Forming a Bank Holding Company

Forming a Bank Holding Company - Structure, Governance, and Regulations

Understanding Banks

Forming and Expanding a Bank Holding Company

Financial Holding Company Requirements

BHC Regulations

Capital Building Options for Bank Holding Companies

Pros and Cons of Forming a Bank Holding Company

Stocks and Governance

Corporate Governance and Banking Law

The Role of Bank and Holding Company Audit Committees

Data Gathering Method

Database of Study

Summary, Conclusions and Recommendations

Forming a Bank Holding Company - Structure, Governance, and Regulations

This research paper describes the process of forming a bank holding company in the United States. The behavior of a bank holding company is strongly linked to the success of the banks it holds. Therefore, if business leaders can pinpoint how to set up a successful holding structure, they may have a better chance of successfully progressing their business.

Chapter 1 - Introduction

Statement of the Problem

Over the past few decades, the banking industry has undergone some difficult economic times. In the 1980s, banks were failing, and capital was scarce (Kolveit and Owens, 2000). However, today's industry reports relatively high profitability, and capital is more widely available. Many banks face the challenge of growing fast enough to leverage the increased capital generated by earnings.

Bank holding companies that qualify as S corporations can manage capital levels by paying significant amounts of current income as dividends to their shareholders (Kolveit and Owens, 2000). This can be a positive alternative for many banks. However, the current limitations make this alternative impossible for many community banks. Banks and bank holding companies with excessive capital that cannot elect S corporation status have limited choices. They can: (1) continue to hold capital and increase capital levels; (2) distribute capital as taxable dividends; (3) buy a bank or bank-related business; or (4) some combination of all of these.

The challenge of appropriately leveraging capital is ongoing for all banks. Banks seeking high returns on assets often find it difficult to leverage capital, because adding incremental loans and deposits with lower interest margins reduces return on assets, even though return on equity increases. Consequently, return on equity is likely to become a more common measure of success than return on assets. Thus, forming a bank holding company seems to be an excellent option for institutions with an abundance of capital.

However, according to experts, one of the most common mistakes made by institutions is forming holding companies prematurely (Dalton, 1997). Many community banks are eager to acquire, buy back company stock or boost earnings per share. Still, many also fail to do their homework on the subject.

Purpose and Importance of the Study number of institutions are forming holding companies prematurely," said John Carusone, president of the Hartford, Conn.-based Bank Analysis Center Inc. (Dalton, 1997). "If it's tied to expansion or stock buy back, it can work, but otherwise it can be very labor-intensive and expensive. A lot of banks are jumping in when they shouldn't."

The holding company structure, under which the bank becomes the subsidiary, offers flexibility and tax advantages, but also brings more regulation, expense and red tape. The holding company also can be used as a way to buy community banks, while preserving the historic community bank names.

In this light, it can be beneficial to form a holding company, and in a healthy economy, it can be an excellent business strategy, but only if it is done for the right reasons. "A lot of banks feel their stock is undervalued in the market, but they should think long and hard before buying back stock," according to Carusone (Dalton, 1997).

Many community banks and thrifts form holding companies as part of cash management strategies. When an industry has a great deal of capital, one way to manage growth is to repurchase stock, and current tax laws make it nearly impossible for a bank to buy back its own stock without forming a holding company.

Basically, repurchasing stock has two purposes. First of all, it enables a bank to improve return on equity, a key ratio used by analysts. Second, a buyback lessens the number of shares in circulation without affecting a company's earnings, so earnings per share increase.

The earnings per share ratio (EPS) has several implications. According to Dalton (1997), "Thrifts' stock usually sells for 10 times EPS, therefore, boosting EPS can nudge stock prices up to increase shareholder value. If another bank buys a thrift, the stock usually is valued at about 15 times EPS. In this case, increasing EPS can drive up the acquisition price and possibly hold off an unwanted merger." On the other hand, tax laws prevent a bank from acquiring another financial institution for two years after buying back stock, so their opportunity to acquire is reduced.

Implemented another way, forming a holding company can ease acquisitions. The parent company can hold several banks as subsidiaries without having to merge them or change their names.

In the face of the large bank mergers, the holding company structure enables smaller banks to expand without giving up their greatest assets -- their community name and identity. "It can be an attractive way to facilitate a merger as the community banks are staking out their turf," according to Carusone (Dalton, 1997).

For example, in 1995, Lexington Savings Bank and Waltham-based The Federal Savings Bank jointly formed a holding company, Affiliated Community Bancorp Inc. The holding company, now the parent of both banks, then bought Newton-based Middlesex Bank & Trust Co. Each of the three banks, and any subsequent acquisitions by Affiliated, has its own board of directors and president. They were able to both preserve localness and grow.

This study will examine the positive and negative aspects of forming a bank holding company. By reviewing existing literature and conducting an empirical study, the author aims to provide recommendations about the structure and governance of bank holding companies to help interested parties determine the best way to form a bank holding company.

Scope of the Study

Assumptions affect the scope of the study by describing the factors that were believed to be true to interpret and validate the results. Limitations describe factors excluded from the study by choice or circumstances.

Assumptions

The following conditions were assumed to be true:

The sample drawn for the study is of sufficient size to provide valid and comprehensive questionnaire responses for this type of project.

The professionals surveyed in the study completed the questionnaire accurately and honestly.

The data requested was interpreted in an objective manner that were beneficial to institutions forming bank holding companies.

Limitations of the Study

The study and questionnaire were limited only to those professionals who had been involved in the process of forming a bank holding company.

The clientele used in the questionnaire process were chosen from press releases, white papers and research papers discussing bank holding companies.

The results of the study were based solely on the response created from the questionnaire. Each response was that of a professional who had been involved in some aspect of forming a bank holding company. The responses were that of each respondent's personal opinion about the topics discussed.

Rationale of the Study

The study is conducted to provide rational basis for forming a bank holding company. The study thoroughly examines existing literature and solicits the opinions of professionals to reveal a series of conclusions and recommendations regarding the process of forming a bank holding company.

Definition of Terms bank holding company is an entity whose principal business purpose is holding shares of stock in a bank. If the holding company is a corporation, the holding company is itself owned by the holders of its stock.

Bank holding companies exercise control over and provide additional support to banks in the form of management and monetary resources. In addition, following enactment of the Gramm-Leach-Bliley Act, a bank holding company may elect to become a financial holding company in order to participate in a broad range of financial activities, including securities underwriting, insurance sales and underwriting, and merchant banking. The top ten United States bank holding companies are listed below.

Table 1 -- TOP TEN U.S. BANK HOLDING COMPANIES, 2002 ($ http://www.financialservicesfacts.org/img/pxl.gif http://www.financialservicesfacts.org/img/pxl.gif

Assets

Citigroup Inc.

