BANKING LAW RULE ATTACK OUTLINE

I. NB ACT PREEMPTION1. State law in some cases does apply to NBs:

a. Some state regulations: States have some residual control over NBs, and not everything is preempted by the NB Act. Some regulation is left to the states. NB v. CW.

2. NB’s Preemption of State Law: a. Preempts if state law interferes w/ federally granted power: States can regulate NB’s but they

cannot interfere, undercut, or undermine the NB’s exercise of a federally granted power. Barnett Bank (OCC said NB’s could sell insurance, Fla. Statute said the could and it was preempted).

b. NB’s do have the option of augmenting their rules w/ state law where:i. The bank has a main office

ii. The BHC is incorporatediii. DE corp law oriv. Model Business Corp. Act

c. Does not preempt state enforcement power: i. Enforcement yes, administrative visitorial powers: States cannot exercise administrative

visitorial powers over NBs, but they can bring ordinary law enforcement actions through the courts. Cuomo.

3. State regulation of operating subs (Dodd-Frank overruled): a. Pre-Dodd-Frank: An operating sub gets the same preemptive immunity that the parent does

under the NB Act. Waters v. Wachovia.b. Dodd Frank Rule: The NBA no longer preempts state law as applied to state chartered subs and

affiliates of NBs and Federal Savings Banks, the legal standard under Barnett would apply4. Preemption ANALYSIS: 12 U.S.C. 25(b):

a. Note on procedure: First analyze preemption under 12 U.S.C. 25(b) then go to OCC reg if it makes it through preempted.

b. NB Act Preempts state consumer financial law only if the law would: i. (1) Discriminatory effect on NBs: In comparison with the effect of the law on a state

chartered bank, (OR)ii. (2) Go against the ruling in Barnett: Prevent or significantly interferes with the exercise

of the banks power1. Note : Statute overturns Waters, excludes field preemption and codifies Cuomo.

5. After look at 4 go through the OCC’s Statutory Preemption statute: a. Deposit Taking; 12 CFR 7.4007:

i. (b) State laws that are Preempted: A NB may exercise its deposit taking powers w/o regard to state law limitations concerning:

1. abandoned or dormant accounts2. checking accounts3. Disclosure requirements4. Fund availability 5. Savings accounts orders of withdraw6. State licensing or registration requirements, and7. Special purpose savings services

ii. (c) State laws not preempted: Unless interfere w/ Bennett the following are not preempted:

1. contracts2. torts3. criminal law4. rights to collect debt5. acquisitions and property transfers

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6. taxation7. zoning

b. Lending; 12 C.F.R. 7.4008:i. (d) State laws preempted: A NB may make non real-estate state loans w/o regard to state law

limitations concerning: 1. Licensing registration2. The ability of a creditor to inquire or obtain insurance for collateral or other credit

enhancements or risk mitigation, in furtherance of safe and sound banking3. Loan-to-value ratios4. The terms of credit, including schedule for repayment of principle and interest,

amortization of loans, balance, payments due, minimum payments, or terms to maturity of the loan, including the circumstances under which a loan may be called due and payable upon the passage of time or a specified event external to the loan

5. Escrow accounts, impound accounts, and similar accounts6. Security property, including leaseholds7. Access to and use of credit reports8. Advertising and disclosure rules9. Disbursement’s and repayments

10. Rates of interest on loans. ii. (e) Not preempted: above.

II. PERMISSIBLE BANKING ACTIVITIES 1. Bank Powers by 12 U.S.C. 24(SEVENTH):

a. Establishment; 12 USC 24(SEVENTH): Exercise incidental powers as shall be necessary to carry on the business of banking. The Provisions applies for expansive Chevron deference to OCC to expand powers of NBs:

i. Explicit banking activities: 1. Discounting and negotiation of promissory notes, drafts, bills of exchange and

other evidence of debt2. Receiving deposits3. Buying and selling exchange coin or bullion4. Loaning money on personal security, and 5. Obtaining, issuing and circulating notes

ii. Denied to banks: 1. Ownership in real property2. Ownership in corp. stock or underwriting securities, 12 U.S.C. 24 (SEVENTH)3. Underwriting insurance, 15 U.S.C. 6712(a)4. Charging interest above the legal rate, 12 U.S.C. 85

b. OCC has power to expand power of NBs through regulation: i. Authorized to expand the NBs power

1. Can expand the power the power of NBs if reasonable: the business of banking is not limited to the enumerated owners listed in section 24(SEVENTH) and so the OCC clearly has the discretion to authorize activities beyond what is specifically enumerated. NB of NC.

2. Must limited the OCC’s discretion however: The exercise of the OCCs discretion however must be kept with in reasonable bounds. Distant ventured from dealing from in financial instruments –for example, operating a general travel agency are outside of the definition. Id.

ii. Powers Authorized by the OCC are subject to Chevron deference:

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1. If congress has clearly spoken on the issue: Then it is clear and the court and the agency must clearly interpret the statute, if the OCC decision is contrary then must be rejected.

2. If congress is silent on the issue: Then the issue is whether the agency’s answer is based on permissible construction of the statue

3. If congress has left a gap for agency to fill: Then the court should defer to the agency to fill the gap of a specific provision or regulation.

a. The court will only intervene if the decision is: Arbitrary, capricious, or manifestly contradicts the statute.

iii. The OCC has stated that the following activities were among the business of banking: 1. Data processing, 12 CFR 7.5006: The business of banking include data

processing if it is (a) financial or banking related and (b) if it is derivative of banking activity.

2. Correspondent banking services 7.5007: large banks offer banking services to facilitate small bank operations

3. Finder services 7.1002: Business of making may include finder services that include:

a. Identifying potential partiesb. Making inquires as to interestc. Introduce or arrange contracts or meetings of interested partiesd. Act as n intermediary between interested parties and e. Otherwise bring parties together for a transaction that the parties

themselves negotiate and consummate4. Building a webpage and webhosting: Webhosting allows the banks to perform a

finder function and is part of the business of banking also allows for process reports and economic data. OCC Interp. Let 875.

c. Permissible banking activities that have been labeled as incidental: i. Business of banking: w/ in the scope of banking if the activity if:

1. Functionally equivalent or logical out growth of a traditional banking activity,2. Would respond to customers needs or otherwise benefit the bank or its customers,

ANDa. i.e., needed to carry on the business of banking.

3. Involves risks similar to those already assumed by banks ii. The test if incidental to the business of banking: Arnold tours put forth a 3 part test:

1. Convenient or useful, 2. In connection o the performance of a traditional activity, (AND)3. Under one of the banks expressed authorized powers

iii. Arnold tours must be viewed through the lens of M&M leasing: 1. Must look to see if functionally similar to a traditional activity: An activity is

functionally similar/ interchangeable with an expressed power will be considered “incidental to banking,” i.e., functional similar to what the banks have already done.

2. Expansion of banking powers as incidental through 24(SEVENTH): a. Travel agency services: Not incidental to banking powers. Arnold Tours.b. Personal Property leasing:

i. Is incidental to the power of banking: Leasing in light of all relevant circumstances the transaction constitutes a loan of money secured by a leased property, is incidental to the loan of money on personal security an activity authorized by the NBA. M&M Leasing.

c. Insurance: i. Bank may act as an insurance agencies to sell insurance polices issued by other firms:

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1. Acting as an agent, a bank does not take on any underwriting riks and the issuing insurer, no the bank bears the risk

ii. Statutory Authorization; NB Act 12 U.S.C. 92: 1. May sell insurance as long as:

a. (1) Population in city less than 5K and b. (2) Insurance companies that they are selling on behalf of are authorized

by the state. 2. These activities include:

a. (1) Soliciting and selling insurance, and b. (2) collecting premiums on policies issued by some companies.

3. The OCC has drastically expanded the reach of this provision; 12 CFR 7.1001: A bank van utilize 92 if it has a branch office located in a community having a population of less than 5k even though the bank’s principle office is located in a population that exceeds 5k.

iii. Application and extension of the insurance rule: 1. Annuities: Banks are permitted to broker annuities incidental to the powers of

banking, not selling insurance, professor believes that variable annuities, not hybrid annuities are functionally similar. VALIC.

2. May sell to populations Outside of 5k: A bank located in a small town may sell insurance nationwide, and the statute puts no real geographic restraint on this. Ludwig.

3. Crop insurance: 24(SEVENTH) does not authorize them to sell crop insurance protecting farmers from disasters, the court is concerned that this would open Pandora’s box.

4. Credit life insurance: Banks can sell credit life insurance b/c unlike other forms of insurance, credit life insurance is a limited special type of coverage written to protect loans, and is incidental to a loan.

iv. Insurance underwriting: 1. FHCs can underwrite insurance in a sub: FHCs may underwrite insurance in a

sub, but BHCs may not2. Banks cannot underwrite insurance: May not provide insurance as a principle

and this rule applies to FDIC insured state banks. 15 U.S.C. 6712(a). a. GLB Act: Excludes letters of credit from the definition of insurance.

3. Cannot issue guarantees: But can issue standby letters of credit, which function a lot like a guarantee under the functional equivalency test. NB Banks of Dallas.

d. Real Estate: i. NBs cannot own real property but there are exceptions: Banks have broad power to make

loans secured by real property, 12 USC 371, but they have very limited power to own real property. Pursuant to 12 USC 29 a bank may purchase, hold, and convey real estate for a certain purpose and for ONLY the following four purposes:

1. Exceptions to prohibition of holding real-estate: a. Foreclosing on debt: May hold real property acquired by foreclosing on

debt. 12 USC 29. b. Satisfaction of Ks: A bank may hold real property acquired in satisfaction

on debts previously contracted in the course of dealings, 12 USC 29(THIRD)—property acquired by foreclosing on or settling a debt is known as a DPC property (Debt Previously Contracted or REO (real estate owned property).

c. Conducting its business: A bank may acquire and hold real property as necessary for tis accommodation in the transaction of its business. 12 U.S.C. 29 (FIRST)—the bank can own their premises and real properties

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d. Public welfare: A NB can hold real property pursuant to its power to make investments designed primarily to promote the public welfare.

i. Limit: 5% of capital w/ OCC permission but can never exceed 10%.

ii. Extensions of these rules by the OCC: 1. Hotels/ lodging; 12 CFR 7.1000(a)(2)(v)(d)(2): Can own residences to

accommodate out of town employees if there is no suitable lodging in region. a. Has been extended to: condos and large hotels.

e. Personal Property:i. NBs can hold personal property: 12 USC 24 (TENTH): Can invest w/o limitation in

vehicles, manufactured homes, machinery, equipment, or furniture for lease financing transactions on a net basis

1. BUT: such investments may not exceed 10% of the assets of the corporationf. Trusts:

i. May administer a trust in a fiduciary capacity: May act as a trustee when not in contravention of state law.

g. Securities:i. Restrictions:

1. Can only deal and hold securities for the account of customers and no on own account: NBs are prohibited from owning stock. 12 U.S.C. 24.

2. May not underwrite and take deposits: Banks may not underwrite securities unless you are dealing eligible securities: 12 USC 378(a)(1).

a. Eligible securities: i. Can underwrite government securities: but firms have found

other ways to underwrite securities under 24(SEVENTH)b. Other restrictions on underwriting:

i. Cannot operate an investment fund that underwrites: May not operate an investment fund that involves the bank underwriting securities. ICI v Camp.

c. Can deal in commercial papers: i. May issue commercial paper in private placements: There is

only a 16 violation if there is a public offering a private placement is not a violation. Secs Indust. Association.

ii. But NBs can: 1. Participate in the business of brokering in securities and stock: Can purchase

and sell such securities and stock w/o recourse, solely upon the order, and for the account of, customers, and in the case for its own account.

