Introduction to Banking Regulation

December 4, 2014

Paul T. ClarkDaphne A. Trainor

Introduction and Themes

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Historic Policy Concerns• Populist fear of concentrated economic power in large

financial institutions, including the concern of affiliation between banking and commercial companies.

• Deference to power of the states to license and regulate banks, and related concerns about centralized regulation in the federal government.

• Encouraging home ownership, including creating separate federal charter and deposit insurance fund to support home lending.

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Timeline of Major Banking Legislation

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1913 1933 1956 1980 1989 1991 1994

1999

Federal Reserve

Act

Banking Act of 1933 (includes Glass-Steagall)

Bank Holding Company Act of

1956

Depository Institutions

Deregulation and

Monetary Control Act

of 1980

FDICIA

Riegle-Neal Act

GLBA

FIRREA

Great DepressionGreat DepressionHyper Inflation

2008

Financial Crisis and Severe Recession

Emergency Economic

Stabilization Act (TARP)

Dodd-Frank Act

Savings & Loan CrisisFinancial Panics

2010

Elvis performs on Ed Sullivan

Newt Gingrich elected Speaker of the House

Wayne Gretzky retires

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Decrease in Number of Insured Depository Institutions(including thrifts and U.S. branches of foreign banks)

1985-2014

Year Insured Depository Institutions

1985 18,043

1987 17,345

1992 13,973

1997 10,923

2002 9,354

2007 8,544

2012 7,083

2013 6,821

6/30/2014 6,665

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Concentration of Assets among Top Five Banking Institutions

As of June 30, 2014 As of December 31, 1992

Bank Assets/percent of assets of all

banking institutions ($14.5

Trillion)

Bank Assets/percent of assets of all

banking institutions

($3.5 Trillion)

JP Morgan Chase $2.0 Trillion/13.2%

Citibank $164 Billion/4.7%

Bank of America $1.5 Trillion/9.9%

Bank of America $133 Billion/3.8%

Wells Fargo $1.4 Trillion/9.2%

Chemical Bank $109 Billion/3.1%

Citibank $1.4 Trillion/9.2%

Morgan Guaranty (JP Morgan)

$77 Billion/2.2%

US Bank $.4 Trillion/2.0%

Chase Manhattan $74 Billion/2.1%

Total$6.7 Trillion/43.5%

$557 Billion/15.9%

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Decrease in Number of Savings and Loans

(state and federally-chartered)

1984: 3,428

2014*: 899

*As of 6/30/14

Elimination of Exclusive State Regulation

Total Number of Insured Depository Institutions

Number of Insured Depository Institutions That Were Not Members of the Federal Reserve

System

Percentage of Insured Depository Institutions That Were Not Members of the Federal Reserve

System

December 31, 199015,158

9,724 64%

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What Is a Bank?

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Depository Institutions Are Overwhelmingly State-Chartered

State Chartered: 5,083

Federally Chartered: 1,582

as of 6/30/14

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17 states define "banking" to include solicitation and receipt of deposits:

"No person who has not received a certificate from the commissioner authorizing it to engage in the banking business shall solicit or receive deposits…" (California Financial Code,§790).

31 states define "banking" to include receipt and/or acceptance of deposits but are silent regarding solicitation:

"No corporation, domestic or foreign, other than a national bank or a federal reserve bank, unless expressly authorized by the laws of this state, shall employ any part of its property, or be in any way interested in any fund which shall be employed for the purpose of receiving deposits, making discounts, receiving for transmission or transmitting money in any manner…" (New York Banking Law, §131)

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3 states do not define "banking" by reference to specific activities:

"Banking institution means an institution that is incorporated under the laws of this State as a State bank or trust company." (Maryland Financial Institutions Code, §101.d)

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What Is a “Deposit”?

“the unpaid balance of money or its equivalent received or held by a bank . . . in the usual course of

business and for which it has given or is obligated to give credit, either conditionally or unconditionally. . .”

