have operated or held themselves out to the public as a single entlty, or the polLcLes of the falled affillate were dlrected to the interest of survlvlng affillates, rather than to lts own interests.

Second, holding company problems may be transmitted to banks Ln the form of adverse transactLons. Even wlth lawc JeLigned to prevent such transactLons, banklng authoritles may not be able to prevent them in all cases. One reason le that examiners who would monitor these transactlons cannot be entlrely sure whether some transactLons are on terms that are entirely fair to the bank. For example, lt is difficult for an examiner to determlne whether the amount of management fees that the bank pays the holdlng company is approprlate for the
8 servicas rendered to the banks Likewise, iiithin a cartaln range, it is dlfflcult for an examlner to judge whether the tax payment that the bank makes to the holdlng company to cover the bank's share of the cunsolidttsd organization's tax llabillty is approprlate, or whether the bank,s operations have been manipulated ln varlous ways to maximize this ttnx payment.

in ads.tion to the problem, of effectively monitoring intercompany transactlono, it is poselble that desperate holdlng company management will knowlngly vlolate banking laws by forclng the bank to bail out a falling holding company affilLate. In banking, the pressurea to avoid a fai -re are great because banking is preeminently a reputation business.

The third way that holding company financlal problems could be tranumitted to the bank is through a loss of market confldence in the bank. This loss of confLdence might occur because deposltors closely identlfy the bank with the holding company. In other words, depoostors viow the entire bank holding company organization as a slngle entity, ignoring the fact that the organization actually is composed of a number of legally separate corporate ertltles.

There are a number of reasons why market participants may view the entire holding company organLzation as a single entity. One reason is that holding companies often try to project a single entity image through such devices as giving similar names to their various units. This device could capitalize on name recognltlon and the organization's favorable reputation in the marketplace. Another reason is that holding companles usually operate thelr organization as a single entity, rather than as a group of unrelated units. Market participants perceLve thli managerial approach and are in&iuenced by lt. Flnally, holding companies are likely to do most or all of their flnancial reporting on a consolidated basis. Thli practice tends to foster a slngle entity perception in
9 the marketplace. It also maker, it difficult for market participarnts to evaluate the financial condition of individual u-its in the holding company, including the bank.

Even if market participants were not conditioned to vlew bank holding companies as a oingle entity, they still might commence a run on the bank if an important holding company unit failed. One reason is that major units of holding companies usually are managed by essentially the same group of people. Consequently, if one holding company affiliate has been seriously mismanaged, it is not unreasonable for market participants to assume that other units in the organization, including the bank, may be in trouble too. Moreover, market participants might fear that the bank may be abused in a desperate attempt by holding company management to bail out the troubled affiliate.

As discussed earlier, one of the alleged aevantages of the holding company proposal is that it would avoid spreading bank-type regulation throughout much of the finpncial system. This contentlon rests on the assumption that banks, in fact, can be effectively insulated. If it is subsequently discovered that Jnoulation does not work, it is probable that the government would subject holding companies to bank-type regulation, thereby spreading this type of regulation to other areas of finance. In addition, if holding companied were subsequently subjected to bank-type regulation, another alleged advantage of the proposal -- the equal regulatory treatment of banking and nonbanking competitors -- would be eliminated.

Finally, it is alleged that the holding company proposal would promote competitive equ&lLty by removing banking organization's inherent funding advantage over nonbanking firms. It appears that this contention has been almost universally accephed in public policy discussimns. In fact, the argument is
10 oariously flawed. As discussed earlier, the funding advantage would presumably be eliminated because any bank funding of holding company affiliates would have to be on market terms. The crucial implicit assuzmption in the argument is that these alfiliates would then use this regulatory mandated cost of funds as the basis for setting _pricds_ for services offered the public. In fact, it is unlikely that the affiliate would use itz gwn cost of funds because this cost merely represents an internal transaction between two units in the same organization. Consequently, this cost figure would have no implications for the consol.dated organization and would not be used by a profit maximizing organization to set prices. Instead, the organization would use the bank's "subsidized* cost of funds, because this represents the consolidated organization's external borrowing cost. In final analysis, the only way that a banking organization's funding advantage can be removed is to prohibit the bank from funding affiliates, thereby forcing these affiliates to do their own funding in the marketplace, presumably at "nonsubsidized" market rates.

