Fintech Flash
October 23, 2018

So, You Want to Be a Bank? Consequences of Forming or Acquiring a Depository Institution - Part II

The first installment of this series of insights on bank charter considerations addressed the reasons why a non-bank financial services provider might want to operate through a depository institution, the types of charters available and high level considerations relevant to choosing the right charter. Some of the benefits of operating through a depository institution include access to broader funding sources, the ability to operate through a federal charter that offers uniformity of regulation on a nationwide basis through preemption of many state laws and licensing requirements, and exportation of interest to borrowers throughout the country.

This installment describes the consequences of operating through a depository institution charter, including capital requirements, supervision and examination by bank regulatory authorities and potential limitations imposed on controlling shareholders and investors.

An upcoming third installment will address the process for seeking regulatory approval to form or acquire a depository institution.

Capital Requirements

Depository institutions typically must operate with higher levels of capital than non-bank financial services businesses. All new and existing depository institutions must meet leverage and risk-based capital requirements imposed by the federal banking regulators. The risk-based capital ratios measure capital as a percentage of risk-adjusted assets, which means a bank with riskier assets on its balance sheet generally requires more capital than one that operates on a lower-risk model. The leverage ratio measures capital as a percentage of total average assets, which constrains the overall amount of leverage. There is also a requirement to maintain a certain amount of common equity Tier 1 capital, which prohibits excessive reliance on preferred stock as a means of capital support. Bank capital requirements are complex, necessitating careful management on a go-forward basis.

As a practical matter, an institution must be well capitalized, which requires more capital than the minimum requirement, since institutions that are only adequately capitalized are not permitted to accept or roll over brokered deposits without approval from the Federal Deposit Insurance Corporation (FDIC), and other institutions are not permitted to accept or roll over brokered deposits at all.

These capital requirements apply not only to depository institutions but also to bank holding companies and savings and loan holding companies on a consolidated basis. However, holding companies with less than $3 billion in consolidated assets that do not engage in significant non-banking activities and meet certain other requirements may qualify for relief under the Federal Reserve’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement. A group seeking to form or acquire a depository institution must consider whether its existing capital structure would meet the capital requirements applicable to depository institution holding companies.  

In connection with the formation of a de novo charter, applicants for deposit insurance must meet the requirements in the FDIC’s Statement of Policy on Applications for Deposit Insurance, including a requirement to raise initial capital in an amount sufficient for the proposed institution to maintain a Tier 1 capital to assets leverage ratio of at least 8% during the first three years of operations. This requirement means the organizers of a new institution must raise sufficient capital up front to fund the institution for the first three years, including projected losses.

Community Reinvestment Act

Depository institutions generally must comply with the Community Reinvestment Act (CRA), which requires the federal regulatory agencies to evaluate a depository institution’s record of meeting the credit needs of its entire community, including low‑ and moderate‑income neighborhoods and customers. State chartered institutions also may be subject to similar requirements imposed under state law. Institutions that engage in a special purpose business or that do not engage in consumer and small business lending may be eligible to be designated as a “special purpose” or “wholesale” institution and be evaluated for CRA purposes based on their community development loans, investments and services. The CRA does not apply to institutions that do not accept insured deposits or to special purpose institutions that do not engage in retail or commercial banking operations by granting credit to the public in the ordinary course of business. However, the Office of the Comptroller of the Currency has stated that it will require applicants for its special purpose national bank Fintech charter to demonstrate a commitment to financial inclusion that in many respects is similar to the CRA.

A company proposing to form or acquire a depository institution must be prepared to demonstrate to the banking regulators that the institution will be able to meet the credit needs of its entire community, and will need to consider whether a business model of lending nationwide may adversely affect its CRA rating. If an institution does not receive a satisfactory performance evaluation under the CRA, its ability to expand through establishment of new branches or through acquiring other institutions may be hampered, and its holding company may be limited with respect to engaging in new activities.   

Bank Holding Company Act and Control Considerations

Any group proposing to form or acquire a depository institution must consider the requirements imposed under the Bank Holding Company Act (BHC Act) and other laws regulating control of depository institutions. Similar requirements apply under the Home Owners’ Loan Act with respect to the acquisition of control of a savings association or savings and loan holding company.

A “company” that directly or indirectly acquires “control” of a “bank” or bank holding company will be treated as a bank holding company, which has important implications for the company and its investors. In particular, bank holding companies are subject to limitations on their investments and activities, are subject to supervision and examination by the Federal Reserve, must serve as a source of financial and managerial strength to their subsidiary banks, and may be subject to the so-called Volcker rule.

With respect to activities and investments, bank holding companies are generally only permitted to own or control banks or companies engaged in activities that are considered “closely related” to banking. Companies that qualify and elect to be treated as financial holding companies may engage in a broader range of activities that are financial in nature or incidental or complementary to such financial activities. Financial activities include lending, securities brokerage, securities underwriting and dealing, providing investment advice, providing and selling insurance and making merchant banking type investments. However, general commercial activities, such as operating a factory or a retail store, and investing in real estate are not financial in nature and may only be conducted on a limited basis as part of a bona fide merchant banking business, subject to holding period limitations and other requirements.

