The Family Bank
Jan 26, 2020
What Is the Family Bank?
Wealthy families have been establishing their own banks for centuries. Think of the Medici and the Rothschilds in Europe, for instance, or the Mellons in the United States. Some of these family banks grew into major commercial institutions. Today, however, most wealthy families who decide to create a family bank do so strictly as a means of stewarding and leveraging the family assets with an eye toward legacy, to help properly fund and finance the family’s future generations.
As an entity, the family bank is neither legally nor formally defined in Canada or the United States. Indeed, although the term family bank is widely used, its meaning is not universally agreed upon, and some families prefer to use “Family Fund,” “Family Venture Fund,” or “Opportunity Fund” rather than bank. Whatever the families who have them call them, however, family banks share a single characteristic and purpose: they are entities that provide rules, structures, and processes by which family members fund other family members.
Because there is no legislation specifically governing family banks and no universally accepted model or set of model, families who decide to create a family bank are presented with both opportunities and challenges. The family bank gives them many options for creating structures and processes precisely tailored to their needs. For, as is true of the family office, when you have seen one family bank … you have seen one family bank.
The challenge, in this wide-open field, is to avoid making major mistakes. If structure, processes, and governance are crafted poorly, the family bank can be a cumbersome, inefficient, wasteful, and unresponsive endeavor that produces rather than prevents bitter family disputes. It helps to have a family office in place before setting up a family bank. The professional staff of a good family office can, first, help the family decide whether a family bank will likely be helpful for them and, second, it can guide the family in creating a bank that genuinely leverages their wealth for the development and benefit of all participating current and future family members.
Benefits and Purposes of a Family Bank
The most useful way to think of a family bank, is as a bank, albeit one that is unregulated and non-commercial. Its client universe is the family, and its chief purpose is intra-family financing.
Besides funds transfer and investment, the family bank can be used to cultivate and perpetuate the family’s values and their fiscal stewardship, sound governance, entrepreneurship, and intergenerational development. Through the family office, the bank can fund the realization of opportunities to create financial, intellectual, and human capital.
In creating its bank, the family should deliberately turn away from thinking of it as simply a structure for making intra-family gifts, grants, and informal loans. A bank is not needed for these purposes and should not be used for them. Instead, it is far more appropriate to think of the family bank as on a par with the family business—indeed, it is another family business, this one dedicated to the business of financing the family’s future and providing benefits to all participating family members.
Recall our definition of the family office as an entity through which the business of the family is facilitated. This is not the same as the family business. In most wealthy families, not every member is able or wants to work in the family business. But the business of the family should be of concern to all, and the family bank can serve as a mechanism to encourage and enable such universal participation.
The family bank can operate as an arm of the family office to manage family-owned investments. It is also a ready means of servicing the needs of family entrepreneurship, and its resources and processes can be harnessed to develop and encourage sound fiscal practices while managing wealth for the next generation.
The family bank can also serve as a backup source of short-term loans not for investment but to sustain family members experiencing unusual need or cashflow problems. For younger family members who may be taking some early entrepreneurial risks, this source of liquidity can be invaluable in recovering from business or investment setbacks. Entrepreneurship is best learned by doing, yet, in the doing, many errors are made. The bank provides a safety net to support valuable real-world business education.
This said, the family bank should be governed by clearly stated policies mandating accountability, honest and frank communication, family values, family objectives, and specific funding criteria. Again, the bank should not be conceived as a means by which parents give gifts to their children or effect distributions from trust funds. The family bank should be set up specifically as a sustainable family business to fund or finance family members according to stated criteria and terms. It should not be constituted as a piggy bank or a guaranteed slush fund from which any family member may withdraw cash at any time and for any purpose. Sound governance includes provisions for funding application and review in accordance with stipulated criteria.
Establishing a well-governed family bank may be guided by these general rules:
- The bank should be a source of intra-family funds, which may be obtained without creating unexpected tax conflicts or liabilities.
- It should be available, per stated rules, for personal funding, venture funding, and other well-articulated uses that satisfy agreed-upon set criteria.