# VI. EMPIRICAL 3VID'NCE ON INSULATION

Whether banks can be effectively insulated from financial problems in holding companies is ultimately an empirical question. Unfortunately, there Is at present only very limited empirical evidence on this crucial issue. Flrst, there appears to be only one country -- the United States -- where banks have made a concerted effort to convert to the holding company form of organization in order to engage in a broader range of activitie than existing laws permit banks to conduct. Second, even though the holding company form of organization is pervasive in the American banking system, there have been very few real tests of the firewalls concept. One reason is that policymakers have placed fairly
11 strict limitations on the universal banking activities of holding companies. Consequently, these nonbank activities often are not large enough to cause serious problems for the consolidated organization. In addition, since the mid 1970s, holding company nonbar.king activities have been subjected to close supervision by the Federal Reserve. This supervision has tended to constrain risk taking, and probably has led to fewer financial problems than otherwise would have occurred.

However, there have been two cases in the United States that clearly tested the insulation concept. The first occurred in 1973 and involved a small bank holding company in California named Beverly Hills Bancorp. This holding company owned Beverly Hills National Bank, but also was involved in making commercial real estate loans that were funded by commercial paper. When one of the holding company's large borrowers defaulted, the holding company was unable to pay off its maturing commercial paper and was placed in bankruptcy. The adverse publicity that accompanied the bankruptcy, and the close public identification of the bank with the holding ccLpany, resulted in large scale runs on Beverly Hills National Bank. These runs required bank supervisors to merge this illiquid, but solvent, bank into another bank.

The second, and far more important, test occurred in 1975 and involved Hamilton Bankshares. This holding company owned Hamilton National Bank, one of the largest banks in the State of Tennessee. In the early 1970s under new, aggressive management, the holding company set up a mortgage banking company and proceeded to expand the company's operations very rapidly. Within a short period of time, the mortgage company had a large amount of nonperforming loans and was experiencing funding problems. In order to save the mortgage company, management arranged for Hamilton National Bank to buy a large amount of the troubled
12 mortgages. These transactions, which were in clear violation of existing banking laws, subsequently caused the bank to fail. At the time of the failure, Hamilton National Bank was the third largest bank failure in American history.

The Beverly Hills and Hamilton cases understandably have raised some degree of skepticism in the United States regarding the ability to insulate banks from holding company financial problems. Yet, it is important to recognize that both of these cases occurred about 15 years ago, and one involved a relatively insignificant bank. Consequently, while these cases lend some weight against the firewalls concept, they definitely do not constitute conclusive evidence.

There are several other aspects of the American experience with bank holding companies that are worth noting. First, in the two cases where the firewalls were tested, the firewalls cracked for different reasons. In the Beverly Hills case, the spillover effect took the form of a loss of market confidence in the bank. In the Hamilton case, the spillover effect involved massive adverse transactions. So far, there have been no cases where American banks have been "pierced" and forced to honor the debts of holding company affiliates. Moreover, there is almost universal agreement among lawyers, bank regulators and academics that courts in the United States are unlikely to pierce the corporate veil, except in extraordinary cases involving gross commingling of the business affairs of separately incorporated entities.

Second, it is instructive to note how the Federal Reserve, the supervisor of bank holding companies in the United States, reacted to the Beverly Hills and Hamilton failures. Prior to these failures, the Federal Reserve had relied largely on the market to discipline the financial affairs of bank holding companies and their nonbanking affiliates. Shortly after the failures, however, the Federal Reserve changed **its** policy and began to subject holding companies and
13 their nonbank affiliates to bank-type regulation, including on-site examinations, off-site surveillance and ertensive financial reporting (including reports on a wide variety of transactions bp,.ween holding company units and the bank). Mcreover, it appears that the Federal Reserve still does not have great faith in the iirewalls concept, because the Federal Reserve has continued to subject bank holding companies to strict bank-type regulation, even though there have been no known spillover problems since the mid 1970s.

