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From PLI’s Course Handbook

A Guide to Banking and Financial Services Law and Regulation 2008

#14338

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An overview of U.s. regulation of depository institutions

Gary Rice

Simpson Thacher & Bartlett LLP

AN OVERVIEW OF U.S. REGULATION

OF DEPOSITORY INSTITUTIONS

Gary Rice

OVERVIEW OF REGULATION OF U.S. BANKING ORGANIZATIONS

1 Historical Perspective on Bank Regulation

Historically, in an effort to protect the funds of depositors and, to a lesser extent, to protect nonbanks from “unfair competition”, governmental policy limited the activities of banks to certain activities specified in their charters, such as receiving deposits, making loans and providing trust services. Narrow interpretations of bank charters by the courts and regulators prevented banks from offering other financial products, such as underwriting securities and acting as an insurance agent.

In the late 1960s, the major banks attempted to escape the confines of their charters by establishing holding companies through which to offer new products. Congress responded with legislation that brought such holding companies within the jurisdiction of the Federal Reserve and authorized the Federal Reserve to permit holding companies to engage in activities that were “closely related to banking”. The theory was that a bank holding company, as a corporate entity that is separate from its subsidiary insured bank, could be allowed to engage in a broader range of activities than the bank. However, the statute was interpreted so conservatively by the Federal Reserve between 1970 and 1987 that the range of activities allowed for bank holding companies was only slightly broader than those permitted for banks.

Meanwhile, the core business of banks was eroding. Banks had traditionally funded themselves with consumer deposits on which they were permitted to pay little interest and for which, due to regulatory restrictions on interest payments, there was little competition. The monopoly on deposit-taking ended when Merrill Lynch introduced its money market accounts, which functioned much like a checking account but paid money market rates of interest. The popularity of mutual funds further eroded banks’ share of consumer funds. With regard to lending, Fortune 500 companies, which had been the traditional customers of commercial banks, increasingly obtained funds directly from the securities markets. Banks were left lending to businesses that, because they posed higher levels of risk, could not be funded in the securities markets. Loans to governments is Latin America, real estate loans and excessive concentrations of loans in the energy sector contributed in late 1980s to the insolvency of many small banks and several large regional banking organizations and left the country’s largest banking organizations financially weakened. There were more bank failures during this period than in any other period since the Great Depression.

The government responded to these developments in two ways. First, in response to applications from the leading banking organizations, the regulators began to reinterpret old statutes to permit the very activities that the statutes had been enacted to prohibit. For example, the Glass-Steagall Act had been enacted in 1933 to separate commercial and investment banking. The regulators accepted novel interpretations of that legislation to permit banking organizations to engage in securities activities. Securities brokerage was permitted in 1982. Private placements of highly rated commercial paper was permitted in 1985. In 1987 “Section 20” affiliates of banks were permitted to engage, to a limited extent, in underwriting of certain types of debt securities. The types of securities that could be underwritten and dealt in was expanded in 1989 to include all types of securities. In a series of steps taken during the 1990s, the Federal Reserve increased the percentage of revenue that Section 20 affiliates could derive from underwriting and dealing activities until the revenue limitation no longer had practical significance. The Federal Reserve also gradually dismantled virtually all of the “firewalls” it had erected between banks and their Section 20 affiliates. The firewalls had been intended to insulate banks from the risks associates with the securities activities of their Section 20 affiliates.

Insurance activities were proceeding down a similar path. A statute that had been enacted to permit national banks located in small towns to enhance their revenues by acting as insurance agents was interpreted by the Comptroller of the Currency to permit money center banks to offer insurance products on a nationwide basis, requiring little more in the way of a small town connection than having insurance applications processed in a small town. The Comptroller also proposed to interpret the national bank charter in a way which would have permitted national banks to have conducted virtually any financial activity, including insurance underwriting and real estate development, through subsidiaries.

At the same time as the regulators permitted banking organizations to engage in a broader range of activities, they realized that traditional methods of banking regulation had not been effective in managing risk. Prior to 1988, a bank’s capital requirement was a simple ratio of capital to total assets and did not take into consideration whether the bank’s assets consisted of U.S. Treasury securities or loans to Third World countries. Off-balance sheet items, such as standby letters of credit, were not considered at all. The risk-based capital rules, albeit crudely, attempted to adjust capital requirements to the risk each bank incurred by assigning different weights depending on the nature of the asset or off-balance sheet liability. The Federal Reserve recognized that U.S. banking organizations would be at a competitive disadvantage if they alone were subject to risk-based capital rules. The initiative was taken to the Committee on Banking Regulation and Supervisory Practices at the Bank of International Settlements (the “BIS”), on which sit representatives of the central banks of a dozen or so major countries. The BIS risk-based capital rules were implemented in 1990. The rules have been revised from time to time since then and have been adopted by the banking regulators in many countries. The BIS is in the process of implementing a major revision of the risk-based capital rules in an attempt to more finely calibrate the relationship between risk and capital requirements.

The regulatory emphasis on risk management was also reflected in decisions to allow new activities. First, the decision to allow a particular banking organization to engage in riskier activities was based in part on the financial and managerial strength of the organization. For example, any banking organization was permitted to offer securities brokerage services, but only the strongest organizations were allowed to underwrite and deal in equity securities. Second, a banking organization seeking to engage in a new activity was required to demonstrate that it had adopted appropriate risk management systems for that activity. For example, the Comptroller of the Currency authorized national banks to enter the derivatives business on the grounds that it was merely a new form of the traditional bank function of financial intermediation. However, the Comptroller required any national bank that engaged in derivatives activities to establish sophisticated systems to manage the risk associated with these activities.