2. May operate sub that brokers securities: Banks can own subs that engage in the brokerage business, but NBs still cannot buy and sell securities on their own accounts.

3. Banks ability to invest in securities does have a few exceptions:a. Two exceptions to the prohibition of dealing securities:

i. Fed, local, and state gov/ securities: the bank may underwrite, deal in, and invest in U.S. gov/ securities and general obligations of state and local gov/

ii. May purchase investment securities under restrictions from the OCC: Must have a AAA, AA, A, or B rating from at least two rating agencies.

b. Banks have a very limited ability to invest in equity securities: i. May hold shares in subs: But subs must engage only in activities

permissible for the parent bank or authorized by statute5

ii. May invest 10% in service corps: the can invest up to 10% of their capital in bank service cos (12 U.S.C. 1861-7).

iii. Participate in venture capital activities: They can invest up to 5% of their capital in small business investment co’s, 15 U.S.C. 682(b), allowing banks to in essence establish venture capital co’s.

h. Derivatives: i. Banks may engage in derivative transactions as business of banking:

1. May engage directly in hedging: They can cut out the mirror banks and go straight into the physical market in order to hedge risk.

2. Suppose to be used ideally to reduce risk: Hedging against risk of regular activities would be permissible under 24(SEVENTH) and not prohibited by GS-16. OCC interpretive letter.

ii. If engage in shadow banking and enter into physical market could be a 10b-5 violation: Synthetic swaps and options are securities if you enter into the physical trading market. Cailoa.

iii. The Lincoln push out rule has to be considered: 1. Prohibits federal assistance to swap dealers and major swap participants and calls

for all swap activity to be pushed out to a non-affiliate. a. Exception:

i. Risk mitigating hedgingii. Derivatives that are in traditional business of banking.

III. USURY1. Usury laws overview:

a. Usury laws restrict the taking of excessive interest on loans, i.e., set a max an institution can charge. Business loans were not subject to these limitations/ consumer loans were.

b. Differ by state—state laws set different usury laws2. Usury laws and NBs:

a. 12 U.S.C. 85 Permits NBs located in a particular are to charge the greater of 3 rates: these rules are designed to give NBs an advantage

i. Same rate as most favored lender: The rate allowed by the laws of the state ot the most favored lender where the NB is located, except that where a state sets a different rate for state-chartered banks, this rate is allowed for NBs.

ii. 1% above the discount rate: On 90 day commercial paper in effect in at the Fed Reserve district where the bank is located (OR)

iii. 7% interest rate: if there is no rate that is fixed by the stateb. NBs can take advantage of the highest interest rate, even if state banks cannot: NBs enjoy

most favored lender status under state law: They may take advantage of the highest rate allowed to any lender under 85 even if state charted rates are restricted to lower rates. Tiffany.

c. Can charge rate set by state where home bank is located in business in other state: Section 85 plainly provides that a NB may charge interest on any loan at the rate allowed by the laws of the state which the bank is located, i.e., where the certificate says your home bank is. Marquette.

i. Where bank has branches all over the place: OCC 1998: Look to the nexus of the loan and where the loan is services and made from and this allows you to charge an interest rate from nearly any state where you have a branch.

d. May charge late payment rate from home state: Banks can charge late payment fees from home state. Smiley.

e. The nation wide credit markets were made by removal of state usury ceilings: So NB could locate itself in state with favorable rates and then export those rates around the country.

3. Penalty for violating usury laws: a. Forfeiture of interest: May lead to forfeiture of entire interest on noteb. Person may recover damages: Twice the mount of interest they paid

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IV. SAFETY AND SOUNDNESS1. Formulas:

FormulaLeverage Limit Tier 1/Total AssetsTotal Risk-Based Capital Ratio Total Capital (Tier 1+ Tier 2)/ Risk

Weighted AssetsTier 1 Risk Based Capital Ratio Tier 1/ Risk-Weighted AssetsCommon Equity RBC (Common equity + Retained Earnings)/ Risk

weighted assets2. Leverage limit:

a. Leverage limit: FDIC requires at least 4% of capital to total assets in order to qualify as adequately well capitalized.

b. Calculating a banks leverage ration:i. 1. Calculate a banks tier 1 capital by adding (AND THEN):

1. Common shs equity2. Any non-cumulative perpetual preferred shares, AND3. Any minority shareholding in consolidated subs

ii. Divide the bank’s tier 1 capital by the bank’s total assets. c. After making a loan:

i. After making a loan run through this against and make sure that the institution is still adequately capitalized.

3. Calculating Risk based capital standards: a. There are three stages in a 8 step process:

i. Calculate the banks-risk weighted assetsii. Calculate the bank’s total capital, and then

iii. Divide the banks capital by risk-weighted assetsb. Steps:

i. Calculate the banks capital: 1. Find tier 1 capital in the problem: Consists of:

a. Common stock and retained earnings (aka shs equity)b. Non-cumulative perpetual preferred shsc. Minority shareholdings in consolidated subs

2. Find tier 2 capital: Consists of everything else that qualifies as capital such as any other type of preferred sock that does not qualify as tier 1 capital, hybrid capital instruments, term subordinated debt and general loan loss reserves and net unrealized appreciation on equity securities.

3. Calculate the total capital=Tier 1 + tier 2 wit the following limits: a. Only can exclude tier 2 as much as tier 1: in this calculation include tier 2

capital only to the extent that the bank has tier 1 capital, i.e., do not include more dollars of tier 2 than the bank has tier 1.

ii. Next input in the formula: 1. Total risk based capital ratio= total capital/ risk weighted assets

V. PROMPT CORRECTIVE ACTION1. Can take certain regulatory actions if FDIC institutions fall below certain bench marks:

a. PCA statute: System of regulatory statutes that can/must be taken into account if a bank’s capital falls short of the bench marks. 12 U.S.C. 1831o

b. If institution gets critically undercapitalized: The idea is to close the institution b/f it fails. 2. Capitalization bench marks, if one is deficient it will trigger the prompt corrective action provisions:

Capital Category Leverage Ratio* Common equity Tier 1 RBCR Total RBCR*Well Capitalized Greater than or Greater than or Greater than or Greater than or

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Equal to 5% Equal to 6.5% Equal to 8% Equal to 10%Adequately Capitalized

Greater than or Equal to 4%

Greater than or equal to 4.5%

Greater than or Equal to 6%

Greater than or Equal to 8%

Undercapitalized Less than 4% Less than 4.5% Less than 6% Less than 8%Significantly Undercapitalized

Less than 3% Less than 3% Less than 4% Less than 6%

Critically Undercapitalized

Less than 2 % --- --- ---

3. For Dividend Dispersal Common Equity to Total RBCR must be w/ Basil III Buffer: a. Basil III includes capital conservation buffers: A bank that fails to maintain the requisite

buffers looses the freedom to make capital distributions (dividends) and award discretionary bonuses.

b. To make unlimited disbursements: Must keep each of its RBCR ratios above 2.5% required level(Add % of buffer to the adequately capitalized row.

c. The limit applies if: the smallest of the banks three buffers falls below 2.5%d. May make payment from only eligible retained income: namely net income for the preceding

four calendar quarters minus any capital distributions this period. i. The chart determines when the buffer falls what the maximize of the retained income

may be paid out: Smallest Buffer Maximum Payout %>2.5% No Limit>1.875 to less than or equal to 2.5%

60%

>1.25% to less than or equal to 1.875%

40%

>.625% to less than 1.25% 20%Less than or equal to 0.625% 0%

4. Prompt corrective requirements: a. Purpose of the prompt corrective action requirements: To correct the problems b/f they

become too large—to resolve the problems of the insured depository institutions at the least possible long term loss to the deposit insurance fund.

b. Places requirements on regulators: Requires regulators to take timely effective action to prevent loss to the insurance fund and hold regulators accountable for failure to do so.

c. The inspector generals request: If an insured depository institution causes a material loss to the insurance fund, the appropriate Fed Banking agency’s inspector general must review the agency’s supervision of the institution and make a report to the agency.

5. Prompt corrective action statute chart: Limits on all Institutions, 1831o(d)

Limits/ Requirements for undercapitalized Firms, 1831o(e)

Limits on Significantly Undercapitalized Firms

Limits on Critically Undercapitalized Firms

Limits on Capital Distributions and management fees apply to all insured depository institution Cannot make dividend

payments if it would undercapitalize the institution

Cannot pay management fees to any individual or co-controlling the institution if it would

Overview for under capitalization: If comes undercapitalized must: 1.Submit an acceptable capital restoration

plan 2. Comply with limits on its asset growth

and 3. Obtain prior regulatory approval for

acquisitions, branching, and new lines of business, and it may face the appointment of a conservator or receiver.

The details of each on of these is explained in more detail below:

Presumptive safeguards: Requiring the

institution either to sell enough stock or subordinated debt to recapitalize, or undergo a merger/acquisition.

Restrict the institutions transactions w/ affiliated depository

Payment of Sub debt: 60 days after

becoming undercapitalized the institution generally may make no payment of principle or interest on sub debt

sub debt holders agreement o stand

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become undercapitalized Cannot deplete its

required minimum capital to service its owners claims.

institutions by denying the institution the sister bank exemption in section 23A of the Fed Reserve Act.

Prohibiting the institution form paying more than the prevailing regional rates of interest on deposits.

in line behind the insurance fund in the event of receivership

(1)Capital Restoration Plan: Institution must submit an acceptable

capital restoration plan to the appropriate agency:

o A. Must outline steps that it is going to take to become adequately capitalized

o B. Include a year by year time table

AGENCY CAN ONLY APPROVAL PLAN IF: each co having control over the bank guarantees that the institutions will comply w/ the plan.

Cannot approve plans that: that would increase the institutions exposure to credit interest rate or other risks.

Only can approve plans that: o if each co having control over the

bank guarantees that the institution will comply with the plan.

o If it is based on realistic assumptions and is likely to succeed

Absence of a plan: cannot increase its total assets; cannot make acquisitions; open new lines of business and faces additional sanctions.

Discretionary Safeguards: Further restrict the

institutions transactions w/ affiliates

Requiring an institution to dismiss a director or senior executive officer

Restrict an overtly risky activity

Hold a new election for the BOD

Prohibit certain types of deposit acceptances

Require Fed approval for any capital disbursements.

Conservatorship/ Receivership: Being

undercapitalized itself is grounds for appointment of conservator/ receiver

W/ in 90 days after the institution becomes critical, the appropriate fed agency must either appoint or take alternative action that would better serve the purposes of 38

Asset Growth Restrictions for undercapitalized firms cannot increase average assets unless: It has an approved capital restoration plan The assets growth accords w/ the plan, and The institution’s capital ration increases at

a sufficient rate to enable the institution to become adequately capitalized w/ in a reasonable period of time.

Effectively forces the institution to raise new capital, i.e., sell bonds, issue shares)

Need Prior approval required for acquisitions, branches, and new lines of business: Can only be approved it the institution is

implanting a capital restoration plan and regulators determine that the proposed action will further the achievement to of the plan.

