United States: Financial Regulatory Reform - Effects on Federal Thrift Institutions

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act"). The Reform Act consists of the conference report that reconciled the House-passed version of financial regulatory reform ("H.R. 4173") and the Senate-passed version of financial regulatory reform (the "Senate Bill"). This alert focuses specifically on the effects of the Reform Act on federal thrifts and is one is a series of alerts on the Reform Act.

The full Reform Act and an index and links to our other Client Alerts on the Reform Act can be found through Sonnenschein's Financial Regulatory Reform website.

A. Changes in Prudential Bank Regulation

The Reform Act alters the system of prudential bank regulation that has existed for the past 80 years by, among other things, (i) effectively merging the Office of Thrift Supervision ("OTS") into the Office of the Comptroller of the Currency ("OCC") and (ii) transferring certain OTS responsibilities and authorities to the Federal Deposit Insurance Corporation ("FDIC") and the Board of Governors of the Federal Reserve System ("Federal Reserve"). Under the Reform Act, all federal thrifts and all savings and loan holdings companies will experience a change in their primary federal regulator at both the bank and holding company levels.

In addition, by leaving in place the state banking system that governs many community banks, the Reform Act preserves the dual banking system. All state chartered banks would continue to be regulated by their state banking regulator, the Federal Reserve would continue as the primary federal regulator of state member banks and the FDIC would continue as the primary federal regulator of state nonmember banks and state savings associations.

However, due to significant amendments in the Senate prior to final passage of the Senate Bill, the Reform Act does not affect quite the "sea change" in reforming the regulatory environment for banks and thrifts as once had been proposed. Specifically, unlike the version of the Senate Bill proposed by Senator Dodd on March 15, 2010 and discussed in the April Alert, the Reform Act does not:

• prohibit the issuance of new federal thrift charters;
• strip the Federal Reserve of its supervisory authority over state member banks and transferring such powers to the FDIC;
• limit the Federal Reserve's supervisory authority over holding companies to bank and thrift holding companies with consolidated assets of $50 billion or more; and
• transfer supervisory authority over bank and thrift holding companies with consolidated assets of less than $50 billion to the OCC (in the case of national banks and federal thrifts) and the FDIC (in the case of state banks and thrifts).

B. Effect on Federal Thrifts

While proponents of the thrift charter were able to preserve the charter and many of its benefits during the Conference Committee deliberations, the Reform Act nevertheless represents a fundamental regulatory change for thrift institutions, eliminating certain historical benefits of a thrift charter. Some of the provisions which will impact federal thrifts particularly are:

• Abolition of the OTS; Expanded Authority of the OCC and Federal Reserve. Under Title III of the Reform Act, the OTS would effectively be merged into the OCC, with certain OTS responsibilities and authorities also being transferred to the FDIC and the Federal Reserve. Specifically:
• • The OCC will take over all functions and authority from the OTS relating to federal thrifts and the FDIC will take over all functions and authority from the OTS relating to state thrifts. The Federal Reserve will acquire supervisory and rulemaking authority over all savings and loan holding companies. The Federal Reserve will also become the supervisor of all subsidiaries of savings and loan holding companies other than depository institutions (the federal thrift subsidiaries of savings and loan holding companies will be supervised by the OCC). As a result of these changes, the OCC will become the primary federal regulator for all national banks and federal thrifts and the Federal Reserve will be the primary federal regulator for all depository institution holding companies. The FDIC will continue to oversee the deposit insurance fund and retain its resolution authority over depository institutions.
  • The OTS will be merged into the OCC and the foregoing responsibilities and authorities would be transferred on July 21, 2011 unless the Secretary of the Treasury opts to delay the transfer for up to an additional six months. Effective 90 days after such date of transfer, the OTS would be abolished.
  • All OTS personnel will be transferred to the OCC, including the examination staff. However, unlike H.R. 4173, the Reform Act does not create a Division of Thrift Supervision within the OCC.
  • The OCC has been working on a transfer and transition plan and will be grappling with both substantive and practical issues in connection with the transfer. Substantive issues include developing an examination approach for institutions with significant concentrations in 1-4 family residential loans on their balance sheet and understanding and evaluating the related particular interest rate risk issues.
• Survival of the Home Owners' Loan Act. The Home Owners' Loan Act, as amended ("HOLA"), which is the primary statute governing the establishment, operation and regulation of federal thrifts and savings and loan holding companies, will survive under the Reform Act with relatively few changes. The HOLA would have survived under the Senate Bill as well, but would have been abolished under H.R. 4173, which proposed that all existing savings and loan holding companies become bank holding companies and be regulated pursuant to the Bank Holding Company Act.
• Preservation of the Thrift Charter. The Reform Act preserves the power to grant new federal thrift charters. In doing so, the Reform Act avoids the certainty set forth in the Senate Bill, of the phase out and eventual extinction of the federal thrift charter. However, other aspects of the Reform Act discussed herein water down the historical benefits of the thrift charter and thus level the playing field between national banks and thrifts.
• Penalties for Failure to Meet Qualified Thrift Lender Test. The Reform Act establishes penalties for federal thrifts that fail to meet the requirements of the Qualified Thrift Lender Test. Specifically, federal thrifts that fails to meet the Qualified Thrift Lender Test will be prohibited from paying dividends, unless such dividends are: (i) permissible for national banks, (ii) necessary to meet the obligations of the company that controls the thrift and (iii) specifically approved by the OCC and the Federal Reserve. The Reform Act also provides that federal thrifts that fail to meet the Qualified Thrift Lender test will be deemed to have violated Section 5 of the HOLA and be subject to enforcement action under Section 5(d) thereunder. Restrictions on activities and branching applicable to federal thrifts that fail to meet the requirements of the Qualified Thrift Lender Test under current law will also continue to apply.
• Future OCC Rulemaking. The Reform Act requires the OCC to issue rules and conduct studies on a wide range of subjects. By July 21, 2011, the OCC must identify and publish in the Federal Register those regulations, orders and procedures followed by the OTS that the OCC will enforce [Section 316(c)]. By January 21, 2012, in conjunction with the other banking regulators, the OCC must jointly issue final rules to implement limitations on purchases of assets from insiders [Section 621] and also prepare a report on the activities that a banking entity may engage in under Federal and State law, including interpretation and guidance [Section 620(a)-(b)] By April 21, 2011, the OCC, along with the other relevant Federal regulators, must also issue regulations/guidelines for enhanced compensation reporting by each covered institution [Section 956(a)(1)], and rules prohibiting any types of incentive-based payment arrangements that encourage inappropriate risks by covered financial institutions [Section 956(b)].
  