The changes described above, which completely transformed the business of banking over a period of about 15 years, occurred without the participation of Congress. Congress considered and failed to enact financial modernization legislation in every session between 1978 and 1999. Finally, in 1999 Congress passed the Gramm-Leach-Bliley Act (the “GLBA”), the key provisions of which took effect on March 11, 2000. In many respects the GLBA did not modernize banking so much as it ratified the changes that had already occurred. The GLBA formally laid to rest the Glass-Steagall Act’s restrictions on securities activities undertaken by bank affiliates, which already had been substantially eroded by rulings issued by the federal banking regulators. The GLBA provides a framework for banks to offer insurance brokerage services, which they had already commenced pursuant to the Comptroller’s interpretations. The GLBA authorized affiliations of banks and insurance underwriters, which already existed (albeit on a temporary basis) pursuant to a Federal Reserve interpretation that allowed Travelers to acquire Citicorp. The GLBA also adopted the federal banking regulators approach to risk management. Only well capitalized and well managed organizations are permitted to engage in the full range of activities authorized by the GLBA.

To date, the primary significance of the GLBA has been the authority it granted financial holding companies to engage in “merchant banking activities”; i.e., the authority to acquire up to 100% of non-financial companies as an investment, provided that the financial holding company does not routinely manage such portfolio companies and sells them after ten years (or in some circumstances, longer).

The financial crisis of 2008 marks a new stage in the development of the financial system. In order to satisfy a requirement that organizations engaged in banking activities in the European Community have a regulator that regulates them on a consolidated basis, most major investment banks elected to be subject to consolidated supervision by the SEC. In September 2008, and particularly in the aftermath of the bankruptcy of Lehman Brothers, it became apparent that the SEC was not regulating or supervising these institutions in any meaningful way and that, in order to give greater comfort to their counterparties, these investment banks would need to become, or become part of, financial holding companies that are regulated by the Federal Reserve. Merrill Lynch became part of a financial holding company when it was acquired by Bank of America and both Goldman Sachs and Morgan Stanley elected to become financial holding companies and to be regulated by the Federal Reserve.

2 The Depository Institution (Banks and Thrifts)

1 Regulators

1 National banks are regulated by the Office of the Comptroller of the Currency (the “OCC”), an office within the U.S. Treasury Department.

2 State charted commercial banks

1 All state charted commercial banks are regulated by the states that charter them.

2 In addition, all state chartered banks have a federal banking regulator.

The Federal Reserve is the federal banking regulator for state chartered commercial banks that choose to become members of the Federal Reserve System. This group, referred to as “state member banks”, includes most state chartered banks and virtually all the larger ones. The Federal Deposit Insurance Corporation (the “FDIC”) is the federal banking regulator for those that are not members of the Federal Reserve. Such banks are referred to as “state nonmember” banks. Prior to 1980, only members of the Federal Reserve System had access to such services as FedWire and only such members were required to maintain reserves against deposits. Since that time, all depository institutions have access to Fed services and are required to maintain reserves. Membership in the Federal Reserve System is significant now only in that it determines a state bank’s regulator. (All national banks are members of the Federal Reserve System but are regulated by the OCC.)

3 State chartered savings banks are regulated both by the states that charter them and by the FDIC.

4 Federally chartered savings banks are regulated by the Office of Thrift Supervision (the “OTS”), an office within the U.S. Treasury Department.

5 State chartered savings associations are regulated both by the states that charter them and by the OTS.

6 Industrial loan companies (which are referred to as industrial banks in some states) are regulated both by the states that charter them and by the FDIC (if their deposits are insured by the FDIC).

7 Federal credit unions are regulated by the National Credit Union Administration.

2 Powers

1 National Banks

1 Direct Activities

--Traditional powers include lending, deposit-taking, and foreign exchange activities

--The Comptroller interprets the “incidental powers” clause in the National Bank Act as a “broad” and “flexible” grant of authority that was intended to “enable national banks to evolve their operations in order to meet the changing needs of our economy and individual consumers”. For example, the Comptroller has interpreted the clause to permit national banks to act as a “finder”--including arranging on-line sales of all types of merchandise.

--The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), largely confined the powers of state banks to those of national banks, so state banks generally have the same powers as national banks.

--The GLBA and other laws generally prohibit banks from underwriting insurance, investing in equity securities, or investing in real estate (other than bank premises). The GLBA also requires banks to shift most securities activities (such as securities brokerage and private placement activities) out of the bank into subsidiaries or affiliates that are regulated as broker-dealers. The SEC’s “push out” regulations, which were proposed to implement this GLBA provision, were delayed for seven years due to complaints from banks and bank regulators that they would be too cumbersome and restrictive. The SEC, working with the Federal Reserve, finally issued “push out” regulations (Regulation R) in 2008 that will take effect in 2009.

2 Activities of Subsidiaries

--Operating Subsidiaries

An operating subsidiary of a bank may engage in activities in which the parent bank is permitted to engage directly. Banks are not restricted in lending to their operations subsidiaries.

--Financial Subsidiaries

The GLBA authorizes banks to establish “financial subsidiaries” to engage in certain activities, such as securities underwriting and dealing, that a bank is not permitted to engage in directly. However, financial subsidiaries are generally not permitted to underwrite insurance, invest in real estate, or engage in merchant banking activities.

2 State Chartered Commercial Banks

1 As a matter of state law, most state banks are permitted to engage in all of the activities that are permissible for national banks. As a result of FDICIA, state banks are not permitted to directly engage in activities as principal unless those activities are permissible for national banks.

