Industrial Banks are state-chartered, federally insured depository institutions subject to supervision by the FDIC and the applicable state regulator.3 Industrial Banks chartered under state law that meet certain requirements are carved out from the definition of “bank” under the Bank Holding Company Act (BHCA).4 As a result of the carveout, control of an Industrial Bank does not cause the Industrial Bank’s controlling entity to be a bank holding company (BHC) under the BHCA that is subject to supervision on a consolidated basis by the Board of Governors of the Federal Reserve System (the Board). A controlling entity is therefore not precluded from engaging in ordinary commercial activity solely by virtue of its ownership of an Industrial Bank.
Industrial Banks generally have the same commercial and consumer lending power as commercial banks and may offer similar services. Industrial Banks may not offer demand deposit accounts but may offer other deposit products such as savings accounts, certificates of deposit and “negotiable order of withdrawal” or “NOW” accounts. They are subject to the Federal Deposit Insurance Act (FDIA), FDIC regulations and certain provisions of the Federal Reserve Act as well as applicable law of the chartering state.5
Today, interest in Industrial Bank charters has been piqued for emergent business models and innovative technologies because of the flexibility offered by Industrial Bank structures. The industry has seen an uptick in companies, particularly financial technology firms, that “engage in commercial activities or have diversified business operations ... that would not otherwise be permissible for BHCs under the BHCA” pursuing deposit insurance for Industrial Banks.
2. The Rules
The NPR purports to codify the FDIC’s “existing practices” by imposing on certain companies that control or propose to control, directly or directly, an Industrial Bank (each, a Covered Company) certain commitments and restrictions with respect to (i) any grant of deposit insurance by the FDIC to the Industrial Bank on or after the effective date of any final rulemaking (Effective Date) and (ii) any change of control of the Industrial Bank approved by the FDIC on or after the Effective Date.
The purpose of the NPR is to implement a regulatory regime applicable to Covered Companies and administered by the FDIC that is analogous to consolidated oversight of BHCs by the Board, in order to reduce risk and enhance the safety and soundness of Industrial Banks, reduce risk to the deposit insurance fund (DIF) and ensure that Covered Companies act as a “source of financial strength” for Industrial Banks.
The NPR would apply only to Covered Companies that are not subject to federal consolidated supervision by a banking regulator and would apply only prospectively, that is, it does not apply to a Covered Company of an Industrial Bank whose federal deposit insurance was granted before the Effective Date and over which the parent company gained control prior to the Effective Date.6 If a company acquires control of an Industrial Bank after the Effective Date, the NPR would apply, without regard to when the Industrial Bank was granted deposit insurance. Moreover, as indicated below, the FDIC specifically requests comment on whether this is the appropriate approach and whether existing Industrial Banks should be brought under the proposed rule.
Control of an Industrial Bank may be direct or indirect for purposes of determining Covered Company status. Only business entity controllers are Covered Companies. If an Industrial Bank is controlled only by individual shareholders, the NPR would not apply. However, in an important change from past practice, an individual shareholder who controls a Covered Company may be required to enter a written agreement with the FDIC, as noted below. “Control” means the power, directly or indirectly, (i) to vote 25 percent or more of any class of voting shares of any Industrial Bank or any company that controls the Industrial Bank or (ii) to direct the management or policies of any Industrial Bank or any parent company. There is a presumption of control at 10 percent direct or indirect ownership, control or power to vote shares if (i) the Covered Company or Industrial Bank is a public company or (ii) no other person will own, control or hold power to vote a greater percentage.
b. Written Agreement
Each Covered Company must enter a written agreement with the FDIC that includes the following commitments and restrictions. The FDIC has discretion to require an individual controller to join the agreement as a party and may in its discretion impose additional commitments and restrictions. Although this reservation of an unfettered authority to impose additional restrictions is consistent with historical FDIC practice, it undercuts the FDIC’s effort to provide greater certainty to the process. In particular, Covered Companies with substantial commercial activities are at risk that this authority will be used in a way that hinders their applications.
Commitments. The NPR imposes a series of enterprisewide commitments on Covered Companies intended to “provide the FDIC with more timely and more complete information about the activities, financial performance and condition, operations, prospects, and risk profile of each Covered Company and its subsidiaries and affiliates.” Each Covered Company must
- provide and maintain a list of all Covered Company subsidiaries
- consent to FDIC examination of the Covered Company and all subsidiaries with respect to, among other things, compliance with the written agreement and “all relevant laws and regulations”
- submit an annual report describing the Covered Company’s financial condition, risk controls, transactions between the Covered Company and its Industrial Bank and other depository institution subsidiaries and the Covered Company’s compliance with applicable law (including the FDIA)
- maintain records as the FDIC deems necessary to assess risks to the DIF
- submit an annual independent audit of each Industrial Bank subsidiary
- limit the Covered Company’s representation on each Industrial Bank subsidiary’s board to 25 percent, a new limitation that would hinder the ability of a Covered Company to manage the Industrial Bank for which it would have unfettered financial responsibility
- maintain the capital and liquidity of each Industrial Bank subsidiary at such levels as the FDIC deems appropriate and take such other actions as the FDIC deems appropriate to provide the Industrial Bank with a resource for additional capital and liquidity (e.g., pledging assets, third-party letter of credit, indemnity)
- enter a tax allocation agreement with each Industrial Bank subsidiary designating the Covered Company to be an agent of the Industrial Bank, requiring that all tax assets be held in trust and requiring prompt remission of payments or refunds (on timing no less favorable than if the Industrial Bank were a separate taxpayer)
- In the FDIC’s discretion:
- Each Covered Company may be required to adopt an approved “contingency plan” describing both recovery actions to be taken to address various types of stress and strategies for an orderly disposition without the need for a receiver, taking into account the “size, complexity, interdependencies, and other factors relevant to the [Industrial Bank] and Covered Company.”9 The intent is to provide an understanding of risk, stress and interdependencies, and the NPR distinguishes its resolution-related aspects from a formal resolution plan as follows: “The contingency plan would not be a resolution plan, but rather, an explanation of the steps the industrial bank and Covered Company could take to mitigate the impacts of financial and operational stress outside of the receivership process.”10
- The FDIC may require additional commitments, including by a controlling shareholder of a Covered Company.