Federal Deposit Insurance Act §3(l)

Entities That Operate without a Bank License

• Broker-Dealers

• Title Companies

• Issuers of Stored Value Cards

• Social Crowdfunding Websites (i.e., Kickstarter, Indiegogo)

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State Money Transmitter Regulations

"Money transmission" means any of the following:

(1) Selling or issuing payment instruments.

(2) Selling or issuing stored value.

(3) Receiving money for transmission.

Money Transmission Act, Cal. Fin. Code § 2003(o)

FinCEN Regulation of Money Transmitters

Money services businesses (MSBs), which are defined to include money transmitters, must:– Register with FinCEN (FinCEN registration does not satisfy

state money transmitter registration requirements)– Comply with all federal AML laws and other BSA reporting

requirements

The IRS has examination authority over the AML programs of FinCEN-registered MSBs.

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Three Ways to Obtain Trust Powers

1. Apply to the OCC or a state licensing authority for a banking charter with trust powers.

2. Many states (including NY) offer a limited purpose trust charter that permits the exercise of fiduciary authority but does not confer deposit-taking authority and does not require FDIC insurance.

3. Until recently, the OCC offered trust-only charters without FDIC insurance. Now, newly established non-depository trusts are required by the OCC to have FDIC insurance.

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What Makes Banks Special?

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Other Unique Features of Banks• FDIC deposit insurance

• Exemption from certain aspects of the federal securities laws– deposit accounts are not "securities" for '33 and '34 Act

purposes (considered "securities" for purposes of the Investment Company Act and Investment Advisers Act)

– bank-issued "securities" are exempt from registration with the SEC

– guarantee by a bank of securities of other issuers exempts those securities from registration

– ability to conduct certain securities transactions otherwise requiring broker-dealer registration

• Role as credit intermediaries: banks are the primary source of funding for small and mid-size businesses that cannot otherwise access capital markets

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Why Are Banks Afforded Special Treatment?

“This certificate of deposit was issued by a federally regulated bank which is subject to the comprehensive set of regulations governing the banking industry. Deposits in federally regulated banks are protected by the reserve, reporting, and inspection requirements of the federal banking laws; advertising relating to the interest paid on deposits is also regulated. In addition, deposits are insured by the Federal Deposit Insurance Corporation. Since its formation in 1933, nearly all depositors in failing banks insured by the FDIC have received payment in full, even payment for the portions of their deposits above the amount insured...”

Marine Bank v. Weaver, 455 U.S. 551 (1982)

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The Fed’s Use of Banks to Influence Monetary Policy

The Fed influences borrowing rates by: 1. Setting the "federal funds rate”: rate charged by banks on an

overnight loan of federal funds (reserves held at the Federal Reserve) from other banks (.25%)

2. The “federal funds rate” affects the "prime rate”: rate banks charge their best corporate customers. The “prime rate” is established by the WSJ based upon polling of the 10 largest banks, and is usually 3% over the “federal funds” rate (3.25%)

3. Setting the "discount rate”: rate the Fed charges for borrowings from the discount window.

The Fed affects the money supply by establishing reserve requirements for bank deposits.

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The Basic Business of Banking

Banking Is a Spread Business

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• Banks’ primary source of revenue is interest earned on loans and permissible fixed income investments (assets).

• Loan revenue must exceed interest expense on deposits (liabilities).

• To maximize profits, banks need to maintain a stable deposit base, and when possible, match the maturity of deposit liabilities to loans (“match funding”).

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Depository Institutions Fund Themselves with Short-Term Deposits

Dollar Amount Percentage of All Deposits

[$9.4 Trillion]

Savings Accounts $6.6 Trillion 66.0%

Transaction Accounts $1.8 Trillion 17.8%

Total Savings and Transaction Accounts

$8.4 Trillion 83.8%

Data as of 6/30/14

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Federal Deposit Insurance

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Timeline of Standard Maximum Deposit Insurance Amount

0

50,000

100,000

150,000

200,000

250,000

300,000

1934 1950 1966 1974 1980 2010

SMDIA

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FDIC Insurance Coverage of a Husband and Wife with Deposit Accounts in Multiple

