BANKING LAW RULE ATTACK OUTLINE
I. NB ACT PREEMPTION
1. State law in some cases does apply to NBs:
a. Some state regulations: States have some residual control over NBs, and not everything is
preempted by the NB Act. Some regulation is left to the states. NB v. CW.
2. NB’s Preemption of State Law:
a. Preempts if state law interferes w/ federally granted power: States can regulate NB’s but they
cannot interfere, undercut, or undermine the NB’s exercise of a federally granted power. Barnett
Bank (OCC said NB’s could sell insurance, Fla. Statute said the could and it was preempted).
b. NB’s do have the option of augmenting their rules w/ state law where:
i. The bank has a main office
ii. The BHC is incorporated
iii. DE corp law or
iv. Model Business Corp. Act
c. Does not preempt state enforcement power:
i. Enforcement yes, administrative visitorial powers: States cannot exercise administrative
visitorial powers over NBs, but they can bring ordinary law enforcement actions through
the courts. Cuomo.
3. State regulation of operating subs (Dodd-Frank overruled):
a. Pre-Dodd-Frank: An operating sub gets the same preemptive immunity that the parent does
under the NB Act. Waters v. Wachovia.
b. Dodd Frank Rule: The NBA no longer preempts state law as applied to state chartered subs and
affiliates of NBs and Federal Savings Banks, the legal standard under Barnett would apply
4. Preemption ANALYSIS: 12 U.S.C. 25(b):
a. Note on procedure: First analyze preemption under 12 U.S.C. 25(b) then go to OCC reg if it
makes it through preempted.
b. NB Act Preempts state consumer financial law only if the law would:
i. (1) Discriminatory effect on NBs: In comparison with the effect of the law on a state
chartered bank, (OR)
ii. (2) Go against the ruling in Barnett: Prevent or significantly interferes with the exercise
of the banks power
1. Note: Statute overturns Waters, excludes field preemption and codifies Cuomo.
5. After look at 4 go through the OCC’s Statutory Preemption statute:
a. Deposit Taking; 12 CFR 7.4007:
i. (b) State laws that are Preempted: A NB may exercise its deposit taking powers w/o
regard to state law limitations concerning:
1. abandoned or dormant accounts
2. checking accounts
3. Disclosure requirements
4. Fund availability
5. Savings accounts orders of withdraw
6. State licensing or registration requirements, and
7. Special purpose savings services
ii. (c) State laws not preempted: Unless interfere w/ Bennett the following are not
preempted:
1. contracts
2. torts
3. criminal law
4. rights to collect debt
5. acquisitions and property transfers
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6. taxation
7. zoning
b. Lending; 12 C.F.R. 7.4008:
i. (d) State laws preempted: A NB may make non real-estate state loans w/o regard to state law
limitations concerning:
1. Licensing registration
2. The ability of a creditor to inquire or obtain insurance for collateral or other credit
enhancements or risk mitigation, in furtherance of safe and sound banking
3. Loan-to-value ratios
4. The terms of credit, including schedule for repayment of principle and interest,
amortization of loans, balance, payments due, minimum payments, or terms to
maturity of the loan, including the circumstances under which a loan may be called
due and payable upon the passage of time or a specified event external to the loan
5. Escrow accounts, impound accounts, and similar accounts
6. Security property, including leaseholds
7. Access to and use of credit reports
8. Advertising and disclosure rules
9. Disbursement’s and repayments
10. Rates of interest on loans.
ii. (e) Not preempted: above.
II. PERMISSIBLE BANKING ACTIVITIES
1. Bank Powers by 12 U.S.C. 24(SEVENTH):
a. Establishment; 12 USC 24(SEVENTH): Exercise incidental powers as shall be necessary to
carry on the business of banking. The Provisions applies for expansive Chevron deference to
OCC to expand powers of NBs:
i. Explicit banking activities:
1. Discounting and negotiation of promissory notes, drafts, bills of exchange and
other evidence of debt
2. Receiving deposits
3. Buying and selling exchange coin or bullion
4. Loaning money on personal security, and
5. Obtaining, issuing and circulating notes
ii. Denied to banks:
1. Ownership in real property
2. Ownership in corp. stock or underwriting securities, 12 U.S.C. 24 (SEVENTH)
3. Underwriting insurance, 15 U.S.C. 6712(a)
4. Charging interest above the legal rate, 12 U.S.C. 85
b. OCC has power to expand power of NBs through regulation:
i. Authorized to expand the NBs power
1. Can expand the power the power of NBs if reasonable: the business of
banking is not limited to the enumerated owners listed in section 24(SEVENTH)
and so the OCC clearly has the discretion to authorize activities beyond what is
specifically enumerated. NB of NC.
2. Must limited the OCC’s discretion however: The exercise of the OCCs
discretion however must be kept with in reasonable bounds. Distant ventured
from dealing from in financial instruments –for example, operating a general
travel agency are outside of the definition. Id.
ii. Powers Authorized by the OCC are subject to Chevron deference:
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1. If congress has clearly spoken on the issue: Then it is clear and the court and
the agency must clearly interpret the statute, if the OCC decision is contrary then
must be rejected.
