Quite apart from the recapitalization of the holding company, the bridge holding company must be able to downstream enough capital to absorb the losses in the operating
subsidiaries. On the asset side of the holding company, the assets must be in a sufficient amount and eligible to be contributed to the operating subsidiaries. Eligible assets would include any assets held at the parent level that can be contributed to the subsidiaries, such as interests in solvent companies, cash, or portfolio securities, or a reduction or cancellation of loans (which are liabilities of the operating subs).
When considering the downstreaming of assets, the only eligibility restriction is that the subsidiary not be prohibited by regulation from owning the particular assets. For
example, an insured bank subsidiary may not be able to own equity securities in a broker- dealer subsidiary that is engaged in activities that the bank is not permitted to engage in directly. In contrast, an insured bank subsidiary could accept the contribution of a
receivable from a nonbank subsidiary without violating Section 23A of the Federal
Reserve Act because the extension of credit would have been made by the parent, not the bank, and the acceptance of the contribution would not amount to a “purchase” of assets from an affiliate unless an express payment were made or liabilities assumed, which would not be the case here.30
An example of the bail-in of parent-level debt necessary to recapitalize the consolidated entity was illustrated previously in table 16.1, using Citigroup as an example. The point of that example is that bailable debt at the holding company level must be sufficient to cover the losses of the operating subsidiaries—because these losses directly impact their owner, the holding company.
As for the injection of capital into subsidiaries, consider the following example, illustrating the use of parent-to-sub loans for purposes of recapitalizing an operating subsidiary. For simplicity, assume that all assets have equal risk-weighting. Holdco is a bank holding company whose dominant holding is a large bank subsidiary, Bank Sub. In step 1, Bank Sub has tier I capital of $100 billion against RWA of $1.6 trillion, giving it an adequate tier I capital ratio of 6 percent. Holdco has tier I capital of $150 billion against consolidated RWA of $2.5 trillion, and is also adequately capitalized with a tier I capital ratio of 6 percent. In step 2, Bank Sub suffers a $75 billion loss, causing a reduction of its tier I capital to $25 billion. Consequently Bank Sub is in need of a massive capital
injection to avoid approaching insolvency and to re-establish an adequate capital ratio.
Furthermore, as a result of this loss to Bank Sub, Holdco’s tier I capital has also been reduced by $75 billion to $75 billion and Holdco is no longer adequately capitalized itself.
Holdco needs to raise $75 billion in new capital to maintain an adequate capital ratio, which can be done through the bail-in of Holdco level debt. In step 3, a bail-in of $75 billion of Holdco level debt converts $75 billion of that debt into $75 billion of common equity, providing the necessary capital increase for Holdco. Holdco has increased its tier I capital back to $150 billion and is adequately capitalized. However, while the bail-in of Holdco level debt has re-established an adequate capital ratio for Holdco, Bank Sub has not yet received any new capital. Bank Sub continues to be inadequately capitalized with
$25 billion of tier I capital and is in need of a $75 billion injection from Holdco. The
question is: how does Holdco provide fresh capital to Bank Sub?
The main channel for injecting capital from Holdco to Bank Sub is through the
cancellation of debt owed by Bank Sub to Holdco. Assume, as in figure 17.1, Holdco has a loan outstanding to bank sub in the amount of $100 billion. In step 4, Holdco can inject
$75 billion of capital into Bank Sub by canceling $75 billion of the Debt-to-Holdco loans, which will increase Bank Sub’s common equity by $75 billion. As a result Bank Sub’s tier I capital is restored to $100 billion and it becomes adequately capitalized once again.
Figure 17.2 illustrates this transmission mechanism.
Figure 17.1 Recapitalization example
Figure 17.2 Capital downstream example
At the same time, Holdco’s capital remains at $150 billion after the cancellation of the loans. So long as the necessary capital injection is less than the amount of the Holdco-to- Bank Sub loan, this transmission channel will work for re-capitalizing a troubled
subsidiary. However, if Bank Sub’s initial loss were greater than $100 billion (the amount
outstanding of Holdco-to-Sub loans), then a further transmission mechanism would be necessary, or losses would be imposed on the creditors of the bank subsidiary, including short-term uninsured creditors.
These holding company-to-subsidiary loans are common arrangements in US BHCs and could potentially serve as an adequate transmission channel for injecting capital into subsidiaries.
Table 17.1 Top 10 US bank holding company subsidiary data on loans to subs (USD millions)a
a. Top 10 by total consolidated assets; source: National Information Center as collected by the Federal Reserve System, www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx.
b. Includes perpetual preferred stock, noncontrolling interests in subsidiaries and trust preferred capital debt securities (i.e., not tier I common).
c. Source for BHCs: FDIC Bank Data & Statistics Call Reports; source: Parent Company: National Information Center/Federal Reserve, Company Filings.
d. Source: National Information Center/Federal Reserve, Company Filings; includes Loans, Advances, Notes and Bonds in both Bank Operating Subsidiaries as well as Subsidiary Bank Holding Companies.
e. Does not include $14.65 billion of loans to Subsidiary Bank Holding Companies, which includes nonbank subsidiaries.
Table 17.1 shows a snapshot of the top 10 largest US BHCs and their respective largest bank subsidiaries as of March 31, 2012. These data provide insight into the potential for cancellation of holding company loans to subsidiaries as the primary transmission
channel for injecting capital. The final column shows holding company-to-subsidiary loans as a percentage of the bank subsidiary’s tier I capital. While more specific loan detail is necessary for a complete analysis of intercompany loan cancellations as a viable transmission channel, this establishes an upper bound on the percentage of each bank subsidiary’s tier I capital that could be injected through the cancellation of loans from the holding company to the bank subsidiary. For example, JPMorgan Chase & Co. (holding company) has its largest bank subsidiary, JPMorgan Chase Bank, NA (bank sub) holding
$100.8 billion of tier I capital. JPMorgan Chase & Co. also has $40.8 billion of loans outstanding to its bank subsidiaries. If the entirety of those loans were to JPMorgan Chase Bank, NA,31 JPMorgan Chase Bank, NA, could suffer up to a 40.47 percent loss of tier I capital that could be injected by the holding company through a cancellation of the
$40.8 billion of loans. In its “Public Resolution Plan” submitted to the Federal Reserve as required by Dodd–Frank, JPMorgan does indeed indicate its intention to use the
cancellation of intercompany loans as the primary mechanism for recapitalizing troubled bank subsidiaries under a Title II resolution.32
However, any substantial loss that severely impacts a bank subsidiary’s balance sheet (i.e., losses that approach or result in insolvency) may not be sufficiently offset by a
cancellation of the intercompany loans, since not every bank is like JPMorgan in this respect. In particular, half of the banks would be unable to support losses greater than 25 percent of tier I capital through cancellation of intercompany loans. In such cases of
severe losses, the cancellation of intercompany loans is unlikely to be a sufficient means of injecting capital from the holding company into the bank subsidiary.
For this method of recapitalization to work, the regulators would have to require that important financial holding companies have sufficient debt to their operating subsidiaries (e.g., banks and broker-dealers), what some have called internal TLAC. This may be
problematic for institutions whose operating subsidiaries do not need funding from the holding company do to their reliance on funding at the operating subsidiary level. This would be particularly true for retail banking organizations with a wide base of retail deposits. An intercompany loan requirement would require the holding companies to provide funding to banks that did not need or could not use it, imposing a substantial dead weight loss on such institutions.