Non-consolidated subsidiaries enable banks to arbitrage capital rules

Di Gong, Harry Huizinga, Luc Laeven 18 February 2016

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The recent financial crisis has shown the importance of bank capital in safeguarding bank stability, and it has laid bare the inadequacy of the pre-crisis capital regulatory framework.1 Pre-crisis, banks could easily use off-balance sheet structures to lower their effective capitalisation rates below regulatory minimum requirements. Acharya et al. (2013) show how US banks set up asset-backed commercial paper conduits to arbitrage capital regulations. Shin (2009) points out that securitisation enabled banks to increase their credit supply by effectively leveraging up their available capital.

One additional way that banks arbitraged capital regulations was by maintaining minority-owned, non-consolidated subsidiaries.2 A parent bank’s asset exposure to such a subsidiary was taken to be limited to its equity investment in the subsidiary, although effectively banks had to guarantee all the liabilities of such subsidiaries. Non-consolidated subsidiaries thus performed just like other off-balance sheet entities, even if for a long time they escaped the attention of analysts and policymakers.

In a recent paper (Gong et al. 2015), we examine the use of subsidiaries as off-balance sheet vehicles by US bank holding companies (BHCs) during the 2000-2013 period. We find that 15% of BHCs had at least one minority-owned financial subsidiary. For a sample of smaller banks, we are able to pro forma consolidate the subsidiary’s assets onto the balance sheet of the BHC. On average, such pro forma consolidation reduces the equity-to-assets ratio 3.5% below the reported equity-to-assets ratio. Empirically, we find that bank default risk is positively related to the calculated reduction in the equity-to-assets ratio on account of full consolidation. This implies that the non-consolidation of minority-owned subsidiaries led to a reported equity-to-assets ratio that does not fully reflect a BHC’s riskiness. Hence, US banks were able to use non-consolidated subsidiaries to arbitrage the US regulatory leverage ratio requirement.

How much are capital ratios reduced by pro forma consolidation?       

US banks report information on their corporate structures as well as balance sheet information for their constituent parts to the Federal Reserve on a quarterly basis.3 These data allow us to counterfactually consolidate minority-owned, non-consolidated subsidiary banks onto the balance sheet of the parent BHC. This exercise elongates the BHC’s balance sheet without affecting its equity, thereby reducing the equity-to-assets ratio.

In practice, we restrict the pro forma consolidation exercise to a set of 94 relatively small US BHCs for which the necessary interbank ownership and balance sheet data are available. Pro forma consolidation on average reduces the capital ratio by 3.5% (from 10.0% to 6.5%). Figure 1 plots the yearly mean reported capital ratio, and the yearly mean capital ratio after pro forma consolidation over the 2000-2013 period. Both the adjusted and unadjusted capital ratios peaked in 2005 before the crisis, and subsequently went down. Also, the figure shows a smaller gap between the adjusted and unadjusted capital ratios during the crisis years 2007-2009 than before, suggesting that banks scaled back their use of minority-owned subsidiaries as a means to depress effective capital ratios as the crisis unfolded.

Figure 1. Reported capital ratio and capital ratio after pro forma consolidation, 2000-2013

The reported capital ratio is the ratio of equity to assets. The capital ratio after decompression is the ratio of equity to assets after pro forma consolidation of minority-owned subsidiaries.

US BHCs are subject to a regulatory leverage ratio requirement of 3%, which can be approximated by a minimum equity-to-assets ratio of 3%.4 Figure 2 plots the adjusted equity-to-assets ratio against the reported equity-to-assets ratio to see whether some BHCs appear to use non-consolidated subsidiaries to circumvent the regulatory leverage ratio requirement. Interestingly, there are 61 (quarterly) observations in the figure (out of 650) where the reported capital ratio exceeds 3%, but where the capital ratio after pro forma consolidation is less than 3%. These banks are problematic from a regulatory point of view, as they meet the leverage ratio requirement of 3% on the basis of the reported capital ratio, but not on the basis of the capital ratio after pro forma consolidation. These banks seem to be circumventing the regulatory leverage ratio requirement by using non-consolidated financial subsidiaries.

Figure 2. Capital ratio after pro forma consolidation plotted against the reported capital ratio

The reported capital ratio is the ratio of equity to assets. The capital ratio after decompression is the ratio of equity to assets after pro forma consolidation of minority-owned subsidiaries.

BHC default risk reflects the overall asset risk of non-consolidated subsidiaries

A BHC’s riskiness can be expected to reflect the asset risk of all of its subsidiaries even if they have not been consolidated, as the Federal Reserve Board’s ‘source of strength’ principle holds that BHCs are required to stand behind the liabilities of all their subsidiaries.