2. If congress is silent on the issue: Then the issue is whether the agency’s answer
is based on permissible construction of the statue
3. If congress has left a gap for agency to fill: Then the court should defer to the
agency to fill the gap of a specific provision or regulation.
a. The court will only intervene if the decision is: Arbitrary, capricious, or
manifestly contradicts the statute.
iii. The OCC has stated that the following activities were among the business of banking:
1. Data processing, 12 CFR 7.5006: The business of banking include data
processing if it is (a) financial or banking related and (b) if it is derivative of
banking activity.
2. Correspondent banking services 7.5007: large banks offer banking services to
facilitate small bank operations
3. Finder services 7.1002: Business of making may include finder services that
include:
a. Identifying potential parties
b. Making inquires as to interest
c. Introduce or arrange contracts or meetings of interested parties
d. Act as n intermediary between interested parties and
e. Otherwise bring parties together for a transaction that the parties
themselves negotiate and consummate
4. Building a webpage and webhosting: Webhosting allows the banks to perform a
finder function and is part of the business of banking also allows for process
reports and economic data. OCC Interp. Let 875.
c. Permissible banking activities that have been labeled as incidental:
i. Business of banking: w/ in the scope of banking if the activity if:
1. Functionally equivalent or logical out growth of a traditional banking activity,
2. Would respond to customers needs or otherwise benefit the bank or its customers,
AND
a. i.e., needed to carry on the business of banking.
3. Involves risks similar to those already assumed by banks
ii. The test if incidental to the business of banking: Arnold tours put forth a 3 part test:
1. Convenient or useful,
2. In connection o the performance of a traditional activity, (AND)
3. Under one of the banks expressed authorized powers
iii. Arnold tours must be viewed through the lens of M&M leasing:
1. Must look to see if functionally similar to a traditional activity: An activity is
functionally similar/ interchangeable with an expressed power will be considered
“incidental to banking,” i.e., functional similar to what the banks have already
done.
2. Expansion of banking powers as incidental through 24(SEVENTH):
a. Travel agency services: Not incidental to banking powers. Arnold Tours.
b. Personal Property leasing:
i. Is incidental to the power of banking: Leasing in light of all relevant circumstances the
transaction constitutes a loan of money secured by a leased property, is incidental to the
loan of money on personal security an activity authorized by the NBA. M&M Leasing.
c. Insurance:
i. Bank may act as an insurance agencies to sell insurance polices issued by other firms:
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1. Acting as an agent, a bank does not take on any underwriting riks and the issuing
insurer, no the bank bears the risk
ii. Statutory Authorization; NB Act 12 U.S.C. 92:
1. May sell insurance as long as:
a. (1) Population in city less than 5K and
b. (2) Insurance companies that they are selling on behalf of are authorized
by the state.
2. These activities include:
a. (1) Soliciting and selling insurance, and
b. (2) collecting premiums on policies issued by some companies.
3. The OCC has drastically expanded the reach of this provision; 12 CFR
7.1001: A bank van utilize 92 if it has a branch office located in a community
having a population of less than 5k even though the bank’s principle office is
located in a population that exceeds 5k.
iii. Application and extension of the insurance rule:
1. Annuities: Banks are permitted to broker annuities incidental to the powers of
banking, not selling insurance, professor believes that variable annuities, not
hybrid annuities are functionally similar. VALIC.
2. May sell to populations Outside of 5k: A bank located in a small town may sell
insurance nationwide, and the statute puts no real geographic restraint on this.
Ludwig.
3. Crop insurance: 24(SEVENTH) does not authorize them to sell crop insurance
protecting farmers from disasters, the court is concerned that this would open
Pandora’s box.
4. Credit life insurance: Banks can sell credit life insurance b/c unlike other forms
of insurance, credit life insurance is a limited special type of coverage written to
protect loans, and is incidental to a loan.
iv. Insurance underwriting:
1. FHCs can underwrite insurance in a sub: FHCs may underwrite insurance in a
sub, but BHCs may not
2. Banks cannot underwrite insurance: May not provide insurance as a principle
and this rule applies to FDIC insured state banks. 15 U.S.C. 6712(a).
a. GLB Act: Excludes letters of credit from the definition of insurance.
3. Cannot issue guarantees: But can issue standby letters of credit, which function
a lot like a guarantee under the functional equivalency test. NB Banks of Dallas.
d. Real Estate:
i. NBs cannot own real property but there are exceptions: Banks have broad power to make
loans secured by real property, 12 USC 371, but they have very limited power to own real
property. Pursuant to 12 USC 29 a bank may purchase, hold, and convey real estate for a
certain purpose and for ONLY the following four purposes:
1. Exceptions to prohibition of holding real-estate:
a. Foreclosing on debt: May hold real property acquired by foreclosing on
debt. 12 USC 29.
b. Satisfaction of Ks: A bank may hold real property acquired in satisfaction
on debts previously contracted in the course of dealings, 12 USC
29(THIRD)—property acquired by foreclosing on or settling a debt is
known as a DPC property (Debt Previously Contracted or REO (real estate
owned property).
c. Conducting its business: A bank may acquire and hold real property as
necessary for tis accommodation in the transaction of its business. 12
U.S.C. 29 (FIRST)—the bank can own their premises and real properties
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d. Public welfare: A NB can hold real property pursuant to its power to make
investments designed primarily to promote the public welfare.
i. Limit: 5% of capital w/ OCC permission but can never exceed
10%.
ii. Extensions of these rules by the OCC:
1. Hotels/ lodging; 12 CFR 7.1000(a)(2)(v)(d)(2): Can own residences to
accommodate out of town employees if there is no suitable lodging in region.
a. Has been extended to: condos and large hotels.
e. Personal Property:
i. NBs can hold personal property: 12 USC 24 (TENTH): Can invest w/o limitation in
vehicles, manufactured homes, machinery, equipment, or furniture for lease financing
transactions on a net basis
1. BUT: such investments may not exceed 10% of the assets of the corporation
f. Trusts:
i. May administer a trust in a fiduciary capacity: May act as a trustee when not in
contravention of state law.
g. Securities:
i. Restrictions:
1. Can only deal and hold securities for the account of customers and no on
own account: NBs are prohibited from owning stock. 12 U.S.C. 24.
