Introduction to Banking Regulation
December 4, 2014
Paul T. Clark
Daphne A. Trainor
Introduction and Themes
2
Historic Policy Concerns
• Populist fear of concentrated economic power in large
financial institutions, including the concern of affiliation
between banking and commercial companies.
• Deference to power of the states to license and regulate
banks, and related concerns about centralized regulation
in the federal government.
• Encouraging home ownership, including creating
separate federal charter and deposit insurance fund to
support home lending.
3
Timeline of Major Banking Legislation
Banking Act of
1933 (includes
Glass-Steagall)
Bank Holding
Company Act
of 1956
Federal
Reserve
Act
Depository
Institutions
Deregulation
and
Monetary
Control Act
of 1980
FIRREA
FDICIA
RiegleNeal Act
1913
1933
Great
Depression
Great
Depression
Financial Panics
GLBA
1999
1980
1956
Elvis performs on Ed
Sullivan
Emergency
Economic
Stabilization
Act (TARP)
2008
1991
1994
Hyper Inflation
Newt Gingrich elected
Speaker of the House
Savings & Loan Crisis
Financial Crisis and
Severe Recession
Wayne Gretzky retires
1989
Dodd-Frank Act
2010
4
Decrease in Number of Insured Depository Institutions
(including thrifts and U.S. branches of foreign banks)
1985-2014
Year
Insured Depository Institutions
1985
18,043
1987
17,345
1992
13,973
1997
10,923
2002
9,354
2007
8,544
2012
7,083
2013
6,821
6/30/2014
6,665
5
Concentration of Assets among Top Five Banking
Institutions
As of June 30, 2014
Bank
Assets/percent of
assets of all
banking
institutions ($14.5
Trillion)
As of December 31, 1992
Bank
Assets/percent of
assets of all
banking
institutions
($3.5 Trillion)
JP Morgan Chase
$2.0 Trillion/
13.2%
Citibank
$164 Billion/
4.7%
Bank of America
$1.5 Trillion/
9.9%
Bank of America
$133 Billion/
3.8%
Wells Fargo
$1.4 Trillion/
9.2%
Chemical Bank
$109 Billion/
3.1%
Citibank
$1.4 Trillion/
9.2%
Morgan Guaranty
(JP Morgan)
$77 Billion/
2.2%
US Bank
$.4 Trillion/
2.0%
Chase Manhattan
$74 Billion/
2.1%
Total
$6.7 Trillion/
43.5%
$557 Billion/
15.9%
6
Decrease in Number of Savings and
Loans
(state and federally-chartered)
1984: 3,428
2014*: 899
*As of 6/30/14
7
Elimination of Exclusive State Regulation
Total Number of Insured
Depository Institutions
December 31, 1990
15,158
Number of Insured
Depository Institutions
That Were Not Members
of the Federal Reserve
System
Percentage of Insured
Depository Institutions
That Were Not Members
of the Federal Reserve
System
9,724
64%
8
What Is a Bank?
9
Depository Institutions Are Overwhelmingly StateChartered
State Chartered: 5,083
Federally Chartered: 1,582
as of 6/30/14
10
11
17 states define "banking" to include solicitation and
receipt of deposits:
"No person who has not received a certificate from the
commissioner authorizing it to engage in the banking business
shall solicit or receive deposits…" (California Financial Code,§790).
31 states define "banking" to include receipt and/or
acceptance of deposits but are silent regarding
solicitation:
"No corporation, domestic or foreign, other than a national bank
or a federal reserve bank, unless expressly authorized by the laws
of this state, shall employ any part of its property, or be in any
way interested in any fund which shall be employed for the
purpose of receiving deposits, making discounts, receiving for
transmission or transmitting money in any manner…" (New York
12
Banking Law, §131)
3 states do not define "banking" by
reference to specific activities:
"Banking institution means an institution that
is incorporated under the laws of this State as
a State bank or trust company." (Maryland
Financial Institutions Code, §101.d)
13
What Is a “Deposit”?
“the unpaid balance of money or its
equivalent received or held by a
bank . . . in the usual course of
business and for which it has given
or is obligated to give credit, either
conditionally or unconditionally. . .”