Restrictions. The restrictions imposed by the NPR are generally intended to ensure that an Industrial Bank does not engage in high-risk activities and to limit the influence that a Covered Company may have on an Industrial Bank subsidiary. Without FDIC approval, an Industrial Bank controlled by a Covered Company shall not
- make a material change to its business plan (in a change from historical practice, this requirement is not limited to the first three years of the Industrial Bank’s operation)
- add or replace a director or senior executive officer
- employ a senior executive officer “associated in any manner (e.g., as a director, officer, employee, agent, owner, partner or consultant) with” an affiliate
- enter a material contract for services (e.g., loan servicing) with the Covered Company or any subsidiary thereof
In addition, under existing law, the FDIC “may and likely will condition approval on one or more actions or inactions of the applicant or notificant.”12
3. Square and Nelnet Orders
On the same day the FDIC board voted on the NPR, it approved an order granting deposit insurance to SFSI and requiring Square, Inc., SFSI’s parent company, and Jack Dorsey, its controlling shareholder, to enter into separate written agreements with the FDIC.13 Although those agreements do not appear to have been made public, based on a statement by one of the FDIC board members, those documents have the conditions that are largely consistent with the requirements that would be imposed under the NPR but also added some onerous specific financial protections, including the obligation to maintain the leverage ratio of the proposed bank at least 20 percent at all times. The approval order for Nelnet and the separate agreements contemplated therein also appear largely to parallel the NPR.14
4. Key Questions for Consideration
The NPR, together with the FDIC’s grant of deposit insurance the same day to SFSI and Nelnet, suggest that the FDIC may continue to process Industrial Bank applications in the ordinary course. However, certain questions posed in the NPR, including whether the rules should cover existing Industrial Banks and companies owning other forms of special charter such as credit card banks and limited purpose trust companies, also indicate that the FDIC is considering potentially more restrictive limitations in the final rule. Moreover, although the FDIC Chairman indicated that the question of the separation of banking and commerce is one to be resolved by Congress, the FDIC’s selection of two “financial” applications as their first Industrial Bank approvals in over a decade seems to indicate a reluctance to move quickly on applications that raise that issue.
Any company with any interest in the outcome of regulation of Industrial Banks or other special purpose charters should consider commenting on the NPR.
1 Https://www.fdic.gov/news/board/2020/2020-03-17-notational-fr.pdf (Mar. 17, 2020). The NPR has not yet appeared in the Federal Register. It will be subject to a notice and comment period due to expire 60 days following publication.
2 FDIC, Order re: Square Fin. Servs., Inc. (Mar. 17, 2020), https://fdic.gov/news/news/press/2020/pr20033a.pdf (Square Order); FDIC, Order re: Nelnet Bank (Mar. 17, 2020), https://www.fdic.gov/news/news/press/2020/pr20034a.pdf (Nelnet Order).
3 All Industrial Banks in existence today are “state nonmember banks,” meaning they are state-chartered and are not members of the Federal Reserve System. Their primary federal regulator therefore is the FDIC, though it is theoretically possible for an Industrial Bank to become a member and be subject to primary federal regulation by the Board.
4 See Competitive Equality Banking Act of 1987, Pub. L. 100-86, 101 Stat. 552 (Aug. 10, 1987) (amending BHCA definition of “bank”); 12 U.S.C. § 1841(c)(2)(H) (excepting Industrial Banks from BHCA definition of “bank”). To qualify for the exception, (i) the law of the chartering state must have required federal deposit insurance as of March 5, 1987, and (ii) the Industrial Bank must (A) not accept demand deposits, (B) have total assets of less than $100 million or (C) have been acquired prior to August 10, 1987. See 12 U.S.C. § 1841(c)(2)(H).
5 Industrial Banks are currently chartered in California, Hawaii, Minnesota, Nevada and Utah. NPR, at 8.
6 Note, however, that the NPR reserves authority to require out-of-scope Covered Companies that are not subject to federal consolidated supervision by the Board to “to enter into written agreements, provide commitments, or abide by restrictions if necessary to maintain the safety and soundness of the industrial bank.” Id. at 36; see id. at 59.
7 Id. at 29.
8 Id. at 56.
9 Id. at 33–34, 57.
10 Id. at 34.
11 See Square Order, at ¶ 3 (requiring Jack Dorsey to enter into a Capitalization and Liquidity Maintenance Agreement and a Parent Company Agreement as a controlling shareholder of SFSI’s parent, Square, Inc.); Nelnet Order, at ¶ 3 (same with respect to Michael S. Dunlap, as controlling shareholder of Nelnet’s parent, Nelnet, Inc.).
12 See 12 C.F.R. § 303.2(dd) for a list of standard conditions.
13 See Square Order, ¶ 3.
14 See Nelnet Order, ¶ 3.
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