Many contributors helped bring about the most recent financial crisis, bank holding companies among them. The problems with bank holding companies stem less from lax rules or weak enforcement than from the way they are structured.
Bank holding companies are currently structured as financial malls of “shops” offering financial intermediations: brokerage, underwriting, mutual and trust funds, insurance, a securitization machine, custody services and a bank. In regular malls, each store is owned and regulated separately. Customers and investors determine a shop’s success and failure. By contrast, bank holding companies own all of the mall’s shops and collect their revenues. Their top management teams reward the shops’ executives and employees.
This structure creates two big problems. First, large bank holding companies defy effective management. They are complex and act globally, making it hard for management to control risky transactions. Management must also act under conflicting pressures. On one hand, they are expected to limit risk in order to protect government-insured deposits. On the other, they are expected to perform for investors and generate higher revenues, which might involve taking on more risk.
The structure of large bank holding companies also defies effective regulation. The shops’ regulators, and the policies of those regulators, differ. The objective of the Securities and Exchange Commission is to protect investors by requiring companies to provide proper disclosures and abide by fiduciary duties, rather than to ensure the safety and soundness of the intermediaries. By contrast, bank regulators are less concerned with protecting investors than with bank safety and soundness and protecting the Federal Deposit Insurance Corp. and depositors. The raging debate about whether bank holding companies should be allowed to trade securities on their own accounts demonstrates the issue.
What should be done to protect the country from the risks taken by the large bank holding companies? I propose that we allow shareholders of each subsidiary, or shop in the mall, to choose its management and judge its performance. The banking holding company would become a servicer to its subsidiaries, thereby maintaining the benefits of the current system while reducing inefficient, risky behavior.
Breaking up bank holding companies into their unique services would allow for more effective management, risk controls, innovations and profitable services, facilitating market regulation. Each subsidiary would also be regulated in accordance with its form of services. If collaboration among the units was beneficial (such as combining services or offering a full-service package), the collaboration would be facilitated and legalized.
Restructuring holding companies this way would reduce the power concentration their management and regulators hold over any other financial services in the mall. The services would have to raise funds in the markets and enable the markets, rather than the holding companies, to decide which businesses perform best.
Skeptics might argue that business lines currently ensconced in bank holding companies might not survive as stand-alone entities, and that their failure could in turn raise borrowing costs. Yet there are 1,352 stand-alone U.S. banks, and some of them are doing quite well—better than the colossus holding companies. If certain subsidiaries fail, there is no threat to the entire financial system
Others might ask if dismantling bank holding companies is necessary so long as risks are appropriately segregated within subsidiaries. But the truth is that most rules are not as effective as sound structure; self-interest and habits are often stronger than restrictive rules. Without a structural change supported by market pressures, the chances are that bankers' interactions, favoritism and fixed beliefs will overcome regulation.
We should not wait for bank holding companies to pose danger to the financial system or fail at an enormous cost to shareholders and the country before implementing the proposed structure. This can be done with minimal legal changes or government interference. Major shareholders can demand restructuring, while some entrepreneurial bank managers might break off to form new, more prosperous holding companies that operate under the new system.
To be sure, bank holding companies are shrinking—but they are not restructuring as they should. Hopefully, leaders in the banking industry will reconsider and choose the restructuring road.
Tamar Frankel is a law professor and Michaels research scholar at Boston University School of Law. A full version of this article was published in Bank & Financial Services Policy Report, Vol. 32, No. 7, July 2013.