Federal Deposit Insurance Act §3(l)
14
Entities That Operate without a Bank
License
• Broker-Dealers
• Title Companies
• Issuers of Stored Value Cards
• Social Crowdfunding Websites (i.e.,
Kickstarter, Indiegogo)
15
State Money Transmitter Regulations
"Money transmission" means any of the following:
(1) Selling or issuing payment instruments.
(2) Selling or issuing stored value.
(3) Receiving money for transmission.
Money Transmission Act, Cal. Fin. Code § 2003(o)
16
FinCEN Regulation of Money
Transmitters
Money services businesses (MSBs), which are
defined to include money transmitters, must:
– Register with FinCEN (FinCEN registration does not satisfy
state money transmitter registration requirements)
– Comply with all federal AML laws and other BSA reporting
requirements
The IRS has examination authority over the AML
programs of FinCEN-registered MSBs.
17
Three Ways to Obtain Trust Powers
1. Apply to the OCC or a state licensing authority for a
banking charter with trust powers.
2. Many states (including NY) offer a limited purpose
trust charter that permits the exercise of fiduciary
authority but does not confer deposit-taking
authority and does not require FDIC insurance.
3. Until recently, the OCC offered trust-only charters
without FDIC insurance. Now, newly established
non-depository trusts are required by the OCC to
have FDIC insurance.
18
What Makes Banks Special?
19
20
Other Unique Features of Banks
• FDIC deposit insurance
• Exemption from certain aspects of the federal securities laws
– deposit accounts are not "securities" for '33 and '34 Act purposes
(considered "securities" for purposes of the Investment Company
Act and Investment Advisers Act)
– bank-issued "securities" are exempt from registration with the
SEC
– guarantee by a bank of securities of other issuers exempts those
securities from registration
– ability to conduct certain securities transactions otherwise
requiring broker-dealer registration
• Role as credit intermediaries: banks are the primary source of
funding for small and mid-size businesses that cannot otherwise
access capital markets
21
Why Are Banks Afforded Special
Treatment?
“This certificate of deposit was issued by a federally regulated
bank which is subject to the comprehensive set of regulations
governing the banking industry. Deposits in federally
regulated banks are protected by the reserve, reporting, and
inspection requirements of the federal banking laws;
advertising relating to the interest paid on deposits is also
regulated. In addition, deposits are insured by the Federal
Deposit Insurance Corporation. Since its formation in 1933,
nearly all depositors in failing banks insured by the FDIC have
received payment in full, even payment for the portions of
their deposits above the amount insured...”
Marine Bank v. Weaver, 455 U.S. 551 (1982)
22
The Fed’s Use of Banks to Influence
Monetary Policy
The Fed influences borrowing rates by:
1. Setting the "federal funds rate”: rate charged by banks on an
overnight loan of federal funds (reserves held at the Federal
Reserve) from other banks (.25%)
2. The “federal funds rate” affects the "prime rate”: rate banks
charge their best corporate customers. The “prime rate” is
established by the WSJ based upon polling of the 10 largest
banks, and is usually 3% over the “federal funds” rate
(3.25%)
3. Setting the "discount rate”: rate the Fed charges for
borrowings from the discount window.
The Fed affects the money supply by establishing
reserve requirements for bank deposits.
23
The Basic Business of
Banking
24
Banking Is a Spread Business
• Banks’ primary source of revenue is interest
earned on loans and permissible fixed income
investments (assets).
• Loan revenue must exceed interest expense on
deposits (liabilities).
• To maximize profits, banks need to maintain a
stable deposit base, and when possible, match
the maturity of deposit liabilities to loans (“match
funding”).