J.P. Morgan Chase & Co.

Bank of America Corporation

Wells Fargo & Company

Wachovia Corporation

Bank One Corporation

Taunus Corporation

Fleetboston Financial Corporation

U.S. Bancorp

ABN AMRO North America Holding Company

1) Ranked by assets.

Source: Board of Governors of the Federal Reserve System.

SOURCE -- U.S. Small Business Corporation. (2003). Financial Services Fact Book. Financial Services Fact Books.

Overview of the Study

This research paper describes the process of forming a bank holding company in the United States. The behavior of a bank holding company is strongly linked to the success of the banks it holds. Therefore, if business leaders can pinpoint how to set up a successful holding structure, they may have a better chance of successfully progressing their business.

Chapter 2 - Literature Review

Understanding Banks

Because there are so many misconceptions as to the definition of bank mergers and acquisitions, it is important to understand certain terms in order to fully understand how to form a bank holding company. The following terms are often heard in the banking world:

Merge-to unite: to lose identity by being absorbed or combined;

Merger: combining two or more companies into one;

Bank Merger: consolidations of two or more banks' charters (there are two types of mergers).

Bank-Bank Mergers: the mergers are between existing banks (interbank mergers).

Acquisition: Gaining, or acquiring by one's own efforts. In banking terms: acquisitions are a transaction in which the banks retain their separate charters.

One example of the Bank-to-Bank merger would be the Nations Bank and Bank of America merger, in which the two separate companies merged to form one. The other, more common type of merger, which is known as the Bank-Nonbank Merger, involves the merger of a commercial bank and securities firm under a bank holding company. An example of this type of merger would be the Citicorp and Travelers merger into Citigroup.

The policies for bank mergers and acquisitions have been a major part of economical success and growth that raise the living standards of the United States. In this light, the growth of bank mergers and acquisitions is related to its legislation, to move away from competition and the relaxation of branching restrictions.

The United States has also set itself apart from other nations by having thousands of smaller and independently owned banks, rather than the major financial institutions with many branch offices. One unique characteristic of the U.S. is that there is a major legal atmosphere that envelops banking to prevent banks from branching out and reducing competition.

In the U.S., the first successful banks were state banks. Chartered by state authorities, state banks were allowed to issue their own distinct banknotes under a single bank charter. This provided a monopolizing power over state banks and loyalty to the local banker. The introduction of bank branching added power by carrying over there bank charter to separate offices.

It is important to understand that there is a difference between merging and branching. Branching is a part or extension of a company -- a distantly located office of a business, which functions with the same company goal and providing the same services. The laws were considered in keeping branches from spreading outside of state.

It was not until the Bank of the United States (1791), that a national chartered bank was introduced, mostly to create a government note and issue a national debt all proposed by the government. The government's plan was to have a national debt kept perpetual, to keep the rich financiers in the U.S. To become creditors they would receive interest therefore keeping them loyal and dependent on the national government. The Bank of the U.S. was the only bank to branch across state lines that automatically caused opposition from the monopolizing state chartered banks.

Even though the charter expired in 20 years, the agreement was that any bank with too much financial power should be monitored. This caused many states to limit branching both across and within their state borders; many states even outlawed branches, closing down all branches to have only one office. In addition, the charter of the Bank of the U.S. was not renewed until 1816 for a lifespan of 20 years again. However, before this charter ended, the government killed the renewal of the charter with the Bank Veto and War bill. The government funds were pulled out and placed in state banks before the national charter ended in hopes of driving national banks out of business. This started a time of little supervision, called the Free Banking Era. Many banks were free to open anywhere, causing fraudulent scandals over bank notes and a lot of banks failed due to remote head offices.

These problems -- bank failure and fraudulent bank notes -- were rectified by the National Banking Act of 1863, which stated that federal governments could charter national banks and issue a more uniform currency, bank notes that were fully backed. Because of this act, national banks were required to back their banknotes with interest bearing federal government bonds. Therefore, in case of a national bank failure, the bond on deposit would repay the noteholder. This act also created the Controller of the Currency, a department of the U.S. Treasury, which gave the Comptroller of the Currency primary supervisory control of the national banks.

This act gave birth to the national banking system with federally chartered banks. This gave the states the power to limit branching within their borders. This prevented banks from expanding the amount of bank notes in circulation that caused the money supply to decrease. State bank notes were then taxed in order to drive state chartered banks out of business. However, this only made state banks more competitive with the invention of demand deposit accounts or checking accounts. This is another reason the U.S. is different from other countries because of this dual banking system. Banks were supervised side-by-side creating a balance of competition.

The next step toward the supervision of companies that own one or more banks or incorporate their different services was under the Federal Reserve Act. Under this act, lawmakers considered a central bank to safe guard and protect against panics or large bank failures. In 1913, the Federal Reserve Act created the Federal Reserve System, consisting of 12 federal reserve district banks and a Board of Governors to directly monitor banks and monitor bank policies. The Board of Governors approves bank mergers and retain the veto power over district banks choices.

All national banks had to become members of the Federal Reserve System and state banks had the choice to become members. National banks were chartered and supervised by the Comptroller of Currency. The Federal Reserve system is independent of any government agencies, only held accountable to Congress. This means there is no checks and balance of power, operating on its own with no budget that needs to be submitted. To have political independence of a central bank is good though, to avoid favoritism to any political party, platform, or consideration. This helped to create a competitive environment.

According to the McFadden Act of 1927, national banks were not allowed to operate outside of their home states and had to obey state regulations governing intrastate branching. Banks were able to get around this act by the introduction of the bank holding company. The bank holding company is not a bank itself but a corporation that is able to acquire a bank located in another state and operate it as a completely owned subsidiary.

In order to prevent this expansion of power, the legislation passed the Bank Holding Company Act of 1956. In the requirements, expansion was up to the state law to permit interstate acquisitions. Second of all, banking and commerce were to be separated by restricting the companies to banking and closely related activities. Now the Federal Reserve got sole regulatory responsibilities of bankholding companies and for a company to become a bank holding company, they must gain approval. In addition, the act enabled existing banks to retain their bank holding companies. Finally, the act defined bank as an institution that recognizes demand deposits and makes loans. This caused controversy over the word "and" which created nonbanks, which accepted deposits but did not make loans, and then nonbank offices, which made loans but did not accept deposits.

As the number of bank holding companies and mergers grew, the fear of monopolies became an imminent danger. To prevent this rise, the legislation pushed for the Bank Merger Act of 1960 that asked for applications of the acquisition be approved by the Federal Reserve Bank in the district of the takeover. This meant that the surviving bank's location would be under the jurisdiction of one of the twelve reserve banks, and the responsible reserve bank would request the other banking institutions' effect of the merger and their completive factors. Focusing on these things, the criteria for evaluating the merger application were made.