Ownership CategoriesAccount Title

Account Ownership Category

Owner(s) Beneficiary(ies)Maximum Insurable

Amount

Husband Single Account Husband $250,000

Wife Single Account Wife $250,000

Husband & Wife

Joint Account Husband & Wife $500,000

Husband PODRevocable Trust Account

Husband Wife $250,000

Wife PODRevocable Trust Account

Wife Husband $250,000

Husband & Wife Living Trust

Revocable Trust Account

Husband & Wife

Child 1Child 2Child 3

$1,500,000

Husband IRACertain Retirement Account

Husband $250,000

Wife IRACertain Retirement Account

Wife $250,000

Total $3,500,000

Source: https://www.fdic.gov/deposit/deposits/brochures/your_insured_deposits-english.html

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FDIC-Insured Bank Deposits Increased during the Financial Crisis

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“In 1907, in the absence of deposit insurance, retail deposits were much more prone to run, whereas in 2008, most withdrawals were of uninsured wholesale funding, in the form of commercial paper, repurchase agreements and securities lending.”

Ben Bernanke, 2013

The Deposit Insurance Fund

• As of June 30, 2014, Fund assets totaled $51.1 Billion, with a reserve ratio (to insured deposits) of .84%.

• The current designated reserve ratio is 2.0%.

• Premiums were increased in 2010 to replenish the Fund, and will be reduced when the reserve ratio is reached.

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Sources of Deposit Funding without Access to Brokered Deposit Market

Bank is limited to its regional branches in

MA, CT, RI, VT, NH & ME

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Sources of Deposit Funding with Access to Brokered Deposit Market

Bank can access sources of deposit funding well

beyond its NE branches.

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Brokered Deposit Market

Today over $1 trillion of customer funds (out of a total of $9.4 trillion) are maintained in deposit accounts at FDIC-insured banks offered by, and held through, registered broker-dealers and banks.

– $200 Billion: CDs– $800 Billion: Savings deposits/ transaction

accounts

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Death of State-Only Banking Regulation

Last Victory for State Regulation: Bank Holding Company Act of 1956

• The BHCA was adopted to prevent banks from circumventing state branching restrictions by establishing separate banks in each state.

• The BHCA as originally adopted was not intended to impose significant federal regulation on banks or BHCs.

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Thrift Crisis Background• Before 1980, deposit account interest rates were established and

regulated by federal regulators. Thrifts were permitted to pay .25% higher interest rates on savings accounts.

• Capped rates for savings accounts 5.5% for thrifts 5.25% for banks

• In 1980, taxable MMF yields were 12.6%

• This resulted in the disintermediation of deposits from banks and thrifts to MMFs.

• Monetary Control Act of 1980• Gave the Fed power to impose reserves on all FDIC-insured banks

and thrifts• Deregulated interest rates on deposits• Gave all banks and thrifts access to Fed benefits (payment systems,

discount window)

Factors That Contributed to the Thrift Crisis and Increased Federal Regulation

• Thrifts' commitments to 30-year mortgages resulted in thrifts earning low, fixed interest rates on long-term mortgages while paying market rates on deposits after 1980.

• State deregulation of state-chartered S&Ls' investment authority, allowing them to enter riskier loan markets without an accompanying increase in examination resources.

• Reduced regulatory capital requirements led to the use of alternative accounting procedures to increase reported capital levels.

• Excessive chartering of new thrifts.41

Congressional Response: Increased Federal Regulation in Exchange for FDIC Insurance

• Elimination of state discretion over bank powers: no FDIC-insured institution may exercise greater powers than a national bank.

• Uniform risk-based capital requirements for FDIC-insured institutions.

• Prompt corrective action, giving federal regulators increased authority over a bank’s activities as capital declines.

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Primary Federal Regulator by Charter Type

Charter Type Regulator

National Banks OCC

State-Chartered Member Banks

Federal Reserve Board

State-Chartered Non-Member Banks

FDIC

Savings & Loan Associations (State and Federally-Chartered)

Pre-Dodd-Frank: OTSPost-Dodd-Frank: divided between FDIC and OCC

Rise of the Fed: the Fed Uses the BHCA to Assert Greater

Regulatory Power over Banks

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What Is a Bank Holding Company?