Conservatorship and receivership—may be appointed if the firm: Has no reasonable prospect of becoming

adequately capitalized

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Fails to submit a timely and acceptable capital restoration plan

Materially fails to implement a plan If regulators believe that an institution is

not viable, they may act b/f an institution becomes critically undercapitalized

VI. LOANS TO ONE BORROWER 1. Note:

a. This is necessary when doing almost any lending hypo:i. Also look to whether

1. Its to an insider2. Its to an affiliate

2. Calculating the lending limit: a. Amt. of loan/ Tier 1+Tier 2(as much as Tier 1) Capital.

3. Basic rules: a. Can lend 15% of banks capital can be loaned to a single borrower: This is regardless of

whether the loan is secured on not. b. May lend up to 25% of the banks capital is it is secured: These additional amts. are fully

secured by readily marketable collateral having market value at least equal to the amt. of funds outstanding.

i. Readily marketable collateral includes: “financial instruments and bullion” that are salable under ordinary market conditions w/ reasonable promptness at a faire value determined by quotations based upon actual market transactions on an auction or similarly available daily bid and ask price markets.

ii. Good collateral: 1. Securities traded on a national securities exchange2. Commercial paper3. Negotiable certificates of deposit4. Shares in mutual funds

iii. Excludes: 1. Mortgages

c. Bank still ahs to be adequately capitalized after making the loan4. Determining if the loan is attributed to one person (i.e., two borrowers under 10% limit):

a. If attributed to one person: If attributed to one person the it will be treated as one person under the borrowing limits

b. Direct benefit: When the borrower transfers loan proceeds to someone else “other than in a bonafide arms length transaction where the proceeds are used to acquire property, goods or services.

c. When a common enterprise exits between different borrowers of the bank: i. If the borrowers rely on the same expected source of repayment, and neither borrower

had another source of income adequate both to repay the loan and to meet the borrowers obligations

ii. If one borrower controls, is controlled by, or is under common control with the other and derives at least half of its gross receipts or gross expenditures from transactions with the other.

iii. If the borrowers are borrowing to acquire the same business, and will own more than ½ of the voting interest in the business.

iv. If the OCC determines, based on the facts and circumstances of particular transactions that a common enterprise exists.

5. There are higher lending limits that apply to the following transactions: a. Loans secured by live stock

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b. Guaranteed discounted installments of commercial paper c. If it will help the borrower complete the project, i.e., will protect the banks the position.

6. Exceptions to the lending limit: a. The lending limit does not apply to:

i. Making loans to the governmentii. Drawing on uncollected funds that are in the normal process of collection

iii. Renewing or restructuring loansiv. Advancing additional money to pay

1. Taxes, insurance utilities, security, maintenance and operating expenses necessary to preserve the value of real property securing a loan.

v. Financing the sale of the banks own asset1. Including property acquired by foreclosure.

b. Syndication with other banks would allow banks to exceed the limit:i. Loan syndication: enable a bank to meet a customers need for a loan exceeding the

bank’s lending limit, b/f binding itself to make the loan, the originating bank sells participation in the loan to other financial institutions.

ii. Participants then share proportionally in:1. Providing the money loaned2. Bearing the credit risk3. Receiving payments of principle and interest

7. Non-conforming loans: a. A loan may become non-conforming even if it is an adequate loan if:

i. The banks capital has declinedii. Separate borrowers have subsequently merged or formed a common enterprise

iii. The bank has merged w/ another lenderiv. Lending limit or capital rules changed, or v. The value of the collateral has declined

b. If value of the collateral has decline the bank has 30 days to get the value back up:i. The bank must correct the nonconformity in 30 days.

VII. INSIDER LENDING1. People considered to be insiders are:

a. People with certain positions: E.g., executive officers, directors or principle shareholders of any co of which the member bank is a sub, or of any other subs of that co, shall bank executive officers, directors or principle shareholder of the member bank. 375(B)(8)-(A).

i. Executive officers: Anyone who participates or has authority in the majority of the policy making decisions of the bank. 12 U.S.C. 375b(9)(C)

1. Excluded from this definition: Regardless of title if they do not participate in deciding the banks major policies and must follow policy standards set by the banks senior management.

b. Those with control: A person controls a company or a bank if that person, directly or indirectly, or acting through or in concert with 1 or more persons—

i. Controls or has the power to vote 25% or more of any class of the Cos voting securities 1. But note: If have less than 10% you would have to show some sort of other type

of influence like contracts, executive positions, etc. ii. Controls how directors are elected: Controls in any manner the election of a majority of

the co’s directorsiii. Can influence policies: has the power to exercise controlling influence over the cos

management or policies. c. Principle shareholders: anyone who owns, controls, or can vote more than 10% of any class of

voting shares. 12 U.S.C. 375b(9)(F).11

d. “Any related Interest” of the executive officers, directors, or principles: A related interest of a person is:

i. (1) Any co-controlled by that persons; and ii. (2) Any political or campaign committee that is controlled by that person of the or the

companies or services of which will benefit that person. e. Exceptions:

i. The executive officer or director does not have authority to participate and does not participate in major policy making functions of the bank (AND)

ii. The assets of such sub do not exceed 10% of the consolidated assets of a co that controls the bank and such sub (and is not controlled by another co). 375b(8)(B)

2. Covered Transaction: a. Extending credit: Includes making or renewing any loans, granting a line of credit or entering

into any similar transaction as a result of which a person becomes obligated to pay money or its equivalent to the bank. 12 U.S.C. 375b(9)(D).

b. Only 3 types of loans are available to executives: i. First mortgage loans on a residence, 12 U.S.C. 375a(2)

ii. Education loans for their children, id(3)iii. All types of other loans up to 100k in the max for any of the other kind of loans put

together. Id 375(a)(4). iv. If an officer gest loans at another bank for these items, then the bank must lower his

loans. 3. The five basic rules on lending to insiders:

a. (1) Prohibits preferential terms: 12 U.S.C. 375b(2)i. Must be substantially same terms as outsiders: Must be on substantially same terms,

including interest rates and collateral, as those persons who are not insiders or employeesii. Cannot have more than normal risk: if the extension of credit does not involve more than

normal risk of repayment or presents other unfavorable terms. iii. The underwriting process must be equally as stringent: If the bank follows credit

underwriting procedures as stringent as those applicable to comparable transactions with persons who are not insiders

iv. BUT CAN give them benefit of preferential treatment as part of banks compensation plan: Bank can give insiders the benefit of preferential extension of credit or compensation that is widely available to employees of the bank.

b. (2)BOD must approve extensions of credit that exceed lesser of 500K or 5% of bank’s capital:

i. For extensions of credit that exceed 500k or 5% of banks capital: A bank’s total extension of credit to any one insider can exceed the lesser of 500k or 5% of the bank’s capital only after the approval by the banks entire BOD w/ the insider abstaining. 12 USC 275b(3).

c. (3)Limits total extension of credit to anyone insider: i. Cannot exceed lending limit to one borrower: A bank cannot make extensions of credit to

an insured exceed the limit on NBs loans to one borrower. 12 USC 84 ( no matter what the state limit is).

d. (4) Limits aggregate extensions of credit to all insiders:i. Capital limit on disbursement: Cannot be greater than the banks tier 1 and tier 2 capital.

12 U.S.C. 384b(5). ii. Cannot exceed 100% of the banks capital in the aggregate: the banks aggregate extension

of credit to all insiders generally cannot exceed 100% of the bank’s capital. But if bank has les than $100m in deposits, is adequately capitalized, and has satisfactory examination ratings, the board may increase this limit to 200%.

12

e. (5) Restricts overdrafts by executive officers and directors: Bank cannot pay overdraft to one executive except pursuant to a written preauthorized overdraft line of credit or transfer from another account.

4. Supplemental Rules: a. Loans made to company controlled by insider should be treated as loan to insider:

Extension of credit to a business or political committee controlled by the insider is considered to be to the insider.

b. Treat insiders of a bank’s affiliates as insiders of the bank: i. The law generally treats insiders of a bank’s non-depository affiliates as insiders, but will

not be treated as insiders if: 1. The affiliate does not control the bank and constitutes less than 10% of the HCs

consolidated assets. 2. The bank’s board formally excludes those persons from participating in major

policymaking functions of the bank. ii. Prohibits knowing receipt of improper forms of credit

iii. Prohibits preferential lending to a correspondent bank’s insiders iv. Further restrict extensions of credit to executive officers:

1. 375a further regulates a banks extension of credit to its executive officers, notably by:

a. imposing more restrictive lending limitsb. Requiring the bank to reserve the right toe demand immediate repayment

of all extensions of credit to an officer if the officer total borrowing from all banks exceeding the amount that the bank itself could lend to the officer and

c. Requiring periodic reporting by the officer and the bank

VIII. AFFILATE TRANSACTIONS1. Covered Relationships:

a. Definition of affiliate: An affiliate of a bank if it controls, is controlled by, or is under common control with the bank. 12 U.S.C. 1841(k); Id. 1813(w)(6).

i. The application of this is that: Includes every other co that controls the bank(bhc) , every other under the same holding company by that co(holding co affiliate), and every other sub of the bank.

1. Also may extend to: Issue may masquerade as an insider transaction. b. Affiliates of bank under 371c(b)(1):

i. Any co that controls the bank or is controlled by a company that controls the bankii. Any bank that is a sub of the bank

iii. Any co-controlled by or for the benefit of persons who control either the bank or a company that controls the bank.

iv. Any company a majority of whose BOD constitutes a majority of that banks BODv. Any company that the bank or any affiliate of the bank contractually sponsors or advises

vi. Any investment company for which the bank acts as an investment adviservii. Any company that the Fed determines has a relationship with the bank that may to the

detriment of the bank affect covered transactions between the company and the bank. 2. Covered Transactions: 371c(b)(7)

a. Extensions credit to, or for the benefit of an affiliateb. Issues guarantee, including a standby letter of credit of the benefit of an affiliatec. Purchases of assets for an affiliated. Acceptances of securities or debt obligations issued by an affiliatee. Investment in securities including repos issued by an affiliate. 375c(b)(7)

3. Main rules of 23A: 13

a. Lending Limit Calculation:i. Amt. of loan/ Tier 1+Tier 2(as much as Tier 1) Capital.

b. Main rules for transactions with affiliate:i. 10% limit with one affiliate: A bank’s total covered transaction w/ any one affiliate

cannot exceed 10% of the bank’s total capital. ii. Total lent to affiliates may not exceed 20%: The banks total covered transaction w/ all

affiliates combined cannot exceed 20% of the banks capital. iii. Certain transactions require collateral: Extensions of credit, letters of credit and

guarantees must be fully secured w/ qualifying collateral1. The collateral must be worth 100 to 130% of the amount of the covered

transaction, with the % depending on the types of collateral: a. 100% for U.S. obligationsb. 110% for state and local obligationsc. 120% for other obligations, corp. bondsd. 130% for leases, real property, stocks, etc.