The criteria consisted of the financial and organizational assets, the prospects of the new institution, and the convenience and needs of the community it would serve. The Federal Reserve would only approve the merger if it does not lessen competition and create a monopoly unless its effects are beneficial to the community regarding the convenience and the needs of the community. Later in 1977, the Federal Reserve were also given the reporting on bank institutions' small business lending and community involvement under the Community Reinvestment Act. This is important because the merger approval process required further analysis of mergers.

In 1982, the Depository Institutions Act (Garn-St.Germain) gave the Federal Deposit Insurance Company (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC) emergency powers to merge banks and thrifts across state lines. Finally in 1994, The Riegal-Neal Interstate Banking and Branching Efficiency Act eliminated the restrictions from interstate banking. The act would repeal the Mcfadden Act of 1927 of interstate banking and the National Banking Act of 1863 concerning branching within state borders. So after June 1, 1997, holding companies will be allowed to merge banks into branches of a single interstate bank. The United States will have a nationwide banking system and interstate banking through branching.

U.S. bank mergers and acquisitions were a guarantee for banks going under that they could still offer services under new management (to create better benefits for customers and business firms). Banks could be linked to direct markets and create relationships between financial intermediaries such as commercial banks, life insurance companies, savings and loans institutions, mutual savings banks, and money market mutual funds. Together, these mergers or acquisitions form larger companies that can share resources, gain financial expertise, have better access to financial markets, cut transaction costs, offer more services, and increase convenience on consumers. All these mergings and acquisitions eliminate geographic restrictions on banking, to drive out inefficient banks and create a more efficient banking system. This is most apparent today with the reduction of banks and the growing rise in mergers and acquisitions. The policies for bank mergers and acquisitions have been a key part of economical success and growth that raise the living standards of the U.S.

Forming and Expanding a Bank Holding Company

In order to form or expand a bank holding company, there are many steps that must be followed (Bankers Online, 2003). A company that proposes to: become a bank holding company, acquire a subsidiary bank, or acquire control of bank or bank holding company securities must apply for prior approval under section 3 of the Bank Holding Company Act.

However, certain transactions may qualify for prior notice procedures (Bankers Online, 2003). The formation of a one-bank holding company usually qualifies for prior notice if the proposal meets the criteria described in the Bank Holding Company Act. In addition, an existing bank holding company proposing to acquire five percent or more of an additional bank or bank holding company or to merge with another bank holding company may provide prior notice to the Federal Reserve if the proposal meets the criteria in the Bank Holding Company Act. For formation or acquisition proposals not qualifying for one of the prior notice procedures (or for organizations otherwise directed by the Federal Reserve to do so), a company must file an application for prior Federal Reserve approval.

When applying to form a bank holding company, an applicant must also publish a notice in the local newspaper. The Federal Reserve publishes a notice in the Federal Register for proposals submitted under special conditions.

The notice period under section 225.17 expires 30 calendar days after the Federal Reserve receives the notice (Bankers Online, 2003). The notice period under section 225.14 expires up to five business days after the close of the public comment period unless the Federal Reserve extends the period. The Federal Reserve normally acts on an application under section 225.15 within 30 calendar days after receipt or within 5 business days after the close of the public comment period unless the Federal Reserve notifies the applicant that the period is being extended. Applications that require review or action by the Board are typically acted upon within 60 days after receipt unless the Federal Reserve notifies the applicant that the period is being extended.

For formation or acquisition proposals, the Federal Reserve would consider the factors in section 225.13 of Regulation Y (Bankers Online, 2003). Formation proposals under section 225.17 may be consummated immediately. Formation or acquisition proposals under sections 225.14 or 225.15 may not be consummated for 30 calendar days after action by the Federal Reserve unless the Department of Justice authorizes a waiting period of 15 calendar days. Normally a 15-day waiting period is authorized. Authority to consummate any of the transactions would expire three months from the earliest date on which the transaction could have been consummated unless extended by the Federal Reserve. The consummation period may not be extended beyond one calendar year from the date the application was approved by the Federal Reserve.

Basically, a company elects to become a financial holding company in the following ways (Bankers Online, 2003):

a) "Filing requirement. A bank holding company may elect to become a financial holding company by filing a written declaration with the appropriate Reserve Bank. A declaration by a bank holding company is considered to be filed on the date that all information required by paragraph (b) of this section is received by the appropriate Reserve Bank.

(b) Contents of declaration. To be deemed complete, a declaration must:

1) State that the bank holding company elects to be a financial holding company;

2) Provide the name and head office address of the bank holding company and of each depository institution controlled by the bank holding company;

3) Certify that each depository institution controlled by the bank holding company is well capitalized as of the date the bank holding company submits its declaration;

4) Provide the capital ratios as of the close of the previous quarter for all relevant capital measures, as defined in section 38 of the Federal Deposit Insurance Act (12 U.S.C. 1831o), for each depository institution controlled by the company on the date the company submits its declaration; and

5) Certify that each depository institution controlled by the company is well managed as of the date the company submits its declaration.

- Effectiveness of election. An election by a bank holding company to become a financial holding company shall not be effective if, during the period provided in paragraph (e) of this section, the Board finds that, as of the date the declaration was filed with the appropriate Reserve Bank:

1) Any insured depository institution controlled by the bank holding company (except an institution excluded under paragraph (d) of this section) has not achieved at least a rating of "satisfactory record of meeting community credit needs" under the Community Reinvestment Act at the institution's most recent examination; or

2) Any depository institution controlled by the bank holding company is not both well capitalized and well managed.

(d) Consideration of the CRA performance of a recently acquired insured depository institution. Except as provided in paragraph (f) of this section, an insured depository institution will be excluded for purposes of the review of the Community Reinvestment Act rating provisions of paragraph -(1) of this section if:

1) The bank holding company acquired the insured depository institution during the 12-month period preceding the filing of an election under paragraph (a) of this section;

2) The bank holding company has submitted an affirmative plan to the appropriate Federal banking agency for the institution to take actions necessary for the institution to achieve at least a rating of "satisfactory record of meeting community credit needs" under the Community Reinvestment Act at the next examination of the institution; and

3) The appropriate Federal banking agency for the institution has accepted the plan described in paragraph (d)(2) of this section.

(e) Effective date of election -- (1) In general. An election filed by a bank holding company under paragraph (a) of this section is effective on the 31st calendar day after the date that a complete declaration was filed with the appropriate Reserve Bank, unless the Board notifies the bank holding company prior to that time that the election is ineffective.

2) Earlier notification that an election is effective. The Board or the appropriate Reserve Bank may notify a bank holding company that its election to become a financial holding company is effective prior to the 31st day after the date that a complete declaration was filed with the appropriate Reserve Bank. Such a notification must be in writing.