- The bank should foster among family members—especially those of the rising generation—an ethos of fiscal stewardship, responsibility, accountablity, and self-sufficiency, including an understanding of the value of money and of financial planning and discipline.
- Like other aspects of the family office, the bank should facilitate and foster healthy, positive, and productive family relationships.
- In accordance with the family’s values, the bank should contribute positively to developing both human and financial capital within the family.
- In accordance with the family’s values, the bank should promote and support entrepreneurship.
Designing Your Family Bank
As with creating or joining a family office, establishing a family bank is not a step to be taken lightly. It is, rather, an opportunity to create a means of facilitating intra-family funding within the context of the broader family business, its values, and its conception of enterprise. If established, the family bank should be regarded as the central mechanism for all financial exchange within the family. For example, instead of one family member making an informal loan to another or even creating an ad hoc corporate entity to provide financing for some project or enterprise, the bank should be the go-to source and mechanism. Relying on the bank will better coordinate the use of family assets, help to manage issues of taxation, reduce the incidence of unpleasant surprises, and, if everyone follows stated criteria and rules, will go a long way toward preempting family disputes over money.
As with the family office, the family bank needs to be designed expressly to serve the unique needs of the family that creates it. No off-the-shelf solutions are available. The family office executive should work with family members and, as necessary, bring in outside advisors to create the one solution that best serves this family’s needs. The same process by which the family office was created, including the articulation of family values, vision, and mission discussed in Chapter 4 and the contours of family governance addressed in Chapter 5, should prove invaluable in designing the right model of your family bank. For the design process should unfold in the context of values, mission, culture, legacy, and other priorities. Above all, while the bank should provide flexibility and liquidity for current purposes, it is largely an instrument used to create, develop, and preserve assets for the future.
Although each family bank must be finely tuned to the unique needs of the family, there are two broad approaches that guide the investment objectives and governance of most of these entities. They are the “hard bank” approach and the “soft bank.” Family members should decide which of these philosophies they want to embrace.
- A “hard bank” is one that is intended chiefly (or even exclusively) to fund well-articulated investments with the objective of realizing significant return on the investment.
- A “soft bank” operates by more flexible criteria. While it is not designed to simply give away money, it may invest more for the purpose of building and nurturing human capital within the family than to obtain a targeted financial return. (Even under the soft bank scenario, however, some minimum nominal return on investment is typically a criterion.)
The “soft bank” model suits a family that is willing to use the bank as an instrument for developing future entrepreneurs within the family. This is the primary value sought by the “soft” investment, and it prevails above and beyond any immediate financial return. In this model, the soft bank is the equivalent of an educational investment, providing real-world knowledge and experience that cannot be gained in college or graduate school.
Of course, there is no requirement that the family bank be either hard or soft. Rules of governance can be crafted to also allow a balance between the two extremes, with some portion of working funds allocated to investments for which a specific “hard” business case can be made and some other portion set aside for the “soft,” “educational” purpose of cultivating human capital.
Where Does the Bank Get Its Money?
The funding of the family bank comes, over time, from one generation after another. That is, in the present, most of the bank’s assets represent the contributions of prior generations and current senior family members. In addition, trusts and the family business or businesses may allocate a portion of proceeds to the bank.
The rising generation may also contribute to the bank. If circumstances permit, this generally should be encouraged, since investing financially in the family bank creates an emotional investment in younger family members, which tends to produce a continuous commitment to its good governance and sustainability. It also entitles the next generation to a voice in the evolving development—through the bank—of the family’s vision and mission.
Through the family office, shareholder and member agreements should be carefully drafted to cover all issues of family ownership, distribution, transfer, reinvestment, and buying and selling of shares. Rules governing individual and co-investment rights need to be spelled out.
How Much Money Does Your Family Bank Need?
As might be expected, there is no ironclad rule for determining what portion of the family’s assets should be allocated to a family bank. Questions to ask include:
- Does the bank consist of one general fund?
- Or are their separate funds for each beneficiary?
