Chain Banking

What Is Chain Banking?

Chain banking is a form of bank governance that occurs when a small group of people control at least three independently chartered banks. In general, the controlling parties are majority shareholders or the heads of interlocking directorates. Chain banking as an entity has declined along with a surge in interstate banking.

Understanding Chain Banking

Chain banks came into prominence after the stock market crash of 1929. They were popular because they spread risk among groups of banks, instead of concentrating it on a single entity. According to a 1931 report conducted by a Federal Reserve committee, chain banking first emerged in North Dakota, where a David H. Beecher purchased a bank in 1884 and another one in 1887.

Subsequently, this form of bank ownership became popular in the south. Starting in 1896, the Witham organization purchased a series of banks and controlled nearly 200 banks in New York, New Jersey, Georgia and Florida thirty years later.

A major reason why chain banking took root in the northwest and southern states is because they did not allow branch banking. New Jersey became the first state in 1889 to establish legal precedent for the establishment of a corporation that was formed solely for the purpose of holding stocks in other companies. Banking organizations and individuals took advantage of this law to extend their ownership of other financial institutions.

Chain banking is not like branch banking, which involves conducting banking activities (e.g., accepting deposits or making loans) at facilities away from a bank's home office. Branch banking has gone through significant changes since the 1980s. It also differs from group banking.

In group banking, several affiliate banks exist under a single bank holding company. In chain banking, three or more banks function independently without the traditional obstacles of a holding company. A bank holding company is a parent corporation, limited liability company, or limited partnership that owns enough of the original bank's voting stock to control its policies and management. The activities of separate banks within chain banking don't overlap (as occasionally occurs in a holding company) so that the revenue is maximized as much as possible.

Advantages and Disadvantages of Chain Banking

The main advantage of chain banking is that it limits risk for customers. While they are independently chartered, chain banks are connected to each other through a commonality of ownership. This ensures that risk is spread between multiple institutions and, consequently, is manageable. They also allow large banking organizations to reach out to underserved or small communities by taking an ownership stake in a bank operating within that community.

Other advantages of chain banking include streamlining of operations through economies of scale. Financial institutions in a chain banking system can make loans to each other on relatively lax terms. There is also less competition between banks within the same chain banking group. For example, it is hardly likely that banks from a group will compete for customers from the same geographical region.

But less competition and risk can also have an adverse effect on banking services for a particular region because it limits customer choice. By inhibiting competition and risk, chain banking can also lead to centralization of services in the hands of select players. The interrelationships between various banks in a chain banking system means that a failure in one bank can instigate problems in other institutions affiliated to it.

Chain Banking Versus Interstate Banking

Interstate banking grew significantly in the mid-1980s, a time during which state legislatures passed new laws that allowed bank holding companies to acquire out-of-state banks on a reciprocal basis with other states. As noted above, the rise in interstate banking has correlated with a decline in chain banking.

Interstate banking grew in three phases. The first began in the 1980s with regional banks, which formed when smaller, independent banks merged to create larger banks. Following this, the Riegle-Neal Interstate Banking and Branching Efficiency Act allowed banks which met capital requirements to acquire banks in any other state after September 29, 1995. These legislative acts resulted in the onset of nationwide interstate banking.

Chain Banking and Investment Banking

Chain banking is distinct from investment banking in that investment banks create capital by underwriting new debt and equity securities, aid in the sale of securities, and facilitate mergers and acquisitions, reorganizations, and broker trades, along with providing guidance to issuers regarding the issue and placement of stock. Investment banks are by nature interstate (and international), given that many deals, which investment banks broker, include investors worldwide.

Many investment banking systems are subsidiaries of bulge bracket firms like Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America, and Deutsche Bank.

Examples of Chain Banking

Chain banking became a popular method to reach out to rural communities in the Midwest during the 1970s. According to October 1977 article in Economic Perspectives, Iowa had 30 chain banking organizations that controlled 87 commercial banks located mostly in rural counties. Together, they held approximately $1.2 billion in commercial bank deposits. Illinois had 40 chain banking organizations that controlled 197 commercial banks, amounting to one-fifth of the total number of banks in the state. These banks had complex intertwined relationships with shared senior management and board members and loans made to each other.