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Banking Regulation 101


Understanding how the banking regulators fit into the picture during times of crisis.

This article was written by Minyan Peter, author of other popular articles such as Still in the Cards and Discover's Goodwill Hunting.

As the world gets more interesting, I think investors in bank stocks would be wise to understand how the banking regulators fit into the picture during times of crisis.

Being a bank, as opposed to a finance company, is, on the one hand, a great thing. Beyond being able to say you are a "bank", you have the ability to issue Federally insured deposits and transact through the inter-bank market for funding. But those benefits come with a price. And that price is that when it all hits the fan, the regulators have one goal in mind – protect the depositors of the bank.

So what does that really mean? First, it means that the depositors come first. And when a bank fails, the depositors (or the government on their behalf) are at the front of the line. More specifically, the liquidation preference looks something like this:

  • Bank Depositors
  • Bank Note and Unsecured Lenders to the Bank
  • Subordinated Lenders to the Bank
  • Equity Holders of the Bank (Generally speaking the parent or holding company)
  • Senior Debt Holders of the Holding Company
  • Subordinated Debt Holders of the Holding Company
  • Preferred Shareholders of the Holding Company
  • Common Shareholders of the Holding Company

As I hope you can see, the interests (and the preference ranking) of the depositors and the shareholder are pretty far apart.

Second, bank holding companies have to get regulatory approval to dividend capital out of the bank. Why is this important? Because generally speaking the money for a common stockholder dividend comes from the parent company's ability to receive a dividend from the bank. Other than for short periods of time, a bank holding company is unable to sustain paying dividends without receiving a dividend from its underlying bank.

Third, bank holding companies are obligated to raise capital to meet minimum capital ratios if they want to remain open. So what does this mean? The regulators don't care about dividends. Nor do they care about shareholder dilution. If you want to stay open, you better raise capital – at whatever the cost to the existing shareholders.

And speaking of capital, the regulators want the good stuff – real common equity. The regulators limit how much preferred stock and other "quasi" forms of equity count as capital. Further, the amount of preferred stock that counts as capital is a function of the amount of common equity (common stock and retained earnings) below it.

Fourth, unlike most corporate entities in which a bankrupt subsidiary may be cordoned off from the rest of a company, I can't think of a scenario of that happening with a bank. Essentially, by owning a bank, holding companies obligate themselves to apply the good assets of the whole to support the depositors of the bank. So what does that really mean? It means that the regulators can force bank holding companies to sell off valuable non-bank subsidiaries (such as asset management, brokerage etc.) and put the proceeds into the bank as capital (again supporting the depositors).

One need only look at Wamu (WM), Citi (C), E-Trade (ETFC) and H&R Block (HRB) to see the current active role of the regulators. And the regulators' objective is clear and simple – protect the depositors – at whatever cost to the shareholder.

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