2. May not underwrite and take deposits: Banks may not underwrite securities
unless you are dealing eligible securities: 12 USC 378(a)(1).
a. Eligible securities:
i. Can underwrite government securities: but firms have found
other ways to underwrite securities under 24(SEVENTH)
b. Other restrictions on underwriting:
i. Cannot operate an investment fund that underwrites: May not
operate an investment fund that involves the bank underwriting
securities. ICI v Camp.
c. Can deal in commercial papers:
i. May issue commercial paper in private placements: There is
only a 16 violation if there is a public offering a private placement
is not a violation. Secs Indust. Association.
ii. But NBs can:
1. Participate in the business of brokering in securities and stock: Can purchase
and sell such securities and stock w/o recourse, solely upon the order, and for the
account of, customers, and in the case for its own account.
2. May operate sub that brokers securities: Banks can own subs that engage in
the brokerage business, but NBs still cannot buy and sell securities on their own
accounts.
3. Banks ability to invest in securities does have a few exceptions:
a. Two exceptions to the prohibition of dealing securities:
i. Fed, local, and state gov/ securities: the bank may underwrite,
deal in, and invest in U.S. gov/ securities and general obligations
of state and local gov/
ii. May purchase investment securities under restrictions from
the OCC: Must have a AAA, AA, A, or B rating from at least two
rating agencies.
b. Banks have a very limited ability to invest in equity securities:
i. May hold shares in subs: But subs must engage only in activities
permissible for the parent bank or authorized by statute
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ii. May invest 10% in service corps: the can invest up to 10% of
their capital in bank service cos (12 U.S.C. 1861-7).
iii. Participate in venture capital activities: They can invest up to
5% of their capital in small business investment co’s, 15 U.S.C.
682(b), allowing banks to in essence establish venture capital co’s.
h. Derivatives:
i. Banks may engage in derivative transactions as business of banking:
1. May engage directly in hedging: They can cut out the mirror banks and go
straight into the physical market in order to hedge risk.
2. Suppose to be used ideally to reduce risk: Hedging against risk of regular
activities would be permissible under 24(SEVENTH) and not prohibited by GS16. OCC interpretive letter.
ii. If engage in shadow banking and enter into physical market could be a 10b-5 violation:
Synthetic swaps and options are securities if you enter into the physical trading market.
Cailoa.
iii. The Lincoln push out rule has to be considered:
1. Prohibits federal assistance to swap dealers and major swap participants and calls
for all swap activity to be pushed out to a non-affiliate.
a. Exception:
i. Risk mitigating hedging
ii. Derivatives that are in traditional business of banking.
III. USURY
1. Usury laws overview:
a. Usury laws restrict the taking of excessive interest on loans, i.e., set a max an institution can
charge. Business loans were not subject to these limitations/ consumer loans were.
b. Differ by state—state laws set different usury laws
2. Usury laws and NBs:
a. 12 U.S.C. 85 Permits NBs located in a particular are to charge the greater of 3 rates: these
rules are designed to give NBs an advantage
i. Same rate as most favored lender: The rate allowed by the laws of the state ot the most
favored lender where the NB is located, except that where a state sets a different rate for
state-chartered banks, this rate is allowed for NBs.
ii. 1% above the discount rate: On 90 day commercial paper in effect in at the Fed Reserve
district where the bank is located (OR)
iii. 7% interest rate: if there is no rate that is fixed by the state
b. NBs can take advantage of the highest interest rate, even if state banks cannot: NBs enjoy
most favored lender status under state law: They may take advantage of the highest rate allowed
to any lender under 85 even if state charted rates are restricted to lower rates. Tiffany.
c. Can charge rate set by state where home bank is located in business in other state: Section
85 plainly provides that a NB may charge interest on any loan at the rate allowed by the laws of
the state which the bank is located, i.e., where the certificate says your home bank is. Marquette.
i. Where bank has branches all over the place: OCC 1998: Look to the nexus of the loan
and where the loan is services and made from and this allows you to charge an interest
rate from nearly any state where you have a branch.
d. May charge late payment rate from home state: Banks can charge late payment fees from
home state. Smiley.
e. The nation wide credit markets were made by removal of state usury ceilings: So NB could
locate itself in state with favorable rates and then export those rates around the country.