(f) Requests to become a financial holding company submitted as part of an application to become a bank holding company -- (1) In general. A company that is not a bank holding company and has applied for the Board's approval to become a bank holding company under section 3(a)(1) of the BHC Act (12 U.S.C. 1842(a)(1)) may as part of that application submit a request to become a financial holding company.

2) Contents of request. A request to become a financial holding company submitted as part of an application to become a bank holding company must:

i) State that the company seeks to become a financial holding company on consummation of its proposal to become a bank holding company; and ii) Certify that each depository institution that would be controlled by the company on consummation of its proposal to become a bank holding company will be both well capitalized and well managed as of the date the company consummates the proposal.

3) Request becomes a declaration and an effective election on date of consummation of bank holding company proposal. A complete request submitted by a company under this paragraph (f) becomes a complete declaration by a bank holding company for purposes of section 4(l) of the BHC Act (12 U.S.C. 1843(l)) and becomes an effective election for purposes of 225.81(b) on the date that the company lawfully consummates its proposal under section 3 of the BHC Act (12 U.S.C. 1842), unless the Board notifies the company at any time prior to consummation of the proposal and that:

i) Any depository institution that would be controlled by the company on consummation of the proposal will not be both well capitalized and well managed on the date of consummation; or ii) Any insured depository institution that would be controlled by the company on consummation of the proposal has not achieved at least a rating of "satisfactory record of meeting community credit needs" under the Community Reinvestment Act at the institution's most recent examination.

(4) Limited exclusion for recently acquired institutions not available. Unless the Board determines otherwise, an insured depository institution that is controlled or would be controlled by the company as part of its proposal to become a bank holding company may not be excluded for purposes of evaluating the Community Reinvestment Act criterion described in this paragraph or in paragraph (d) of this section.

(g) Board's authority to exercise supervisory authority over a financial holding company. An effective election to become a financial holding company does not in any way limit the Board's statutory authority under the BHC Act, the Federal Deposit Insurance Act, or any other relevant Federal statute to take appropriate action, including imposing supervisory limitations, restrictions, or prohibitions on the activities and acquisitions of a bank holding company that has elected to become a financial holding company, or enforcing compliance with applicable law."

Under the Bank Holding Company Act of 1956, a company cannot become a bank holding company without the prior approval of the Federal Reserve Board (Clodfelter, 2003). In acting on an application to become a bank holding company, the Board must assess the financial and managerial resources and future prospects of the company. A bank holding company cannot engage in any activity other than managing or controlling banks or activities authorized in the Act. Authorized activities are specified in the Federal Reserve Board's Regulation Y, and include lending, leasing, trust activities, financial and investment advisory activities, securities activities and insurance activities.

A bank holding company may engage in activities directly or indirectly through a subsidiary. American bank holding companies are subject to regulation and supervision by the Board, including capital adequacy requirements, as soon as they acquire control of a bank.

The Board defines "financial institution" as "any financial intermediary or other enterprise that is authorized to do business and regulated or supervised as a financial institution under the law of the Party in whose territory it is located (Clodfelter, 2003)." Under U.S. law, U.S. bank holding companies meet all aspects of the definition.

Because a U.S. bank holding company (which is regulated and supervised by the Federal Reserve Board) is permitted to provide financial services to the public, it is a "financial intermediary (Clodfelter, 2003)." This fact in itself establishes that U.S. bank holding companies are "financial institutions" under the definition in the Act.

Also, U.S. bank holding companies are required to meet other aspects of the definition of "financial institution" (Clodfelter, 2003): They are "other enterprise[s]... authorized to do business and regulated or supervised as a financial institution under the law of the Party in whose territory it is located" - or regulated as a financial institution.

Whether a particular enterprise is regulated as a financial institution must be determined on a case-by-case basis. However, a regulated enterprise is not a "financial institution" because it issues debt securities, engages in limited borrowing for the purpose of acquiring shares of banks or other financial institutions, or holds shares of a bank or other financial institution.

U.S. bank holding company becomes subject to supervision and regulation by the Federal Reserve Board as soon as it acquires control of a bank through share acquisition or otherwise.

Statutes in the financial services area generally do not use the term "financial institution," although there are statutes that contain definitions for this term. The U.S. notes that under U.S. law there is no comprehensive, universally applicable definition of "financial intermediary."

According to Clodfelter (2003), 'A non-exhaustive list of relevant factors, no one or set of which is necessarily dispositive, to consider in determining whether an enterprise is regulated as a financial institution includes the following:

whether and the extent to which the business or assets of the enterprise are devoted to financial services, whether intermediation services or others, such as investment and financial advisory activities or merger and acquisition advisory activities;

whether the enterprise is subject to capital requirements or regulation beyond those applicable to companies generally;

whether, and the extent to which, the enterprise is supervised or regulated by the financial authorities as opposed to other regulatory bodies;

whether the purpose of the regulation or supervision is based on or consistent with the prudential reasons referenced in Article 1410(1).

Each of the above factors establishes that U.S. bank holding companies are "authorized to do business and regulated or supervised as a financial institution under" U.S. law (Clodfelter, 2003). Under the Bank Holding Company Act, a U.S. bank holding company is authorized to engage directly in financial service activities and is considered to be engaged indirectly in the activities of its subsidiaries. U.S. bank holding companies are subject to specific capital requirements. The Federal Reserve Board, an agency whose responsibilities deal with the financial sector, regulates and supervises activities of a U.S. bank holding company. And the purpose of the Board's supervision and regulation is firmly grounded in the prudential reasons identified in Article 1410(1). U.S. bank holding companies therefore are "financial institutions" within the meaning of Article 1416."

Financial authorities in the United States include, but are not limited to, the Commodity Futures Trading Commission; the Department of the Treasury; the Federal Reserve Board; the Federal Deposit Insurance Corporation; the National Credit Union Administration; the Office of the Comptroller of the Currency; the Office of Thrift Supervision; the Securities and Exchange Commission; state banking departments and superintendents; state insurance commissioners; and state boards of administration of pension funds.

That Article provides in pertinent part as follows (Clodfelter, 2003):

1. Nothing in this Part shall be construed to prevent a Party from adopting or maintaining reasonable measures for prudential reasons, such as:

a) the protection of investors, depositors, financial market participants, policy-holders, policy-claimants, or persons to whom a fiduciary duty is owed by a financial institution or cross-border financial service provider;

b) the maintenance of the safety, soundness, integrity or financial responsibility of financial institutions or cross-border financial service providers; and ensuring the integrity and stability of a Party's financial system.

Holding companies under the laws of other Parties may differ from bank holding companies under U.S. law, as may be the case with respect to the laws that apply to such companies.

Financial Holding Company Requirements financial holding company is a bank holding company that meets the requirements of this section (Bankers Online, 2003).