Finally, there may be some marginal benefit in reflecting on the following statement relating to the insulation question that was made a few years ago by Walter Wriston, the former Chairman of Citicorp.

"It is inconceivable that any major bank would walk away from any subsidiary of its holding company. 1' your name is on the door, all of your capital funds are going to be behind it in the real world. Lawyers can say you have separation, but the marketp .lace is persuasive, and it would not see it that way."

# VII. OTHER PROPOSALS

While the basic bank holding company proposal conceivably could produce important public benefits, these benefits are crucially dependent on the ability to insulate banks from holding company financial problems. As indicated in the -ast two sections, there are certain reasons, as well as some limited empirical evidence, for doubting that insulation will actually work. Given this skepticism, two other proposals --both variants of the basic proposal -- have been developed. The better known variant is usually referred to as the failproof bank (or narrow bank) proposal. The other variant is known as the fails Financial Institutions Restructurina and Services Act of 1981, Hearings before **the** Senate Committee on Banking, Housing and Urban Affairs, 1981, pp. 58990.
14 proof parent proposal. Both proposals are designed to make insulation more effective than it would be in the basic bank holding company proposal.

Fail-Proof Bank Proposal The fail-proof bank proposal is essentially an extreme form of the basic bank holding company proposal previously discussed.<sup>6</sup> The fail-proof bank proposal would force banks to separate their traditional deposit issuing and lending functions. Once the proposal is implemented, banks would be confined to issuing deposits and investing in virtually risk-free assets, such as short-term government securities or perhaps high quality commercial paper. All previous bank activities that involved any meaningful degree of risk would be transferred to holding company affiliates. These affiliates also would do all of the future lending for the banking organization.

Under the proposal, banks would be required to closely match their asset and liability maturities to virtually eliminate interest rate risk. Moreover, banks would be prohibited from engaging in bond trading, :oreign exchange trading or conducting various off balance sheet activities. Banks also would be required to have a small amount of capital that would be sufficient to absorb any remaining, unavoidable risks. Any transactions between a fail-proof bank and its holding company affiliates would have to be on market terms, and examiners would closely monitor all intercompany transactions to make sure that the bank was not abused.

Because fail-proof banks would be virtually risk-free, the government could fully insure all bank deposits without exposing the government to any significant 6 rhe fail-proof bank proposal was originally eseloped<sup>4</sup> by Robert J. Lawrence, and was subsequently elaborated upon by Robert Litan in a Brookings Institution study. See Robert J. Lawrence, "Minimizing Regulation of the Financial Servlces Industry," Issues in Bank Requlation, (Summer 1985), pp. 2231; and Robert Litan, What Should Banks Do?, The Brookings Institution, 1987.
15 _loses,_ From a depositor's perspective, this insurance would constitute a strong second line of defense behind a virtually risk-free bank.

A final feature of the proposal is that holding company affiliates would not be subject to bank-type regulation. Instead, these affiliates would be disciplined solely by the market.

The great virtue of the fail-proof bank proposal **in** that it would give banks almost perfect insulation against holding company financial problems. First, the proposal would essentially eliminate any possibilty that the bank would be pierced. The reason is that the severe restrictions imposed on failproof banks would make it virtually impossLble for them to commingle their business affairs with those of their affiliates. Second, fail-proof banks would be exposed to only minimal risks of adverse transactions because the banks could not lend to affiliates and could purchase only virtually **risk-free** assets from affiliates. These two types of transactions are potentially the most dangerous ones that banks can have with affiliates. Third, and most important, fail-proof banks would not be threatened by a loss of market confidence if a holding company affiliate failed. The reason is that depositors would know that the bank was virtually risk-free and that their deposits **were** fully insured by the government. Moreover, in the extremely unlikely event that depositors lgnored these protections, the bank would be ln an excellent position to withstand a run. The bank's portfolio would be composed entirely of short-term assets that either would mature within a very short perLod, or could be sold at very little or no loss. Further, the bank would have **access** to the lender of last resort and would have a large portfolio of acceptable collateral.