2 The activities of subsidiaries of state banks are generally subject to the same limitations as apply to the activities of subsidiaries of national banks. However, the FDIC has the authority to permit state nonmember banks to engage in certain activities (such as real estate development) that are not permissible for subsidiaries of national banks. Partly because state nonmember banks tend to be small, and partly because the FDIC has been careful not to allow state nonmember banks to engage in activities involving greater risk, the FDIC has used this authority very sparingly.

3 As a general matter, non-U.S. branches of U.S. banks (state or national) are subject to the same restrictions as apply to U.S. banks in the United States. In particular, they do not share the securities powers of Edge Act corporations.

3 Savings Associations

1 Savings associations (a term that includes federal savings banks) generally are permitted to engage in the same type of activities as national banks. However, the Home Owner’s Loan Act restricts the extent to which the assets of savings associations may include commercial loans.

2 Savings associations must satisfy the Qualified Thrift Lender test, which requires that 65% of the assets of a savings association consist of mortgage related assets and credit card loans.

3 Savings associations, unlike commercial banks, are permitted to establish branches anywhere in the United States.

4 The OTS has broad preemptive authority, which it has used to enable savings associations to operate nationwide without regard to local laws.

4 Industrial Loan Companies

1 The laws of many states provide for “industrial loan companies” or “industrial banks”, which are permitted by state law to engage in a variety of lending and deposit activities. The only significant restriction on the activities of industrial banks is that they are not permitted to offer demand deposit accounts to corporate customers.

2 The primary significance of industrial loan companies is that a company may own an industrial bank that is chartered in one of a handful of states that, as of 1987, required industrial loan companies to have FDIC insurance without becoming subject to the restrictions that apply to bank holding companies (discussed below).

5 Credit Unions

1 Credit unions are not-for profit financial institutions that are owned and controlled by their members. Membership is limited to a group, or multiple groups, that have a common bond of occupation, association or geopraphy.

2 Credit unions offer a variety of deposit and loan products to their members.

6 Edge Act Subsidiaries

1 Almost always organized as subsidiaries of banks

2 Purpose of such organizations is to engage in international banking activities. The activities that Edge Act corporations may engage in within the United States are limited as to type of activities to those that are permissible for banks and, in addition, such U.S. activities must be incidental to international business.

3 Outside the U.S., Edge Act corporations may engage in a broader range of activities than U.S. banks can engage in directly, including insurance and securities activities. They are also permitted to make portfolio investments in non-financial companies.

4 Transactions between a bank and its Edge Act Corporation subsidiary are not subject to the lending restrictions of Section 23A.

3 Preemption

1 A variety of factors have made “preemption” a more important issue: interstate bank mergers that result in multi-state branch operations, the use of the Internet and other technology to conduct business on a regional or national basis, and the inclination of a number of states to adopt their own consumer protection statutes.

2 The assertion of broad preemption authority by the OTS with respect to federal savings banks has been relatively uncontroversial. Similar claims by the Comptroller have resulted in more controversy and Congressional criticism.

3 The Comptroller has preempted broad categories of state laws that, in its view, conflict with the exercise of a national bank’s federally authorized powers. The Comptroller has generally been upheld by the courts and touts preemption as a primary advantage of the national bank charter over state bank charters. In recent years, most of the country’s largest state member banks have switched from a state to a national charter.

4 Loans to Affiliates: Sections 23A and 23B of the Federal Reserve Act

1 The purpose of Sections 23A and 23B of the Federal Reserve Act is to protect FDIC-insured depository institutions (including banks, thrifts, industrial loan companies and insured U.S. branches of non-U.S. banks), which have the benefit of the federal safety net, from entering into transactions with affiliates that are not in the best interest of the bank.

2 For purposes of Sections 23A and 23B, the term “affiliate” includes any company that controls or is under common control with the bank. Control is defined to include the ownership of more than 25% of the voting shares. Therefore the bank holding company of a bank and all of the bank holding company’s nonbank subsidiaries are “affiliates” of the bank for purposes of Sections 23A and 23B. The term “affiliate” also includes companies that are advised on a contractual basis by the bank or any of its affiliates. Subsidiaries of banks are excluded from the definition of “affiliate”. For example, an Edge Act subsidiary of a bank is not an “affiliate”.

3 Covered transactions--The restrictions of Section 23A apply only to certain types of transactions and the restrictions vary depending on the type of transaction.

1 The total amount of “covered transactions” that a bank may have with affiliates is limited to 10% of the bank’s capital and surplus, in the case of any one affiliate, and 20% of the bank’s capital and surplus, in the case of all affiliates.

2 Loans and extensions of credit (including the issuance of guarantees and standby letters of credit) by a bank to its affiliates are “covered transactions” and, in addition to being subject to the quantitative limit above, must be fully collateralized by U.S. Treasury securities or cash (or over-collateralized by other types of collateral).

3 The purchase by a bank of assets from an affiliate is generally a covered transaction, but is not subject to the collateral requirements. However, a bank may purchase participations in loans made by an affiliate without regard to Section 23A provided that the bank makes an independent credit decision before the affiliate commits to making the loan (the so-called “250.250” exception).

4 The purchase by a bank of securities issued by an affiliate and the acceptance of such securities as collateral for a loan by the bank to any person are covered transactions.

5 Any transaction by a bank with a third party in which the proceeds are transferred to an affiliate of the bank is treated as a transaction by the bank with the affiliate.

