January 2000

Financial Institutions Options

13 min

This article updates, in the wake of the Gramm-Leach-Bliley Act of 1999 ("GLB Act"), the options available to commercial and financial companies to engage in "banking" or "financial services" activities. While the GLB Act expands the range of financial services for bank holding companies that choose to become financial holding companies, it forecloses the acquisition of banks or thrift institutions by commercial companies.

The GLB Act removes the Glass-Steagall Act restrictions on affiliation between banks and securities firms and it authorizes financial holding companies that own a bank to engage in a full range of insurance activities. The result is that qualifying bank holding companies may opt to become financial holding companies and thus to hold subsidiaries that engage in banking, securities underwriting and dealing and insurance agency and underwriting. They may also engage in financial activities listed in the GLB Act, including merchant banking or venture capital activities, the distribution of mutual funds and securities lending.

The financial holding company may hold any type of deposit-taking subsidiary, including a national bank, a state chartered bank, or a thrift or savings bank. To qualify as a financial holding company, however, each of the company's deposit-taking subsidiaries must be well capitalized and well managed and not have less than a satisfactory rating under the Community Reinvestment Act, which requires service to low- and moderate-income areas of the community the depository institution serves.

Commercial companies, that is, those engaged in retail activities or manufacturing or any activity that is not financial in nature, were precluded since 1970 from owning banks. They were also excluded from becoming thrift holding companies owning two or more thrifts. They did have the option of acquiring a single thrift and becoming a unitary thrift holding company. That last opportunity to engage in "banking" is foreclosed by the GLB Act. For commercial enterprises, which continue to be free to engage in securities and insurance activities and other financial activities, the only alternatives still available through which to engage in "banking" or certain banking activities are an industrial loan company, a finance company, or certain types of credit card banks. The company may also engage in joint ventures with a financial holding company, a bank or a thrift.

Insured Depository Institutions - Unavailable to Commercial Enterprises

National Bank

A national bank chartered by the Office of the Comptroller of the Currency ("OCC") is authorized to engage in those activities permitted by federal law. In this way, it is unlike the ordinary state chartered corporation which, under virtually all state laws, can engage in any lawful activity unless limited by its articles of incorporation or bylaws. Pursuant to the National Bank Act, 12 U.S.C. &#sect;24 (Seventh), a national bank may engage only in such activities as authorized by statute, that is, it may engage in the business of banking and "all such incidental powers as shall be necessary to carry on the business of banking." This "business of banking" standard is unimpaired by the GLB Act, and the OCC may still permit national banks to engage directly or to create operating subsidiaries to engage in the business of banking.

The GLB Act creates an additional category of subsidiaries for national banks. These "financial subsidiaries" may engage in all of the activities permissible for operating subsidiaries. In addition, they may engage in financial activities similar to those permitted to financial holding companies, including securities underwriting and dealing, general insurance agency activities and those activities determined to be financial in nature by the Department of the Treasury. Specifically excluded from such financial subsidiaries are insurance underwriting, real estate development and merchant banking activities. The GLB Act requires national banks to deduct their investments in financial subsidiaries (including retained earnings) from the capital of the parent banks in computing capital ratios, to limit the total amount of investments in such subsidiaries and to limit dealings between parent banks and their financial subsidiaries. In addition, to qualify to hold a financial subsidiary, the national bank must be well capitalized, well managed, and have not less than a satisfactory rating under the Community Reinvestment Act. Operating subsidiaries are not subject to these financial subsidiary requirements.

State-Chartered Bank

The GLB Act preserves the flexibility of the states to define the scope of permissible activities for their own banks and the subsidiaries of those banks, although certain restrictions are imposed on newly authorized financial subsidiaries of state banks. The first review of the powers of state banks must be with the state laws. Many states have "wild card" statutes that permit the banks chartered in that state to engage in activities permissible for national banks.

With appropriate state authorization, state banks may engage in those activities permitted to financial subsidiaries of national banks. The GLB Act imposes fewer restrictions on the financial subsidiary of a state bank than on the financial subsidiary of a national bank. Although to qualify to hold a financial subsidiary, the state bank must be well capitalized and meet CRA requirements, there is no requirement that it be well managed. Unlike national banks, state banks have no limitation on the total amount of the investments they may make in financial subsidiaries. Yet to be sorted out is the extent to which the Federal Deposit Insurance Corporation ("FDIC") may continue to permit state banks authorized by state law to engage in principal activities under section 24 of the FDIC Act without being subject to any of the GLB Act restrictions imposed on "financial subsidiaries."