Requirements to be a financial holding company:

In order to be a financial holding company:

1) All depository institutions controlled by the bank holding company must be and remain well capitalized;

2) All depository institutions controlled by the bank holding company must be and remain well managed; and

3) The bank holding company must have made an effective election to become a financial holding company.

Requirements for foreign banks that are or are owned by bank holding companies:

1) Foreign banks with U.S. branches or agencies that also own U.S. banks. A foreign bank that is a bank holding company and that operates a branch or agency or owns or controls a commercial lending company in the United States must comply with the requirements of this section, 225.82, and 225.90 through 225.92 in order to be a financial holding company. After it becomes a financial holding company, a foreign bank described in this paragraph will be subject to the provisions of 225.83, 225.84, 225.93, and 225.94.

(2) Bank holding companies that own foreign banks with U.S. branches or agencies. A bank holding company that owns a foreign bank that operates a branch or agency or owns or controls a commercial lending company in the United States must comply with the requirements of this section, 225.82, and 225.90 through 225.92 in order to be a financial holding company. After it becomes a financial holding company, a bank holding company described in this paragraph will be subject to the provisions of 225.83, 225.84, 225.93, and 225.94.

BHC Regulations

All domestic business corporations or foreign corporations, which are engaged exclusively in buying, selling, dealing in, or holding securities for their own behalf and not brokers, except securities of a corporation defined as a DISC, and are regulated bank holding companies under the Federal Internal Revenue Code, and which either apply to the commissioner to be classified as a security corporation before the end of the taxable year and are so classified, or have been so classified by the commissioner for a prior taxable year, must pay an excise equal to thirty-three one hundredths per cent of the gross income, as defined in section thirty of this chapter, received by such corporation during the taxable year or two hundred and twenty-eight dollars, whichever is greater (Kidder, 1998).

To qualify for treatment under 38B (b), then, a corporation must meet three requirements. First, it must engage "exclusively" in buying, selling, dealing in, or holding securities (other than securities of a DISC) on its own behalf. Second, it must qualify as a regulated bank holding company under the Internal Revenue Code. Third, the Commissioner must have classified the corporation as a "security corporation (Kidder, 1998)."

Section 38B (b) refers to the Internal Revenue Code in defining what qualifies as a "bank holding company (Kidder, 1998)." Code 1103(a) defines "bank holding company" as one within the meaning of the Bank Holding Company Act, 12 U.S.C. 1841 et seq. Under the Bank Holding Company Act, a bank holding company is recognized as a company that has power over 25% of a bank's voting securities or controls the election of a majority of the bank's directors or trustees or is found to have a controlling influence over the bank's management or policies.

The federal statute therefore requires a bank holding company to have the power to control a bank's (or another bank holding company's) activities, even though it may not necessarily exercise that control.

Additionally, the Bank Holding Company Act does not dictate what a bank holding company must do; however, it restricts what a bank holding company may do. According to the Board of Governors of the Federal Reserve System (Kidder, 1998), a bank holding company has an obligation to "serve as a source of financial and managerial strength to its subsidiary banks and shall not conduct its operation in an unsafe or unsound manner."

Bank holding companies are expected to serve as a source of strength for their subsidiary banks. When bank holding companies acquire debt and depend upon the earnings of their subsidiary banks as the means of repaying such debt, the probable effect upon the financial condition of the company and its subsidiary bank or banks becomes an issue.

A high level of debt at the parent holding company level impairs the ability of a bank holding company to financially assist its subsidiary bank and, in some cases, the servicing requirements on such debt may drain the bank's resources (Kidder, 1998). For these reasons, the use of acquisition debt in the formation of bank holding companies is unfavorable. Still, the transfer of ownership of small banks often requires the use of acquisition debt. Thus, the formation of small one-bank holding companies with debt levels higher than would be permitted for larger or multi-bank holding companies may be acceptable. Approval of these applications may be given on the condition that the small one-bank holding companies show the ability to service the acquisition debt without straining the capital of their subsidiary bank and that such companies restore their ability to serve as a source of strength for their subsidiary bank relatively quickly.

In an effort to further its policy of aid the transfer of ownership in banks without weakening bank safety and soundness, the Board has simplified the analytical framework and financial criteria it applies when considering the formation of small one-bank holding companies and has adopted certain revisions in its procedures and standards as described below.

This specific criteria shifts the focus from debt repayment to the relationship between debt and equity at the parent holding company (Kidder, 1998). The holding company has the option of improving the relationship of debt to equity by repaying the principal amount of its debt or through the retention of earnings, or both. Under these procedures, newly organized small one-bank holding companies are expected to reduce the relationship of their debt to equity over a reasonable period of time to a level comparable to that maintained by many large and multi-bank holding companies.

Typically, this policy is intended to apply only to one-bank holding companies that would not have significant leveraged non-bank activities and whose subsidiary bank would have total assets of approximately $150 million or less when the application is filed (Kidder, 1998). Small one-bank holding companies formed before the effective date of this policy may switch to a plan that adheres to the intent of this policy if they comply with the criteria listed below.

The criteria are as follows (Kidder, 1998):

General. In evaluating applications filed pursuant to Section 3(a)(1) of the Bank Holding Company Act, as amended, when the applicant intends to incur debt to finance the acquisition of a small bank, the Board will take into account a full range of financial and other information, including the recent trend and stability of earnings of the bank, the past and prospective growth of the bank, the quality of the bank's assets, the ability of the applicant to meet debt servicing requirements without placing an undue strain on the bank's resources, and the record and competency of management of the applicant and the bank. In addition, the Board will require applicants to meet the minimum requirements set forth below. As a general rule, failure to meet any of these requirements will result in denial of the application; however, the Board reserves the right to make exceptions if the circumstances warrant.

1. Minimum Down Payment. The amount of acquisition debt should not exceed 75% of the purchase price of the bank to be acquired. When the owner(s) of the holding company incur debt to finance the purchase of the bank, such debt will be considered acquisition debt even though it does not represent an obligation of the bank holding company, unless the owner(s) can demonstrate that such debt can be serviced without reliance on the resources of the bank or bank holding company.

2. Maintenance of Adequate Capital. An applicant proposing to use acquisition debt must demonstrate to the satisfaction of the Board that any debt servicing requirements to which the bank holding company may be subject would not cause the subsidiary bank's ratio of gross capital to assets to fall below 8% during the 12-year period following consummation of the acquisition. Gross capital is defined as the sum of total stockholders' equity, the allowance for possible loan losses, and subordinated capital notes and debentures.

3. Reduction in Parent Company Leverage. The applicant must demonstrate to the satisfaction of the Board that the parent holding company's ratio of debt to equity will decline to 30% within 12 years after consummation of the acquisition. The holding company must also demonstrate that it will be able to safely meet debt servicing and other requirements imposed by its creditors.