4 Prohibited Transactions

1 A bank is prohibited by Section 23A from purchasing a low-quality asset from an affiliate.

2 A bank is prohibited by Section 23B from entering into virtually any transaction with an affiliate that is not on an arm’s length basis or better from the perspective of the bank.

5 The bank-to-bank exemption

The restrictions of Section 23A (other than the low-quality asset prohibition) do not apply to transactions between two banks each of which 80% or more of the voting stock of which is controlled by the same company.

5 Capital Requirements

1 Risk-based capital guidelines

Until 1989, the federal banking regulators measured capital in terms of the ratio of primary capital (common stock and certain other instruments) to total assets. The ratio did not account for the fact that some assets entail more risk than others. For example, the ratio required that same amount of capital to be held against a speculative real estate loan as against the same amount of U.S. Treasury securities. Moreover, the primary capital ratio did not take into consideration the risks associated with off-balance sheet items, such as letters of credit, loan commitments and swaps.

In 1986, the Federal Reserve proposed risk-based capital guidelines that were intended to remedy these defects by assigning weights to categories of assets and off-balance sheet items based on their relative risk. In order not to place U.S. banking organizations at a competitive disadvantage, the Federal Reserve sought international cooperation in establishing the risk-based capital guidelines. In 1987 agreement was achieved with the Bank of England. In 1988 agreement was achieved with the 12 countries that are represented on the Basle Committee on Banking Regulations and Supervisory Practices, which is part of the Bank for International Settlements. The Federal Reserve, the OCC, the FDIC adopted substantially identical risk-based capital guidelines.

2 The basic elements of the risk-based guidelines

1 Tier 1 and Tier 2 Capital

Tier 1 capital consists of common equity and qualifying preferred stock minus goodwill. Tier 2 capital consists of a limited amount of loan loss reserves, subordinated debt and certain other hybrid instruments. In practice the focus is largely confined to Tier 1 capital and, particularly, tangible common equity.

2 Risk-weighting of assets

Outline of the weightings: U.S. government obligations and cash are weighted at 0%; claims on depository institutions, general obligation municipal bonds, and claims collateralized by Treasury securities or cash are weighted at 0%; mortgage securities, industrial revenue bonds and certain swaps are weighted at 50%; other assets are weighted at 100%.

By putting claims on virtually all nonbank companies in the 100% risk category, the current capital guidelines do not address wide variations in the actual risks covered by that category. Also, the current guidelines also do not address other types of risk, such as those associated with concentrations and operating risks.

3 Off-balance sheet items--Standby letters of credit and guarantees are weighted at 100%; commitments are weighted at 0% or 50% depending on whether they are more or less than a year; special rules apply to swaps.

3 The New Basel Accord

The Federal Reserve and, perhaps to a lesser extent, the other federal banking regulators have concluded that the current risk-based capital guidelines are too crude to address the activities of the largest banking organizations. The failure of the current system to calibrate risk more finely has resulted in the more sophisticated banking organizations using securitization and other techniques to exploit differences between regulatory and economic risk assessments.

2 The Three Pillars of Basel II

Pillar 1: minimum capital requirements

Basel II employs more sophisticated measures of credit risk. In increasing degrees of sophistication those measures would rely on (i) external ratings; (ii) internal ratings based assessment of the probability of default; and (iii) internal ratings based assessment of both the probability of default and the loss given default.

Basel II also imposes an explicit capital charge based on operational risk.

Pillar 2: Supervisory review

Pillar 3: Market discipline by means of improved disclosure

3 Differential Effect

Because of its complexity, only a handful of the largest U.S. banking organizations will be subject to Basel II. Smaller banks have expressed concerns that Basel II will result in lower capital requirements for large banks, giving them a competitive advantage. In response, the federal banking regulators modified the Basel II proposal to ensure that it would not result in significantly lower capital requirements for large banks, at least not until it is fully implemented in 2012.

The regulators also requested public comment on possible changes to the existing risk-based capital rules (which will continue to apply to banks that do not adopt Basel II) to make them more risk sensitive and, presumably, to provide for such banks decreases in capital requirements of similar (modest) magnitude that large banks are expected to realize under Basel II.

4 Leverage Ratio Guidelines

6 Deposit Insurance

1 The deposits of all federally chartered commercial banks and savings associations (other than those limited to trust activities) are insured by the FDIC. The deposits of virtually all state chartered commercial banks and savings associations are also FDIC insured. For example, in New York, it is not permissible for a bank or savings association to accept deposits unless it is insured by the FDIC.

2 Federal Deposit Insurance Reform

1 A risk-based premium system was adopted pursuant to FDICIA, but almost all institutions qualified for the lowest rate. Because the insurance funds were fully funded as of 1997, most banks and thrifts did not pay any insurance premiums—and some large institutions had never paid insurance premiums. To address this and other issues Congress passed the Federal Deposit Insurance Reform Act of 2006.

2 Pursuant to the legislation, (a) the Bank Insurance Fund and the Savings Association Insurance Fund were merged into a single Deposit Insurance Fund; (b) modest increases were made to the per customer deposit insurance limits; (c) a one-time credit against future premiums was provided to banks and thrifts that contributed to the deposit insurance funds prior to 1997, (d) the FDIC was given greater flexibility to adjust the size of the reserve fund; and (e) the FDIC implemented a new and more risk sensitive risk-based system for assessing insurance premiums.

7 The Community Reinvestment Act of 1977 (“CRA”)

1 CRA requires banks and savings associations to demonstrate that their deposit facilities serve the credit needs of the community in which they are located, including low- and moderate-income (“LMI”) segments of the community (consistent with safe and sound operations).