**The** fall-proof bank proposal .iould mLnimize the amount of regulation of the banklng **system. As** stated above, there would be no need to regulate holding
16 company affiliates because banks would be almost perfectly insulated from holding company problems. In addition, the proposal wculd permit a substantial cutback in the existing regulation of banks. For example, the banking agencies would no longer have to revLew banks, loan portfolios, a partlcularly time consuming and expensive affair. Instead, the examination of fail-proof banks would be limited largely to determining whether the banks were in compliance with the special requirements for faLl-proof banks, whether any bank transactions with holding company affiliates were on market terms, and whether there had been any misappropriation of bank funds.

The fail-proof bank proposal also would get high marks in promoting competitive equality between banking organizations and their nonbanking rivals. First, by prohibiting banks from lending to affiliates and forcing these affiliates to do their own furding, the proposal would prevent banks from transferring their inherent funding advantage to their affliLates. Second, the proposal would subject holding company affiliates and nonbanking firms to the same degree of regulation. Under the proposal, holding company affiliates would not be subject to bank-type regulation. As a result, in those nonbanking actlvLties that are regulated, these affiliates would be supervised only by the traditional functional regulator, as would their nonbanking rivals. In those nonbanking activities that are not regulated, both holding company affiliates and theLr nonbanking rivals would be subject only to the discipline of the marketplace.

From the perspective of achieving public benefits from the transfor of risk within a banking organizatLon, the fail-proof bank proposal **is** clearly superior to **the** basic bank holding company proposal. **The** reason **is** that with the failproof bank prcjposal, public benefits are virtually **assured** becauso **the** effective
17 insulatLon of banks Lo basically guaranteed. By contrast, wLth the basic bank holding company proposal, public beneflts are problematic because the effective insulatLon of banks **is** in question.

If the fail-proof bank proposal can produce vLrtually assured, major public benefLts, why hasn't it been used? The answer is that its implementatlon might not be **feasible.?** First, the proposal would requir. a wrenchLng change in the structure and operation of the banking and fLnancLal system. Under the proposal, banks could, continue tco hold only a small portion of their exLstlng assets. Consequently, banks either would have to sell most of their assets in the open market or sell them internally to holding company affilLates. Both types of asset sales would produce major problems, particularly sLnce the entire banking system presumably would be selling assets at about the same time. Large asset sales in the open market would drive down market prices, thereby causing banks to incur capital losses. Large asset sales to holdlng company affiliates would require these affiliates to do a large amount of flnancing, thereby driving up thelr cost of funds.

Another problem is that there might not be enough virtually risk-free assets in existence for banks to hold. Indeed, there are probably few, if any, financlal systems in the world where the amount of virtually risk-free assets exceeds the amount of bank deposits. In this case, the only way that the proposal could be implemented would be to relax the requirement that banks hold virtually rlsk-free assets. If this were done, however, the basic character of the proposal changes from a fail-proof bank proposal to a "somewhat less than

> _7_ For a detailed discuseLon of why the fail-proof bank proposal may not **be** feasLble ln the United States, see Robert J. Lawrence and Samuel H. Talley, "Implementing a Fall-Proof Banking System," Proc-adina. of a Conferonce on Bank Strumture and Coetition, Federal **Roserve** Bank of ChLcago, May 1988, pp. 344-59.
18 fail-proof bank" proposal. And with **this** change, **the assurance** that banks will be totally lnoulated and that public beneflts will bo achieved begins to slip. in sum, the faLl-proof bank proposal Lnvolves an inevitable trade off between achieving public benefits and the feasibilLty of implementP- the proposal. FAil-Proof PArent Prgogal