25
Depository Institutions Fund Themselves
with Short-Term Deposits
Dollar Amount
Percentage of All
Deposits
[$9.4 Trillion]
Savings Accounts
$6.6 Trillion
66.0%
Transaction Accounts
$1.8 Trillion
17.8%
Total Savings and
Transaction Accounts
$8.4 Trillion
83.8%
Data as of 6/30/14
26
Federal Deposit Insurance
27
Timeline of Standard Maximum
Deposit Insurance Amount
300,000
250,000
200,000
150,000
SMDIA
100,000
50,000
0
1934 1950 1966 1974 1980 2010
28
FDIC Insurance Coverage of a Husband and
Wife with Deposit Accounts in Multiple
Ownership Categories
Account
Account Title Ownership
Category
Owner(s)
Beneficiary(ies)
Maximum
Insurable
Amount
Husband
Single Account Husband
$250,000
Wife
Single Account Wife
$250,000
Husband &
Wife
Joint Account
Husband & Wife
$500,000
Husband POD
Revocable
Trust Account
Husband
Wife
$250,000
Wife POD
Revocable
Trust Account
Wife
Husband
$250,000
Husband &
Wife Living
Trust
Revocable
Trust Account
Husband &
Wife
Child 1
Child 2
Child 3
Husband IRA
Certain
Retirement
Account
Husband
$250,000
Wife IRA
Certain
Retirement
Account
Wife
$250,000
Total
$1,500,000
$3,500,000
Source:
29
https://www.fdic.gov/deposit/deposits/brochures/your_insured_de
posits-english.html
30
FDIC-Insured Bank Deposits Increased during the
Financial Crisis
31
“In 1907, in the absence of deposit insurance,
retail deposits were much more prone to run,
whereas in 2008, most withdrawals were of
uninsured wholesale funding, in the form of
commercial paper, repurchase agreements and
securities lending.”
Ben Bernanke, 2013
32
The Deposit Insurance Fund
• As of June 30, 2014, Fund assets totaled $51.1
Billion, with a reserve ratio (to insured deposits)
of .84%.
• The current designated reserve ratio is 2.0%.
• Premiums were increased in 2010 to replenish the
Fund, and will be reduced when the reserve ratio is
reached.
33
34
Sources of Deposit Funding without Access to
Brokered Deposit Market
Bank is limited to its
regional branches in
MA, CT, RI, VT, NH & ME
35
Sources of Deposit Funding with Access to
Brokered Deposit Market
Bank can access sources
of deposit funding well
beyond
its NE branches.
36
Brokered Deposit Market
Today over $1 trillion of customer funds (out of
a total of $9.4 trillion) are maintained in deposit
accounts at FDIC-insured banks offered by, and
held through, registered broker-dealers and
banks.
– $200 Billion: CDs
– $800 Billion: Savings deposits/ transaction
accounts
37
Death of State-Only Banking
Regulation
38
Last Victory for State Regulation: Bank
Holding Company Act of 1956
• The BHCA was adopted to prevent banks from
circumventing state branching restrictions by
establishing separate banks in each state.
• The BHCA as originally adopted was not
intended to impose significant federal regulation
on banks or BHCs.
39
Thrift Crisis Background
• Before 1980, deposit account interest rates were established and
regulated by federal regulators. Thrifts were permitted to pay .25% higher
interest rates on savings accounts.
• Capped rates for savings accounts
 5.5% for thrifts
 5.25% for banks
• In 1980, taxable MMF yields were 12.6%
• This resulted in the disintermediation of deposits from banks and thrifts to
MMFs.
• Monetary Control Act of 1980
• Gave the Fed power to impose reserves on all FDIC-insured banks
and thrifts
• Deregulated interest rates on deposits
• Gave all banks and thrifts access to Fed benefits (payment systems,
discount window)
40
Factors That Contributed to the Thrift Crisis and
Increased Federal Regulation
• Thrifts' commitments to 30-year mortgages resulted in
thrifts earning low, fixed interest rates on long-term
mortgages while paying market rates on deposits after
1980.
• State deregulation of state-chartered S&Ls' investment
authority, allowing them to enter riskier loan markets
without an accompanying increase in examination
resources.
• Reduced regulatory capital requirements led to the use of
alternative accounting procedures to increase reported
capital levels.
• Excessive chartering of new thrifts.
41
Congressional Response: Increased Federal
Regulation in Exchange for FDIC Insurance
• Elimination of state discretion over bank powers: no
FDIC-insured institution may exercise greater powers
than a national bank.
• Uniform risk-based capital requirements for FDICinsured institutions.
• Prompt corrective action, giving federal regulators
increased authority over a bank’s activities as capital
declines.
42
Primary Federal Regulator by Charter Type
Charter Type
National Banks
State-Chartered Member
Banks
Regulator
OCC
Federal Reserve Board
State-Chartered NonMember Banks
FDIC
Savings & Loan
Associations
(State and FederallyChartered)
Pre-Dodd-Frank: OTS
Post-Dodd-Frank: divided
between FDIC and OCC
43
Rise of the Fed: the Fed Uses
the BHCA to Assert Greater
Regulatory Power over Banks
44
What Is a Bank Holding
Company?