  The OCC, jointly with the other financial regulators, is directed to establish minimum requirements to be applied by a State in the registration of appraisal management companies [Section 1473 (f)] and, quarterly, to publish and submit a list of the Comptroller's preemption determinations [Section 1044 (a)]. By January 21, 2011, the OCC must also establish an Office of Minority and Women Inclusion responsible for all matters related to diversity [Section 342(a)(1)(A)] and thereafter submit an annual report as to the efforts of the OCC and the Office pursuant to Section 342.
• Effect on Savings and Loan Holding Companies. Like the Senate Bill but unlike H.R. 4173, the Reform Act does not eliminate the savings and loan holding company or expressly provide that savings and loan holding companies will be regulated as bank holding companies. Savings and loan holding companies will continue to be subject to the HOLA, but now administered by the Federal Reserve. However, by vesting rulemaking authority and supervision over savings and loan holding companies with the Federal Reserve, savings and loan holding companies may become subject to activities restrictions and other new regulatory requirements to which they may not have previously been subject and the Federal Reserve could use such rulemaking authority to effectively cause savings and loan holding companies to be regulated like bank holding companies. In addition, the Reform Act explicitly requires that regulatory capital requirements be imposed on savings and loan holding companies for the first time.
• Interstate Branching and Acquisitions. In a significant change from the Senate Bill, the Reform Act does not make any change to the ability of a federal thrift to branch interstate. However, a federal thrift that converts to a bank will be permitted to continue to operate branches in existence, or in the process of being formed, prior to the enactment, and may establish additional branches in the states in which it operated prior to becoming a bank (provided such establishment would be permissible for a State bank under such State's laws). The Reform Act also expands the interstate branching opportunities afforded to national banks and insured state banks by eliminating state reciprocity requirements, the primary state obstacle to interstate de novo branching. National banks and insured state banks will now be permitted to establish a de novo branch in a state if a bank chartered by such state would have been permitted to establish the branch. These changes remove one of the significant advantages that the federal thrift charter historically had over the national bank charter. The Reform Act also bolsters the requirements for interstate acquisitions, now requiring that the acquiring financial institution be well-managed and well-capitalized, as opposed to the current requirement that such institution be adequately capitalized and adequately managed. The change in the interstate acquisition requirements indicates that the regulators are expecting a cushion over the well-capitalized levels.
• Preemption Issues. The Reform Act specifically states that the HOLA "does not occupy the field in any area of State law" (emphasis added) and adds a new section to the HOLA which requires the OTS (and the OCC as its successor agency) and any court to make federal preemption determinations in accordance with the laws and legal standards applicable to national banks regarding the preemption of state law. Therefore, the Reform Act ends the broad field preemption authority that federal savings associations have enjoyed in the past and expressly applies the preemption standards applicable to national banks to federal thrifts. Because the Reform Act also significantly rolls back the broad preemptive authority that the OCC has enjoyed by requiring that (1) a state consumer financial law "prevent or significantly interfere with" the exercise of a national bank's powers before it can be preempted and (2) any preemption determination be made on a case-by-case basis, rather than by a blanket rule, the Reform Act effectively "levels the playing field" between federal savings associations and national banks on the preemption issue so that both are now subject to the Barnett standard. Accordingly, this provision is a "game changer" for thrifts.
• Transaction with Affiliates. The Reform Act broadens the scope of covered transactions to effectively limit the assets an insured depository institution can place at risk through the operations of an affiliate. The definition of a "covered transaction" in Regulation W is expanded to subject derivative transactions and any credit exposure by a bank to its limits and requirements. Any purchase of assets from, or sale of assets to, an executive officer, director, or principal shareholder by a bank must be on market terms and, if the transaction represents more than 10% of the capital stock and surplus of the bank, must be previously approved by a majority of the uninterested board of directors. The Federal Reserve would retain rulemaking authority over transactions with affiliates, including Regulation W, which has been expanded to include derivative transactions and any credit exposure by a bank to its limits and requirements for covered transactions.
• Mutual Holding Company Dividend Waiver. The Reform Act grandfathers mutual holding companies that had waived receipt of dividends prior to December 1, 2009 from having waived dividends, past or future, be counted against the exchange ratio in any second-step conversion transaction. In addition, the Reform Act preserves the right of mutual holding companies that had waived receipt of dividends prior to December 1, 2009 to waive dividends going forward, so long as any such dividend waiver would not be detrimental to the safety and soundness of a savings association and the board of directors of the mutual holding company expressly determines that such dividend waiver is consistent with the board's fiduciary duty to the mutual members of the mutual holding company. Although the intent of this language was and is to permit mutual holding companies that had waived dividends in the past in reliance on existing OTS regulations to continue to do so, it remains to be seen how the Federal Reserve will administer dividend waiver requests and interpret the "safety and soundness" requirement in light of the historical animosity of the Federal Reserve towards dividend waivers. Mutual holding companies that had not waived dividends prior to December 1, 2009 will not be permitted to waive dividends going forward.
• Mortgage Loan Origination and Risk Retention. The Reform Act amends the Truth in Lending Act to impose new standards for residential mortgage loan originations on all lenders, including all banks and thrifts. Of significance are new standards with respect to the originator's determination of a borrower's ability to repay the loan in accordance with its terms, including income verification by the originator in connection with processing a borrower's loan application. Under the Reform Act, the originator is obligated to make a reasonable and good faith determination based on verified and documented information that the borrower has a reasonable ability to repay the loan in accordance with its terms. Among other requirements in connection with this determination, income verification should include the expected income or assets, determined by reviewing the consumer's Internal Revenue Service Form WÐ2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of the consumer's income or assets. Following the lead of many state legislatures which have implemented ability-to-repay requirements on non-depository lenders at the state-level, this new provision creates a federal standard requiring that residential mortgage loans are fully-underwritten to confirm the appropriateness of the loan product for the borrower. Qualified mortgages (as defined and discussed below) will be presumed to comply with the repayment ability requirement.
  