2 CRA does not mandate that a bank make a specific percentage of its loans to LMI borrowers, but banks are expected to make efforts to ensure that their products are available to the entire community and they are expected to make loans to LMI borrowers roughly to the same extent as similarly situated banks.

3 CRA evaluations are based on a bank’s “assessment area”, which is the geographic area that includes its branch network. The regulators have struggled to apply this concept to banks and savings associations that do not use the Internet or nationwide telephone solicitations rather than traditional branch delivery systems.

4 As a general matter, a banking organization will not receive approval to establish branches or acquire other banks unless its existing banks have at least a satisfactory CRA rating.

8 Equity Investments by Banks and U.S. Branches and Agencies of Non-U.S. Banks

1 These institutions are subject to Section 16 of the Glass-Steagall Act, which generally prohibits investments in equity securities.

2 The exception for “Equity Kickers”

In a lending transaction, banks are permitted to acquire from the borrower warrants to acquire stock issued by the borrower. Such “equity kickers” may not be in lieu of repayment of principal, but may be in lieu of part of the normal interest that would be earned on the loan. The equity kicker need not be in the form of a warrant; e.g., it may be in the form of a payment from the borrower based on its profitability. The bank may not exercise the warrants. It may sell them to others, including affiliates that are authorized to hold equity security. There is no specific ceiling on the percentage of the borrower’s equity that the warrants may represent, but at a level above 25% a question arises as to whether the interest is just an equity kicker or represents an investment.

3 The exception for equity acquired “DPC”

When a bank makes a loan in good faith to a borrower and it subsequently appears that the borrower will be unable to repay the loan in accordance with its terms, the bank is permitted to acquire common stock of other equity from the borrower in satisfaction (partial or whole) of the debt previously contracted (“DPC”). There is no limit on the percentage of the borrower that a bank may acquire DPC. DPC shares may be held for up to five years.

4 Limited Partnership Shares

5 Equity investments outside the United States

1 Edge Act subsidiaries of banks and bank holding companies (“investors”) are permitted to make equity investments outside the United States pursuant to the Federal Reserve’s Regulation K.

2 The extent of control that may be exercised depends on the extent to which the company derives its assets and revenues from the financial activities listed in the Federal Reserve’s Regulation K. At 95%, an investor may acquire all of the company; at 90%, an investor may acquire up to half of the company’s voting shares; at less than 90%, an investor may acquire up to 19.9% of the voting shares and 40% of the total equity.

3 Investments may not be made under Regulation K in companies that have offices or subsidiaries in the United States that engage in activities other than those permissible for an Edge corporation (i.e., financial activities related to international business other than underwriting and dealing in securities).

9 Derivatives Activities of Banks

1 Banks are permitted to enter into derivative transactions (swaps, options, futures) on an unmatched basis if the transactions are based on instruments (loans or eligible securities) or commodities (such as precious metals) that banks are authorized to buy and sell as for their own account.

2 Banks are permitted to enter into other derivative transactions if they are entered into on a matched basis, including portfolio matching, or if they obtain permission from their principal regulators to enter into such transactions on an unmatched basis.

3 A bank is permitted to enter into oil swaps and equity swaps even though they are not permitted to buy and sell oil or equity securities. Banks are generally not permitted to accept delivery of commodities in connection with their derivative activities, but may do so on a very limited basis.

4 Although the federal banking regulators have been relatively liberal in allowing banks to engage in different types of derivative transactions, they have issued extensive guidelines regarding risk management.

10 Tie-Ins

1 As a general rule, banks may not condition the price or availability of a one product or service on the customer purchasing another product or service from the bank or its affiliates.

2 It is important to note that the anti-tying statute does not prohibit a bank from providing two different products to a customer if requested by the customer. It is common, for example, for a bank to commit to provide bridge financing to a customer at the same time as the customer enters into an exclusive engagement letter with a securities affiliate of the bank to underwrite securities that will take out the bridge financing. Because the bank is not requiring that the customer purchase the underwriting services as a condition of providing the bridge loan, the transaction is not prohibited.

3 Other limitations on the anti-tying rule.

1 Nonbank affiliates of banks are not subject to this restriction. Although a bank cannot, for example, condition a loan on the customer hiring an affiliate to underwrite securities, a nonbank affiliate of a bank is permitted to impose such a condition.

2 The traditional bank products exception. A bank is permitted to condition the provision of a loan, deposit or trust service on the customer purchasing other loan, deposit or trust services.

3 Foreign customer exception. The anti-tying law does not apply if the customer is organized under foreign law and has its principal place of business outside the United States.

11 Issues Relating to the Insolvency of Depository Institutions

1 Insured deposits

When an FDIC-insured institution is placed in receivership, the FDIC normally finds another bank that is willing to assume all of the insured deposits in exchange for good assets of the failed bank and, if they amount to less than the deposits, cash.

2 Uninsured deposits and other claims

--The Financial Institution Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) requires that the FDIC pay all creditors at least the amount that they would have received had the failed institution been liquidated. As long as this is done, it is permissible to treat some creditors, such as uninsured depositors, better than others.

--FDICIA effectively prevents the FDIC from paying uninsured depositors and other creditors more than the liquidation value of their claim.

--In 1993 Congress enacted legislation which provides the claims of all depositors with priority over the claims of other senior creditors (other than secured creditors).

6 FDIC authority to repudiate contracts

--The FDIC is authorized by FIRREA and normally does repudiate loan commitments made by the failed bank.

--The FDIC is also authorized to repudiate most other contracts, subject to a claim for damages that have occurred as of the date of the repudiation.

