SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 21)

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Bank Holding Companies and Financial Holding Companies

by

Charles Lamson

When we hear the name Johnson & Johnson many of us probably think of baby powder, shampoo, and Band-Aids. These are major products associated with the J&J brand name. In fact, J&J is a conglomerate, producing numerous other products through its many subsidiaries, including Tylenol, surgical instruments, sausage casings, toys, tranquilizers, and contraceptives. In other words, J&J is a company that owns and operates many firms that produce a wide variety of products.

A bank holding company is a corporation that owns several firms, at least one of which is a bank. The remaining firms are engaged in activities that are closely related to banking. If the holding company owns one bank, it is called a one-bank holding company. If it owns more than one, it is called, not surprisingly, a multibank holding company.

Many banks organize themselves into holding companies, because they expect this organizational form to be more profitable than a simple bank would be. More specifically, this corporate form allows banks (1) to circumvent restrictions on branching, and thus, seek out sources and uses of funds in other geographical markets, and (2) to diversify into other product areas, thus providing the public with a wider array of financial services, while reducing the risk associated with limiting operations to traditional banking services.

Thus, organizing as a bank holding company allowed banks to effectively circumvent prohibitions on intrastate and interstate branching, which have now become virtually eliminated, and to participate in activities that otherwise would be barred. Such activities include data processing, leasing, investment counseling, and servicing out of state loans.

Perhaps even more dramatic than the conversion of large banks to bank holding companies is the ongoing trend for bank holding companies to convert to financial holding companies. Under the Gramm-Leach-Bliley Act (GLBA) of 1999, bank holding companies, securities firms, insurance companies, and other financial institutions can affiliate under common ownership to form financial holding companies. A financial holding company can offer their customers a complete range of financial services, many of which were previously prohibited. These activities include:

• securities underwriting and dealing
• insurance agency and underwriting activities
• merchant banking activities
• any other activity that the Fed determines to be financial in nature or incidental to financial activities.
• any nonfinancial activity that the Fed determines is complementary to the financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or to the financial system

Merchant banking is the making of direct equity investments (purchasing stock) in start-up or growing nonfinancial businesses. Under GLBA, financial holding companies will be able to own up to 100 percent of commercial, nonfinancial businesses as long as ownership is for investment purposes only, the financial holding company is not involved in the day-to-day management of the company, and the investment is for 10 years or less. Prior to this law, bank holding companies could own only 5 percent of a commercial company directly and up to 49 percent through certain subsidiaries.

To become a financial holding company, bank holding companies that meet certain criteria must file a declaration with the Federal Reserve. The declaration must certify that, among other things, all the bank holding company's depository institution subsidiaries are well capitalized and well managed.

To summarize, banks, under the holding company corporate umbrella, have been expanding the geographical areas they serve and the array of financial services they offer to the public. Bank holding companies may also apply to become financial holding companies if they meet certain criteria. Under the financial holding company status, bank holding companies, insurance companies, and securities firms can affiliate under common ownership. In addition, financial holding companies can engage in an even broader array of financial and nonfinancial services than bank holding companies can. The expansion by banks into areas traditionally served by other more specialized FIs (financial institutions) has been matched by other FIs and other nonfinancial institutions expanding into areas traditionally served mainly by banks, such as the checkable deposits offered by S&Ls and the credit cards offered by General Motors.

*THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 260-262*

END