This second installment in a series of insights on bank charter considerations describes the consequences of operating through an insured depository institution charter, including capital requirements, supervision and examination by bank regulatory authorities, and potential limitations imposed on controlling shareholders and investors.
The first installment addressed the reasons why a nonbank financial services provider might want to operate through a bank,1 the types of charters available, and high-level considerations relevant to choosing the right charter. Some of the benefits of operating through a bank charter include access to lower-cost funding sources, the ability to operate through a federal charter that offers more uniformity of regulation on a nationwide basis through preemption of many state licensing and compliance requirements, and general exportation of interest to borrowers throughout the country.2
An upcoming third installment will address the process for seeking regulatory approval to form or acquire an insured depository institution.
Capital Requirements
Banks typically must operate with higher levels of capital than nonbank financial services businesses. New and existing banks must meet leverage and risk-based capital requirements imposed by 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. Qualifying banks can opt into the community bank leverage ratio framework, which alleviates the burdens of periodically calculating and reporting risk-based measures of capital. 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, a bank should be well capitalized, which requires more capital than the minimum capital requirement; banks that are merely adequately capitalized are not permitted to accept or roll over brokered deposits without approval from the Federal Deposit Insurance Corporation (FDIC), and banks that are less than adequately capitalized are not permitted to accept or roll over brokered deposits at all.
These capital requirements apply not only to banks 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 nonbanking 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 bank must consider whether its existing capital structure would meet the capital requirements applicable to depository institution holding companies. Companies with significant amounts of preferred stock in their capital structure may need to convert preferred stock to common stock in order to meet risk-based capital requirements to establish minimum amounts of common equity Tier 1 capital and to address control considerations addressed below.
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
Bank must comply with the Community Reinvestment Act (CRA), which requires federal regulatory agencies to evaluate a bank's record of meeting the credit needs of its entire community, including low and moderate income neighborhoods and customers. State-chartered banks 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.
A group seeking to form or acquire a bank must demonstrate to banking regulators that the bank will be able to meet the credit needs of its entire community. If a bank 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
A group proposing to form or acquire a bank must consider the requirements imposed under the Bank Holding Company Act (BHC Act) and other laws regulating control of depository institutions.3
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.4 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 permitted to engage directly or indirectly only in banking or managing or controlling banks and other activities permitted under the BHC Act, including activities that are considered "closely related" to banking, subject in certain cases to compliance with prior-approval requirements. These "closely related" activities include agency securities brokerage, lending, and providing investment advice. Bank holding 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. In addition to activities that have been determined to be closely related to banking, activities that are financial in nature include securities underwriting and dealing, 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 (other than bank premises or real estate acquired through foreclosure or otherwise in satisfaction of a debt previously contracted), are not closely related to banking or financial in nature and may be conducted only on a limited basis as part of a bona fide merchant banking business or insurance underwriting business, subject to holding period limitations (with respect to merchant banking investments) and other requirements.
In addition, any company that controls a bank, or is affiliated with such a company, is generally treated as a "banking entity" subject to the Volcker rule, which means 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 to not only the holding company but also its nonbank subsidiaries and controlling investors. 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 are exempt from the Volcker rule. This exemption from the Volcker rule for qualifying organizations may make it significantly easier for nonbank 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 bank 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 do not have practical day-to-day involvement with the company. Because 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. To avoid the possibility that certain investors may be regarded as having control for BHC Act purposes, a company that is considering forming or acquiring a bank may need to consider eliminating separate class or series protective rights or converting preferred stock to common stock.
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; many states have change-in-control requirements that may be applicable to persons or entities acquiring a direct or indirect interest in a state-chartered institution.
Industrial Banks
Industrial loan companies, sometimes called industrial banks (collectively, ILCs), 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.
A commercial company may own or control 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 that, 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 must not have assets exceeding $100 million or 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. Because 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 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). In addition, a company that directly or indirectly controls a California industrial bank may engage only in activities that are considered financial in nature. Further, a provision in the Dodd-Frank Act mandates that 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. Finally, FDIC regulations also require certain conditions and commitments for approval or non-objection to filings involving an ILC whose parent company is not subject to supervision by the Federal Reserve; the regulations also require the FDIC's prior written approval before an ILC that is a subsidiary of such a covered parent company may take certain significant business and managerial actions.
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.
We discuss ILCs and the FDIC's rules applicable to covered parent companies in more detail here.
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The consequences of operating a bank charter can be significant, and a group considering the formation or acquisition of a bank charter should consider the capital requirements, supervision and examination by bank regulatory authorities, and potential limitations imposed on controlling shareholders and investors.
Footnotes
1. We reference bank here to mean an insured depository institution.
2. State-chartered insured banks do not generally benefit from federal preemption of state laws (other than with respect to interest rate exportation) but may in some cases be able to avail themselves of exemptions from state licensing requirements that are not available to nonbank entities.
3. 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.
4. See our alert about the Federal Reserve's control rule here.
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.