--Special protection is afforded for “qualified financial contracts”, which includes swaps, repurchase agreements and foreign exchange contracts. With respect to such qualified financial contracts, FIRREA prevents the FDIC from “cherry picking”, allows for damage claims based on industry standards (“cost of cover”) and allows counterparties to exercise their rights under the agreement unless the FDIC informs them promptly that it will honor the contract.

10 Collateralized letters of credit

The FDIC takes the position that unless a drawing has been made at the time the receiver is appointed, the claim is contingent and not provable. This means that there is a risk that a bank that has received collateral for confirming a letter of credit for a troubled bank may not be able to satisfy its losses from the collateral.

11 Effect of insolvency on participation interests

--A valid setoff of the borrower against the lead bank relieves the borrower of its obligation to the extent of the setoff. Banks that purchased a participation in the loan are left with an unsecured loan to the lead bank.

--Any aspect of the participation that was not part of the original transaction or that is not fully reflected in the records of the lead bank is subject to attack by the FDIC under Section 1823(e).

14 Liability of affiliates of insolvent institutions

In considering applications by bank holding companies to make acquisitions or to engage in new activities, the Federal Reserve takes the position that a bank holding company is required to serve as a “source of strength” to its bank subsidiaries. The Federal Reserve attempted to extend this doctrine to a requirement that a bank holding company should use its assets for the benefit of a failing bank subsidiary, even at the expense of the holding company’s own creditors. In 1990 the Fifth Circuit rejected the “source of strength” doctrine in MCorp Financial Inc. v. Board of Governors of the Federal Reserve System, but was reversed by the Supreme Court on procedural grounds.

16 Liability of commonly controlled affiliates

--Under FIRREA, the FDIC is authorized to impose liability on an insured depository institution for losses incurred by the FDIC in connection with the failure of a commonly controlled depository institution. Liability may be imposed on a depository institution affiliate even if there were no transactions between the affiliate and the failed depository institution. This liability may not be imposed on a nonbank affiliate, such as a bank holding company for a failed bank. However, the claims of such a bank holding company against a depository institution subsidiary will be subordinated to any claims the FDIC may have against that subsidiary due to the failure of a cross-stream depository institution affiliate.

18 Prompt corrective action

--FDICIA added a section to the Federal Deposit Insurance Act that is intended to force the federal bank regulators to act more quickly and aggressively when the financial condition of a depository institution begins to deteriorate.

--Most of the corrective actions mandated by FDICIA are triggered by declining capital ratios. If a depository institution fails to meet the minimum capital ratios applicable to it, then it must submit an acceptable plan to restore its capital. The bank holding company for the institution is required to guarantee the plan for an amount equal to the lesser of 5% of the institution’s assets and the amount by which its capital is deficient.

--If a depository institution is significantly undercapitalized, then the regulators may limit dividends by the parent bank holding company or require that it divest the depository institution or any nonbank affiliate.

3 Depository Institution Holding Companies

1 Bank Holding Companies

1 Significance of Owning a “Bank”

A company that controls a “bank” is subject to regulation as a bank holding company. The most important ramifications of this status are: (i) the company is subject to capital adequacy requirements on a consolidated basis; and (ii) the company and its affiliates are not allowed to engage in commercial activities and may engage in financial activities only subject to certain restrictions.

2 Definition of “Bank”

1 The term “bank” includes any bank that is insured by the FDIC and any institution that both accepts demand deposits and makes commercial loans.

2 Exemptions from “Bank” Definition

Institutions that are engaged solely in trust activities

Credit unions

Banks that are engaged solely in credit card activities and do not accept demand or retail deposits

Savings banks

Industrial banks that are chartered in one of a handful of states that, as of 1987, required industrial loan companies to have FDIC insurance

3 The Industrial Bank Exception

--As a practical matter, this exception is limited to Utah and Nevada. The other states that were grandfathered have either stopped offering this charter or no longer allow their industrial banks to be acquired by commercial firms.

--Industrial banks have been acquired or established by commercial firms (e.g. Volvo and GE) as well as financial firms (e.g., American Express).

--The attempt by Walmart to establish an industrial bank gave rise to concerns regarding the traditional separation of banking and commerce. As a result:

---The FDIC declared a moratorium on allowing commercial firms to acquire FDIC-insured industrial banks. The moratorium expired on January 31, 2008, but the FDIC does not appear willing to approve such applications .

---The FDIC proposed rules that will require financial companies that are not regulated as bank or savings and loan holding companies to commit, prior to acquiring control of an industrial bank, to: submit reports to, and allow examination by, the FDIC; to provide additional capital to the industrial bank (though no capital requirements would apply to the holding company); and obtain approval prior to significant deviations from the industrial bank’s business plan. The FDIC has not acted on these rules, but in two cases that have come up since the expiration of the moratorium, the FDIC has required the acquirer to enter into agreements committing it to provide capital and liquidity to the industrial bank.

---The House of Representatives passed legislation that would prohibit commercial firms from acquiring industrial banks and authorize capital and other regulations for companies that control industrial banks, but no further action was taken.

3 Concept of “Control”

1 A company that acquires 25% or more of the voting shares of a bank (or bank holding company) is conclusively presumed to control the bank (or bank holding company).

2 A company that acquires 10% or more but less than 25% of the voting shares of a bank (or bank holding company) will be presumed to control the bank (or bank holding company) if the bank (or bank holding company) is a public company or the investor will be the largest shareholder. Prior to the Federal Reserve’s 2008 policy statement, such a company could not obtain a noncontrol determination unless it did not have a board seat and agreed to remain passive. The 2008 policy statement indicates that having one director (two if the target is controlled by another company) is consistent with noncontrol (provided that the board representation is not disproportionately greater than the investor’s equity interest), and that such investors will be allowed to actively attempt to influence the policies of the target.

