WASHINGTON -- When the Supreme Court returns to the bench Oct. 7, it will step into the middle of a long-running dispute over whether the Federal Reserve Board can require bank holding companies to pump up ailing subsidiary banks.

The bone of contention is a Fed regulation, known informally as the agency's "source of strength" doctrine, requiring holding companies "to use available resources to provide adequate capital to subsidiary banks during periods of financial stress or adversity."

The regulation was struck down on May 15, 1990, by the U.S. Court of Appeals for the Fifth Circuit, which ruled in a case brought by the Dallas-based holding company MCorp that the regulation exceeded the Fed's statutory authority.

The Supreme Court earlier this year agreed to review the appellate court's decision, and the case -- Board of Governors of the Federal Reserve System v. MCorp Financial Inc. -- is slated to be the second dispute argued before the high court when it begins its 1991-1992 term.

The rule, formally adopted in 1984 and clarified in 1987, has been controversial from the outset.

The Federal Deposit Insurance Corp., for example, hs been a strident detractor of the rule, with now departing Chairman L. William Seidman arguing it could unintentionally limit the flow of new capital into the banking industry.

In testimony before the House Banking Committee last year, Mr. Seidman said that repeated enforcement of the rule "would reduce market efficiency, restrain the ability of banks to be viable competitors in the financial marketplace, and limit the ability to obtain new capital for the banking industry."

But the Fed maintains that the regulation helps ensure the banking industry is adequately capitalized. Capital is money put into an institution by a bank's owners and shareholders, who in theory want to protect their investments. These investors then serve as watchdogs to minimize the likelihood of a bank engaging in speculative activities.

The MCorp case arose in 1988, when the Fed ordered the holding company to transfer about $400 million of its assets to subsidiary banks. MCorp never complied, and 20 of the firm's 25 subsidiary banks eventually failed. They were then seized by the FDIC and sold to BancOne Corp. of Columbus.

MCorp filed for bankruptcy and sought an injunction barring the Fed from taking further enforcement actions against the firm.

The U.S. District Court for the Southern District of Texas ruled the Fed no longer had authority over MCorp because the firm had been "entrusted to the authority of the bankruptcy court."

The U.S. Court of Appeals for the Fifth Circuit went futher, ruling that the Fed exceeded its statutory authority when it tried to make MCorp funnel money into its troubled banks.

The appellate court said the Fed's regulation "can hardly be considered a 'generally accepted standard of prudent operation,'" and held that the rule "would amount to a wasting of the holding company's assets in violation of its duty to shareholders."

The ruling was a rare rebuff to the Fed, which generally wins cases challenging its interpretation of banking statutes. Particularly where the laws are vague, courts usually defer to the agencies entrusted with implementing the statutes.

A case in point is the securities industry's failed challenge to the Fed's interpretation of the Glass-Steagall Act, which generally prohibits the integration of investment and commercial banking activities. The Fed nevertheless decided that bank holding companies could establish securities subsidiaries so long as the units limited their activities in bank-ineligible debt, and the U.S. Court of Appeals for the Second Circuit sided with the central bank in a 1988 ruling.

But the Fed may be on more shaky ground in the MCorp case. Pointing to various provisions of the Bank Holding Company Act of 1956, the Financial Institutions Supervisory Act of 1966, the International Lending Supervision Act of 1983, and the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, the Fed has concluded it has authority to impose its source of strength rule.

However, the fact that authority is not expressly authorized in any of the statutes could prove to be the Achille's heel of the Fed's case. During its last term, which ended in June, the high court consistently took a literal approach to statutory interpretation, ruling it would not find authority for actions unless specifically provided for in the law.

The court's review of the matter comes as Congress considers sweeping bank reform legislation. Versions on both sides of Capitol Hill would specifically require cross guarantees among financial subsidiaries of holding companies, but they differ in their particulars. However, the legislation faces an uphill fight, and passage is far from certain.

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