Steps to Calculate1. Determine lending limit for the affiliate2. Find out which type of collateral it is3. Divide (Amt. of Loan)/Collateral=should give you % that it is secured4. If not enough times (collateral x %) and then subtract it from loan and

mention that that is the amount that can be secured.5. Make sure after issuing the loan the bank is not undercapitalized

2. Unacceptable collateral:a. Securities of an affiliate and low quality assets are not acceptable as

collateral for a bank’s extension of credit to an affiliate. 12 U.S.C. 371c(c)(3)-(4).

b. Definition of low quality assets: i. Bank examiner says that the assets are low quality

ii. Obligor has a crappy creditiii. Principle or interest payment on assets that are 30 days past dueiv. The terms of the loans have been renegotiated

c. Exemptions: i. Sister bank exemptions: Frees commonly controlled FDIC-insured depository institutions

from most provisions of 23A1. The exemption allows a bank to:

a. Permits the banks to be treated as a single economic entityb. Commonly controlled-exempts transactions btw FDIC insured banks

under 80% common control. c. If one sister bank fails, then the FDIC can take capital from the surviving

sister bank, even if they never availed themselves to the sister bank exemption.

d. Exempts the % of capital limitations and collateral requirements, but does not except the prohibition against low quality assets.

e. Regulators may deny a sister-bank exception to any significantly undercapitalized bank

ii. Fully secured by U.S. gov/ securities: Transactions fully secured by U.S. Gov/ securities or segregated ear marked deposit accounts

iii. Purchase of publically traded assets: that are on an exchangeiv. Certain loans: Purchasing loan w/o recourse from affiliated banks, subject tot the loans

quality asset return prohibitions.

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v. Giving credit for items collected: Giving immediate credit for items submitted for collection in the ordinary course of business.

vi. Deposits: Making deposits in an affiliated bank in the ordinary course of correspondent banking services.

vii. Investing in bank services corps. d. 23 A afford special treatment to operating subs of banks:

i. Treats them as if they were formed as part of the parent bank themselves: 1. The basic rules do not apply to banks transactions w/ an op sub: But do apply

to the subs transactions with the banks other affiliates2. Financial Subs after Dodd-Frank: after Dodd-Frank they will be treated as if

they are any other affiliates. 4. Limitations placed on transactions with affiliates under 23B:

a. Arms length dealings w/ affiliates: A bank must deal w/ an affiliate on market terms and if no comparable transactions exist the bank must deal with an affiliate on terms and under the circumstances that in good faith would apply to unaffiliated third parties.

i. Applies to: 1. Any covered transaction defined in 23A 2. A banks sale of securities or other assets to an affiliate including sales under a

repurchase agreement3. A banks payment of money or furnishing services to an affiliate4. Any transaction in which an affiliate acts as an agent or broker, or receives a fee

for its services to the bank or any other person 5. Any transaction, or series of transactions between a bank and a 3rd party if an

affiliate has a financial interest in the 3rd party, or participates in the transaction. 12 USC 371c-1(a)(2).

b. May not purchase securities form an affiliates underwriting: The bank cannot, as a principle fiduciary, purchase securities while an affiliate is a principle underwrite for those securities

i. Exception: If a majority of banks directors approved the purchase b/f the securities were initially offered for sale to the public. 371c-1(b)(1)(B), (2).

c. Affiliates cannot make it seem like the bank and the affiliate back each other: Neither the bank nor its affiliates can publish any advertisement stating or suggesting that the bank shall be in any way liable for the obligations of its affiliates. 371c-1(c).

23A Transactions In Which Bank: 10%-20% Limit

Collateral Required

Arm’s Length Dealing

Extends credit to affiliate Yes Yes YesMakes guarantee for affiliate Yes Yes YesPurchase assets from an affiliate Yes No YesTakes affiliates securities as collateral

Yes No Yes

Invests in affiliates securities Yes No Yes23B Transactions In Which Bank 10%-20%

LimitCollateral Required

Arm’s Length Dealing

Sells assets to affiliate No No YesPays Money to an affiliate No No YesProvides services to affiliate No No Yes Bank’s transaction w/ anyone, if affiliate

10%-20% limit

Collateral Required

Arm’s Length Dealing

Acts as agent or broker No No YesReceives Fee No No YesParticipates in transaction No No Yes

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Has Financial Interest in any party No No Yes

IX. BANK HOLDING COMPANIES1. Definition of a BHC:

a. Company having control over a bank. 12 U.S.C. 1841(a)(1):i. Company: Any corporation, partnership, business, trust, association of similar orgs, or

any other trust, unless by its terms it must terminate w/ in 25 years of 1841(b): 1. Partnership def. from UPA: Partnership is an association or 2 or more people to

carry on as co-owners of a business for profit. 2. Captures all business entities except: individuals, qualifying family trusts,

qualified partnerships, and corps owned by the gov. ii. Control: A company has control in 3 circumstances:

1. 25% or more of any class of bank’s voting securities: If the company owns, controls or has power to vote 25% or more of any calls of the bank’s voting securities:

a. Rebuttable Presumption again control if: If the company does not exercise controlling influence over a bank or have power to vote more than 5% of securities.

i. But if own more than 10%: Then there is an inference of control if you meet certain requirements

2. Ability to elect majority of bank directors3. If the Fed says that they have control: If the fed determines, after notice and

opportunity for a hearing that the company directly, or indirectly exercised a controlling influence over the management or policies of the bank. 12 USC 1841(a)(2).

iii. Bank: 1. Competitive equality bank acts definition of a bank:

a. (1) Any FDIC insured bank b. (2) any institution that accepts “Deposits that the depository may w/ draw

by check or similar means for payment to third parties or others andc. (3) Engages in the business of making commercial loans.

2. Under 1841(c)(2) definition of bank excludes:a. An FDIC insured branch of a foreign bankb. Thrift institutionsc. An org that does business in the US only as an incident to its activities

outside of the USd. A trust co that accepts deposits only as a fiduciary and does not offer

checking or other transition accounts, cross-markets its FDIC insured accounts through affiliates, use Fed wire, or borrower from the discount window

e. A credit unionf. A credit card bankg. A limited purpose internal financial institutions of the sort known as

Agreement corpsh. One of certain industrial loan banks

i. The Industrial bank loophole: (does not create a BHC)1. Any company can control an FDIC insured industrial bank

if the bank meets any of the following criteria: a. It does not accept certain kinds of demand depositsb. It has not under gone a change in control since 1987

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b. Prior approval required from the Fed to become a BHC: May not become a BHC w/o the approval of the fed:

i. It will also need approval to acquire control of an additional bank, more than 5% of a banks voting shares, acquire substantially of the banks assets or merge with another BHC

2. Permitted and prohibited activities: a. Activity restrictions:

i. The BHC Act restricts the activities that a BHC can conduct directly or through non bank subs

ii. It generally limits the co to: 1. Banking or management and controlling banks and other subs authorized under

this act or furnishing to or performing series for its subs and2. Activities that the Fed had before enactment of BLB determined to be closely

related to 1843(a)(2)(c)(8). iii. If participating in a prohibited activity then: A firm has 2 years after becoming a BHC to

divest itself of impermissible activities. The Fed may extend the deadline by 3 years. 1843(a)(2).

b. Powers of a BHC; 4(c)(8): i. BHCs are authorized to own shares of a company that: 1843(c)

1. Owns and operates bank premises2. Performs services for the BHCs banks3. Conducts a safe deposit business4. Temporarily owns shares acquired in satisfaction of a debt5. Owns shares of the very limited types in which a NB can invest6. Owns shares of any company as long as they do not include more than 5% of any

class of voting securities7. Owns shares of an investment company, as longs as the investment company does

not own more than 5% of any companies voting shares8. Does business in the US only as an incident of its international or foreign business

(OR)9. Engages in export trade

ii. Activities that a BJC can invest in as a BHC: List closed due to GLB Act: 1. Making, acquiring, brokering, or servicing loans and other extensions of credit2. Activities that relate to extending credit, i.e., any activity usually in connection w/

making, acquiring, brokering or servicing loans or other extensions of credit3. Leasing personal or real property w/o operating or serving leased property during

the lease term 4. Operating nonbank depository institutions—industrial banking and savings

associations5. Acting as a trust company 6. Providing financial and investment advisory activities including serving as

investment adviser to an investment co7. Acting as a securities broker8. Underwriting and dealing in gov/ securities and other debt obligations that a state

member bank may underwrite and deal in9. Management consulting, employee benefits consulting and career counseling10. Providing courier services for checks, docs and written instruments exchanged

among financial institutions and printing and selling checks and related docs. 11. Acting as an insurance agent under narrowly limited circumstances12. Community development13. Issuing and selling money orders, savings bonds and travelers checks14. Processing banking, economic and financial data

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15. Administrative services for mutual funds16. Owning share son an exchange17. Certifying digital signatures18. Providing employment histories for credit decisions19. Cashing checks and transmitting money and 20. Acting as a notary public

3. Approval requirements: a. A BHC must get approval b/f:

i. Prior Fed approval to acquire a bank and become a BHC (discussed previously)ii. Prior Fed approval to acquire additional banks

1. Or more than 5% of the bankiii. Restriction on nonbank activitiesiv. Must give notice of activities and acquisitionv. Must make reports

vi. Must undergo examinations vii. Must comply w/ capital requirements

viii. Are subject to enforcement actionsb. A BHC must give notice of activities and acquisitions:

i. Give Fed 60 days notice b/f: Commencing a non-banking activity or acquiring a share of a nonbanking company:

1. If the bank does not hear back from the Fed: The bank may proceed with the activity (note that FHCs only need 30 days notice)

ii. Must give 10 days notice b/f: Undergoing non-banking activity or 12 days notice for an acquisition if they meet certain management and capital criteria

1. Criteria: a. The bank is well managed and well capitalizedb. The BHC’s lead insured depository institution is well capitalized and well

managedc. The BHC controls no insured depository institution that is

undercapitalized or has a poor examination rating for managementd. At least 80% of the risk weighted assets of the BHC’s FDIC insured banks

are in well capitalized banks and at least 90% are well-managede. No formal administrative enforcement actions have been commenced or

taken during the past year or is currently pending against the BHC or its depository institution

f. The Fed has not specifically required the BHC to file a notice for the activity or acquisition (AND)

g. Any acquisition would cost more than 15% of the BHCs consolidated their 1 capital or increased consolidated risk-weighted assets by more than 10%. 1843(j)(3)-(5).

iii. Acquisitions of non-banking depository institutions: The BHC must follow the notice procedures governing non-bank activities w/ one exception:

1. Even if the BHC otherwise qualifies to commence activities closely related to banking w/o prior notice, the BHC must obtain the Feds prior approval to acquire an FDICs insured institution.

X. FINANCIAL HOLDING COMPANY1. Overview of FHCs:

a. FHCs can: i. Engage in (directly or through subs) in “financial” activities and activities “incidental” or

complementary to financial activities. 18

b. Companies held under a FHC:i. FHCs may own: Bank, securities broker-dealers, insurance companies, a commodities

dealer, other financial incidental or complimentary related companies, and can participate in merchant banking.

ii. Note: Cannot operate a money market or hedge fund but there can be 3% ownership in these funds.

