Are Bank Holding Companies a Source of Strength to their Subsidiaries? New Evidence on the Operation of Internal Capital Markets

A bank affiliated with a multi-bank holding company (MBHC) is significantly safer than either a stand-alone bank or a bank affiliated with a one-bank holding company. Not only does affiliation reduce the probability of future financial distress, but distressed affiliated banks are more likely to receive capital injections and recover more quickly than other banks. Interestingly, the effect of affiliation on bank performance is greatly amplified if a subsidiary bank is owned by an expanding bank holding company. This result implies that the expansion of bank holding companies over the last decade has had an important moderating effect on bank behavior, and suggests that the relative calm in the banking industry over this time period might be more attributed to BHC expansion than risk-based capital regulation. There is also evidence that internal capital markets are so strong that a MBHC not only behaves like a large stand-alone bank, but might actually be safer. I attribute this result to the extra layer of regulation to which these institutions are subjected. Since the current capital adequacy framework is designed as if source-ofstrength regulation is impotent, this evidence should motivate discussion about whether or not MBHCs should be regulated only on a consolidated basis. Finally, I conclude that the effect of affiliation is largely driven by regulation and not market discipline, implying that it will be hard to apply any lessons learned about the operation of internal capital markets in bank holding companies to non-financial firms. # Preliminary and incomplete. Please do not cite or circulate without permission. Thanks to Jonathan Guryan for his constructive comments and to Martin Castellano for excellent research assistance. Any remaining errors are my own, and the views expressed here are those of the author and not of the Federal Reserve Bank of New York or the Federal Reserve System.