3. Penalty for violating usury laws:
a. Forfeiture of interest: May lead to forfeiture of entire interest on note
b. Person may recover damages: Twice the mount of interest they paid
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IV. SAFETY AND SOUNDNESS
1. Formulas:
Leverage Limit
Total Risk-Based Capital Ratio
Tier 1 Risk Based Capital Ratio
Common Equity RBC
Formula
Tier 1/Total Assets
Total Capital (Tier 1+ Tier 2)/ Risk
Weighted Assets
Tier 1/ Risk-Weighted Assets
(Common equity + Retained Earnings)/ Risk
weighted assets
2. Leverage limit:
a. Leverage limit: FDIC requires at least 4% of capital to total assets in order to qualify as
adequately well capitalized.
b. Calculating a banks leverage ration:
i. 1. Calculate a banks tier 1 capital by adding (AND THEN):
1. Common shs equity
2. Any non-cumulative perpetual preferred shares, AND
3. Any minority shareholding in consolidated subs
ii. Divide the bank’s tier 1 capital by the bank’s total assets.
c. After making a loan:
i. After making a loan run through this against and make sure that the institution is still
adequately capitalized.
3. Calculating Risk based capital standards:
a. There are three stages in a 8 step process:
i. Calculate the banks-risk weighted assets
ii. Calculate the bank’s total capital, and then
iii. Divide the banks capital by risk-weighted assets
b. Steps:
i. Calculate the banks capital:
1. Find tier 1 capital in the problem: Consists of:
a. Common stock and retained earnings (aka shs equity)
b. Non-cumulative perpetual preferred shs
c. Minority shareholdings in consolidated subs
2. Find tier 2 capital: Consists of everything else that qualifies as capital such as
any other type of preferred sock that does not qualify as tier 1 capital, hybrid
capital instruments, term subordinated debt and general loan loss reserves and net
unrealized appreciation on equity securities.
3. Calculate the total capital=Tier 1 + tier 2 wit the following limits:
a. Only can exclude tier 2 as much as tier 1: in this calculation include tier 2
capital only to the extent that the bank has tier 1 capital, i.e., do not
include more dollars of tier 2 than the bank has tier 1.
ii. Next input in the formula:
1. Total risk based capital ratio= total capital/ risk weighted assets
V. PROMPT CORRECTIVE ACTION
1. Can take certain regulatory actions if FDIC institutions fall below certain bench marks:
a. PCA statute: System of regulatory statutes that can/must be taken into account if a bank’s
capital falls short of the bench marks. 12 U.S.C. 1831o
b. If institution gets critically undercapitalized: The idea is to close the institution b/f it fails.
2. Capitalization bench marks, if one is deficient it will trigger the prompt corrective action provisions:
Total RBCR*
Capital Category Leverage Ratio* Common equity Tier 1 RBCR
Well Capitalized
Greater than or
Greater than or
Greater than or
Greater than or
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Equal to 5%
Greater than or
Equal to 4%
Less than 4%
Less than 3%
Equal to 6.5%
Greater than or
equal to 4.5%
Less than 4.5%
Less than 3%
Equal to 8%
Greater than or
Equal to 6%
Less than 6%
Less than 4%
Equal to 10%
Greater than or
Equal to 8%
Less than 8%
Less than 6%
Adequately
Capitalized
Undercapitalized
Significantly
Undercapitalized
Critically
Less than 2 %
------Undercapitalized
3. For Dividend Dispersal Common Equity to Total RBCR must be w/ Basil III Buffer:
a. Basil III includes capital conservation buffers: A bank that fails to maintain the requisite
buffers looses the freedom to make capital distributions (dividends) and award discretionary
bonuses.
b. To make unlimited disbursements: Must keep each of its RBCR ratios above 2.5% required
level(Add % of buffer to the adequately capitalized row.
c. The limit applies if: the smallest of the banks three buffers falls below 2.5%
d. May make payment from only eligible retained income: namely net income for the preceding
four calendar quarters minus any capital distributions this period.
i. The chart determines when the buffer falls what the maximize of the retained income
may be paid out:
Smallest Buffer
Maximum Payout %
>2.5%
No Limit
>1.875 to less than or equal to 60%
2.5%
>1.25% to less than or equal to 40%
1.875%
>.625% to less than 1.25%
20%
Less than or equal to 0.625%
0%
4. Prompt corrective requirements:
a. Purpose of the prompt corrective action requirements: To correct the problems b/f they
become too large—to resolve the problems of the insured depository institutions at the least
possible long term loss to the deposit insurance fund.
b. Places requirements on regulators: Requires regulators to take timely effective action to
prevent loss to the insurance fund and hold regulators accountable for failure to do so.
c. The inspector generals request: If an insured depository institution causes a material loss to
the insurance fund, the appropriate Fed Banking agency’s inspector general must review the
agency’s supervision of the institution and make a report to the agency.
5. Prompt corrective action statute chart:
Limits on all Institutions,
1831o(d)
Limits/ Requirements for undercapitalized
Firms, 1831o(e)
Limits on Significantly
Undercapitalized Firms
Limits on Critically
Undercapitalized
Firms
Limits on Capital
Distributions and
management fees apply to all
insured depository institution
 Cannot make dividend
payments if it would
undercapitalize the
institution
 Cannot pay management
fees to any individual or
co-controlling the
institution if it would
Overview for under capitalization: If comes
undercapitalized must:
 1.Submit an acceptable capital restoration
plan
 2. Comply with limits on its asset growth
and
 3. Obtain prior regulatory approval for
acquisitions, branching, and new lines of
business, and it may face the appointment
of a conservator or receiver.
The details of each on of these is explained in
more detail below:
Presumptive safeguards:
 Requiring the
institution either to
sell enough stock or
subordinated debt to
recapitalize, or
undergo a
merger/acquisition.