2. Requirements to become a FHC: a. There are 3 requirements to be eligible to be a FHC:

i. FHC and each one of its FDIC insured subs must be well capitalized and well managed: Being well capitalized requires at least a satisfactory composite rating for management

1. Dodd-Frank: Requires that the entire FHC, not just the banks be well captilized and well managed.

ii. Each of these institutions must have a satisfactory review under the CRA; 12 USC 2903(c)(2): Even if it does not meet the CRA requirement it will be ok if it has a plan to meet the requirement that is adequate

iii. Must file a declaration with the Fed that it elects to become a FHC: 1843(1)(l), 2903(c)(1)

b. If a FHC becomes deficient in any one of these categories: i. 180 days to correct: If the FHC does not correct w/ in 180 days then it will be required to

cease the activity that is impressible and may have to divest the subii. Cannot engage in any new activity: If any of its subs has an unsatisfactory CRA ratings

3. Permissible activities, i.e., activities that are financial: a. Permissible activities that the FHC may engage in or acquire the shares of or engage in are:

i. Financial in natureii. Incidental to such financial activity

iii. Complementary to a financial activityiv. Posing no substantial risk to the safety and soundness of depository institutions or the

financial system generally. 1843(k)(1). v. BUT KEEP EYE OUT FOR VOLKER RULE:

1. Enacted as part of Dodd-Frank prohibits FHCs and any other affiliated of a FIDC insured bank from engaging in proprietary trading and from owning a hedge fund or private equity firm.

b. Generally there are no pre-notice requirements for engaging in activities except when: i. Must give notice 30 days after: Engaging in permissible activity

ii. Except when acquiring a thrift c. Activities that are financial under 1843(k):

i. Lending $, transferring $, exchanging $, investing $ for others, transferring securities, or safeguarding $ or securities

ii. Underwriting, brokering, selling any kind of insurance guarantee, or indemnityiii. Providing financial, investment or economic advice, including acting as an investment

adviser to an investment companyiv. Securitizing loans or other assets that a bank could hold directlyv. Underwriting in, dealing in, or making a market in securities

vi. Engaging in activities that the Fed had b/f GLB-determined to be closely related to banking under 5(c)(8)

vii. Merchant banking-acquiring shares in any company w/ certain requirementviii. Investing in any company through an insurance company in the ordinary course of the

insurance companies business w. relevant state law and w/o routinely managing or operating that entity except as necessary to obtain a reasonably return on investment.

ix. Lending, exchanging, transferring, investing for others, or safeguarding financial assets other than money or securities

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x. Arranging, effecting or facilitating financial transactions or the account of third parties4. Merchant Banking Provisions Expands List of Permissible Activities:

a. Allows bank to: Engage in nonfinancial affiliationsb. Merchant banking activities:

i. May engage in limited private equity like investments: Under this rubric the FHC an own non-financial firms

ii. There are four main constraints on owning them; 1843(k)(4)(h): 1. The FHC must acquire the shares as part of a bonafide underwriting or

merchant or investing banking activity: Includes investment activities engaged in for purpose of appreciation and ultimate resale or disposition of the investment.

2. The shares must be held by a securities affiliate, e.g., a registered broker dealer: Cannot reside in their banking sub, but another one of the entities in the holding company

3. Has to be held for a period of time to enable the sale or disposition on a reasonable basis consistent w/ the financial viability of the activities involved, i.e., to turn a profit: A FHC may actually satisfy this by holding the shares until it is the right time to sell.

4. The FHC must not routinely manage or operate the company: Only manage the company as necessary in order to obtain a reasonable return on their investment

iii. While not a real constraint, these provisions attempt to limit the routine management: 1. Can only hold for 10 years if held directly or 15 years if by private equity:

Investment generally cannot exceed 10 years if held directly and 15 years if held through private equity

2. The FHC cannot have an officer, director or employee interlocking with the company in which it has invested unless the company:

a. Has its own officers and employees responsible for routinely managing the company

b. The holding company does not routinely manage the companyi. Note: If these two requirements are met the holding company can

name the entire board of directors for the company 3. The FHC’s officers, directors, or employees generally cannot supervise and

officer, director, or employee of the portfolio company: In that the companies day to day operations

a. But in can manage the day-to-day operations when: Intervention is required to obtain a reasonable return on the FHCs investment upon resale or other disposition of the investment to avoid loss.

4. The FHC CANNOT contractually restrict the portfolio company’s routine business decisions: The holding company cannot contractually restrict the portfolio company’ routine business decision but can contractually require the holding company’s approval for actions outside the ordinary course of business

a. Non-routine activities include: i. Issuing or redeeming securities

ii. Removing or replacing executive officers, independent accountants, auditor, or investment bankers

iii. Amending bylaws or articles of incorporationiv. Making significant acquisitionsv. Selling a significant acquisition

vi. Selling a significant sub orvii. Significantly changing the company’s business plan or accounting

methods or policies.20

5. To facilitate monitoring of holding company involvement in managing the portfolio the FHC: Must document any such involvement and reason for it.

c. Further limitations are placed on these activities by the Volker rule: i. The Volker rule: Enacted as part of Dodd-Frank prohibits FHCs and any other affiliate of

an FDIC-insured bank from engaging in proprietary trading and from owning a hedge fund or private equity fund

1. But there are exceptions: Banking entity may engage in risk mitigating hedging activities and it may buy and sell instruments in connection w/ underwriting or market making.

a. Market making: The Volker rule interferes with the banks ability to market make b/c they must have an inventory of securities

b. To avail themselves to the Volker rule market making firms must: i. Must have an internal compliance program

ii. The market making must be designed to not exceed the reasonably expected near term demands of customers and counterparties

iii. Must engage in bonafide market making that is not a subterfugeiv. Must register or be exempt from registration from the securities

lawsv. Profit must be from market making and not from appreciation as a

result of the tradesvi. Profits must reward for performing market making services and

not risk takingvii. Market making must comply with regulation

c. Note that these regulation are all nearly impossible to comply with. 5. Extensions of these rules to the FHCs subs:

a. Operating subs, i.e., 23A:i. May only engage in activity in which NB can directly: An operating sub can engage as

principle in activities impermissible for a sub of a national bank only if the sate bank is adequately capitalized and the FDCI has found that the activity is not a threat to the FDIC fund.

b. Financial Subs, i.e., 23B:i. Engage in one or more actively that bank cannot act in directly

ii. Can engage in activity that is not insurance underwriting, issuing annuities, and merchant banking

iii. Bank must remain well capitalized and well managed and must have a good CRA recordiv. Must deduct from its reg. cap every dollar of the banks equity invested int eh sub and stay

well capitalized after the deduction. v. The total assets that FHC can have in its sub cannot be over 50 Billion or 45% of the

banks consolidated assetsvi. Bank cannot do any real estate development.

XI. FEDERAL REGULATOR’S ENFORCEMENT ARSENAL1. Parties Covered by 1818u which is the key enforcement statute for FDIC depository institutions:

a. Institutions affiliated parties:i. Management or agent of FDIC insured depository institutions: Any director, officer,

employee, or controlling shareholder of an FDIC insured depository institution, any agent for such a bank or any person acquiring control of such a bank.

ii. People who participate in the company: Any shareholder (other than a BHC), consultant, joint venture partner and any other person determine by the appropriate Federal Banking agency who participate in the conduct to of the banks affairs.

21

iii. The tree As: An independent contractor (attorney, appraiser, accountant) who knowingly or recklessly participates (mere negligence is not enough) in:

1. A violation of any law or regulation, 2. Breach of fiduciary duty, or 3. An unsafe or unsound practice

2. Conditional Approvals; 1818(b), (e), (i)(2): a. The agency may condition approval activities on compliance w/ some restriction or

requirement: When a bank or a BHC applies to a Fed banking agency for approval to acquire a bank, engage in a new activity or open a new branch, or the like the agency may seek to condition the approval on the applications compliance with some restriction or requirement.

b. These conditional approvals can serve as a potent enforcement tool:i. Banks may need formal agency approval to engage in a variety of activities: Even to take

such apparently routine steps as opening a new branch or commencing a new line of business in which many other banks already engage.

ii. If a bank violates the condition it could lead to other disciplinary action: If the bank subsequently violates such condition the agency can punish the violation by issuing a cease and desist order, imposing civil money penalties and removing the persons responsible.

3. Written Agreements, 12 U.S.C. 1818(b): a. Regulator may enter into an agreement with a bank: The banking agency may seek to

negotiate a written agreementb. This agreement has 2 advantages over formal enforcement mechanisms:

i. The written agreement gets the attention of top bank managersii. They provide independent grounds for cease-and-desist orders, civil money penalties and

removalc. The statute provides express authority to base an enforcement action off of breach of these

agreements: Breaching one of these statues may be the basis of an agency cease-and-desist order.

d. May be more strict than the formal enforcement sanctions: Written agreements, like conditional approvals, may include restrictions and requirements more stringent and intrusive than the agency could have imposed through formal enforcement proceedings.

4. Cease-and-desist orders: a. The grounds for a cease-and-desist proceedings: The agency must show that an insured bank

or institution affiliated party:i. Unsafe and unsound practice: Has engaged, is engaged, or is about to engage in an unsafe

or unsound practice, OR1. Embraces: Any action, or lack of action which is contrary to generally accepted

standards of prudent operation, the possible consequences of which if continued would be an abnormal risk or less or damage to an institution, its shareholders, or the insurance fund.

ii. Violation of law Has violated or is about to violate of a statute, or regulationiii. Agreement with agency: A condition imposed in writing by the agency or a written

agreement with the agency. b. Notice on temporary cease-and-desist orders:

i. The agency has the option of issuing a temporary cease-and-desist order: In order to do this it must satisfy two requirements:

1. Notice: It must have served notice of charges seeking a regular cease-and-desist order

a. Does not require a hearing: The agency may then issue a temporary cease-and desist order ex parte of a hearing

22

2. Misconduct must be determined to have the potential to harm the institution: The agency must determine that the misconduct specified in that notice is likely to render the bank insolvent, significantly dissipate its assets or earning weaken its condition, or otherwise prejudice the internet of its depositors. 12 U.S.C. 1818(c).

5. Suspension, Removal, and Prohibition: a. Gives the Fed Regulatory Agency Broad Sway over the banks by giving them powers to:

i. Can withhold charter or deposit insurance: If they do not want someone to be involved in the bank

ii. Can prevent someone from being a executive: The agency can prevent an existing bank form making someone a director or executive.

iii. They can also remove the person from office: They can remove someone form officer and prohibit them for life form participating in a federally insured depository institution

b. Removal v. Prohibition:i. The agency removes a respondent from office: But prohibits them form participating in

the affairs of a depository institution. ii. Prohibition may encompass a wide variety of people: Not only officers and directors but

anyone who participates in conducting the banks affiliates and may even extend to independent contractors who fall with in the definition of institution affiliated party.

c. PREREQUISTIES FOR REMOVAL i. The pre-requisites for removal: To remove an institution an institution-affiliated party,

the agency must establish three substantive parts (misconduct, effect, and culpability):1. Must demonstrate that 1 to 3 types of misconduct is present:

a. Violation of law or agreement: Violating a statue, regulation, final cease-and-desist order, condition imposed in writing, or written agreement;

b. Engaging in unsafe or unsound practice: Engaging or participating in an unsafe or unsound practice, OR

c. Breach of fiduciary duty 2. Effect that resulted in:

a. Loss or damage to the bank: Actual or probable loss or other damage to the bank

b. Prejudice to the bank’s depositors: Actual or probable prejudice to the interest of the bank’s depositors

c. Benefit to the respondent: Financial or other benefit to the respondent3. Culpability (beyond mere negligence):

a. Involved personal dishonestyb. Demonstrated willful or continuing disregard for the bank’s safety and

soundness. 12 USC 1818(e)(1). d. There are other provisions that allow to suspend a person:

i. Authorizes the agencies to suspend persons charged w/ federal felonies involving dishonesty or breach of trust if the individual continued service or participation may pose a threat to the interest of the depository institutions. 12 U.S.C. 1818(g).

e. Industry wide bar: i. The effect of an industry wide bar: Respondent cannot hold any office in any FDIC-

insured bank, any federally insured credit union, certain other federally regulated financial institutions, or nay depository institution regulatory agency.

ii. The Fed Agency has to show that the D acted w/ Scienter: The level of culpability has to be beyond negligence, it has to be proven that the defendant acted with knowing or a reckless disregard.