The term "debt," as used in the ratio of debt to equity, means any borrowed funds (exclusive of short-term borrowings that arise out of current transactions, the proceeds of which are used for current transactions), and any securities issued by, or obligations of, the holding company that are the functional equivalent of borrowed funds.

The term "equity," as used in the ratio of debt to equity, means the total stockholders' equity of the bank holding company adjusted to reflect the periodic amortization of "goodwill" (defined as the excess of cost of any acquired company over the sum of the amounts assigned to identifiable assets acquired, less liabilities assumed) in accordance with generally accepted accounting principles. In determining the total amount of stockholders' equity, the bank holding company should account for its investments in the common stock of subsidiaries by the equity method of accounting.

Ordinarily the Board does not view redeemable preferred stock as a substitute for common stock in a one-bank holding company formation. Nevertheless, to a limited degree and under certain circumstances the Board will consider redeemable preferred stock as equity in the capital accounts of the holding company if the following conditions are met: 1) the preferred stock is redeemable only at the option of the issuer and 2) the debt to equity ratio of the holding company would be at or remain below 30% following the redemption or retirement of any preferred stock. Preferred stock that is convertible into common stock of the holding company may be treated as equity.

4. Dividend Restrictions. The bank holding company is not expected to pay any corporate dividends on common stock until such time as its debt to equity ratio is below 30%. However, some dividends may be permitted provided all of the following conditions are met: a) the applicant has begun making scheduled repayments of principal on the acquisition debt; b) such scheduled repayments of principal are reasonable in amount, will be made at least annually, and will allow for the retirement of the acquisition debt over a period not to exceed 25 years; and c) the applicant can clearly demonstrate at the time the application is filed that such dividends will not jeopardize the ability of the holding company to reduce its debt to equity ratio to 30% within 12 years of consummation of the proposal or cause the gross capital to assets of the subsidiary bank to fall below 8% over the same period. Also, it is expected that dividends will be eliminated if the holding company is not meeting the projections made at the time the application was filed regarding the ability of the holding company to reduce the debt to equity ratio to 30% within 12 years of consummation of the proposal." major principle underlying the Federal Reserve's supervision and regulation of bank holding companies is that bank holding companies assume a role as sources of financial and managerial strength to their subsidiary banks. It is the policy of the Board that a bank holding company should be ready to use its resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks in a manner consistent with the provisions of this policy statement.

Since the enactment of the Bank Holding Company Act in 1956, the Board has formally stated on numerous occasions that a bank holding company have an obligation to serve as a source of financial and managerial strength to its subsidiary banks. As the Supreme Court stated in the 1978 First Lincolnwood decision, Congress supports the Board's long-standing view that a holding company must serve as a "source of strength to subsidiary financial institutions." (According to Kidder, 1998): "In addition to frequent pronouncements over the years and the 1978 Supreme Court decision, this principle has been incorporated explicitly in Regulation Y since 1983. In particular, 225.4(a)(1) of Regulation Y provides that:

1. A bank holding company shall serve as a source of financial and managerial strength to its subsidiary banks and shall not conduct its operations in an unsafe or unsound manner.

2. The important public policy interest in the support provided by a bank holding company to its subsidiary banks is based upon the fact that, in acquiring a commercial bank, a bank holding company derives certain benefits at the corporate level that result, in part, from the ownership of an institution that can issue federally insured deposits and has access to Federal Reserve credit.

3. The existence of the federal "safety net" reflects important governmental concerns regarding the critical fiduciary responsibilities of depository institutions as custodians of depositors' funds and their strategic role within our economy as operators of the payments system and impartial providers of credit. Thus, in seeking the advantages flowing from the ownership of a commercial bank, bank holding companies have an obligation to serve as sources of strength and support to their subsidiary banks."

One of the major determinants of a bank's financial strength is the competence of its capital base (Kidder, 1998). Capital provides a bumper for individual banking organizations to absorb losses in times of financial strain, promotes the safety of depositors' funds, helps to maintain confidence in the banking system, and supports the reasonable expansion of banking organizations as an essential element of a strong and growing economy. A strong capital defense also limits the exposure of the federal deposit insurance fund to losses experienced by banking institutions. For these reasons, the Board considers adequate capital to be critical to the solidity of individual banking organizations and to the safety and stability of banking and financial systems.

For these reasons, it is the Board's policy that a bank holding company should not withhold financial support from a subsidiary bank in a weakened or failing condition if holding company is in a position to support it. A bank holding company's failure to assist a troubled or failing subsidiary bank under these circumstances is typically viewed as an unsafe and unsound banking practice or a violation of Regulation Y or both. If necessary, the Board will take supervisory action to require such assistance. Finally, the Board understands that there may be unusual circumstances where flexible application of its principles might be necessary, and the Board may choose to identify situations that may justify exceptions to the policy.

According to Kidder (1998): "A bank holding company's failure to meet its obligation to serve as a source of strength to its subsidiary bank(s), including an unwillingness to provide appropriate assistance to a troubled or failing bank, will generally be considered an unsafe and unsound banking practice or a violation of Regulation Y, or both, particularly if appropriate resources are on hand or are available to the bank holding company on a reasonable basis. Consequently, such a failure will generally result in the issuance of a cease-and-desist order or other enforcement action as authorized under banking law and as deemed appropriate under the circumstances."

Capital Building Options for Bank Holding Companies

Banks and bank holding companies are always in need of additional capital for many reasons (Harris, 2002):

to meet regulatory guidelines; increase lending limits; finance acquisitions; invest in new branches; purchase new equipment and technology; obtain and enhance the interest of community and business leaders in the business of the bank; cash out shareholders; and assistant the next generation of owners in paying estate taxes.

In the past, bank holding companies were limited to two choices when raising capital (Harris, 2002):

selling additional equity in the holding company or bank; and borrowing money at the holding company level and investing it in the bank.

However, today, bank holding companies have a new option for capital that "combines the best of equity and debt, giving bank holding companies the additional capital they need, but providing significant tax advantages and avoiding dilution."

According to Harris (2002), the simplest form of capital is common stock. Common stock produces cash, creates additional Tier 1 capital and s a widely understood concept by potential purchasers. However, there are disadvantages involved with raising capital through the sale of common stock. Potential purchasers are often reluctant to buy a minority interest in a company without the promise of dividends, the ability to exit the investment and protections regarding corporate governance issues. Additionally, following the new investment, existing shareholders are required to share the future growth in value of the bank holding company with the new investors. Also, dividend payments are not deductible by the bank holding company for tax purposes.

Preferred stock as many of the advantages of common stock. It also has additional pros and cons. Most investors are familiar with preferred stock and due to its flexibility, bank holding companies can give investors the rights and assurances that they demand. For example, they can pay dividends -- on either a cumulative or non-cumulative basis. Cumulative preferred stock requires that accrued but unpaid dividends from previous years must be distributed before other classes of stock receive dividends. Noncumulative dividends are forfeited after the year they are accrued passes.