 Restrict the
institutions
transactions w/
affiliated depository
Payment of Sub debt:
 60 days after
becoming
undercapitalized
the institution
generally may
make no payment
of principle or
interest on sub
debt
 sub debt holders
agreement o stand
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
become undercapitalized
Cannot deplete its
required minimum
capital to service its
owners claims.
(1)Capital Restoration Plan:
 Institution must submit an acceptable
capital restoration plan to the appropriate
agency:
o A. Must outline steps that it is
going to take to become
adequately capitalized
o B. Include a year by year time
table
 AGENCY CAN ONLY APPROVAL
PLAN IF: each co having control over the
bank guarantees that the institutions will
comply w/ the plan.
 Cannot approve plans that: that would
increase the institutions exposure to credit
interest rate or other risks.
 Only can approve plans that:
o if each co having control over the
bank guarantees that the
institution will comply with the
plan.
o If it is based on realistic
assumptions and is likely to
succeed
Absence of a plan: cannot increase its total
assets; cannot make acquisitions; open new
lines of business and faces additional sanctions.
Asset Growth Restrictions for undercapitalized
firms cannot increase average assets unless:
 It has an approved capital restoration plan
 The assets growth accords w/ the plan, and
 The institution’s capital ration increases at
a sufficient rate to enable the institution to
become adequately capitalized w/ in a
reasonable period of time.
 Effectively forces the institution to raise
new capital, i.e., sell bonds, issue shares)
Need Prior approval required for acquisitions,
branches, and new lines of business:
 Can only be approved it the institution is
implanting a capital restoration plan and
regulators determine that the proposed
action will further the achievement to of
the plan.
Conservatorship and receivership—may be
appointed if the firm:
 Has no reasonable prospect of becoming
adequately capitalized
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institutions by
denying the
institution the sister
bank exemption in
section 23A of the
Fed Reserve Act.
 Prohibiting the
institution form
paying more than
the prevailing
regional rates of
interest on deposits.
Discretionary
Safeguards:
 Further restrict the
institutions
transactions w/
affiliates
 Requiring an
institution to dismiss
a director or senior
executive officer
 Restrict an overtly
risky activity
 Hold a new election
for the BOD
 Prohibit certain
types of deposit
acceptances
 Require Fed
approval for any
capital
disbursements.
in line behind the
insurance fund in
the event of
receivership
Conservatorship/
Receivership:
 Being
undercapitalized
itself is grounds
for appointment
of conservator/
receiver
 W/ in 90 days
after the
institution
becomes critical,
the appropriate
fed agency must
either appoint or
take alternative
action that would
better serve the
purposes of 38



Fails to submit a timely and acceptable
capital restoration plan
Materially fails to implement a plan
If regulators believe that an institution is
not viable, they may act b/f an institution
becomes critically undercapitalized
VI. LOANS TO ONE BORROWER
1. Note:
a. This is necessary when doing almost any lending hypo:
i. Also look to whether
1. Its to an insider
2. Its to an affiliate
2. Calculating the lending limit:
a. Amt. of loan/ Tier 1+Tier 2(as much as Tier 1) Capital.
3. Basic rules:
a. Can lend 15% of banks capital can be loaned to a single borrower: This is regardless of
whether the loan is secured on not.
b. May lend up to 25% of the banks capital is it is secured: These additional amts. are fully
secured by readily marketable collateral having market value at least equal to the amt. of funds
outstanding.
i. Readily marketable collateral includes: “financial instruments and bullion” that are
salable under ordinary market conditions w/ reasonable promptness at a faire value
determined by quotations based upon actual market transactions on an auction or
similarly available daily bid and ask price markets.
ii. Good collateral:
1. Securities traded on a national securities exchange
2. Commercial paper
3. Negotiable certificates of deposit
4. Shares in mutual funds
iii. Excludes:
1. Mortgages
c. Bank still ahs to be adequately capitalized after making the loan
4. Determining if the loan is attributed to one person (i.e., two borrowers under 10% limit):
a. If attributed to one person: If attributed to one person the it will be treated as one person under
the borrowing limits
b. Direct benefit: When the borrower transfers loan proceeds to someone else “other than in a
bonafide arms length transaction where the proceeds are used to acquire property, goods or
services.
c. When a common enterprise exits between different borrowers of the bank:
i. If the borrowers rely on the same expected source of repayment, and neither borrower
had another source of income adequate both to repay the loan and to meet the borrowers
obligations
ii. If one borrower controls, is controlled by, or is under common control with the other and
derives at least half of its gross receipts or gross expenditures from transactions with the
other.
iii. If the borrowers are borrowing to acquire the same business, and will own more than ½
of the voting interest in the business.
iv. If the OCC determines, based on the facts and circumstances of particular transactions
that a common enterprise exists.
5. There are higher lending limits that apply to the following transactions:
a. Loans secured by live stock
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b. Guaranteed discounted installments of commercial paper
c. If it will help the borrower complete the project, i.e., will protect the banks the position.
