What's Happening?
Research by Nicola Cetorelli of the Federal Reserve Bank of New York and Shohini Kundu of UCLA Anderson reveals that U.S. bank holding companies are meeting Basel III capital requirements for their regulated bank subsidiaries by transferring equity from
their nonbank subsidiaries. This practice, termed 'regulatory arbitrage,' allows holding companies to avoid the expensive route of issuing new stock. After Basel III implementation in 2015, bank subsidiaries reported a 5-8 percentage point increase in excess capital. However, this gain is achieved by siphoning equity from less-regulated or unregulated affiliates, thereby weakening the capital position of these nonbank entities. The study, which analyzed data from 2010 to 2024, indicates that these equity transfers are approximately ten times larger than other internal funding methods. Nonbank subsidiaries, which constitute about 25% of all assets held by U.S. nonbanks and are present in nearly half of all bank holding companies, are also subjected to increased dividend extraction and higher interest rates for internal funding, further draining their resources.
Why It's Important?
This practice has significant implications for the stability of the U.S. financial system. While regulated bank subsidiaries appear safer on paper due to increased capital, the overall capital cushion of the parent bank holding company does not necessarily improve. By weakening nonbank subsidiaries, holding companies create a potential vulnerability. These nonbank entities, often involved in riskier consumer loans, do not have federal backstops like deposit insurance, and holding companies are not legally obligated to bail them out if they face trouble. However, there is a market expectation that parents would intervene due to reputational concerns and the risk of broader financial contagion. A stress test modeled on 2008-scale losses suggests that covering nonbank subsidiary losses could deplete about 18% of holding companies' excess capital, and for the most vulnerable 4-6% of holding companies, it could wipe out all their excess capital, indicating meaningful systemic fragility during a crisis.
What's Next?
The findings suggest a need for regulators to consider the entire organizational structure of bank holding companies, rather than focusing solely on regulated bank subsidiaries. The researchers highlight that regulatory requirements can be met without achieving the underlying goal of those regulations if different parts of an organization fall under varying oversight. This could prompt discussions among policymakers and financial regulators about potential adjustments to capital requirements or oversight mechanisms to ensure that the overall financial system remains robust. The continued reliance on nonbank subsidiaries for capital transfers and their shift towards riskier loans could lead to increased scrutiny and potentially new regulations aimed at strengthening the capital positions of these entities and preventing systemic risks.
Beyond the Headlines
The study uncovers a deeper issue regarding regulatory effectiveness and the unintended consequences of financial regulations. It demonstrates how complex organizational structures within the banking sector can be exploited for 'regulatory arbitrage,' where the letter of the law is met, but its spirit is circumvented. This raises ethical questions about the responsibility of bank holding companies to maintain the financial health of all their subsidiaries, not just those under strict regulatory scrutiny. The shift of nonbank subsidiaries towards riskier consumer loans due to weakened balance sheets also has societal implications, potentially exposing more consumers to higher-risk lending practices. This highlights the ongoing challenge for regulators to create comprehensive frameworks that account for the intricate and evolving nature of financial institutions and prevent the creation of new vulnerabilities within the system.