6. Civil Money Penalties: a. There are three types of civil money penalties and most of them are per se

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i. Unlike criminal fines, civil penalties can be imposed administratively, w/o most of the procedural protections in criminal cases and unlike compensatory damages they are not limited to the amount of actual harm.

b. There are 3 tiers of fines under 12 U.S.C. 18(j)(2): Tier 1 Tier 2 Tier 3

Types of Conduct Minor violations; namely any violation of a statute or regulating, cease-and-desist order, suspension, removal, or prohibition order, prompt corrective action order, condition imposed in writing, or written agreement.

1 of 3 types of misconduct:1. Committing a

violation of the type that would support tier 1 penalties

2. Recklessly engaging in an unsafe or unsound practice, or

3. Breaching a fiduciary duty

The respondent knowingly committed 1 of the 3 types of misconduct:1. A violation of the

type that would support tier 1 penalties

2. An unsafe or unsound practice

3. A breach of fiduciary duty

$ Amt in fines Damages

5k per day 25k per day 1 Million per day

Intent Do not need to show intent

N/A Knowingly or recklessly

Effect Do not need to show effect

Must involve a certain pattern or effect

The respondent knowingly or recklessly caused one or two substantial effects:1. A substantial loss

to the bank2. A substantial

pecuniary gain or other benefit to the respondent.

7. The FDIC’s back-up enforcement Authority: a. If the primary regulator does not take action for an insured bank the FDIC can: It may

suspend insurance and can also take enforcement action on its own. b. Exercising back up authority is a two-step process:

i. The FDIC must recommend in writing that the other agency take specific enforcement action: Give 60 days for the agency to act or provide a plan of action. Period can be shortened if needed

ii. If the problems remain unresolved, the FDIC’s BOD must determine that: 1. The bank is unsafe and unsound2. The bank or institution-affiliated party is engaging I unsafe/unsound practices3. The conduct in Q poses a risk to the deposit insurance fund or may prejudice the

interest of the bank’s depositorsa. The FDIC may itself then take the recommended enforcement action. 12

U.S.C. 1818(t). 8. Terminating or suspending deposit insurance:

a. May terminate deposit insurance on 3 different grounds:

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i. (1) If the bank is in an unsafe and unsound condition to continue operationsii. (2) If the bank or its directors have engaged or are engaging in unsafe/unsound practices

in conducting the bank’s businessiii. (3) If the bank or its directors have violated any statute, regulation, order condition

imposed in writing by the FDIC, or written agreement with the FDICb. The FDIC will also put in place safety measures in place for 6 months after suspension to

prevent runs: To reduce the likelihood of a rune, existing deposits retain insurance for at least 6 months after the order takes effect. But insurance does not apply to new deposits.

c. Suspension: Of deposit insurance is an interim remedy, once the suspension takes effect, insurance applies to existing deposits, but no longer to any new deposits.

XII. BANK FAILURES2. Receivership vs. Conservatorship:

a. Receivership:i. Receiver liquidates the bank and sells its assets: The old corporation ceases to exist

ii. Can maintain deposits: A different corporation may take the banks business at the same location, and have many of the same assets and liabilities

b. Conservatorship: i. Take control of the troubled institution: conservator operate a bank as a going concern and

unlike receiver, lack the authority to liquidate the bank. ii. In a conservator process they try to rehabilitate the troubled bank: Regulators can use

conservatorships to wrest control of a bank from management or seek to rehabilitee that troubled bank

iii. OLA is a process of conservatorship: Where the FDIC creates a bridge financial company in which a too big to fail institution can be taken care of four 5-8 years only

a. Problem is that liquidation is not really an option in these types of situations. 3. Grounds for Receivership:

a. FDIC serves as a receiver for all failed NBs and failed thrifts: In practice the FDIC serves as a receiver to all failed FDIC insured state banks and thrift institutions.

b. Grounds for receivership; 12 U.S.C. 1821(c)(5):i. Bank has obligations that are greater than their assets

ii. Bank cannot/ probably cannot meet its obligations in the normal course of business iii. Bank is unsafe and unsound condition to transact businessesiv. Bank incurs/likely to incur loses depleting its capital and no reasonable prospect of

becoming adequately capitalizedv. Bank is critically under capitalized or has substantially insufficient capital (PCA issues)

vi. Bank is undercapitalized and (a) has no reasonable prospect of becoming adequately capitalized, (b) fails to recapitalize when ordered to do so under the prompt corrective action statute, 12 USC 1931o(f)(2)(A),(c) fails to submit a timely and acceptable capital restoration plan, (d) materially fails to implement such a plan.

vii. Bank substantially dissipates assets or earning through a violation of a statute or regulation or thorough an unsafe/unsound practice

viii. The bank conceals records or assets or refuses to let authorized examiners inspect recordsix. The bank willfully violates a cease-and-desist orderx. The bank commits any violation of a law or regulation, or unsafe unsound practice or

condition that is likely to cause insolvency or substantial dissipation of assets or earnings, weaken the bank’s condition or otherwise seriously prejudice the interest of the deposit insurance fund

xi. The bank is convicted of money launderingxii. The bank looses its FDIC insurance—this is virtually a death sentence

xiii. The bank consents to receivership/conservatorship25

4. Marshaling assets: a. A receiver may Marshall a bank’s assets: by identifying all of the items of potential value of

the bank and turning them into cashb. The four main powers of a receiver:

i. Avoiding Fraudulent transfers : Debtor and creditor law has long prohibited a debtor from transferring property to hinder, delay or defraud a creditor. 12 U.S.C. 1821(d)(17)(A). By providing these transactions fraudulent, the receiver may obtain a judgment invalidating them. 1821(d)(17)(A)-(B).

ii. Pursuing claims against failed bank directors and officers: claims include:1. Breach of fiduciary duty2. Intentional wrong-doing or 3. Other actionable misconduct4. When receiver identifies a credible claim it will consider whether the bank or

insiders has insurance to pay the claimiii. Terminating K’s and leases

5. TERMINATING FAILED BANK’S K’S AND LEASESType of Agreement

Consequences if Receiver Terminates Agreement

Agreement not w/ in any category

Receiver is liable only for an “actual direct compensatory damages” determined as of date bank entered into receivership. Receiver is not liable for punitive damages or damages for lost profits, opportunities, or pain and suffering.

Lease under which bank is the lessee

Lessor can recover only rent accrued b/f termination. Lessor has no claim for damages under any acceleration clause or penalty provision.

Lease under which bank is the lessor

Lessee, if not in default when receiver terminates lease, may either treat lease as terminated or remain in possession of property for remainder of lease term. If lessee remains in possession, lessee must continue to pay rent, and if receiver fails to perform bank’s duties under lease, lessee may deduct any resulting damages from rent due to receiver.

K for sale of real property

If purchase has possession of property and is not in default when receiver terminates K, purchaser may either treated K as terminate or remain in possession of property. The following rules apply if purchaser elects to remain in possession: Purchaser must continue to make payments; if receiver fails to perform bank’s duties under K, purchaser may offset resulting damages against payments due to receiver; receiver shall deliver title as provided in K and reliever has no other duty or liability.

Service K If receiver accepts services under K b/f terminating K, receiver shall pay under K for those services and treat payment as administrative expense. Receiver can terminate K even if receiver has accepted services under K

QFC Receiver must terminate either all or non of a party’s qualified financial Ks w/ the bank. If receiver terminates QFC, other party may recover reasonable cost of cover

XIII. PAYING VALID CLAIMS IN ORDER OF PRIORITY:1. Creditors must petition the receiver in order to get claims

a. The receiver determines which claims are valid: All creditors must provide proof of claims and then the receiver decides which claims are valid, creditors who are dissatisfied may seek payment of the claims in court

b. Claims priority: Pays secured claims first, i.e., those backed by collateral and then pays the unsecured claims

2. Calculating how to pay secured claims: a. If collateral worth less then claim, the secured claim is only paid up to the collateral: The

remainder constitutes an unsecured claim, 12 U.S.C. 1821(d)(5)(D)(ii), if a creditor has not protected its security interest the receiver treats the claim as unsecured.

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3. Unsecured Claims a. Paid in the following order:

i. The cost of the receivership (administrative expenses)ii. Deposits—insured and uninsured

iii. General liabilities, i.e., bonds and most unpaid bills and wages incurred b/f receivership—a residual category for liabilities that do not fit into any other category

iv. Subordinated debtv. Cross-guarantee liability to the FDIC

vi. The ownership interest of the bank’s shareholder equityb. Pay claims in the category completely b/f moving onto the next: However, the FDIC as

receiver has leeway to deviate from these priorities as long as each claimant receives no less than it would have received in a straight liquidation. 1821(i).

4. Determining the validity of claims: a. Applying the same rules as if there were no receivership when determining value of claims:

But four special rules apply to receivership: i. The claim must arise form a legal obligation that existed b/f the receivership and its value

must be certain or promptly ascertainable. ii. If no assets remain to pay a claim, nether the receiver nor a court need determine the

validity of the claim. iii. The receiver can make payments (dividends) on properly provide claims at any time—

thus the claimant would go unpaid b/c it had no provide its claim b/f the dividend. 12 U.S.C. 1221(d)(10)(B).

iv. The so-called ide agreement rule can invalidate a claim that depends on an agreement w/ the failed bank, if the agreement is adverse to the FDICs interests as receiver or insurer and the banks records do not adequately evidence the agreement.

b. Set offs:i. Courts have long allowed a failed bank’s to setoff: Deduct what the banks owes them to

what they owe to the bank. c. Subrogation: When the FDIC as insurer pays a failed bank’s insured deposits it becomes

subrogated to their claims against the bank, 12 USC 1821(g). i. The FDIC in effect steps in those depositors’ shoes, becoming entitled to receive

whatever share of the bank’s assets would otherwise have gone to those depositors. 5. Structuring the resolution:

a. How receivership and deposit insurance intertwines:i. The FDIC as receiver has a lot of different options: It can try to find a white knight or it

could sell off the assets in a piecemeal fashion. b. Pays depositors off immediately:

i. May pay depositors off immediately w/o paying off banks assets: It can retain or credibly guarantee doubtful assets and it does not have to dump them when it is not a good time to make a profit off of them.

ii. After immediately paying off depositors: After immediately paying off depositors claims it replenishes the insurance fund ocean the receiver pays off these claims.

c. There are four options that the FDIC uses to resolve a failed FDIC institutions:i. In a deposit payoff (straight liquidation) the FDIC liquidates the bank’s assets and pays

the bank’s liabilitiesii. In an insured deposit transfer the FDIC pays a healthy bank to assume the failed bank’s

insured depositsiii. In a purchase and assumption the FDIC arranges for an acquirer to purchase some or all

of the failed bank’s assets or all of the bank’s liabilities.