6. Exceptions to the lending limit:
a. The lending limit does not apply to:
i. Making loans to the government
ii. Drawing on uncollected funds that are in the normal process of collection
iii. Renewing or restructuring loans
iv. Advancing additional money to pay
1. Taxes, insurance utilities, security, maintenance and operating expenses necessary
to preserve the value of real property securing a loan.
v. Financing the sale of the banks own asset
1. Including property acquired by foreclosure.
b. Syndication with other banks would allow banks to exceed the limit:
i. Loan syndication: enable a bank to meet a customers need for a loan exceeding the
bank’s lending limit, b/f binding itself to make the loan, the originating bank sells
participation in the loan to other financial institutions.
ii. Participants then share proportionally in:
1. Providing the money loaned
2. Bearing the credit risk
3. Receiving payments of principle and interest
7. Non-conforming loans:
a. A loan may become non-conforming even if it is an adequate loan if:
i. The banks capital has declined
ii. Separate borrowers have subsequently merged or formed a common enterprise
iii. The bank has merged w/ another lender
iv. Lending limit or capital rules changed, or
v. The value of the collateral has declined
b. If value of the collateral has decline the bank has 30 days to get the value back up:
i. The bank must correct the nonconformity in 30 days.
VII. INSIDER LENDING
1. People considered to be insiders are:
a. People with certain positions: E.g., executive officers, directors or principle shareholders of
any co of which the member bank is a sub, or of any other subs of that co, shall bank executive
officers, directors or principle shareholder of the member bank. 375(B)(8)-(A).
i. Executive officers: Anyone who participates or has authority in the majority of the policy
making decisions of the bank. 12 U.S.C. 375b(9)(C)
1. Excluded from this definition: Regardless of title if they do not participate in
deciding the banks major policies and must follow policy standards set by the
banks senior management.
b. Those with control: A person controls a company or a bank if that person, directly or
indirectly, or acting through or in concert with 1 or more persons—
i. Controls or has the power to vote 25% or more of any class of the Cos voting securities
1. But note: If have less than 10% you would have to show some sort of other type
of influence like contracts, executive positions, etc.
ii. Controls how directors are elected: Controls in any manner the election of a majority of
the co’s directors
iii. Can influence policies: has the power to exercise controlling influence over the cos
management or policies.
c. Principle shareholders: anyone who owns, controls, or can vote more than 10% of any class of
voting shares. 12 U.S.C. 375b(9)(F).
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d. “Any related Interest” of the executive officers, directors, or principles: A related interest of
a person is:
i. (1) Any co-controlled by that persons; and
ii. (2) Any political or campaign committee that is controlled by that person of the or the
companies or services of which will benefit that person.
e. Exceptions:
i. The executive officer or director does not have authority to participate and does not
participate in major policy making functions of the bank (AND)
ii. The assets of such sub do not exceed 10% of the consolidated assets of a co that controls
the bank and such sub (and is not controlled by another co). 375b(8)(B)
2. Covered Transaction:
a. Extending credit: Includes making or renewing any loans, granting a line of credit or entering
into any similar transaction as a result of which a person becomes obligated to pay money or its
equivalent to the bank. 12 U.S.C. 375b(9)(D).
b. Only 3 types of loans are available to executives:
i. First mortgage loans on a residence, 12 U.S.C. 375a(2)
ii. Education loans for their children, id(3)
iii. All types of other loans up to 100k in the max for any of the other kind of loans put
together. Id 375(a)(4).
iv. If an officer gest loans at another bank for these items, then the bank must lower his
loans.
3. The five basic rules on lending to insiders:
a. (1) Prohibits preferential terms: 12 U.S.C. 375b(2)
i. Must be substantially same terms as outsiders: Must be on substantially same terms,
including interest rates and collateral, as those persons who are not insiders or employees
ii. Cannot have more than normal risk: if the extension of credit does not involve more than
normal risk of repayment or presents other unfavorable terms.
iii. The underwriting process must be equally as stringent: If the bank follows credit
underwriting procedures as stringent as those applicable to comparable transactions with
persons who are not insiders
iv. BUT CAN give them benefit of preferential treatment as part of banks compensation
plan: Bank can give insiders the benefit of preferential extension of credit or
compensation that is widely available to employees of the bank.
b. (2)BOD must approve extensions of credit that exceed lesser of 500K or 5% of bank’s
capital:
i. For extensions of credit that exceed 500k or 5% of banks capital: A bank’s total
extension of credit to any one insider can exceed the lesser of 500k or 5% of the bank’s
capital only after the approval by the banks entire BOD w/ the insider abstaining. 12
USC 275b(3).
c. (3)Limits total extension of credit to anyone insider:
i. Cannot exceed lending limit to one borrower: A bank cannot make extensions of credit to
an insured exceed the limit on NBs loans to one borrower. 12 USC 84 ( no matter what
the state limit is).
d. (4) Limits aggregate extensions of credit to all insiders:
i. Capital limit on disbursement: Cannot be greater than the banks tier 1 and tier 2 capital.
12 U.S.C. 384b(5).
ii. Cannot exceed 100% of the banks capital in the aggregate: the banks aggregate extension
of credit to all insiders generally cannot exceed 100% of the bank’s capital. But if bank
has les than $100m in deposits, is adequately capitalized, and has satisfactory
examination ratings, the board may increase this limit to 200%.
12
e. (5) Restricts overdrafts by executive officers and directors: Bank cannot pay overdraft to one
executive except pursuant to a written preauthorized overdraft line of credit or transfer from
another account.
4. Supplemental Rules:
a. Loans made to company controlled by insider should be treated as loan to insider:
Extension of credit to a business or political committee controlled by the insider is considered to
be to the insider.
b. Treat insiders of a bank’s affiliates as insiders of the bank:
i. The law generally treats insiders of a bank’s non-depository affiliates as insiders, but will
not be treated as insiders if:
1. The affiliate does not control the bank and constitutes less than 10% of the HCs
consolidated assets.
