The funding of subsidiaries equity, double leverage and the risk of bank holding companies

• Author: Silvia Bressan
• Published date: 01 January 2018
• DOI: http://doi.org/10.1111/jbfa.12288
• Date: 01 January 2018

DOI: 10.1111/jbfa.12288

The funding of subsidiaries equity, double leverage

and the risk of bank holding companies

Silvia Bressan

LiberaUniversita di Bolzano Facolta di Economia

Correspondence

SilviaBressan, Libera Universita di Bolzano

Facoltadi Economia, Bolzano, Trentino-Alto

Adige,Italy.

Email:silvia.bressan@unibz.it

Abstract

Banking groups exploit double leverage when ‘debtis issued by the

parent company and the proceeds are invested in subsidiaries as

equity’.Financial authorities have frequently raised concerns about

the issue of double leveragebecause this type of intra-firm financing

appears to allow for both the arbitrage of capital and the assumption

of risk. This article focuses on the relationship between double lever-

age and risk-taking within banking groups. First, we discuss this rela-

tionship based on an examination of balance sheet figures. Second,

we analyze a large sample of United States Bank Holding Compa-

nies (BHCs) from 1990–2014. The results show that BHCs are more

proneto risk when they increase their double leverage, namely, when

the stake of the parent within subsidiaries is larger than the stand-

alone capital of the parent. This paper's primary implication for pol-

icymakers is that the regulators of complex financial entities should

more efficiently address the issue of double leverage, thereby lim-

iting the potential negative consequences that arise from corporate

instability.

KEYWORDS

bank holding companies, equity financing, double leverage,risk

1INTRODUCTION

Companies in the financial sector are often organized as groups, i.e., as large structures of multiple firms under a single

economic entity. Whereas banking groups predominantly engage in banking activities, financial conglomerates also

specialize in the businesses of insurance or securities. Typically, at the centre of a group, there is one parent com-

pany controlling a set of independent subsidiaries. This paper studies so-called ‘double leverage’. Double leverage

occurs when ‘debt is issued by the parent company and the proceeds are investedin subsidiaries as equity’ (Board of

Governors of the FederalReserve System, 2016, section 1050.0). The parent injects capital into the subsidiary, which

is able ‘to (further) increase its borrowings, thereby compounding the original parent debt’ (Office of the Comptroller

of the Currency,2009, section 300.6). Hence, provided that the parent's stand-alone capital does not change, through

double leveraging,the parent becomes more heavily exposed to the subsidiary.

The issue of double leverage has received frequent attention from financial authorities engaged in the regulation

of banking capital. Indeed, one concern is that double leverage makes it more difficult to assess group-wide capital

J Bus Fin Acc. 2018;45:209–231. wileyonlinelibrary.com/journal/jbfa c

2017 John Wiley & Sons Ltd 209

210 BRESSAN

because it leads the group to overstate the capital ultimately available to the corporation.The IMF affirms in its Finan-

cial Soundness Indicators Compilation Guide that ‘when capital is double leveraged, the capital actually available to the

group to meet unanticipated losses is less than the data implies’ (International Monetary Fund,2006, p. 274). The Joint

Forum on Financial Conglomerates dictates principles for the regulation of financial conglomerates,denoting ‘double

gearing’ as a situation in which ‘the same capital is used simultaneously as a buffer against risk in two or more legal

entities’ (2001, p. 13).

Because assessments of capital adequacy are confounded by the occurrence of double leverage, regulators rec-

ommend that groups provide evidence of intra-firm participation in such assessments (Joint Forum on Financial

Conglomerates, 2012; and Board of Governors of the Federal Reserve System, 2016).1Furthermore, any double-

counting of capital should be avoided when group entities consolidate their accounting figures into a single balance

sheet, given that the consolidated capital is deducted from investments of the parent in the subsidiaries. Indeed, capi-

tal standards established under the Basel Capital Accord are applied to banking groups according to their consolidated

items, and the ultimate value of group-wide capital should also be subtracted from holdings within non-consolidated

subsidiaries (Basel Committee, 1999).

Despite these recommendations, it appears that the potential for double leveragingleaves gaps for regulatory arbi-

trage in that financial groups can takeon additional risk without increasing their capital proportionally (Dierick, 2004;

Yoo,2010). This article focuses on the relationship between double leverage and risk. First, we examine balance sheet

figures, which allow for a more in-depth discussion of the relationship. We then analyze a large sample of Bank Hold-

ing Companies (BHCs) from the United States from 1990–2014. The empirical section encompasses a wide range of

methods. Using ordinary least squares (OLS) regressions, we find that the ‘double leverage ratio’of BHCs (Office of

the Comptroller of the Currency, 2009) is positively associated with risk-taking. This result is robust to the use of

different proxies for risk, including the standard deviation of equity,non-performing assets and z-scores. Toaddress

potential endogeneity in our data, we employ techniques suited to addressing the issue. The methodologies employed

include propensity score matching, endogenous treatment effects, and regression discontinuity designs (RDDs). All

these approaches produce consistent results, indicating that the double leverage ratiois an important determinant of

risk, without rejecting the claim of causality within the data.

Todate, the issue of double leverage has been emphasized more often byregulators than by academics. In this paper,

we argue that a discussion and documentation of the existence of double leverage can provide new and interesting

information about the behaviour of business groups.2In particular, this article makes an important contribution to

research on financial corporations. In our view, double leveragerenders banking groups more complex and unstable.

Therefore, the results of this article are of primary interest for regulators and should encouragepolicymakers to imple-

ment changes that will more efficiently regulate complex corporatestructures in the financial sector.

The paper proceeds as follows. Section 2 relates our topic to previous research. Section 3 discusses the relationship

between double leverage and risk-taking within banking groups. Toobtain quantitative evidence on this relationship,

Section 4 analyzes a large sample of BHCs in the United States. Section 5 provides a more in-depth discussion of the

issue of endogeneity in the data. Section 6 concludes.

2REFERENCES TO THE PREVIOUS LITERATURE

The topic of this paper is new to the financial literature. However, we can link our article to earlier research on

the complexity of financial firms. For example, according to Carmassi and Herring (2016), the complexity of Global

1TheJoint Forum on Financial Conglomerates recommends that ‘supervisors should require that capital adequacy assessment and measurement techniques

address excessiveleverage and situations where a parent issues debt and downstreams the proceeds in the form of equity to a subsidiary’ (2012, sectionIV).

TheBoard of Governors of the Federal Reserve System advises Bank Holding Companies (BHCs) that ‘capital should also be addressed at the parent company

levelby specifying the degree of double leverage that the parent is willing to accept’ (2016, section 2010.1).

2Wefind reference to double leverage in earlier studies of Holland (1975), Pozdena (1986) and Wall (1987).