- How much capital will the initial beneficiaries likely require?
- When is it anticipated that funds should or must be made available for withdrawal?
- What levels of risk tolerance are deemed suitable in investing as well as lending?
- What is the prevailing level of willingness and capacity to transfer assets?
If you think of the family bank mainly in terms of providing for the next generation, eligible participants i will probably want to calculate the amount they are willing to provide each of their young children to enable them to go into business in the future. Drawing on the expertise of the family office, they can calculate the rate of growth of the fund over time at various levels of contribution. With these calculations in hand, they can begin contributing to the bank accordingly.
Some parents may want to leave their children more than a fund to start a business. They will need to calculate such costs as funding education and providing purchase cash for a home, perhaps in addition to funding a startup business at some point.
Of course, to these calculations, rules must be applied governing the permissible uses of the fund. If the money is intended to finance a future business, education, and a home, withdrawals must be restricted to these purposes and all other withdrawals restricted or disallowed, either absolutely or subject to exigencies.
Deciding on contribution amounts poses some challenges, but, typically, the far more difficult, even painful, questions involve deciding who—and who is not—eligible to be a beneficiary. Moreover, the question is not necessarily as simple as Who benefits? but is more often Who benefits under what conditions? And how much does a beneficiary receive under condition A versus condition B?
It is one thing to dedicate a fund to helping your child start a business, but what if that child fails to complete the necessary level of schooling? What if that child shows neither aptitude nor interest in launching a business? What if your child proposes to go into business with someone outside of the family? Or with some outsider who seems to possess little capacity for a serious business venture? And what if your child simply makes bad choices? Clearly, as with any legacy bequest, a trustee or trustees should be appointed, at least until the child comes full of age.
No one has a crystal ball, but it is possible to draw up a reasonable list of requirements that must be met before making funds available.
- Draw up a list of minimum educational attainments required before funds are made available.
- Draw up a list of minimum business skills that must be demonstrated (to the parent or to a trustee) before funds are made available.
- Specify the existence of a business plan judged suitable and competent by the parent or a trustee before funds are made available.
- Consider providing funding for all or some of the education required for the proposed business venture.
- Consider providing funding to finance professional consultation in preparing the business plan.
- List any other conditions, such as a requirement for matching funds from the (adult) child’s personal resources.
- Secure the beneficiary’s commitment to a fulltime dedication to the business for as long as the family bank has a financial stake in it.
You may further constrain your beneficiaries by stipulating clearly how funds may and may not be used. For instance, education, starting a business, purchasing an existing business, acquiring an interest in a business, and research and development toward a new business may be approved, but all other uses may be proscribed.
If one of the purposes of the family bank is to cultivate family entrepreneurship, it is counterproductive to penalize business failure. No one can meaningfully command success. By definition, a venture is subject to failure. If that failure teaches a meaningful lesson, the money spent is likely well invested.
The manner of disbursement of funds should be clearly specified in any specifically dedicated bequest. The purpose of a fund is a major consideration, but so are tax regulations. It is, of course, possible to leave the amount and pace of withdrawal of available funds to the discretion of the beneficiary. Bear in mind, however, that if one generation depletes the family bank through bad decisions, the bank’s financial legacy is no longer available to subsequent generations.
An alternative to funding the person of the beneficiary is to fund the beneficiary’s business directly. Funding the business (as an equity investment) may be preferable to financing it (as a loan), as tax laws often place burdensome requirements on inter-family business loans. Moreover, a loan may end up loading the startup company with a level of debt that precludes subsequent loans from commercial sources. The family bank should be a resource for growth, not a source of problems.
Do not use the family bank informally
Funding through the family bank should never be casual or in any way convey a sense of entitlement to those who draw funds. Rules should specify criteria based on purpose, the merits of the purpose, and the alignment of the purpose with the values and vision of the family.
Inspire more than restrict
Rules and guidelines governing the family bank should avoid micromanaging either the money or, for that matter, the lives of members of the family’s rising generation. The purpose of cultivating and inspiring family entrepreneurship and informed independent business thought is an important function of a family bank, which is intended to grow both human and financial capital. Don’t use money to compel obedience.