Savings Association

A savings association generally has powers comparable to commercial banks, although, in order to qualify for affiliation powers, a federal savings association must comply with the Qualified Thrift Lender ("QTL") test. Under the QTL test, 65% of a federal savings association's assets must be invested in assets that are considered qualified thrift investments. These include real estate related loans, mortgage-backed securities, educational loans or credit card loans, among other things. The deposits of the savings association are insured by the Savings Association Insurance Fund of the FDIC. The savings bank is regulated primarily by the Office of Thrift Supervision ("OTS"). The OTS also reserves the right to regulate the holding company. At a minimum, the OTS requires the holding company to file quarterly and annual reports comparable to public company reports filed with the Securities and Exchange Commission. A federally chartered savings association may establish branches throughout the country, largely without restriction, if it complies with the QTL test.

Although the GLB Act prohibits commercial enterprises from owning thrifts, the thrift charter continues to be a viable option for financial companies, including securities firms and insurance underwriters. The thrift charter presumably can provide the same scope of financial activities that are permissible for a financial subsidiary of a bank and can permit affiliation with the same entities as a financial holding company, subject to OTS approval. The thrift or its subsidiary engaging in these activities will not be subject by law to the conditions imposed in the GLB Act, except as imposed by the OTS. In addition, a federal thrift and its parent holding company will be regulated by a single regulator, the OTS. In the case of a state nonmember bank or a national bank, there will be a primary federal regulator for the subsidiary bank (OCC or FDIC) and a different regulator for the parent holding company (Fed).

Examples of non-banking organizations that own or have owned a savings association include The Allstate Corporation, Sears and Archer-Daniels-Midland. Most recently, Nordstrom's has been approved to convert its national credit card bank into a federal savings bank.

Options Available for Commercial Enterprises

Industrial Loan Company

A nonbank company may own an industrial loan company ("ILC") chartered in certain states that authorize such entities (e.g., Utah, California). ILCs typically have bank-like powers authorized by the chartering state and may offer all types of consumer and commercial loans. In order to avoid the Bank Holding Company Act ("BHCA"), the ILC cannot (1) accept demand deposits (a deposit payable on the demand of the depositor, such as a checking account) if the ILC has total assets of over $100 million, and (2) incur overdrafts at the Federal Reserve Banks on behalf of its affiliates. 12 U.S.C. &#sect; 1841(c)(2)(H). The GLB Act eases this overdraft limitation to permit what is available to a nonbank bank. There are also restrictions on the transfer of "grandfathered" ILCs. However, we are unaware of any federal law prohibiting an ILC from offering NOW accounts (interest bearing accounts with unlimited third party payment capabilities available to individuals, nonprofit organizations, governmental units and fiduciary arrangements) and MMDAs (interest bearing accounts with limited third party payment capabilities available to all depositors). The branching powers of an ILC generally are limited to the same extent as those of a state bank.

Many of the existing ILCs are chartered in Utah. The Utah Department of Financial Institutions has for approximately ten years been prohibited under Utah law from issuing new industrial loan charters. However, legislation recently enacted in Utah permits the issuance of new industrial loan company charters. Materials prepared by the Utah Department of Financial Institutions that provide more detail on who owns a Utah ILC and what services an ILC can provide are available. The GLB Act provides limits on industrial loan company overdrafts but does not eliminate the exemption from the definition of bank in section 2(c)(2)(H) of the BHCA for industrial loan companies.

Credit Card Bank

A nonbank company may own a national bank or state chartered bank that limits its activities to credit card operations and the acceptance of large denomination time and savings deposits. Credit card banks provide access to the federal payments system and allow for preemption of state consumer credit laws limiting interest rates and fees. Specifically, a credit card bank may engage only in credit card operations, may not accept demand deposits, generally may not accept savings or time deposits of less than $100,000, may maintain only one office that accepts deposits, and may not engage in the business of making commercial loans. 12 U.S.C. &#sect; 1841(c)(2)(F). The credit card bank would be subject to the jurisdiction of the Office of the Comptroller of the Currency ("OCC") (if federally chartered) or the chartering state (if state chartered), and the FDIC.

A list of national credit card banks, both with retail and non-retail affiliates, is available.

Finance Company

A company may own a nonbanking company that engages in consumer and commercial lending, leasing and a wide variety of other non-deposit taking banking activities. Because this company would not be a bank, it may not be FDIC-insured nor would it be subject to regulation by federal banking regulators. Depending upon its activities, these types of finance companies are frequently subject to state regulation and licensing, particularly if they engage in mortgage banking or retail installment sales finance. State laws often require these companies to be incorporated in that particular state in order to provide loans to residents in that state, thus requiring a nationwide lending operation to have nearly 50 finance affiliates. Many activities of finance companies are also subject to the jurisdiction of the Federal Trade Commission.