“any company which has control over any bank or over any company that is or becomes a bank holding company…”

BHCA, §2(a)(1)

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Control under the BHCAControl is presumed if:

a. the company directly or indirectly or acting through one or more other persons “owns, controls, or has power to vote” 25% or more of any class of voting securities;

b. the company controls the election of a majority of the trustees; or

c. the Fed determines that the company has a “controlling influence” over management of the company.

There is a presumption of non-control when the company owns, controls or has power to vote less than 5% of any class of voting securities. Nonetheless, the Fed may find that the company has controlling influence over management; in such a case, the Fed has the burden of proving controlling influence.

Control under the BHCA, cont.

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5% to 9.99% control is a grey area. Control will be determined by facts and circumstances (e.g., control of management).

There is a rebuttable presumption (rebuttal by acquirer) of control when the company owns, controls, or holds power to vote 10% or more of any class of voting securities of the bank and either:

(1) the bank has securities registered under the Exchange Act, or

(2) no other person will own, control, or hold the power to vote a greater percentage of that class of voting securities.

Any acquisition of 10% or more requires prior notice to and approval by the Fed.

The approval process for a determination of control requires a simultaneous application to the Fed under the Change in Bank Control Act.

•

The Fed has the power to determine which activities are “closely related to banking.”

The Fed also has the authority to take into consideration “the financial and managerial resources and future prospects of the company or companies” when considering applications for new activities and mergers & acquisitions requiring Fed approval.

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Erosion of Barriers to Concentration of Financial

Power

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Glass-Steagall Restrictions on Underwriting by Banks

Section 16: restricts a bank's ability to underwrite and deal in securities and stocks (other than "bank-eligible" governmental securities) and prohibits such banks from purchasing or selling securities except upon the order of, and for the account of, customers.

Section 21: prohibits a person or entity engaged in the business of underwriting, issuing, selling or distributing securities (unless permitted by Section 16) from engaging in the business of accepting deposits.

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Glass-Steagall Restrictions on Banks’ Affiliations with Underwriters

Section 20: prohibits a bank from affiliating with a company " engaged principally" in underwriting, dealing, publicly selling or distributing securities.

Section 32: prohibits officer, director or employee interlocks between a member bank and a company or person "primarily engaged" in underwriting, dealing, publicly selling or distributing securities.

The Gramm-Leach-Bliley Act (1999)

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Gramm-Leach-Bliley Act (GLBA)• Repealed Glass-Steagall affiliation restrictions (Sections 20 and 32)

• Amended the BHCA to permit affiliations between banks, securities firms, and insurance companies within a "financial holding company" structure subject to application to and approval by the Fed to act as a "financial holding company.”

• For FHCs only, replaced the “closely related to banking” standard with a “financial in nature” standard.

• Conditions include: – The banks are well-capitalized and well-managed;– Non-bank subsidiaries engage only in activities that are

"financial" in nature as defined by the Fed; – No affiliation with commercial companies; and– Must have BHC status to apply for FHC status.

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Functional Regulation• GLBA provides for functional regulation of FHC nonbank

subsidiaries (i.e., registered broker-dealers regulated by the SEC, commodities brokers by CFTC and insurance companies by state insurance commissioners).

• Reliance on “firewalls” to impose limitations on affiliate transactions.

• “Pushed out” most bank securities brokerage activities to registered broker-dealers.

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The Housing Bubble and Subsequent Financial Crisis

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Legal and Regulatory Factors • Monetary policy (low interest rates and banks reaching

for yield)

• Changes in U.S. tax law– 1986: reforms favored mortgage debt over other forms of credit– 1997: reforms created more favorable rules for residential capital

gain recognition

• Federal preemption of consumer protection and subsequent inaction (e.g., failure to regulate mortgage brokers)

• SEC’s grant of credibility to credit ratings and leverage exemptions to largest investment banks

Credit: Mark Palim, Vice President, Fannie Mae

Legal and Regulatory Factors, cont.

