Does subsidiary bank failure affect parents’ capital decisions? Evidence from US bank holding companies

I explore the dynamics of capital structure decisions of US bank holding companies (BHCs) around the years of their subsidiary bank failures. I find that financial policies of BHCs are significantly distorted by the failure of their subsidiary banks. Specifically, affected BHCs raise leverage ratios as early as one year prior to the failure of their subsidiaries, and then reduce their leverage following the failure, with this result stronger for small or poorly capitalized holdings and weaker for one-bank holding companies or holdings that have less than full ownership of their subsidiaries. Moreover, BHCs with subsidiary failure also hoard cash or liquidity assets, and cut lending prior to the failure. Overall, the findings are consistent with my theory that BHCs boost their financing to offset the shortfalls in internal funds prior to their subsidiary failure due to more capital funds being transferred to distressed subsidiaries as mandated by the “source of strength” regulation.