Trust Company

Section 2 of the Bank Holding Company Act, 12 U.S.C. 1841, excludes from the definition of "bank" an institution that functions solely in a trust or fiduciary capacity if all of its deposits are in trust funds and are received in a bona fide fiduciary capacity and no deposits of such institution which are insured by the Federal Deposit Insurance Corporation are offered or marketed through an affiliate of the institution and such institution does not accept demand deposits or make commercial loans and such institution does not obtain payment or payment-related services from any Federal Reserve bank or exercise or borrowing privileges subject to section 19 of the Federal Reserve Act. This provision permits a commercial company to operate a limited purpose trust company that may be federal or state chartered, provided that the deposits it accepts are trust deposits and it does not have access to the payments system. As an entity that does not qualify as a bank, such an entity would not have the benefit of the securities registration exemptions available to a bank.

Grandfathered Nonbank Banks

Prior to 1987, commercial entities could own FDIC-insured banks that either did not engage in the business of making commercial loans or did not accept demand deposits, and still avoid the restrictions of the BHCA. See, e.g., 12 U.S.C. &#sect; 1841(c)(2)(H)(ii). These banks were referred to as "nonbank banks" because traditional commercial banks engaged in both of these activities. Although the BHCA was amended in 1987 to close this loophole in the BHCA, commercial entities then owning these nonbank banks were grandfathered, subject to certain conditions. Under the 1987 Competitive Equality in Banking Act, these banks were known as "grandfathered nonbank banks." Grandfathered nonbank banks were subject to limits on new activities, and were prohibited from incurring an overdraft at the Federal Reserve on behalf of an affiliate. Moreover, an entity that after 1987 acquires either a grandfathered nonbank bank or an entity that directly or indirectly owns a grandfathered nonbank bank becomes subject to the activity and other restrictions of the BHCA. The GLB Act eliminated the cross-marketing restrictions and loosened the overdraft provisions for nonbank banks. It also provided that a nonbank bank will not lose its grandfathered status if its parent holding company acquires more than 5% of the assets of an industrial bank or credit card bank. A list of nonbank banks prepared by the Federal Reserve in 1996 is available.

Joint Venture

A nonbank company may participate in a joint venture with one or more banks. The joint venture could, for example, take the form of a new entity that is jointly owned by the company and the bank(s). The banking regulators impose certain conditions and limitations on such joint ventures. Historically, these joint ventures were limited to activities in which the participating bank(s) could engage, but with the passage of the GLB Act, a joint venture with a bank should be permitted to involve the newly authorized activities of a financial subsidiary. Joint ventures with a financial holding company should be permitted to engage in activities the Fed determines to be financial in nature. Traditionally, in a joint venture, bank(s) had to have a mechanism to veto the joint venture's participation in a non-permissible activity. The bank(s) investment in the joint venture has been limited historically to a specified percentage of the bank's capital, although the rules after the GLB act are uncertain. Certain transactions between the joint venture and the bank(s) are prohibited. While the joint venture itself could be subject to supervision and examination by those banking regulators with jurisdiction over the bank participant(s), if the venture is not subject to another functional regulator, the nonbank company would not become subject to such supervision and examination by virtue of the joint venture.

Minority Investment in Bank

While a company may make a minority investment in a bank or bank holding company, restrictions often will be imposed on the company's participation in the affairs of the bank to ensure that the company does not "control" the bank. A company may purchase up to 10% of any class of voting stock of a bank or bank holding company without approval from the banking regulators; however, they may scrutinize the transaction and potentially could impose restrictions subsequently to avoid control by the nonbank company. Acquisition of between 10% and 25% of any class of voting securities would require a bank regulatory filing. As a condition of providing its approval, the banking regulator would impose a multitude of restrictions designed to ensure that the company does not, through the joint venture, control the banking organization, including potentially prohibiting any joint business activities between the company and the bank. Acquisition of 25% or more of any class of voting securities or 25% or more of the total equity of the bank or bank holding company would subject the nonbanking company to the activity and other limitations of the BHCA. 12 U.S.C. &#sect; 1842.

Marketing Arrangement

Various marketing arrangements, including the sale of securities and insurance on bank premises, have been permitted by federal and state regulations for some time. Similarly, banks and retailers have had arrangements permitting supermarket branches and credit card co-brands for some time. These arrangements have been increasingly subject to federal and state regulation in connection with customer privacy.