• Financial Holding Companies: Pros and Cons
  • May 2, 2003 | Author: Karen L. Grandstrand
  • Law Firm: Fredrikson & Byron, P.A. - Minneapolis Office
  • Before forming a financial holding company ("FHC") as allowed by the Gramm-Leach-Bliley Act, do a careful assessment of the benefits and risks of this new form of financial entity. An FHC allows expansion into nonbanking activities previously prohibited for banking organizations, but it may present capital, enforcement, and regulatory oversight risks.

    The Gramm-Leach-Bliley Act enables a bank holding company ("BHC") that qualifies as an FHC to engage in nonbanking activities that are financial in nature, incidental to financial activities, and complementary. Thus, the law allows affiliations between banks, insurance companies, and securities firms. FHCs can now engage in securities underwriting, provide a full range of insurance products without geographic and other limitations, and engage in merchant banking. Over time, the Federal Reserve will expand this list, thereby widening the gap between BHCs and FHCs.

    FHCs have been in existence only since March. However, over 430 BHCs have elected to become FHCs. Almost 75% of these FHCs have assets of less than $1 billion, and roughly a quarter of them are under $150 million. Many are not currently using the FHC structure to enter new lines of business but have "warehoused" the authority in case they wish to use it in the future.

    The primary reasons for forming an FHC are to expand into new activities and to offer current activities in a more streamlined, less restricted manner. The FHC structure allows a banking organization to engage in nonbanking activities to the fullest extent allowed by law.

    Most banking organizations assume that forming an FHC has no downsides. This may not necessarily be the case. Before forming an FHC, an organization should consider three potential risks.

    The first risk relates to capital requirements. The Federal Reserve System, the primary regulator of FHCs, is currently reviewing whether all FHCs should be subject to consolidated capital requirements. Currently, BHCs under $150 million are not subject to such requirements.

    The second risk concerns enforcement actions. If an FHC's depository institutions fail to maintain their well-capitalized and well-managed status (requirements that must be met to form an FHC), the FHC will receive a notice from the Federal Reserve and will have 45 days in which to execute an agreement with the Federal Reserve on corrective action. The Federal Reserve is given broad powers to limit the conduct or activities of the FHC or any of its affiliates. Continued noncompliance can even result in forced divestiture of an FHC's banks.

    The third risk relates to supervisory examinations and inspections. Over the past several years, the Federal Reserve has established a separate oversight program for small shell BHCs. Under this program, such companies are subject to significantly less on-site supervision. Because FHCs by definition are not "shells" or "noncomplex," the Federal Reserve is currently deciding how best to monitor them. They will likely be subject to greater supervision than small BHCs.

    Banking organizations should not avoid forming FHCs simply because of the risks noted above. These risks may be small compared to the benefits of the structure. However, banking organizations should evaluate all structural options and pick the one best-suited to the organization's current and future business plans.