2. The bank’s board formally excludes those persons from participating in major
policymaking functions of the bank.
ii. Prohibits knowing receipt of improper forms of credit
iii. Prohibits preferential lending to a correspondent bank’s insiders
iv. Further restrict extensions of credit to executive officers:
1. 375a further regulates a banks extension of credit to its executive officers,
notably by:
a. imposing more restrictive lending limits
b. Requiring the bank to reserve the right toe demand immediate repayment
of all extensions of credit to an officer if the officer total borrowing from
all banks exceeding the amount that the bank itself could lend to the
officer and
c. Requiring periodic reporting by the officer and the bank
VIII. AFFILATE TRANSACTIONS
1. Covered Relationships:
a. Definition of affiliate: An affiliate of a bank if it controls, is controlled by, or is under common
control with the bank. 12 U.S.C. 1841(k); Id. 1813(w)(6).
i. The application of this is that: Includes every other co that controls the bank(bhc) , every
other under the same holding company by that co(holding co affiliate), and every other
sub of the bank.
1. Also may extend to: Issue may masquerade as an insider transaction.
b. Affiliates of bank under 371c(b)(1):
i. Any co that controls the bank or is controlled by a company that controls the bank
ii. Any bank that is a sub of the bank
iii. Any co-controlled by or for the benefit of persons who control either the bank or a
company that controls the bank.
iv. Any company a majority of whose BOD constitutes a majority of that banks BOD
v. Any company that the bank or any affiliate of the bank contractually sponsors or advises
vi. Any investment company for which the bank acts as an investment adviser
vii. Any company that the Fed determines has a relationship with the bank that may to the
detriment of the bank affect covered transactions between the company and the bank.
2. Covered Transactions: 371c(b)(7)
a. Extensions credit to, or for the benefit of an affiliate
b. Issues guarantee, including a standby letter of credit of the benefit of an affiliate
c. Purchases of assets for an affiliate
d. Acceptances of securities or debt obligations issued by an affiliate
e. Investment in securities including repos issued by an affiliate. 375c(b)(7)
3. Main rules of 23A:
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a. Lending Limit Calculation:
i. Amt. of loan/ Tier 1+Tier 2(as much as Tier 1) Capital.
b. Main rules for transactions with affiliate:
i. 10% limit with one affiliate: A bank’s total covered transaction w/ any one affiliate
cannot exceed 10% of the bank’s total capital.
ii. Total lent to affiliates may not exceed 20%: The banks total covered transaction w/ all
affiliates combined cannot exceed 20% of the banks capital.
iii. Certain transactions require collateral: Extensions of credit, letters of credit and
guarantees must be fully secured w/ qualifying collateral
1. The collateral must be worth 100 to 130% of the amount of the covered
transaction, with the % depending on the types of collateral:
a. 100% for U.S. obligations
b. 110% for state and local obligations
c. 120% for other obligations, corp. bonds
d. 130% for leases, real property, stocks, etc.
Steps to Calculate
1. Determine lending limit for the affiliate
2. Find out which type of collateral it is
3. Divide (Amt. of Loan)/Collateral=should give you % that it is secured
4. If not enough times (collateral x %) and then subtract it from loan and
mention that that is the amount that can be secured.
5. Make sure after issuing the loan the bank is not undercapitalized
2. Unacceptable collateral:
a. Securities of an affiliate and low quality assets are not acceptable as
collateral for a bank’s extension of credit to an affiliate. 12 U.S.C.
371c(c)(3)-(4).
b. Definition of low quality assets:
i. Bank examiner says that the assets are low quality
ii. Obligor has a crappy credit
iii. Principle or interest payment on assets that are 30 days past due
iv. The terms of the loans have been renegotiated
c. Exemptions:
i. Sister bank exemptions: Frees commonly controlled FDIC-insured depository institutions
from most provisions of 23A
1. The exemption allows a bank to:
a. Permits the banks to be treated as a single economic entity
b. Commonly controlled-exempts transactions btw FDIC insured banks
under 80% common control.
c. If one sister bank fails, then the FDIC can take capital from the surviving
sister bank, even if they never availed themselves to the sister bank
exemption.
d. Exempts the % of capital limitations and collateral requirements, but does
not except the prohibition against low quality assets.
e. Regulators may deny a sister-bank exception to any significantly
undercapitalized bank
ii. Fully secured by U.S. gov/ securities: Transactions fully secured by U.S. Gov/ securities
or segregated ear marked deposit accounts
iii. Purchase of publically traded assets: that are on an exchange
iv. Certain loans: Purchasing loan w/o recourse from affiliated banks, subject tot the loans
quality asset return prohibitions.
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v. Giving credit for items collected: Giving immediate credit for items submitted for
collection in the ordinary course of business.
vi. Deposits: Making deposits in an affiliated bank in the ordinary course of correspondent
banking services.
vii. Investing in bank services corps.
d. 23 A afford special treatment to operating subs of banks:
i. Treats them as if they were formed as part of the parent bank themselves:
1. The basic rules do not apply to banks transactions w/ an op sub: But do apply
to the subs transactions with the banks other affiliates
2. Financial Subs after Dodd-Frank: after Dodd-Frank they will be treated as if
they are any other affiliates.