**The** falL-proof parent proposal **iL** another variant of **the** basic bank holding company proposal, although a considerably less extreme **one** than the fail-proof bank proposal.<sup>8</sup> Like the **basic** proposal, **the** fail-proof paront proposal would require banking organizations to transfer relatively risky activities (but not all activities involving risk) from the bank to the holding company. However, unlike the basic proposal, which would allow **these** rlskier activities to be conducted either in the parent company or nonbank subsidiaries of the parent, the fail-proof Farent proposal would require these actLvities to be conducted only in nonbank affiliates. The reason is to assure that the parent company would not fail as the result of sustaLning large operating losses. Another major feature of the proposal is to prohibit the parent company from losuLng debt. This provision would assure that the parent would not fail because it could not service its debt obllgations.

The proposal also would prohibit banks from engaging in most types of transactLons with holding company affiliates, such as lending or the purchase of assets. Only transactions that are essential, *uch as paying dividends and ' The fail-proof parent proposal was originally developed by staff of the Federal Reserve Board in the mid 1970s. The proposal was presented for consideration by the Board in 1975, but **was** not implemented. For a discussion of the-proposal, see Robert J. Lawrence and Samuel H. Talley, "An Alternative Approach to Regulating Bank Holding Companies," Proceedinas of a Conference on Bank Structure an C2mnetiion, Federal Reserve Bank of Chicago, 1978, pp. 1-10. For a more recent discussion, see Robert J. Lawrence, "Holding companies and Deregulation," Proceedins of a Conference on Dank Struture nd Competition, Federal **Reserve** Bank of Chicago, 1983, pp. 39-52.
19 making tax payments to the parent, would be permitted, and theeo would be subject to close oversight by bank supervisors to prevent any abuse of the bank.

It should be noted that under the fail-proof parent proposal, nonbank affiliates probably would do most of their own funding. However, the parent company could issue stock and use dividend income to fund these affiliates. Also, the holding company could set up a financLng subsidiary that could raLse funds for the nonbank affiLiates. ThLi procedure could centrallze funding for the entire nonbanking part of the holding company organization, thereby exploitlng any economies of scale that might be involved.

Under the fail-proof parent proposal, nonbank affLILates would not be regulated and supervlsed by banking authorities. Instead, these affiliLates would be subject only to the diseipiLne of the marketplace.

The crucLal asumptLons underlying the fall-proof parent propooal are: (i) it makes a differenca where risky activities are conducted in the holding company structural and (LL) it L better for these activlties to be conducted in nonbank subsLdlarles of the parent than ln the parent company ltself. The reason is that the failure of a nonbe k affiliate L likely to have a signifLcantly less adverse effect on market psychology, and would be less likely to cause a loos of public confldence ln the bank, than would the failure of the parent. In a holding company organLzatLon, the parent is a partleularly important entlty. It is the top tler of the organLzatLon and, even more $mportant, lt ls the entity whose stock is held by the public. aLven these factors, lt ls hard to imagLne that the fallure of the parent would not Lnflict severe reputatLon damage on the bank. By contrast, a nonbank affiliate **li** only a branch ln the holdlng company structure, and lts stock ls not held by the public. Consequently, the failure of a nonbank affliLate probably would not lnflict **as** much reputation damage on
20 the bank. Moreover, if the parent company is debt free, the failure of a nonbank affiliate would not cause the failure of the parent, and the continued existence of the highly visible parent should help to sustain public confidence ln the bank.

In addition to giving banks greater insulation, the fall-proof parent proposal ham several other desirable features. First, by not subjecting holding company affiliates to regulation by the banking authorities, it would not spread bank-type regulation throughout the financial sector or result in regulatory duplication. Second, the proposal would promote competitive equality between banking and nonbanking rivals: (i) by subjecting them to sLmilar regulation; and (ii) by removing the inherent funding advantage of banking organizations by prohibiting banks from lending to their nonbank affiliates.