2 Bank Holding Company Activity Restrictions

1 Unless a bank holding company is a financial holding company (“FHC”), Section 4 of the Bank Holding Company Act restricts the nonbanking activities in which the bank holding company may engage to those that the Federal Reserve determined, as of November 9, 2000, were “so closely related to banking as to be a proper incident thereto”. Those activities include lending, leasing, investment advice, securities brokerage, futures contract brokerage and advice, and trust activities, and, to a limited extent, underwriting and dealing in securities. The Federal Reserve cannot add new activities to the “closely related” list.

2 Qualifying as an FHC

To qualify as an FHC, a company must be a bank holding company and all of its depository institution subsidiaries must be “well capitalized”, “well managed” and have at least a satisfactory CRA rating. These requirements need not be met by the FHC itself.

A company that was not a bank holding company or a non-U.S. bank prior to the enactment of GLBA, may retain (but not expand) a limited amount of nonfinancial activities for up to 15 years after becoming an FHC.

3 Powers

An FHC, directly or through a state regulated insurance company, may engage in all types of insurance activities. (However, the Federal Reserve has not resolved the extent to which insurance companies may invest in and develop real estate, which is a traditional asset for insurance companies, especially life insurance companies.)

An FHC, through an SEC regulated broker-dealer, may engage in all types of securities activities, without the limitations that apply to other bank holding companies.

An FHC’s “merchant banking” powers permit it to acquire up to 100% of the shares of a nonfinancial company, provided that it does not “routinely manage” the day to day activities of the portfolio company, and that it sells the investment within ten years.

--Companies in which merchant banking investments are made are treated as affiliates for purposes of Section 23A if the investment constitutes more than 15% of the equity of such a company.

--As interpreted by the Federal Reserve, the merchant banking authority authorizes investments in “shares”, not assets. If assets are acquired, they must be promptly transferred to a company that has management that is separate from the financial holding company.

4 Functional Regulation

The various entities within the FHC are functionally regulated: broker-dealers are regulated by the SEC; insurance companies are regulated by the states in which they are domesticated; banks are regulated by their appropriate federal banking regulator. The Federal Reserve is the “umbrella” regulator for the FHC, with power to examine and establish capital requirements for the FHC.

3 Equity Investments by Bank Holding Companies Other Than Pursuant to the FHC Merchant Banking Authority

1 Voting Equity

Bank holding companies may acquire 5% or less of the voting shares of any company without the prior approval of the Federal Reserve (which would not be granted unless the activities of the company are closely related to banking). Any instrument that is convertible immediately at the option of the holder into a voting security is regarded as a voting security for this purpose. Limited partnership shares are treated as voting securities if they include the right to vote for the general partner. Preferred stock will be treated as a voting security if it gives the holder voting rights beyond those customarily granted to preferred stockholders under state law.

3 Nonvoting Equity

In addition to acquiring 5% or less of any class of the voting securities, a bank holding company may acquire nonvoting equity of a company without the prior approval of the Federal Reserve, provided that the bank holding company does not acquire control of the company.

--“Control” for this purpose must be understood in its context: a person with 25% of the voting shares is conclusively presumed to have control, even if an unrelated person holds the other 75% of the voting shares.

--In order to avoid a determination of control, certain guidelines must be followed:

--The total investment of the bank holding company should be less than 25% of the total “equity” of the company (or not more than 33% if the investor holds less than 15% of the voting shares). Equity includes subordinated debt, but only if the bank holding company acquires a meaningful amount of subordinated debt and holds any common or preferred stock. Equity held by affiliates, other than shares held DPC, are included in the calculation

--As a general rule, the investor may not have more than one director on the target’s board of directors.

--The ability to transfer a substantial block of convertible nonvoting securities to a person who can convert them into voting securities may, in the Federal Reserve’s view, give a bank holding company control over a company. Accordingly, if the block is for more than 10% of the shares, then the company should have a right of first refusal; and the block should be sold (i) in a widespread public distribution; (ii) in a private placement where no party acquires more than 2% of the shares of the target; or (iii) in a sale to a party that, prior to such sale, holds a majority of the target’s shares.

--Senior debt is relevant to the determination of control if the bank holding company or its affiliates provides and holds 25% or more of the senior debt of the company.

5 DPC Transactions

1 Bank holding companies may acquire securities DPC. The analysis is the same as for banks.

2 The BHC Act prescribes a specific holding period for voting stock that is acquired DPC of two years, with the Federal Reserve authorized to grant up to a total of ten years.

3 The divestiture requirement does not apply to securities that may be held under other authority (e.g., the authority to own 5% or less of any class of the voting stock of a company).

4 A separate analysis applies to exchanges of debt of lesser developed countries (“LDC”) for equity securities of companies located in LDC countries.

4 Savings and Loan Holding Companies

1 Regulated by the QTS, except in the case of a company that is also a bank holding company.

2 Prior to GLBA, any type of company could acquire a single savings association or federal savings bank institution without incurring restrictions on the activities of its affiliates other than the thrift. This fact, combined with improvements in the savings association charter such as liberalizing the QTL test, equalization of FDIC premiums with banks, and nationwide branching, resulted in a stampede by investment banks and insurance companies to acquire a savings association charter.

3 After GLBA, a company may acquire a savings association only if limits its activities to those that are permissible for financial holding companies. A company engaged in commercial or industrial activities cannot acquire a savings association unless it filed an application to do so by May 4, 1999.