  The Reform Act also requires the federal banking agencies to jointly promulgate regulations by April 21, 2011 which, among other things, require any securitizer to retain an economic interest (generally 5%) in the credit risk for any residential mortgage loan that the securitizer, through the issuance of a mortgage-backed security, transfers to a third party. The securitizer's required percentage of risk retention will be reduced by the percentage of risk retention obligations required of the mortgage originator. The regulations are required to specify the permissible forms of risk retention and the minimum period of time for which the risk must be retained. The Reform Act instructs the federal regulators to develop separate rules governing the securitization of different asset classes, including for residential mortgages, commercial mortgages, commercial loans, auto loans and any other classes that such regulators deem appropriate.
  
  The Reform Act requires that the federal banking regulators jointly issue regulations to exempt "qualified residential mortgages" from the risk retention requirements of the Reform Act. The definition of "qualified residential mortgage" cannot be broader than the definition of "qualified mortgage," which is defined as any residential mortgage loan which has the following characteristics:
• • the regular periodic payments do not result in an increase of the principal balance or permit the consumer to defer repayment of principal, except as otherwise provided in regulations issued by the Federal Reserve;
  • the terms of the loan do not result in a balloon payment, except as otherwise provided in regulations issued by the Federal Reserve;
  • the income and financial resources of the borrowers are verified and documented;
  • in the case of a fixed rate loan, the underwriting process is based on a payment schedule that fully amortizes the loan and takes into account all applicable taxes, insurance and assessments and, in the case of an adjustable rate loan, the underwriting is based on the maximum rate permitted under the loan during the first 5 years and a payment schedule that fully amortizes the loan and takes into account all applicable taxes, insurance and assessments;
  • the loan complies with any guidelines established by the Federal Reserve relating to debt-to-income ratios or alternative measures of ability to pay;
  • loans for which the total points and fees (as defined under HOEPA) minus bona fide discount points which do not exceed 3% of the total loan amount; and
  • the term of the loan does not exceed 30 years, except as provided by the Federal Reserve.

C. Next Steps

The many new financial regulations that are expected to be proposed, amended and finally adopted to implement the Reform Act will require careful review and analysis as they are likely to have a significant impact on the way that federal thrifts must conduct their business. The process for the consideration of these regulations will provide important opportunities for financial institutions, including federal thrifts that may be adversely impacted, to influence the substance of these regulations by offering comments and suggesting more attractive alternatives. Finally, as financial regulations are considered and ultimately adopted to implement the Reform Act, federal thrifts should review whether changes are required in their operations or in their regulatory compliance programs to ensure that they can comply with their new obligations under the new bank regulatory regime. Although the impact of the consolidation of the OTS into the OCC has yet to play out, all federal thrifts should begin to consider the following actions:

• Evaluate the existing OCC examination guidelines in advance of their next examination Ð although the formal transfer is at least a year in the future, the OCC and the OTS will be working with each other and are likely to conform examination approaches at some point
• Compare the benefits of the new thrift charter with a national bank and applicable state bank charter -- charter conversion remains available to interested thrifts
• Evaluate consolidated holding company capital and capital alternatives available in the market place, especially for the thrift holding companies with significant double leverage through the issuance of holding company debt where the debt proceeds were contributed as equity to the thrift subsidiary
• Review their regulatory compliance programs to ensure that they can comply with their new obligations under the new bank regulatory regime.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.