Section 606 of the Dodd-Frank Act adds a standard for bank holding companies that elect to become, or already are, financial holding companies.
In order for a bank holding company, or BHC, to choose or maintain FHC status, it not only must certify that its bank subsidiaries are well capitalized and well managed and have satisfactory CRA ratings but also must be deemed well capitalized and well managed.
The Federal Reserve lists more than 500 BHCs in the country whose choices to become or be treated as FHCs have taken effect. In the current enforcement environment, many community BHC boards of directors would be well advised to re-examine the decision to choose FHC status.
Why did so many community BHCs rush to elect FHC status after the Gramm-Leach-Bliley Act? GLB, which was enacted primarily to allow the cross-ownership of banking, securities and insurance companies through FHCs, also allowed FHCs to engage without prior approval in new activities that were "financial in nature" or incidental or complementary to such activities.
Several years after GLB was enacted in 1999, a Federal Reserve report found that, other than insurance agency purchases, few of the more than 450 FHCs with assets under $1 billion had used any new GLB powers.
That appears to remain true at present, in part perhaps because few new activities have been given the designation as financial in nature.
FHC status was initially viewed as validating a BHC as a strong competitor and suggested a regulatory blessing as well, though few community BHCs had plans to exercise any new GLB power when they chose FHC status.
This same lack of motivation was apparent when many community BHCs, which now seek to repay Tarp capital as soon as possible and to be released from its constraints, initially sought Tarp capital without having made specific plans for lending out the money.
What is the harm of having elected FHC status?
The downside of unnecessarily getting FHC status first appeared when banks saw their composite and management Camels ratings slide to "less than satisfactory," as asset-quality and other problems were identified by banking regulators in the early days of what became a tsunami of enforcement actions.
When an FHC falls under the strictures of an enforcement action, it is required by Federal Reserve Regulation Y to enter into a "cure agreement" with the central bank within 45 days and to regain well-capitalized and well-managed status within 180 days thereafter unless an extension is granted.
There are draconian potential consequences in Regulation Y if an FHC cannot return to well-capitalized and well-managed status within 180 days.
It must cease or divest any activities engaged in or acquisitions made through the use of FHC authority, or the Federal Reserve can order the BHC to divest its bank subsidiary.
Since raising capital in the current environment has proven slow and difficult for many BHCs, and since it generally takes at least one or two examination cycles before a regulatory enforcement action can be terminated and Camels grades of 3 and 4 can be upgraded, cure agreements often cannot be satisfied as quickly as Regulation Y contemplates.
Thus, in practice, cure agreements usually require extensions and become little more than an additional supervisory burden that can distract management and directors from tending to the subsidiary bank's core problems.
Though the new Section 606 reflects the intent of Dodd-Frank to mitigate risks to financial stability and impose heightened capital and other prudential standards, its requirements are somewhat ironic.
BHCs tend to mirror their subsidiary bank's capital and supervisory ratings. Furthermore, commonly, soon after a community bank's composite and management ratings are downgraded, it is deemed to be in "troubled condition" or receives an enforcement action, the Federal Reserve will notify the BHC that its ratings are accordingly being trimmed, and therefore the BHC is also considered "troubled," and a parallel enforcement order is issued.
Dodd-Frank's Section 606 is therefore principally important as a reminder to many community BHCs to consider whether they have any reason to be an FHC.
There was no decertification process when the Federal Reserve first observed that FHC status was unnecessary for many community BHCs and posed a supervisory challenge when examination ratings began to decline.
However, if an FHC has not used any GLB authority, it may submit a letter electing to forgo FHC status. It may also be possible, with Federal Reserve concurrence, to restructure over a longer period certain subsidiaries or financial activities that required FHC status.
Nonbanking activities previously authorized for BHCs by the Federal Reserve remain available to BHCs with or without FHC status. State and national banks also may engage in most financial activities through finance subsidiaries if the bank is and remains well capitalized and well managed.