For bank holding companies, no more than 25% of Tier 1 capital may consist of cumulative preferred stock. However, there is no limitation to the amount of noncumulative preferred stock included in Tier 1 capital, even though the Federal Reserve has specifically stated that bank holding companies should not overly rely on preferred stock.

According to Harris (2002): "The chief advantage that debt has over equity is that interest payments to the holders of debt are deductible by the bank holding company for tax purposes. In addition, except in unusual cases, holders of debt have no share in the future growth in value of the bank holding company. But, debt at the bank holding company will not constitute capital for regulatory purposes. Thus while borrowings generate cash and the interest payments thereon are deductible, the benefits of increased regulatory capital are not achieved." recent innovation involves the combination of the best features of equity and debt. Known by many names, including tax advantaged preferred securities (TAPS), trust preferred securities (TRUPS) and many more, these hybrid instruments combine the capital enhancing element of preferred stock with the tax advantage of debt.

As much as 25% of Tier 1 capital may include a combination of preferred stock and these hybrid instruments (Harris, 2002). In addition, the bank holding company can forge a tax deduction for the interest payments made on this hybrid. Finally, the holders of these hybrids have no share in the future growth in the value of the bank holding company, and the securities do not disqualify the institution from electing a corporation status. Due to these advantages, many institutions are using these hybrid securities to expand their capital. These hybrids provide a way for bank holding companies to enjoy the benefits of both debt and equity.

Pros and Cons of Forming a Bank Holding Company is a corporation that owns enough voting stock in another corporation to influence its board of directors and control its policies and management. A holding company does not have to own a majority of the shares of its subsidiaries or be engaged in similar activities. However, to gain the benefits of tax consolidation, which include tax-free dividends to the parent and the ability to share operating losses, the holding company must own 80% or more of the subsidiary's voting stock.

Among the advantages of a holding company as opposed to a merger as an approach to expansion are:

the ability to control sizeable operations with fractional ownership and commensurately small investment;

the somewhat theoretical ability to take risks through subsidiaries with liability limited to the subsidiary corporation; and the ability to expand through unobtrusive purchases of stock, instead of having to obtain the approval of another company's shareholders.

Among the disadvantages of a holding company are:

partial multiple taxation when less than 80% of a subsidiary is owned, plus other special state and local taxes;

the risk of forced divestiture (it is easier to force dissolution of a holding company than to separate merged operations); and the risks of negative leverage effects in excessive pyramids.

Stocks and Governance recent study by Adams and Mehran (2003) compared a range of variables, or characteristics, shown by bank holding companies (BHCs) and manufacturing firms to reveal how governance structures differ between firms in regulated and unregulated industries.The authors identified important differences in the characteristics, which they attributed to the investment patterns of the two types of firms and to the presence of regulation in the banking industry.

The differences observed enhance those found by other studies comparing manufacturing firms with insurance industry firms or with public utilities firms. Accordingly, Adams and Mehran's results support the argument that governance structures are industry-specific and suggest that governance reforms, to be effective, should account for industry differences.

A slew of recent corporate scandals have driven regulators, creditors, shareholders, and academics to focus more on the corporate decision-making process and propose changes in governance structures aimed at enhancing accountability and efficiency (Adams and Mehran, 2003). To the extent that the proposals are based on academic research, they often draw upon a large body of studies on the governance of firms in unregulated, non-financial industries. Financial institutions, however, are extremely different from firms in unregulated industries, such as manufacturing firms. Therefore, it is important to consider whether proposals and reforms can also be effective in enhancing the governance of financial institutions.

One major theory in the governance literature holds that board structure, ownership structure, and compensation structure are determined by one another, as well as by a range of variables, including risk, real and financial assets, cash flow, firm size, and regulation (Adams and Mehran, 2003). These variables may influence a firm's conduct and performance. While many studies have examined these complex governance relationships in unregulated firms, few have focused on institutions in a regulated environment.

Adams and Mehran incorporated this environment into their study of corporate governance characteristics. They described the differences and similarities in the characteristics of regulated bank holding companies and unregulated manufacturing firms, and considered the effect of regulation on banking firm behavior. Because many typical external governance mechanisms, including the threat of hostile takeovers, are absent from the banking industry, the researchers focused on internal governance structures and shareholder block ownership.

The study sample consisted of thirty-five bank holding companies over the 1986-96 period. For these institutions, Adams and Mehran constructed governance variables identified by researchers and practitioners in law, economics, organization, and management as key variables correlated with governance practices. They compared the variables with similar ones for manufacturing firms found in other studies.

Adams and Mehran supplied many findings from their comparison of bank holding companies and manufacturing firms. For instance, they found that BHCs have larger boards of directors and a slightly larger share of outside directors. These differences most likely result from BHC size and organizational structure, the regulatory framework, and constraints on the ability of BHCs to connect in hostile acquisitions. From these results, the researchers warn that conclusions about board size or board composition may be misleading when they leave out the effect of industry differences.

BHC boards were also found to rely less on long-term incentive-based compensation for CEOs (Adams and Mehran, 2003). In addition, CEO ownership, measured by direct equity holdings, is smaller in BHCs in both percentage and market value terms. Adams and Mehran found that because compensation packages and ownership result from a contracting process that takes into account industry structure as well as regulation, the CEO compensation structures of BHCs and manufacturing firms are not expected to become similar in the future.

In conclusion, the study found that fewer institutions held shares of BHCs relative to shares of manufacturing firms, and that institutions held a smaller percentage of BHC equity (Adams and Mehran, 2003). One major issue raised by this result, according to the researchers, is whether institutions that do hold BHC stock are active in governance. Adams and Mehran stated that this is a hard issue to address because there are few documented cases of institutions taking a reactive or proactive role in the governance of banking firms. The researchers hypothesized that institutional investors may prefer to resolve governance issues privately to avoid public announcements, or may rely on regulators to resolve the governance troubles of banking firms.

Corporate Governance and Banking Law

According to Baxter (2003): "For lawyers, the Sarbanes-Oxley Act, which was signed into law on July 30, 2002, was a watershed event. The act has significant implications for publicly traded companies, the people who govern those companies, company auditors and attorneys, and analysts and investment banks. The act is important not only for its content but also for its symbolism; it has placed corporate governance at the top of current policy issues."

In 1991, following a series of insured depository institution failures,

Congress enacted legislation known as the Federal Deposit Insurance Corporation Improvement Act, or FDICIA (Baxter, 2003). Section 36 of FDICIA is titled "Early Identification of Needed Improvements in Financial Management." Section 36 requires each insured depository institution to prepare a report, have it approved by the chief executive officer and the chief accounting officer, acknowledging management's responsibilities for the annual financial statements, for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and for complying with laws and regulations relating to safety and soundness. Another requirement is an assessment by management of the effectiveness of the insured depository institution's internal control structure and procedures, and of the institution's compliance with such laws and regulations.