• Increase in subprime, low-doc, interest only and ARM mortgages

• Increased securitization of home loans

• Overconfident borrowers, brokers, investment bankers, GSEs and credit rating agencies

• Failure of bank regulators to recognize flawed asset strategies

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FHC/BHC Status before and after the Financial Crisis

Firm FHC/BHC Before? FHC/BHC After?

Merrill Lynch No Yes, part of B of A, an FHC

Lehman Brothers No N/A (bankrupt)

Morgan Stanley No Yes, a BHC

Bear Stearns No Yes, part of JP Morgan, an FHC

Goldman Sachs No Yes, a BHC

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The Dodd-Frank Wall Street Reform and Consumer Protection

Act

Role of FSOC– Identify asset bubbles.

– Designate nonbank financial companies as “Systemically Important Financial Institutions” (SIFIs) subject to Fed regulation, including capital and liquidity requirements.

– Designate systemic financial market utilities and systemic payment, clearing, or settlement activities, requiring them to meet prescribed risk management standards and heightened oversight by the Fed, SEC or CFTC.

– If FSOC determines that certain practices or activities pose a threat to financial stability, FSOC may make recommendations to the primary financial regulators.

– Determine whether action should be taken to break up those firms that pose a "grave threat" to the financial stability of the U.S.

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SIFIs– BHCs with $50 billion or more in consolidated assets

(currently 38).

– Non-bank entities designated as SIFIs by FSOC thus far:• AIG• Prudential Financial• GE Capital Corporation• MetLife (appeal pending)

– Once an entity is designated as a SIFI, the Fed is authorized to:

1. Impose enhanced capital requirements;2. Impose enhanced liquidity requirements; and3. Subject the entity to increased examination

requirements.

The Volcker Rule (Dodd-Frank §619)

1. Prohibits “banking entities” from engaging in short-term “proprietary trading” of securities, derivatives, commodity futures, and options on these instruments for their own accounts.

2. Prohibits “banking entities” from acquiring or retaining any equity, partnership or other ownership interest in, or sponsoring, a hedge fund or PE fund that would be a 1940 Act investment company but for §3(c)(1) (100 or less beneficial owners) or §3(c)(7) ("qualified purchasers") (“covered funds”).

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Volcker Rule “Banking Entities”1. Any (FDIC) insured depository institution

2. Any company that controls an insured depository institution [BHC or S&L Holding Company]

3. Certain foreign banking organizations that have U.S. branches or agencies or which own U.S. banks or certain other U.S. subsidiaries and are subject to BHCA

4. Any affiliate or subsidiary of an insured depository institution, a company that controls an insured depository institution, or a foreign bank or company subject to BHCA

– Affiliate means any company that controls, is controlled by, or is under common control with another company [control determined using BHCA analysis]

Bottom Line: the term “banking entity” can include insurance companies, investment banks and asset management firms that have affiliated banks in their corporate family.

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Permitted Proprietary Trading and Fund Activities

Permitted Proprietary Trading

Trading transactions in government securities

Trading transactions in connection with underwriting or market-making, to the extent that either does not exceed near-term demands of clients, customers, or counterparties

Trading transactions on behalf of customers

Trading transactions by an insurance company or affiliate for the general account of the insurance company [subject to state law]

Certain risk-mitigating hedging activities

Investments in small business investment companies

Proprietary trading conducted in accordance with specified BHCA provisions solely outside the U.S. if banking entity is not directly or indirectly controlled by banking entity organized under U.S. law

Permitted Covered Fund Sponsorship

Organizing and offering a covered fund if:

• the banking entity provides bona fide trust, fiduciary or investment advisory services;

• the covered fund is organized and offered only in connection with, and to customers of, such services;

• ownership interest in the fund limited to a seed or de minimis investment;

• banking entity complies with 23A and 23B affiliate transaction limitations; and

• certain other requirements are satisfied (i.e., name sharing prohibition)

Organizing and offering a covered fund outside the U.S. in accordance with specified BHCA provisions if:• no ownership interests are offered to U.S.

residents; and• the banking entity is not directly or

indirectly controlled by a U.S. banking entity

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Material Conflicts of Interest and High-Risk Activities

Permitted proprietary trading and covered fund activities are subject to three general prohibitions:

If the permitted activity would result in a material unaddressed conflict of interest between the banking entity and its clients, customers or counterparties;

If the permitted activity would create a material exposure by the banking entity to high-risk assets or high-risk trading strategies; or

If the permitted activity would pose a threat to the safety and soundness of the banking entity or to the financial stability of the U.S.