“any company which has control over
any bank or over any company that is
or becomes a bank holding
company…”
BHCA, §2(a)(1)
45
Control under the BHCA
Control is presumed if:
a. the company directly or indirectly or acting through one or more other
persons “owns, controls, or has power to vote” 25% or more of any
class of voting securities;
b. the company controls the election of a majority of the trustees; or
c. the Fed determines that the company has a “controlling influence” over
management of the company.
There is a presumption of non-control when the company owns, controls or
has power to vote less than 5% of any class of voting securities. Nonetheless,
the Fed may find that the company has controlling influence over
management; in such a case, the Fed has the burden of proving controlling
influence.
46
Control under the BHCA, cont.
5% to 9.99% control is a grey area. Control will be determined by facts and
circumstances (e.g., control of management).
There is a rebuttable presumption (rebuttal by acquirer) of control when the
company owns, controls, or holds power to vote 10% or more of any class of
voting securities of the bank and either:
(1) the bank has securities registered under the Exchange Act, or
(2) no other person will own, control, or hold the power to vote a
greater percentage of that class of voting securities.
Any acquisition of 10% or more requires prior notice to and approval by the
Fed.
The approval process for a determination of control requires a simultaneous
application to the Fed under the Change in Bank Control Act.
47
The Fed has the power to determine
which activities are “closely related to
banking.”
The Fed also has the authority to take into
consideration “the financial and
managerial resources and future
prospects of the company or companies”
when considering applications for new
activities and mergers & acquisitions
requiring Fed approval.
48
Erosion of Barriers to
Concentration of Financial
Power
49
Glass-Steagall Restrictions on Underwriting
by Banks
Section 16: restricts a bank's ability to underwrite
and deal in securities and stocks (other than
"bank-eligible" governmental securities) and
prohibits such banks from purchasing or selling
securities except upon the order of, and for the
account of, customers.
Section 21: prohibits a person or entity engaged
in the business of underwriting, issuing, selling or
distributing securities (unless permitted by
Section 16) from engaging in the business of
accepting deposits.
50
Glass-Steagall Restrictions on Banks’
Affiliations with Underwriters
Section 20: prohibits a bank from affiliating with
a company " engaged principally" in underwriting,
dealing, publicly selling or distributing securities.
Section 32: prohibits officer, director or
employee interlocks between a member bank
and a company or person "primarily engaged" in
underwriting, dealing, publicly selling or
distributing securities.
51
The Gramm-Leach-Bliley Act
(1999)
52
Gramm-Leach-Bliley Act (GLBA)
• Repealed Glass-Steagall affiliation restrictions (Sections 20 and 32)
• Amended the BHCA to permit affiliations between banks, securities
firms, and insurance companies within a "financial holding
company" structure subject to application to and approval by the
Fed to act as a "financial holding company.”
• For FHCs only, replaced the “closely related to banking” standard
with a “financial in nature” standard.
• Conditions include:
– The banks are well-capitalized and well-managed;
– Non-bank subsidiaries engage only in activities that are
"financial" in nature as defined by the Fed;
– No affiliation with commercial companies; and
– Must have BHC status to apply for FHC status.
53
Functional Regulation
• GLBA provides for functional regulation of FHC
nonbank subsidiaries (i.e., registered broker-dealers
regulated by the SEC, commodities brokers by CFTC
and insurance companies by state insurance
commissioners).
• Reliance on “firewalls” to impose limitations on affiliate
transactions.
• “Pushed out” most bank securities brokerage activities to
registered broker-dealers.
54
The Housing Bubble and
Subsequent Financial Crisis
55
Legal and Regulatory Factors
• Monetary policy (low interest rates and banks reaching
for yield)
• Changes in U.S. tax law
– 1986: reforms favored mortgage debt over other forms of credit
– 1997: reforms created more favorable rules for residential capital
gain recognition
• Federal preemption of consumer protection and
subsequent inaction (e.g., failure to regulate mortgage
brokers)
• SEC’s grant of credibility to credit ratings and leverage
exemptions to largest investment banks
Credit: Mark Palim, Vice President, Fannie Mae
56
Legal and Regulatory Factors, cont.