5 Investment Bank Holding Companies

1 The GLBA permits a holding company that controls a broker-dealer but does not control a “bank” to elect to be supervised by the SEC. Investment banking organizations have done this to satisfy EEC requirements that financial institutions be subject to “comprehensive supervision on a consolidated basis”.

2 SEC supervision of investment bank holding companies is much less robust than Federal Reserve supervision of bank holding companies. Although the SEC regulations indicate what types of instruments count as capital for investment bank holding companies, the SEC has not imposed any capital adequacy requirements on such companies.

3 As discussed above, in part due to the perceived inadequacy of the SEC as a holding company regulator, in 2008 most major investment banks either were acquired by, or became, financial holding companies.

OVERVIEW OF U.S. REGULATION OF NON-U.S. BANKS

1 Historical Background

1 Prior to 1978, entry of non-U.S. banks into the United States was not subject to any federal application unless it was done by the establishment of a bank subsidiary. For example, a non-U.S. bank could engage in banking on an interstate basis through state-licensed branches without any limitations on the nonbanking activities of the non-U.S. bank.

2 The International Banking Act of 1978 (the “IBA”) subjected branches of non-U.S. banks to interstate banking restrictions, while grandfathering their existing branches. The IBA also subjected nonbanking activities of non-U.S. banks with U.S. branches or agencies to the same restrictions on nonbanking activities as apply to bank holding companies, but grandfathered securities affiliates.

3 The BCCI scandal resulted in enactment of the Foreign Bank Supervision Enhancement Act of 1991 (“FBSEA”), which shifted the primary regulatory authority over non-U.S. banks from the states to the Federal Reserve.

2 Structure and U.S. Regulation of Non-U.S. Banks

1 U.S. offices other than subsidiaries

1 Full service branches

1 Unless grandfathered, may not be established outside “home state”

2 Must be FDIC-insured to take retail deposits; after FBSEA, new branches cannot obtain FDIC insurance

3 May obtain a state or federal license; in the past few non-U.S. banks have chosen a federal license

4 As a matter of state law, generally permitted to engage in the same range of banking activities (other than retail deposits, if not insured) as banks in the same state; however, as a result of FBSEA, federal law now restricts the nonbanking activities of branches to those permitted for national banks.

5 Generally treated as banks for purposes of bank exemptions from the federal securities laws

6 Establishment requires the approval of the Federal Reserve and the primary (state or OCC) supervisor, with the primary criterion being the quality of home country supervision

7 Transactions between a non-insured branch and the parent bank are not subject to the restrictions of Section 23A of the Federal Reserve Act (discussed below)

2 Limited Branches and Agencies

1 Everything said above regarding full-service branches applies to agencies and limited branches except that agencies and limited branches may be established on an interstate basis and they are more restricted in the types of deposits they can take.

2 Agencies may accept deposits only from persons that are not residents or citizens of the United States.

3 Limited branches may accept deposits to the same extent as Edge Act corporations may accept deposits in the United States—i.e., each deposit must be related to international business.

3 Representative offices

1 Activities must be confined to acting as a liaison between U.S. customers and the parent bank. No loan decisions may be made at a representative office.

2 Formerly, there was very little state regulation of representative offices and federal regulating was limited to a notice sent to the U.S. Treasury Department. Under FBSEA, such offices must be approved by the Federal Reserve.

2 U.S. Subsidiaries

1 U.S. Bank Subsidiaries

1 Relatively few foreign banks have acquired substantial U.S. bank subsidiaries. Most focus on wholesale operations which can more easily be conducted through a branch. However, in recent years a number of non-U.S. banks have grown their U.S. retail banking operations (e.g., HSBC, Toronto-Dominion, Royal Bank of Scotland, BNP Paribas) in the view that excess capital could be more profitably employed in the United States than in their home market.

2 For regulatory purposes, a U.S. bank subsidiary is treated like any other U.S. bank. For example, transactions between the bank and the parent non-U.S. bank are subject to Section 23A.

3 The critical issue is capital adequacy of both the U.S. bank subsidiary and the parent non-U.S. bank.

4 In the wake of BCCI, there is also an intense focus on the nature of home country supervision.

2 U.S. Non-Bank Subsidiaries

1 The general rule is that a non-U.S. bank that has a branch or agency in the U.S. is treated as a bank holding company and such a non-U.S. bank may not engage in nonbanking activities without the prior approval of the Federal Reserve pursuant to Section 4(c)(8) of the Bank Holding Company Act.

2 A non-U.S. bank may qualify as an FHC if it and each of its U.S. depository institution subsidiaries are well capitalized and well managed. Non-U.S. banks that are FHCs may engage in the same broad range of financial activities as other FHCs.

3 The exceptions for QFBOs

Qualifying Foreign Banking Organization (“QFBO”) are foreign banking organizations that are engaged, based on asset and revenue tests, primarily in banking and the banking activities of which are primarily engaged in outside the United States. The non-U.S. activities of QFBO’s are not restricted by the IBA or the BHC Act.

4 The Section 2(h)(2) exemption permits QFBOs to control foreign companies that are engaged in commercial and industrial activities outsider the United States, even if those activities extend into the United States. The purpose of the Section 2(h)(2) exemption is to permit non-U.S. banks from countries that, unlike the United States, permit their banks to control commercial and industrial companies, to continue such affiliations after they enter the U.S. banking market. In order to maintain as level a playing field for U.S. and non-U.S. banking organizations as possible, consistent with this purpose, the exemption is limited to commercial and industrial activities.

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