The certification provisions of the Sarbanes-Oxley Act relate to these FDICIA Rules (Baxter, 2003). Like FDICIA, the Sarbanes-Oxley Act requires that the principal executive officer and the principal financial officer acknowledge in each annual or quarterly report their responsibility for internal controls and determine the effectiveness of those internal controls. To ensure that this provision is met, the certification required by Sarbanes-Oxley is more vigorous than that mandated by FDICIA. While FDICIA requires that internal controls be adequate, Sarbanes-Oxley requires that internal controls ensure that information material to the company and its consolidated subsidiaries is known to the appropriate officers. Sarbanes-Oxley takes the FDICIA regulations a step further by detailing the type of information that must be included in reports regarding the effectiveness of controls and procedures.

Basically, prudential banking laws and regulations, regarding safety and soundness, were designed to safeguard the government's interest in the bank (Baxter, 2003). Sarbanes-Oxley employs many of these same principles to protect the stakeholders interested in publicly traded companies, including the company shareholders. Due to the fact that many of the Sarbanes-Oxley provisions are safety and soundness provisions, they provide a safety net to other parties interested in issuer safety, including creditors and employees, and retirees whose retirement plans include stock in the bank or bank holding company.

According to Baxter (2003), there are two distinct reasons why banks are special. First, unlike other corporate entities, banks have special access to the credit facilities of the Federal Reserve. Monetary theorists refer to this as access to the lender of last resort. Second, unlike most corporations, banks have liabilities called deposits that are insured by an agency of the U.S. government, the Federal Deposit Insurance Corporation. Deposit insurance enables banks to have a lower funding cost than non-banks.

With these special privileges come special obligations. According to Baxter (2003), banks must take into account a stakeholder other than the owner/shareholder. For banks, this other interest is the "public interest." These factors raise an important question that must be considered by the governing body of any holding company -- Who speaks for the bank? When the bank has a stakeholder constituency that is broader than just its holding company, the answer is unclear.

Considering corporate governance practice in the context of a holding company structure, it is important to look at the issue of whether a holding company should control the management of the bank by controlling the bank's board of directors. A major concern is that overlapping directors would speak only for the holding company and that there would be no representative at the bank level would speak for the public interest.

According to Baxter (2003): "The public interest in the bank subsidiary is protected by a panoply of prudential laws and regulations. The ownership interest of the holding company in the bank is protected by the holding company's ability to control the bank's board of directors. The ultimate owners, the shareholders, are interested in profitability, to be sure. A profitable bank may pass dividend value to its parent, and the parent presumably will pass value to the shareholders, either by dividend or by a higher share price. But the interests of the shareholders and the public are reconciled because compliance and profits will, in the majority of situations, go hand in hand. As the ultimate owners, the shareholders will achieve their profits only if the bank subsidiary and its parent effectively manage credit, legal, reputational, operational, and other risks."

FDICIA demonstrates that the government interest is protected (Baxter, 2003). Under the Part 363 regulations, the audit committee of the bank subsidiary is the agency that considers management's assessment that it is complying with the laws and regulations relating to safety and soundness. According to Part 363, this committee must be independent of both the bank and the holding company. In this light, when seeking to answer the question about who in a bank speaks for the public interest, the answer is that an independent audit committee represents the public interest by having an obligation to consider compliance with laws and regulations relating to safety and soundness. Given the audit committee's special functions with respect to laws and regulations relating to safety and soundness, and in view of the audit committee's independence from the management of both the holding company and the bank, there seems to be no valid reason to break that parental control.

The Role of Bank and Holding Company Audit Committees

The audit committee has a responsibility to both the bank and the bank holding Company (Baxter, 2003). The committee is expected to concentrate on those laws and regulations that relate to safety and soundness. To be effective, the audit committee must be well served by its agents: the bank's auditors and counsel, both internal and external. These players must be completely engaged in and knowledgeable about the business and affairs of the bank, or the audit committee will be unable to accomplish its intended purpose. Additionally, the audit and legal resources that focus on compliance within the bank subsidiary must be qualified and suitable for the job in terms of resources, skill level, and experience.

The demands on the auditors and lawyers may vary with the particular business conducted in the bank. In a large and complex banking organization, a sizable staff of well-trained and experienced in-house auditors and attorneys should be employed.

According to Baxter (2003): "The culture of the control group of lawyers and auditors is also very important. These individuals need to ask, and be asked, the question that Federal Reserve Governor Susan S. Bies articulated in a recent speech on corporate governance: "Are we getting by on technicalities, adhering to the letter but not the spirit of the law?"

Another important element of good corporate governance is the procedure the audit committee of a bank follows when it learns that the bank has been involved in a material violation of law and regulation. In many cases, the bank audit committee finds this out from an auditor, counsel, or both. The committee's agents identify the violation and bring it to the attention of the responsible authority. In this case, the bank audit committee must take action. First, it must disclose what it has learned, making sure that management reveals the material violation of law and regulation to the supervisor of the bank, as this step is required by law and regulation.

Next, it must ensure that management discloses the material violation either to the audit committee of the holding company or to the holding company's board of directors. The reason for this disclosure is related to the holding company's responsibility to manage and control the enterprise's legal and reputational risk. If the holding company is oblivious to what is happening in the bank, it will not be able to succeed in this objective. Holding company control is a major factor here. If there were no ability to control the conduct of the bank, there would be no legal way for the holding company to manage risk on an enterprise-wide basis.

Once the bank is informed, the major players usually hold a meeting about remedying the violation. Due to the fact that the existence of the violation poses a threat to the public interest, a meeting is perceived as an appropriate safeguard. According to Baxter (2003): "If the violation is of a law or regulation relating to safety and soundness -- an insider lending violation, for example -- then the government will likely have an immediate interest in a prompt and effective remedy. In most cases, the interests of the bank and the holding company will be identical. The need for remediation may be less critical in the case of other violations of law, but these violations will still get attention from the bank supervisor."

It is important to understand that there is an independent reason for disclosing a material violation of law and regulation to the bank supervisor -- systematic protection. In theory, a bank that materially violates laws and regulations relating to safety and soundness avoids compliance costs that are practiced by its law-abiding competitors. In the short-term, these cost savings may benefit shareholders, the ultimate owners, for as long as the violation occurs without notice. However, banking systems function best if everyone complies with the rules. If a violation of law is discovered, the banking system benefits, as the consequences of the violation send a strong message that the playing field is equal and fair. In most cases, this means that the violator pays a penalty that will exceed the savings realized from noncompliance.