• Increase in subprime, low-doc, interest only and
ARM mortgages
• Increased securitization of home loans
• Overconfident borrowers, brokers, investment
bankers, GSEs and credit rating agencies
• Failure of bank regulators to recognize flawed
asset strategies
57
58
FHC/BHC Status before and
after the Financial Crisis
Firm
FHC/BHC Before?
FHC/BHC After?
Merrill Lynch
No
Yes, part of B of A, an
FHC
Lehman Brothers
No
N/A (bankrupt)
Morgan Stanley
No
Yes, a BHC
Bear Stearns
No
Yes, part of JP Morgan,
an FHC
Goldman Sachs
No
Yes, a BHC
59
The Dodd-Frank Wall Street
Reform and Consumer Protection
Act
60
Role of FSOC
– Identify asset bubbles.
– Designate nonbank financial companies as “Systemically Important
Financial Institutions” (SIFIs) subject to Fed regulation, including capital
and liquidity requirements.
– Designate systemic financial market utilities and systemic payment,
clearing, or settlement activities, requiring them to meet prescribed risk
management standards and heightened oversight by the Fed, SEC or
CFTC.
– If FSOC determines that certain practices or activities pose a threat to
financial stability, FSOC may make recommendations to the primary
financial regulators.
– Determine whether action should be taken to break up those firms that
pose a "grave threat" to the financial stability of the U.S.
61
SIFIs
– BHCs with $50 billion or more in consolidated assets
(currently 38).
– Non-bank entities designated as SIFIs by FSOC thus far:
• AIG
• Prudential Financial
• GE Capital Corporation
• MetLife (appeal pending)
– Once an entity is designated as a SIFI, the Fed is
authorized to:
1. Impose enhanced capital requirements;
2. Impose enhanced liquidity requirements; and
3. Subject the entity to increased examination
requirements.
62
The Volcker Rule
(Dodd-Frank §619)
1. Prohibits “banking entities” from engaging in short-term
“proprietary trading” of securities, derivatives,
commodity futures, and options on these instruments
for their own accounts.
2. Prohibits “banking entities” from acquiring or retaining
any equity, partnership or other ownership interest
in, or sponsoring, a hedge fund or PE fund that
would be a 1940 Act investment company but for
§3(c)(1) (100 or less beneficial owners) or §3(c)(7)
("qualified purchasers") (“covered funds”).
63
Volcker Rule “Banking Entities”
1. Any (FDIC) insured depository institution
2.
Any company that controls an insured depository institution [BHC or
S&L Holding Company]
3.
Certain foreign banking organizations that have U.S. branches or
agencies or which own U.S. banks or certain other U.S. subsidiaries
and are subject to BHCA
4.
Any affiliate or subsidiary of an insured depository institution, a
company that controls an insured depository institution, or a foreign
bank or company subject to BHCA
– Affiliate means any company that controls, is controlled by, or
is under common control with another company [control
determined using BHCA analysis]
Bottom Line: the term “banking entity” can include insurance companies,
investment banks and asset management firms that have affiliated banks in
their corporate family.
64
Permitted Proprietary Trading and Fund Activities
Permitted Proprietary Trading
Trading transactions in government
securities
Trading transactions in connection with
underwriting or market-making, to the
extent that either does not exceed
near-term demands of clients,
customers, or counterparties
Permitted Covered Fund
Sponsorship
Organizing and offering a covered fund if:
•
•
Trading transactions on behalf of
customers
•
Trading transactions by an insurance
company or affiliate for the general
account of the insurance company
[subject to state law]
•
Certain risk-mitigating hedging
activities
Investments in small business
investment companies
Proprietary trading conducted in
accordance with specified BHCA
provisions solely outside the U.S. if
banking entity is not directly or
indirectly controlled by banking entity
organized under U.S. law
•
the banking entity provides bona fide trust,
fiduciary or investment advisory services;
the covered fund is organized and offered
only in connection with, and to customers
of, such services;
ownership interest in the fund limited to a
seed or de minimis investment;
banking entity complies with 23A and 23B
affiliate transaction limitations; and
certain other requirements are satisfied
(i.e., name sharing prohibition)
Organizing and offering a covered fund
outside the U.S. in accordance with specified
BHCA provisions if:
• no ownership interests are offered to U.S.
residents; and
• the banking entity is not directly or
indirectly controlled by a U.S. banking
entity
65
Material Conflicts of Interest and High-Risk
Activities
Permitted proprietary trading and covered fund activities are
subject to three general prohibitions:
 If the permitted activity would result in a material
unaddressed conflict of interest between the banking entity
and its clients, customers or counterparties;
 If the permitted activity would create a material exposure by
the banking entity to high-risk assets or high-risk trading
strategies; or
 If the permitted activity would pose a threat to the safety and
soundness of the banking entity or to the financial stability of
the U.S.
