What’s a bank holding company for?  There are two working hypotheses.  One is epitomized in the FRB’s proposal yesterday to provide a bit of relief for BHC directors.  I’ll call this the “Big Daddy bank” hypothesis because – promised relief notwithstanding – the Fed expects BHCs to be super-banks, not parent companies owing nothing to an insured depository beyond serving as a source of strength.  The other hypothesis underlies proposals in which banks get tough rules and the BHC gets cut loose – call this the “bye-bye bank” option.  The choice between these two hypotheses is as much one of rule as of law, making it an essential decision defining the future of U.S. finance that can be made with or without Congress’ assent.    And, as events this week demonstrated, it’s also a critical call the Trump Administration may be readying to make on the side of bye-bye.

The distinction between BHCs and banks is largely an American construct, evident initially in the purpose of the Bank Holding Company Act – a shell parent for multi-state banks – along with inter-affiliate transaction restrictions and other barriers between the bank and its BHC.  Universal banking around the world eschewed these distinctions, favoring instead behemoth, “universal” banks engaged in a wide array of banking, securities, insurance, and even commercial activities. 

Over time, the Fed demanded more and more of BHCs, moving largely on a de facto rather than de jure basis to alter the old bye-bye model into Big Daddy.   Since the crisis, Daddy has gotten even bigger and far more autocratic – see Dodd-Frank’s Section 165 for a very important case in point.  Around the world, the Bye-Bye Bank approach prevails – see the U.K.’s Vickers rules as a case in point.  Although most countries do not have holding companies and a wide range of activities are in-bank, ring-fencing and lots of rules now place firewalls between intermediation and everything else.

Could the U.S. be willing now to say bye-bye, insulating banks and freeing BHCs? 

In a little-noticed exchange during his Senate confirmation hearing, Fed supervision vice chairman nominee Quarles said:

…[U]sually when people are talking about, today, about the re-imposition of Glass-Steagall they are talking about insuring that the depository institution is protected from risks in other parts of the large financial institution. I think that’s a very worthy goal.

Asked in a May Wall Street Journal interview directly about what the White House wants when it comes to the interplay between banks and their holding-company affiliates, Acting Comptroller Noreika said, “...[W]e want to make sure that risk from the affiliate doing its activities doesn’t come back to the bank.  And so that is our challenge.”  Asked during his confirmation about the Volcker Rule, Secretary Mnuchin said his idea of a 21st-century Glass-Steagall Act would sharply limit proprietary trading and other activities in an insured depository while freeing up the holding company, an idea the head of the National Economic Council repeated later in a closed-door meeting with Senate Banking members.

Would the Fed support what Messrs. Quarles, Noreika, Mnuchin, and Cohn have hinted at?  Being Big Daddy is deeply embedded in the essence of the Federal Reserve, which has believed since the late 1970s in requiring BHCs to serve as a source of strength.  Even as one after another court decision challenged this construct, the Fed has soldiered on, winning implicit if not yet fully express authority to require BHC backstops in, yes, Dodd-Frank. 

But why should BHCs be big daddy?  Wouldn’t it make more sense to push banks far from non-banking activities housed then in their holding companies?  As Mr. Mnuchin also said, this way insured depositories would go into FDIC receivership and parent-company counterparties and investors would have to fare for themselves.

It’s not so easy, of course.  As the FDIC Vice Chairman’s take on bye-bye bank makes clear, much now housed inside insured depositories is far from traditional financial intermediation and thus hard to resolve under traditional FDIC protocols.  This isn’t new – the Federal Reserve Bank of New York blog posts we’ve analyzed this week go back to the 1950s to show how banks have gone far beyond traditional intermediation even when Glass-Steagall was a full force before 1999.  One reason for this is the significant funding benefits derived from bank affiliation along with the TBTF perceptions that dominated investor and counterparty perception until post-crisis reforms took hold. 

But, that banks have been integrated full-service enterprises for more than a century doesn’t make it right to continue this integrated approach either from a policy or bottom-line perspective.  In the absence of restructuring, BHCs – especially the largest and most diverse – will face a never-ending stream of tough prudential and resolution demands no matter what the Trump Administration may promise in the form of regulatory relief.  This leaves the biggest BHCs with two hard choices:  agree to be Big Daddy and pay a hefty price in terms of lost shareholder value for the profit impact on non-banking activities not offset by funding benefits or say bye-bye to these benefits and compete fully and fairly with securities, insurance, wealth-management, fintech, and all sorts of other financial companies.

BHCs with small bank subsidiaries and large non-banks will happily jettison non-traditional activities in their insured depositories because they don’t have many.  For them, holding company freedom purchased without a high capital ratio and stringent inter-affiliate restrictions is more than worth the price of constrained bank subsidiaries.  For banks with complex structures and diversified activities in every nook and cranny, the trade-off is far more complex. 

One way to solve for this is to keep Big Daddy yet make him say a bit of bye-bye.  This is done by retaining the source-of-strength obligation and codifying it more decisively to ensure that BHCs have unencumbered, liquid resources at hand to ensure orderly resolution of all of their insured depositories.  TLAC is one form of backstop, but it doesn’t come with regulatory relief for the parent.  Marry the two and one may well have the model of the modern American banking company.