In addition, any company that controls an insured depository institution, or is affiliated with such a company, is generally treated as a “banking entity” subject to the Volcker rule, which means that the company may not engage in proprietary trading of securities and other financial instruments and may not sponsor or acquire or retain an ownership interest in certain types of “covered” investment funds. These restrictions apply not only to the holding company, but also its nonbank subsidiaries and controlling investors.  In May 2018, Congress enacted the Economic Growth, Regulatory Relief, and Consumer Protection Act, the regulatory reform law better known as S. 2155, which exempted banks and holding companies with less than $10 billion in total consolidated assets and trading assets and liabilities comprising not more than 5% of total assets from the Volcker rule. This exemption from the Volcker rule for qualifying organizations may make it significantly easier for non-bank financial services providers to operate through a depository institution charter because investors in this space often engage in activities that are not compatible with the Volcker rule.

The BHC Act applies not only to an entity that forms or acquires a bank but also to its controlling shareholders or investors. Groups seeking a depository institution charter must carefully consider whether investors—who often purchased preferred stock in separate financing rounds—may have “control” of a company under the BHC Act’s definition of control even if the investors own a relatively small percentage of the company’s equity on a fully-diluted basis and even if they don’t have practical day-to-day control over the company. Since investors may be engaged in (or invest in companies engaged in) activities that would be impermissible for a bank holding company or a financial holding company under the BHC Act or in activities that are circumscribed by the Volcker rule, the consequences for these investors of indirectly acquiring control of a bank or bank holding company can be quite onerous and thus undesirable.

There are also other federal and state change in control requirements that may apply in certain circumstances. For instance, the Change in Bank Control Act prohibits any person from acquiring control of an insured depository institution unless the person has first provided at least 60 days’ prior notice to the appropriate federal banking agency for the institution and obtained the agency’s non-objection to the transaction.

Industrial Banks

As noted in the first installment of this series, industrial loan companies (ILCs), sometimes called industrial banks, are state chartered institutions that may be formed under the laws of certain states, including Utah, Nevada, Minnesota, California, and Colorado. ILCs are regulated by state banking authorities and the FDIC, and they are empowered to make loans, provide trust services, and accept certain types of deposits. As insured depository institutions, they may avail themselves of interest rate exportation under the Federal Deposit Insurance Act.

ILCs offer a significant advantage for their owners. A commercial company may own an ILC without becoming a bank holding company if the ILC qualifies under an exemption in the BHC Act for ILCs. To qualify, the ILC must be organized in a state which, on March 5, 1987, had in effect or under consideration in its legislature a statute requiring such an institution to obtain FDIC insurance and either (1) must not have assets exceeding $100 million or (2) must not accept demand deposits. While the limitation on accepting demand deposits is significant, it does not preclude an ILC from providing checking accounts to consumers, since negotiable order of withdrawal accounts—or “NOW accounts”—that provide check writing and other transactional capabilities may be offered to individuals but are not considered demand deposits. Since qualifying ILCs are not “banks” for purposes of the BHC Act, a company that acquires control of an ILC is not a bank holding company and need not comply with the BHC Act’s limitations on activities and investments.

Notably, while the ILC exception from the BHC Act is quite significant, it comes with some important limitations. In particular, any company that directly or indirectly controls an ILC will be considered a “banking entity” subject to the Volcker rule (unless exempted under S.2155). In addition, a company that directly or indirectly controls a California industrial bank may only engage in activities that are considered financial in nature. Further, a provision in the Dodd-Frank Act mandates that the Federal banking regulators require any company that directly or indirectly controls an insured depository institution that is not a subsidiary of a bank holding company or a savings and loan holding company to serve as a source of financial strength for the institution. This requirement means that a controlling investor could be called upon to provide capital support to a subsidiary depository institution, such as an ILC, at a time when it might prefer not to do so. As a result, it is essential that any company considering acquiring control of an ILC evaluate the impact of these requirements on the company and its investors.

While there are many potential benefits of operating through an ILC, in recent years the charter has as a practical matter been unavailable to new entrants and acquirers since the FDIC has not acted on an application for deposit insurance for a new ILC or approved a change in control of an existing ILC in more than a decade. However, there is currently no legal moratorium or prohibition in effect that would prevent the FDIC from approving deposit insurance for an ILC or a change in control of an ILC, and there are signs that the agency may be willing to do so in the near future.

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Goodwin’s Financial Institutions practice is recognized as a leading provider of banking and consumer financial services legal advice. We counsel our clients on all aspects of bank regulatory and consumer financial services law, including bank chartering proposals and bank mergers and acquisitions. Our attorneys also work with entrepreneurs seeking to establish non-bank financial services providers, including Fintech businesses, and with venture capital and private equity firms that invest in these businesses.