66
Issues Raised by the Volcker Rule
Hotel California (“You can check in anytime you like/but you can’t ever leave”):
why doesn’t Goldman-Sachs simply drop its bank, avoiding BHC status and thus
the Volcker Rule?
• Goldman is a BHC that had $50 B in assets as of 1/1/10 and received TARP
funds. If it ceases to be a BHC, it automatically becomes a SIFI.
• SIFIs that are not “banking entities” are nevertheless subject to additional
capital requirements and quantitative limits to the extent they engage in
proprietary trading or covered fund activities not permitted by Volcker.
The Sponsorship Exception’s Name Sharing Prohibition
• An asset manager under common control with a bank (and therefore a
Volcker Rule “banking entity”) that wants to rely on the Rule’s sponsorship
exception to sponsor a covered fund must eliminate not only the bank’s
name, but also its own name, from the name of that covered fund.
• This may require major fund rebranding efforts for bank-affiliated asset
managers.
Affiliate Transaction Restrictions in the Context of the Sponsorship Exception
67
International Regulatory
Framework for Banks as
Established by the Basel
Committee on Banking
Supervision
(“Basel III”)
68
Basel III Two-Part Regulatory Framework
1.
Increased Capital Requirements
– Increased minimum requirements for both the quantity and
quality of capital
Status: Effective January 1, 2015
2.
Liquidity Risk Measures
– Liquidity Coverage Ratio (LCR): intended to require banks to
maintain a sufficient amount of “high quality liquid assets” to
withstand a hypothetical 30-day liquidity stress period
Status: Effective January 1, 2015 (phased-in transition)
– Net Stable Funding Ratio (NSFR): intended to limit banks’
reliance on short-term wholesale funding. It is similar to the
LCR, but is focused on a longer time horizon (1 year vs. 30
days).
69
Status: Not yet proposed by U.S. regulators
LCR Runoff Rates
Category
Agencies' LCR
Outflow Amount
Unsecured Retail Funding
Stable retail deposits (Entirely insured “transactional deposits” and entirely insured other deposits of depositors
that have a relationship with the bank)
3%
Other retail deposits
10%
Retail Brokered Deposits
Brokered deposits remaining maturities over 30 days
Reciprocal brokered deposits, entirely covered by deposit insurance
10%
10%
Reciprocal brokered deposits, not entirely covered by deposit insurance
25%
Brokered sweep deposits, issued by a consolidated subsidiary, entirely covered by deposit insurance
10%
Brokered sweep deposits, not issued by a consolidated subsidiary, entirely covered by deposit insurance
25%
Brokered sweep deposits, not entirely covered by deposit insurance
40%
All other retail brokered deposits, including time deposits with remaining maturities 30 days or under
100%
Unsecured Wholesale Funding
Category 2: Non-operational deposits not provided by a regulated financial company, investment company, nonregulated fund, pension fund, investment adviser, identified company, sovereign entity, U.S. governmentsponsored enterprise, public sector entity, or multilateral development bank, or any consolidated subsidiary of the
foregoing, entirely covered by deposit insurance and not a brokered deposit
20%
Category 2: Non-operational deposits, not provided by a regulated financial company, investment company, nonregulated fund, pension fund, investment adviser, identified company, sovereign entity, U.S. governmentsponsored enterprise, public sector entity, or multilateral development bank, or any consolidated subsidiary of the
foregoing, not entirely covered by deposit insurance or the funding is a brokered deposit
40%
Category 1: All other wholesale funding, including funding provided by a regulated financial company, investment
company, non-regulated fund, pension fund, investment adviser, identified company, sovereign entity, U.S.
government-sponsored enterprise, public sector entity, or multilateral development bank, or any consolidated
subsidiary of the foregoing.
100%
70