Our empirical evidence confirms that BHC riskiness reflects the asset risk of its nonconsolidated financial subsidiaries. Specifically, we find that a BHC’s default risk, as reflected in its Z-score, is positively related to the capital ratio adjustment following pro forma consolidation. This means that a BHC’s reported capitalisation does not adequately reflect the asset risk stemming from its minority-owned subsidiaries. The effect is economically significant, as a one-standard-deviation increase in the capital ratio adjustment (relative to the reported capital ratio) following pro forma consolidation reduces the Z-score by 32% of its standard deviation.5

The US and broader Basel III policy response

Regulators have noticed the potential for banks to arbitrage capital regulations through non-consolidated subsidiaries, and steps have been taken towards eliminating this regulatory loophole in the recent Basel III capital adequacy framework, and in its US implementation. The US and broader Basel III approaches have been to require BHCs to make deductions from their consolidated regulatory capital that reflect their equity investments in non-consolidated subsidiaries. These deductions are taken to be capital that is set aside against risks stemming from unconsolidated financial subsidiaries, and hence this capital is not available as a buffer against losses arising elsewhere in the BHC structure. The new required capital deductions in the US vary by the degree of BHC ownership of the financial subsidiary, and they are being phased in gradually between 2014-2018.6

The deduction approach to adjusting a BHC’s capital ratio for its investments in non-consolidated subsidiaries is a step in the right direction. Importantly, it is relatively easy to implement, as it only requires information on a BHC’s equity investments in its non-consolidated subsidiaries. However, the deduction approach falls short of adjusting the BHC’s capital ratio ‘correctly’ through a pro forma consolidation of its non-consolidated financial subsidiaries. Empirically, we find some evidence that the ‘pro forma consolidation approach’ is superior to the ‘deduction approach’, as bank default risk more strongly reflects the capital ratio adjustment stemming from pro forma consolidation than from implementing the deduction. Unfortunately, however, the pro forma consolidation approach appears to be too burdensome to be applied in practice, especially in the case of larger, more complex banks.

References

Acharya, V, P Schnabl and G Suarez (2013) “Securitization without risk transfer”, Journal of Financial economics, 107: 515-536.

Basel Committee on Banking Supervision (2010) Basel III: A global regulatory framework for more resilient banks and banking systems.

Beltratti, A and R Stulz (2012) “The credit crisis around the globe: Why did some banks perform better?”, Journal of Financial Economics, 105: 1-17.

Berger, A and C Bouwman (2013) “How does capital affect bank performance during financial crises?”, Journal of Financial Economics, 109: 146-176.

European Commission (2013) Regulation No 575/2013 on prudential requirements for credit institutions and investment firms.

Federal Reserve Board (2013) “Regulatory capital rules: Regulatory capital, implementation of Basel III, capital adequacy, transition provisions, prompt corrective action, standardized approach for risk-weighted assets, market discipline and disclosure requirements, advanced approaches risk-based capital rule, and market risk capital rule”, in Federal Register, 78(198), 11 October 2013, Rules and Regulations.

Gong, D, H Huizinga and L Laeven (2015) “Nonconsolidated subsidiaries, bank capitalization and risk taking”, CEPR, Discussion paper 10992.

Shin, H (2009) “Securitization and financial stability”, Economic Journal, 119: 309-332.

Footnotes

1 Berger and Bouwman (2013) show that higher levels of pre-crisis capital increased a bank’s probability of survival during the crisis. Beltratti and Stulz (2012) find that banks that were better capitalised before the crisis had a better stock market performance during the crisis.

2 According to US GAAP, parent banks need to consolidate subsidiaries that they unilaterally control. An ownership share of common stock exceeding 50% is traditionally taken to imply control.

3 We use information on BHC corporate structures made available through the National Information Center (NIC), and balance sheet information reported in Call reports, FR Y-9C and Y-9SP.

4 The regulatory leverage ratio is defined as Tier1 capital divided by assets. We illustrate that some banks appear to have been effectively circumventing the regulatory leverage ratio requirement over the 2000-2013 period by considering the ratio of equity to assets before and after consolidating minority-owned financial institutions.

5 A lower Z-score signals higher default risk.

6 The final US rule implementing Basel III (Basel Committee on Banking Supervision 2010) was approved by the Board of Governors of the Federal Reserve System on 2 July 2013 (Federal Reserve Board 2013). The EU correspondingly adopted a new regulation on prudential requirements for credit institutions in 2013 including required deductions from common equity Tier1 for investments in nonconsolidated financial sector entities (see section 3 of European Commission 2013).

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Topics:  Frontiers of economic research Global crisis

Tags:  US, banks, subsidiaries, risk, banking capitalisation, regulation, BASEL III, banking, off-shore

Assistant Professor at University of International Business and Economics, Beijing

Professor of Economics and Chairman of the European Banking Centre, Tilburg University

Director-General of the Directorate General Research, European Central Bank and CEPR Research Fellow

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