Engage family members
The family bank should include, not exclude. Devise ways in which the younger generation can participate fully in the bank—through intellectual as well as financial contributions. The bank survives on the presence of money, but it thrives on the ongoing commitment of the family from one generation to the next.
A major benefit of a well-regulated but accessible family bank is that the transparent and orderly processes that govern it can go a long way to preempting conflict over money. Do not allow the running of the family bank to become a source of bitter argument. Doubtless, conflict will sometimes arise. Use the sound governance of the bank to resolve issues as objectively and as fairly as possible. Strive for consensus rather than enforced compliance. Call on the staff of the family office to intervene in those disputes that can be resolved by subject matter expertise or informed advice.
Put away the cookie cutter
Do not stint when it comes to planning and customizing your family bank. In most matters relating to fiscal stewardship, there are no hard and fast rules or set patterns. There are best practices that can be consulted, and these make good starting points. In the end, however, the family bank must serve your family, with its unique needs, vision, values, and goals, as well as members’ available resources and their collective appetite for risk.
Assume nothing. Ask about everything when planning the bank. Determine what it is that the majority of the family wants—and why. Ask and answer:
- Whom will the bank serve? All descendants? Or a single branch—with separate banks being established for each of the other branches?
- What rules should govern investment in the bank? When does the rising generation become eligible to participate?
- What are the limits on loans?
- What types of loans are permissible?
- Who is eligible for a loan? Spouses? Stepchildren? Distant relatives? (And what constitutes a “distant” relative?)
- What is the minimum acceptable level of return on investments?
- Should the bank be “hard,” “soft,” or balanced?
Treat the family bank as a (family) business
Treat the family bank as a real business. Hold it to a professional standard. Allow this to break down, and disputes will arise, not to mention errors that may cost opportunity or cash or both—especially in the area of taxation. The bank is one of the family’s businesses. Treat it as such. Establish a board and have it meet regularly. Bring in outside advisors when special expertise is required.
Avoid favoritism and the appearance of favoritism
Give the bank’s investment board and loan review committee independence from the family by including expert members from outside of the family. These can be recruited from the professional staff of the family office as well as from trusted businesses. Additionally, ensure that all board members operate from the same set of evaluative criteria and rules.
Governance is key
Strong governance will give family members oversight and control while reining in many sources of family conflict. Spell out the rules and requirements for communications, joint decision making, meetings open to all stakeholders, commitment to shared values, vision, and mission, and use of outside advisors in operational matters requiring special expertise.
Dip a Toe
Just as no single form of family bank suits every family, not every family needs, wants, or will benefit from having a family bank. Since no set of laws—not in Canada, not in the USA—govern family banks, there is nothing to stop you from starting informally and experimentally. Create a fund with some features of the family bank model. Have a family meeting about it. Agree on its contours. Agree to test it. Set a specific time for a review. Then, dip a toe in the ocean.
When the time set for the review approaches, announce a meeting. Seek candid opinions, and review the results ruthlessly. Based on the outcome, decide whether to create a formal family bank, extend the trial run, modify the trial run, table the whole notion for a time, or abandon it altogether.
If the family does decide to proceed with a formally constituted bank, do not chisel its structure stone. Use a pencil. All great constitutions provide for their own amendment. Do the same with your plans for the family bank. As with a family constitution, include an orderly process for modification. As with a constitution, you may want to require more than a simple majority of the board or the eligible participants to vote for change. Or you may want to appoint a special trustee who has authority to implement changes.
One source of change is inevitable. It is the inexorable march of time, which brings births, maturation, deaths, and other alterations of circumstance. Your children—and those of other family members—should be included in all important conversations about the future of the bank just as they are included in conversations concerning the future of the family. The family bank is first and foremost about the future—about funding legacy and encouraging creativity, innovation, and productivity—so it is fitting that those of the mature generations should foster in the young support for and commitment to the bank that is intended to serve them. This is the foundation of legacy.