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iv. If the FDIC plans to sell the failed bank as a going concern but odes not find and acquirer it can form a bridge financial bank, transfer assets to the bank and have the bridge bank carry on the failed Bank’s business until the FDIC lines up an acquirer.

6. Least-cost resolution requirement: a. Least-Cost Resolution Requirement:

i. General rule: In dealing w/ a particular bank the FDIC must adopt the resolution method that is “least costly to the insurance fund” 12 U.S.C. 1823(c)(4).

1. How to identify this: To identify the least cost approach the FDIC must “evaluate alternatives on a present value basis, using a realistic discount rate and a document that evaluation and the assumption on which the evaluation are based

b. Systematic risk exception: A narrow systematic exception exists for cases in which least-cost resolution of a particular bank “would have serious adverse effects on economic conditions or financial stability.” 12 U.S.C. 1823(c)(4)(G).

i. Defining systematic risk: Refers to a possibility of a sudden, usually unexpected event the disrupts the financial markets, and thus the efficient channeling of resources quickly enough on a large enough scale to cause a significant loss to the real economy.

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POLICY ATTACK OUTLINE

1. Systemic Risk: a. Bailouts:

i. 1984 FDIC bailed out all creditors of Continental Illinois1. Allowing the bank to fail and its uninsured depositors to suffer loss would cause

incalculable damage to the U.S. financial system a. This bail out established the notion that some banks are too big to fail(TBTF).

i. This is largely defined by the financial systems exposure to each other2. Problems with TBTF logic:

a. It can create a moral hazard b/c it promptes complacency and increases the potential for a big firms failure to cause panic among invesotrs

2. The Market and Financial Disasters: a. Alan Greenspan(Pre-financial collapse):

i. Believes in the virtues of the free market1. Greenspan believes in the benefits of free market capitalism and criticizes the

regulation of the 70s which created inflation. 2. Believes that flexibility in the economy has made it more resilient to shocks and more

stable that it has been in the decades3. Thinks that the regulators are poor controllers of the economy and the firms/business

are a much stronger alternative4. Not concerned with the changing function of banks and that derivatives and complex

financial products are unregulated and are changing the function of banks and does not recognize that the industry is highly regulated and bolstered up by bailouts.

ii. Pre-write: 1. Alan Greenspan in a speech b/f the financial crisis highlighted a reliance on the free

market and his ideology while at the Fed that the industry was the best mitigator of risk. In many ways Greenspan’s speech demonstrates a dogmatic outlook of the economy which may have lead to the financial crisis. Greenspan believed that the banking industry was the best mitigator of risk, and that by their use of complex financial products they could resist down swings in the economy.

2. In reflection, his view is quite absurd. He ignores the fact that these industries are profit driven entities that pose a systematic risk to the U.S. economy and will not act in the best interest of the economy as a whole, but only look at short term profits even if it increases the risk of a failure.

b. Posner—Excerpt—A Failure of Capitalism:i. Posner’s argument is contrary to Greenspan’s. Posner argues that the financial crisis was the

result of too little regulation and the government should have been more aggressive at curving the risky lending practices of banks that resulted in the housing market bubble and ultimately the financial crisis.

ii. He criticizes the regulatory agencies for not being able to gather intelligence that could have allowed them to predict the crisis and their failure to have any sort of intelligence about the financial system.

iii. Posner also criticizes laissez faire capitalism saying that the polices of that put reliance in industry and the free market allowed for the recession and for the damages that it put onto the economy.

iv. Posner also sees danger in the governments response, that the massive bailouts running up the deficient will lead to inflation and that banking should not be a free market industry but should be highly regulated.

3. The Financial Crisis of 2008: a. Timeline of financial crisis:

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i. 2008 housing crisis that began in 2008 1. This was after a fundamental run up in housing prices in the Us which was a bubble

a. One of the reasons that this was caused was b/c of the loose monetary poice during this period and low interest rates to a near historic lows, making credit both cheap and readily avaliable for households and business alike.

b. Banks began to ignore underwriting standards for lending c. The originators took the originate and distribute model where they would

originate it and then sell it quicklyd. A lot of these loans were of poor quality and poor credit so defaults began to

sky rocket, especially w/ the subprime mortgagese. The process of securitization fed off and fed into the housing bubble. f. The mortgages were put into ppols were they were securitized into asset back

securities and then they were formed with exotic products likes CDOS and SPVs and CDS, so they could get a triple AAA rating.

g. They were thought of having been a safe investment but since their value depended on the housing market, when the housing market went so did the mrotages

h. When the forclsoure crisis hit it began to erode the value of these products that were on the books of almost every bank in the world

i. Banks in Europe began to carsh firth and the govenrments had to take steps to stem a run

i. Soon after the American banking sytem started to implde were the big firms Lehman Borthers and Bear Sterns begin to collapse and

i. Feddie Mae and Freddi Mac also began distressed and had to be bailed out

j. In the midst of the bail out Aigb egan to fail b/c it had backed all of the bonds with CDS and could not raise the funds to pay them off

k. The government had to resuce it ii. The fed response

1. The fed had to take extraordinary steps and they had to come in and bail out the bnaks and the nonbank situtions

2. They had to nearly nationalize all of the big banks 3. The

b. Kenneth Scott: Summarizes the financial crisisi. There was not a singular cause of the financial crisis. In many ways, it was the perfect storm.

It started with poorly chosen mortgages and reckless lending. Then there were the issue of poorly crafted financial products RMBs which were comprised of these poorly chosen mortgages. Then in addition there was the derivatives, which insured these mortgages and gave them a boost in their credit ratings. Then there were the banks that invested in the RMBs who thought that they we were a secure financial product. When in reality the derivatives and the RMBs helped create an interlink age between the major financial intuitions, which led to a cascade. Where one bank failed, the next bank would fail or if there was a wide spread failure in the RMBs then the derivative contracts would bankrupt the insurers. Essentially, there was the perfect storm, unregulated products that were on the balance sheet of every major bank, and linked to almost every major financial instituions. When the underlying products began to fail the entire system came crashing down.

ii. The government played a large role in the subprime mortgage crisis and the major banks were also complicit. The Fed, under the supervision of Alan Greenspan made the decision to stimulate the housing market. It did this in 2001 by cutting interest rates on loans. This allowed people to afford loans easily and get mortgages for houses that they would never be able to pay off. Also many of these mortgages were made to low income individuals who

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were never able to pay off the loans. This financial industry was complicit in this and lent to people w/o properly vetting them.

iii. The GSE’s Fannie, Freddie, etc guaranteed these loans and helped make securitizing the mortgages attractive. Backing the loan, the government made the securities seem like a safe investment.

iv. The fiancnail industry and the banks began to develop asset backed securities pools with the residential mortgages referred to as RMBs and they were divided into tranches that had different levels of seniority. In essence, the seniority was allowed for each level to provide a better credit rating and to be a more attractive investiment. With the lower wouns being subprime. The lower pools were hard to seel, so they were put into new pools to create CMOs. Then the processes was repeated and the farther you went along the less of a connection there was with the original loan.

v. In addition, these products were assured by large insurance agencies like AIG through the use of CDSs.

vi. Financial collapse became result largely of the lower loans going underwater and the foreclosure crisis. When the lower tranches started to go the tranches with the better credit ratings became more risky. The banks also began to not to be able to identify which loans were still good and which ones were bad. In essence, the RMBs and CMOs had become toxic and they became worthless. When these products began to fail this caused the insurance policies to be triggered, and AIG had over insured and could not pay out on its investments. This led to a chain of failures through out the financial system and led to the global financial collapse.

c. Regulatory Failures: i. Gaps in the US regulatory structure were at least partly responsible for the crisis but

specifically the fragmented structure of regulation, with specialized regulatory agencies operating across articifically segregated lines of servies sucha s banking isnruance, securities and futures.

d. There are multiple lessons that were learnt from the financial crisis. i. The danger of defects in financial products:

1. The CDSs were not necessarily the problem with the financial products. While the CDS and derivatives are risky investment the problem during the financial crisis was the bundling of subprime loans into RMBSs which magnified the impact of the crisis by making large defective products.

ii. Firm Risk Management: 1. The originators of the mortgages retained very little risks on the loans that they made,

they just received fees or the origination of the loans and immediately sold them. In addition, the GSE’s failed to effectively monitor the underwriting of the loans that they backed. Furthermore, deposit insurance provided a government safety net for banks that made debt cheaper and gave and allowed for banks to leverage and led bank management to take excessive risk, regardless of its compensation structure.

iii. Government Regulation: 1. There was ample authority for US regs to have addressed these issues, provided they

had perceived the need and acted on ite. Shelia Blair Speech—FDIC on the causes of the current state of the Financial Crisis 2010:

i. It was estimated that half of all financial services were conducted in institutions that were not subject to regulation and supervision. The crisis demonstrate that many of the financial institutions that were not subject to prudential regulations had grown to large and complex to resolve under the existing bankruptcy law and currently they cannot be wound down under the FDIC’s receivership authorities.

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ii. There was a failure of market discipline and regulation. This was demonstrated by the shadow banking system that were incorporating products and services into their own more lightly regulated affiliates and subs.

iii. In the years leading up to the financial crisis there was a failure of market discipline. The consumers and business had access to easy credit and there was a lack of sound underwriting by the institutions who were issuing credit.

iv. The banks and thrifts in the 1980s-90s began securitizing a major share of their mortgage loans with the GSEs and started to focus on originating rather then holding onto the mortgages.

1. This allowed uniformed consumers to be subject to predatory terms that were not readily transparent to many borrowers.

f. Reforms after the Financial Crisis: i. Housing and Economic Recovery Act of 2008:

ii. TARP Program—to initiate some of the bail outsiii. American Recovery and Reinvestment Act of 2009—Which was a economic stimulus

packageiv. Dodd-Frank Wall Street Reform Act of 2010—

1. Created the FSOC in order to regulate non-bank SIFIs by allowing them to come under prudential rules

2. Created stress testing of organizations3. Get rid of the office of thrift supervision 4. Creation of the CFPB which consolidated the consumer protection laws5. Creation of the a swap clearance process w/ in the CFTC

a. Title VIb. Title IX

6. Orderly Liquidation process to try to save the good aspects of a FHCs, but this model is flawed b/c it essentially creates a bail out process

4. Problems/Policies with FDIC insurance: a. Congress created the FDIC in order to:

i. Congress’s purpose in creating the FDIC: Banking Act of 19331. Faced w/ virtual panic after the great depression Congress wanted to find a way to

protect people’s earnings against bank failures, which could deplete their savings. Congress wanted to make sure that the sums of money deposited in the banks were not tied up and also wanted to make sure that people’s assets were protected from bank faulres

b. They are intended to: i. B/F FDICIA system of Fed deposit insurance and depository institutions regulation

encourage the banks and managers to act in ways that could harm the FDIC insurance fund. But the prompt corrective provisions, risk based deposit insurance premiums, and least-cost resolution attempt to try to limit the moral hazard issues with deposit insurance.

1. How this changes the behavior of owners and managers: Deposit insurance has changed the behavior of bank managers and owners in two distinct ways. First, banks do not have to make a choice between being risk adverse and attracting depositors. Depositors, due to insurance, will have their funds secure at banks that take risks and ones which are conservative. Second, contingent on their capitalization requirement, banks that take risks and those that do not will pay the same deposit premiums. So, this encourages institutions to take greater risks than they would otherwise, or effectively they are subsidizing other institutions risk taking.