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Issues Raised by the Volcker Rule

Hotel California (“You can check in anytime you like/but you can’t ever leave”): why doesn’t Goldman-Sachs simply drop its bank, avoiding BHC status and thus the Volcker Rule?

• Goldman is a BHC that had $50 B in assets as of 1/1/10 and received TARP funds. If it ceases to be a BHC, it automatically becomes a SIFI.

• SIFIs that are not “banking entities” are nevertheless subject to additional capital requirements and quantitative limits to the extent they engage in proprietary trading or covered fund activities not permitted by Volcker.

The Sponsorship Exception’s Name Sharing Prohibition • An asset manager under common control with a bank (and therefore a

Volcker Rule “banking entity”) that wants to rely on the Rule’s sponsorship exception to sponsor a covered fund must eliminate not only the bank’s name, but also its own name, from the name of that covered fund.

• This may require major fund rebranding efforts for bank-affiliated asset managers.

Affiliate Transaction Restrictions in the Context of the Sponsorship Exception

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International Regulatory Framework for Banks as Established by the Basel Committee on Banking

Supervision(“Basel III”)

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Basel III Two-Part Regulatory Framework1. Increased Capital Requirements

– Increased minimum requirements for both the quantity and quality of capital

Status: Effective January 1, 2015

2. Liquidity Risk Measures– Liquidity Coverage Ratio (LCR): intended to require banks to

maintain a sufficient amount of “high quality liquid assets” to withstand a hypothetical 30-day liquidity stress period

Status: Effective January 1, 2015 (phased-in transition)

– Net Stable Funding Ratio (NSFR): intended to limit banks’ reliance on short-term wholesale funding. It is similar to the LCR, but is focused on a longer time horizon (1 year vs. 30 days).

Status: Not yet proposed by U.S. regulators

LCR Runoff Rates

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Category Agencies' LCROutflow Amount

Unsecured Retail Funding Stable retail deposits (Entirely insured “transactional deposits” and entirely insured other deposits of depositors that have a relationship with the bank)

3%

Other retail deposits 10%Retail Brokered Deposits Brokered deposits remaining maturities over 30 days 10%Reciprocal brokered deposits, entirely covered by deposit insurance 10%Reciprocal brokered deposits, not entirely covered by deposit insurance 25%Brokered sweep deposits, issued by a consolidated subsidiary, entirely covered by deposit insurance 10%

Brokered sweep deposits, not issued by a consolidated subsidiary, entirely covered by deposit insurance 25%

Brokered sweep deposits, not entirely covered by deposit insurance 40%All other retail brokered deposits, including time deposits with remaining maturities 30 days or under 100%

Unsecured Wholesale Funding Category 2: Non-operational deposits not provided by a regulated financial company, investment company, non-regulated fund, pension fund, investment adviser, identified company, sovereign entity, U.S. government-sponsored enterprise, public sector entity, or multilateral development bank, or any consolidated subsidiary of the foregoing, entirely covered by deposit insurance and not a brokered deposit

20%

Category 2: Non-operational deposits, not provided by a regulated financial company, investment company, non-regulated fund, pension fund, investment adviser, identified company, sovereign entity, U.S. government-sponsored enterprise, public sector entity, or multilateral development bank, or any consolidated subsidiary of the foregoing, not entirely covered by deposit insurance or the funding is a brokered deposit

40%

Category 1: All other wholesale funding, including funding provided by a regulated financial company, investment company, non-regulated fund, pension fund, investment adviser, identified company, sovereign entity, U.S. government-sponsored enterprise, public sector entity, or multilateral development bank, or any consolidated subsidiary of the foregoing.

100%