# VIII. CONCLUSION

_This_ paper has dealt with the question whether it would be deairable to conduct universal banking activities (or at least those that are relatively risky) in bank holding companies, rather than directly in banks. Stated differently, from a publie policy perspective, does it make any sense to encourage or force the transfer of risk among units of a banking organization? The major conclusions of thu study are as follows:

1. The **use** of **the** bank holdlng company devlce for conducting universal banking activities holds out the promise of important public benefits. These beneflts includes (l) a sounder commercSal banking system; (Li) a redu-tIon in banking regulation; and (lii) greater competitlve equality between banking and nonbanking units. However, **theme benefits** are critlcally dependent on the abillty to Lnoulate banks from future problems that might arise in holdlng
21 company **affiliates. There are** three bailc ways that holdlng company problems could bo transoLtted to banks (L) through piercLng the corporate veill (LL) through adverse transactLonug and (LLL) through a loss of market confLdence ln the bank. **The** fLrat two spillover effects would Lnflict losses on the bank and erode the bank' capital. The thLrd would result in the bank experlenclng liquldlty problems that mlght force the bank to sell assets at a loss.

2. At present, **there** is no conclusive empLrLcal evidence on whether banks can be offectLvely lnoulated from holding company flnancial problems. Bank holdlng companles have been used extensively as a devlce for conductLng unLvereal banklng actlvLtLes ln only one country, **the** UnLted States, and tha evldence from that country la very llmlted. In those two cases where holdLng company affillaues experLenced major fLnancLal trouble, the problems dld spill over onto the bank and caused the bank to fail.

3. Public polLcymakers can do much to prevent banks from bolng pLerced by requLrLng banks not to commLngle thelr business affairs wlth holdLng company affliLates. Likewise, polLcymakers can mlnlmize the likelihood of banks being forced lnto adverse transactLons by: prohlbitlng all bank transactLons wlth affillates except those that are eseentLal (such as paying dLvldends and taxes to rhe parent company)t havLng bank supervisors closely monltor these essentLal transactlons to assure that the bank is not abused; and imposing stiff penalties for vlolatilng rulae governlng bank transactions with afflilates.

4. it is much harder to prevent a **loss** of market confidence ln a bank if holdlng company affillates get into trouble. In thli event, deposLtors are likely to commence a run on the bank because they typlcally do not have detalled lnformatlon on the condition of the bank, and they **are** aware that *esentLally the same people usually manage both the holding company and the bank. Consequently,
22 depositors **are likely** to play lt **safe** and assume that if the holdLg company **iL** in trouble, **the** bank **way be** ln trouble too.

S. One way to vlrtually **eliminate** the poslbility that holding company problems would lead to bank runs lo to requlre banks to **be** fall-proof. However, the **process of** convertlng banks lnto fail-proof lnstltutLons would probably result ln unacceptable shocks to the flnancial **system.** A **loess extreme** proposal that would reduce, but not **eliminate, the** prospect of bank runs would requires (ij universal banklng activltles to be conducted ln nonbank **subsidlarles** of the parent company, rather than dlrectly in the parent; and (Li) the parent company to be debt-free (or at least lowly leveraged). wlth these requlrements, bank runs would be less llkely because the hlghly veisble parent company would survlve.

6. While a major objectlve of having unlversal banklng actlvities conducted ln holding companles is to preserve banklng stabllity, lt is possible that lt could have the opposlte effect. The major rlsk is that policymakers wlll assume that the flrewall. protectlng banks are imprognable and allow holding companies to engage ln hlghly risky actlvlties that pol-cymakers would never conslder permitting banks to conduct. If holdlng company affiliates subsequently encountered serious problems and lt turns out that tho flr6walls have cracks, banks could be serlously harmed. It also should be recognlzed that having unlversal banklng actlvltles ln holdlng companles could concentrate specific types of rlske in a number of lndividual holdlng company afflilates, rather than havlng a wide dlversification of risks ln one unit, the bank.