2. Regulators: Regulators also face perverse incentives due to deposit insurance, which are forbearance, i.e., failing to take appropriate action to reduce the risk of a unhealthy institution poses the deposit insurance fund; and over extending the federal

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safety net –needlessly shielding an insured depository institution from market discipline.

c. FDICA is intended to better align the owners and managers and regulators with that of the deposit insurance found. By forcing prompt corrective action from the bank owners and managers or face remove and by mandating regulator action in order to prevent forbearance. However, the overextension of the federal safety net, as seen during the 2008 financial crisis, has not been something that the FDICIA has seemed to have curtailed

i. FDICIA: 1. Includes a series of provisions intended to improve supervision of insured depository

institutions, with a signifcant emphasis on capital supervision as a primary tool. 5. The purpose of deposit insurance:

a. Shifts risks of runs form the private sector to the Government by reducing the borrowers costs and enabling banks to operate w/ higher leverage than they otherwise would, DI may give banks an advantage over competitors that fund themselves on market terms. By conferring on banks a benefit unavailable to ordinary business firms, deposit insurance offers a possible rationale for subjecting banks to duties not imposed by other firms.

b. The effect of deposit insurance is that it has reduced deposit insurance bank capitalization rates were much higher, the banks had to hold more capital to protect itself form large unforeseen customer with draws.

c. The main idea of deposit insurance was to prevent runs when the public believed that the bank was at risk.

6. Justification for deposit insurance: Milton Friedmana. FDIC was created b/c in the Great Depression the Fed was unable to prevent bank failures. This was

not the only problem with FDIC insured institutions. In the 1970s problems developed with the deposit insurance fund due to inflation which destroyed the net worth of some financial enterprises.

b. According to Friedman in order for deposit insurance to work, there has to be some private personal incentive for safe banking.

7. Reforms to FDIC insurance: Blinder and Westcott, Reform of DI: a. Blinder and Westcott put fourth seven principles that should guide reform to the deposit insurance

fundi. DI should enhance macroeconomic stability and financial stability

ii. DI should prevent most bank runs—first, by guaranteeing depositors that they will not suffer losses if the bank fails, DI also reduces incentive for a rational DI to run his or her bank. Second, the existence of Deposit insurance should reduce the risk of contaigen

iii. Di should be designed to minimize moral hazard problem of excessive risk takingiv. Public funded DI should neither subsidize nor tax the banking system. It should be void as a

cost of doing business. v. Deposit insurance should minimize the risk to the tax payer

vi. Di should relive small depositors of burden of monitoring their banksvii. If the deposit system is not broken there is no need to fix it.

b. Reforming FDI: i. Analogy to private insurance:

1. The problem with FDIC insurance is the same as other insurance, it presents a moral hard problem.

a. Banks may exploit DI insurance by taking greater risks then they would otherwise

2. Deposit insurance does not have the risk reducing mechanisms of private insurance. It has no deductible or other coinsurance and insurance depositors have little incentive to monitor their bank’s financial health. However, the safeguards in place, such as capital standards, prompt corrective actions, self dealing restrictions, examination, supervision and enforcement do help restrain risk taking.

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c. Narrow Banks may help reduce the risk to the deposit insurance fund: i. A narrow bank is:

1. Permits FDIC insured banks to only invest in short-time, high quality, readily marketable assets

2. Would hold deposits and provide payment services3. Other banking activities must take place in an uninsured affiliates.

8. Separating finance and commerce: a. Policy for and against non-financial affiliations:

i. Against non-financial affiliations:1. The separation of banking from commerce helps ensure that banks allocate credit

impartially and without conflict of interest2. If allowed, if a nonbank bank’s apparent or affiliates encounter financial difficulties,

the public will tend to perceive the bank as suffering from the same difficulties which could lead to a run on the bank.

3. The nonbank loophole threatens the nation’s payment system by giving large diversified firms access to that system.

a. A bank cannot resist the parents orders to make payments that would create overdrafts on the bank.

ii. Non financial affiliations: 1. The US has never had a complete separation of banking and commerce2. The arguments are too attenuated when they implicitly deny the feasibility of

maintaining corp. separateness between banks and their affiliates3. Experience does not suggest that non financial affiliations as particularly prone to

conflicts of interest competitive inequalities4. Any concerns about access to payment system can and should be resolved by

properly pricing and controlling the use of the system rather than arbitrarily limiting the affiliations permissible for bans.

b. Statements by Corrigan 91’ President of Fed Reserve Bank of NY: i. The main issue presented:

1. The core issue is whether a business entity (non-financial) should be permitted to own and control financial institutions, that have direct or indirect access to the federal safety net associated w/ banking institutions.

a. It follows that there must be clear conception of: i. Control—presumed to existed when ownership is >24.9% and may

exist when there is far lest Does not exist however when there is less than 5%.

ii. Access to safety net: 1. Financial firm as access when it directly or indirectly has

deposit insurance, has access to the discount window of the central bank has access to the account and pay to official supervision.

ii. Opposed to the combinations of commercial banking orgs b/c: 1. Firewalls are ineffective:

a. When they are needed most firewalls fail to work2. Safety nets get over extended:

a. It is inevitable that at least parts of the safety net will not be extended to commercial owners

3. Risk of concentration of power4. The potential benefits that might grow out of banking-commercial combinations are

remote at best and illusory at worse under present circumstances.

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iii. History of banking and commerce in the US—shows that there has been a public policy against such corps. Arguments for combining banking and commerce.

1. In the face of the concerns about conflicts of interest, unfair competition, and concentration and the extension of the safety net, the argument is made that allowing such combinations will provide important public benefits that—given appropriate safeguards and fire walls more than compensate for the risks.

iv. The risks associated with combining banking and commerce: 1. COI unfair competition and concentration2. Contagion risk—it is inconceivable that any major bank would walk away from any

subs of its holding co. If your name is on the door all of your capital funds are going to behind it in the real world. Lawyers can say you have separation but the market forces are persuasive and it would not see it nay that way.

3. The risks surrounding the potential extension of the safety net to the firms that control the banking orgs.

v. Favors combining banking and securities firms b/c:1. Unlike banking and commerce, combinations of banking and securities firms are the

rule not the exception through the industrial view. 2. Combinations of banking and securities cos strike Corrigan as while in keeping w/ the

sprit of congeneric financial corps3. BHCs are and should be subject to official supervision at the level of the holding co. 4. While there is something to be said for the so-called limited universal bank model,

Corrigan believes that securities activities of banking firms houdl be organized similarly.

9. Safety and Soundness: a. History of Basil:

i. Precursors1. Basil originated in an effort to correct for some of the leverage limit’s blind spots,

notably failures to account for credit risk and off-balance sheet items. 2. In the 1980, US bank regulators seeking to reverse decades of decline in bank captail

levels—tightened enforcing of the leverage limit3. Many banks responded by exposing themselves to greater credit risk and took more

off-balance sheet liabilities such as contingent liabilities ii. The regulators response:

1. The Federal Banking agencies began to develop risk-based capital standards to help control the differing risks of the assets and take into account some of the different risks.

2. The banking institutions complained that the agreement would place American banks at a competitive disadvantage , and that there should be some approach that places banks on a equal footing with foreign banks.

3. The Basil committee was designed to establish a frame work where the regulators from the leading industrialized could work together to establish risk based standards frame work

iii. Pre Basil: 1. They were subject to two main kind of restrictions

a. Activitiyb. Examination—seeing if the underwriting of loans were being reasonable

being well down. b. Basil I

i. In 1988: 1. 12 leading industrialized countries met and they were to adopt risk based standards.

a. Established the proposition that there are ought to be internatlion standards35

2. The US would only apply them to FDIC insured banks3. From the very outset these international outcomes have always had an interest in:

a. The safety and soundness of the financial system, b. Relative economic position

i. How our banks are compared to foreign banks4. Most important:

a. Risk weighted capital requirements are going to be essential to banking regulation

i. This is more important than all other types of regulation like controlling activity b/c it is hard to circumvent.

ii. Avalaible to buffer losses no longer WHERE they come from iii. If well captilizaes the equity is still there to absorb the loss regardless

of the actvityii. The standards:

1. Risk based capital standards achieved acceptance. a. But they had major limitations:

i. Took account of only credit risk and this measurement was crudeii. Banks were able to game the system and did

iii. The agreement gave the banks very little credit for taking risk mitigating techniques such as hedging or obtaining collateral guarantees

iv. The banks risk management techniques were becoming much more sophisticated and the banks were not doing anything to mitigate the risk.

b. Fell short: i. In some sense it was a static template or structure, it made the buckets

and put things in the bucketii. So it created a lot of room of regulator arbitrage so not as well aligned

with the risk of the firms as it should be.1. This led to a revised Basil accord.

c. Basil IIi. Goal of Basel II:

1. Sought to take a broader and more nuanced view of banking risks2. It keyed risk weights to credit ratings. 3. IT dealt with market risk and interest rate risk4. It made use of banks internal risk management models

ii. Short falls: 1. It did not increase required capital levels2. By reduce risk weights for securities and borrowers with high credit ratings, it

facilitated the decline in capital levelsiii. Expected to make banks more safe but was mistaken:

1. The credit ratings on which regulators had set such stored proved unreliable, most notable concerning RMBs in the U.S.

iv. These failures by a large part led to Basil III. v. Preverse effects of Basil II:

1. Have regulatory capital being set by the people who are being regulated in effecta. If your loans are set by your internal model, it has incentive to manipulate its

risk rates2. It is very hard to understand a risk model, they are standardized for the most part but

the big banks have there own teams of quants that are very complex and hard to penetrate

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a. The models are problematic when there is discontinuity with the financial market then the internal models do not reflect it.

3. If Basil II had been fully implementeda. If Basil II would have been fully implemented then the financial crisis would

have been much worki. Northern Rock in the UK and was on Basil II and was pro-cicycle and

it resulted in the bank going insolvent. vi. Basil II:

1. While Basil I was about raising capital Basil II stated purpose that as a whole capital should be about the same after Basil II was put into place.

a. In the industry there was a notion that there may be a reduction in the amt of capital held by the banks by implementing these models.

d. Basil IIIi. General

1. The creation of capital conservation buffers and at keeping bank’s capital well above the required minim levels during good times to that banks can better withstand the stress of band times.

2. Added buffers for distribution of dividends ii. Highlight’s of three

1. About increasing the amount and quality of capital but did not come to grips with the methodology

a. Raised the leverage ratio: i. Changes the way that this is calculated, put all of the assets in the

demoninatorii. Takes a broad view

b. Has risk based standards that change the way that Risk Based ratios are calculated.

i. Tries to be risk sensitive1. Looks more closely at the riskiness and the risk of loss

10. Stress Testing: a. To evaluate the adequacy of the banks capital

i. The Fed did so b/c there was enormous problems with the stability of those firms. ii. Wanted to ensure confidence in the 19 biggest financial firms in the U.S.

b. Suggests three types of test by Truilloi. Simple Leverage Ratio

1. Very blunt ii. Bucket Tests

1. Intermediateiii. A stress testing regime

1. Sophistacated and focused on supervisory and not on the banks own modelc. Thinks that this is essential to stress testing.

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