4. Limitations placed on transactions with affiliates under 23B:
a. Arms length dealings w/ affiliates: A bank must deal w/ an affiliate on market terms and if no
comparable transactions exist the bank must deal with an affiliate on terms and under the
circumstances that in good faith would apply to unaffiliated third parties.
i. Applies to:
1. Any covered transaction defined in 23A
2. A banks sale of securities or other assets to an affiliate including sales under a
repurchase agreement
3. A banks payment of money or furnishing services to an affiliate
4. Any transaction in which an affiliate acts as an agent or broker, or receives a fee
for its services to the bank or any other person
5. Any transaction, or series of transactions between a bank and a 3rd party if an
affiliate has a financial interest in the 3rd party, or participates in the transaction.
12 USC 371c-1(a)(2).
b. May not purchase securities form an affiliates underwriting: The bank cannot, as a principle
fiduciary, purchase securities while an affiliate is a principle underwrite for those securities
i. Exception: If a majority of banks directors approved the purchase b/f the securities were
initially offered for sale to the public. 371c-1(b)(1)(B), (2).
c. Affiliates cannot make it seem like the bank and the affiliate back each other: Neither the
bank nor its affiliates can publish any advertisement stating or suggesting that the bank shall be
in any way liable for the obligations of its affiliates. 371c-1(c).
23A
Transactions In Which Bank:
10%-20%
Collateral
Arm’s Length
Limit
Required
Dealing
Extends credit to affiliate
Yes
Yes
Yes
Makes guarantee for affiliate
Yes
Yes
Yes
Purchase assets from an affiliate
Yes
No
Yes
Takes affiliates securities as
Yes
No
Yes
collateral
Invests in affiliates securities
Yes
No
Yes
23B
Transactions In Which Bank
10%-20%
Collateral
Arm’s Length
Limit
Required
Dealing
Sells assets to affiliate
No
No
Yes
Pays Money to an affiliate
No
No
Yes
Provides services to affiliate
No
No
Yes
Bank’s transaction w/ anyone, if
10%-20%
Collateral
Arm’s Length
affiliate
limit
Required
Dealing
Acts as agent or broker
No
No
Yes
Receives Fee
No
No
Yes
Participates in transaction
No
No
Yes
15
Has Financial Interest in any party
No
No
Yes
IX. BANK HOLDING COMPANIES
1. Definition of a BHC:
a. Company having control over a bank. 12 U.S.C. 1841(a)(1):
i. Company: Any corporation, partnership, business, trust, association of similar orgs, or
any other trust, unless by its terms it must terminate w/ in 25 years of 1841(b):
1. Partnership def. from UPA: Partnership is an association or 2 or more people to
carry on as co-owners of a business for profit.
2. Captures all business entities except: individuals, qualifying family trusts,
qualified partnerships, and corps owned by the gov.
ii. Control: A company has control in 3 circumstances:
1. 25% or more of any class of bank’s voting securities: If the company owns,
controls or has power to vote 25% or more of any calls of the bank’s voting
securities:
a. Rebuttable Presumption again control if: If the company does not
exercise controlling influence over a bank or have power to vote more
than 5% of securities.
i. But if own more than 10%: Then there is an inference of control if
you meet certain requirements
2. Ability to elect majority of bank directors
3. If the Fed says that they have control: If the fed determines, after notice and
opportunity for a hearing that the company directly, or indirectly exercised a
controlling influence over the management or policies of the bank. 12 USC
1841(a)(2).
iii. Bank:
1. Competitive equality bank acts definition of a bank:
a. (1) Any FDIC insured bank
b. (2) any institution that accepts “Deposits that the depository may w/ draw
by check or similar means for payment to third parties or others and
c. (3) Engages in the business of making commercial loans.
2. Under 1841(c)(2) definition of bank excludes:
a. An FDIC insured branch of a foreign bank
b. Thrift institutions
c. An org that does business in the US only as an incident to its activities
outside of the US
d. A trust co that accepts deposits only as a fiduciary and does not offer
checking or other transition accounts, cross-markets its FDIC insured
accounts through affiliates, use Fed wire, or borrower from the discount
window
e. A credit union
f. A credit card bank
g. A limited purpose internal financial institutions of the sort known as
Agreement corps
h. One of certain industrial loan banks
i. The Industrial bank loophole: (does not create a BHC)
1. Any company can control an FDIC insured industrial bank
if the bank meets any of the following criteria:
a. It does not accept certain kinds of demand deposits
b. It has not under gone a change in control since 1987
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b. Prior approval required from the Fed to become a BHC: May not become a BHC w/o the
approval of the fed:
i. It will also need approval to acquire control of an additional bank, more than 5% of a
banks voting shares, acquire substantially of the banks assets or merge with another BHC
2. Permitted and prohibited activities:
a. Activity restrictions:
i. The BHC Act restricts the activities that a BHC can conduct directly or through non bank
subs
ii. It generally limits the co to:
1. Banking or management and controlling banks and other subs authorized under
this act or furnishing to or performing series for its subs and
2. Activities that the Fed had before enactment of BLB determined to be closely
related to 1843(a)(2)(c)(8).
iii. If participating in a prohibited activity then: A firm has 2 years after becoming a BHC to
divest itself of impermissible activities. The Fed may extend the deadline by 3 years.
1843(a)(2).
b. Powers of a BHC; 4(c)(8):
i. BHCs are authorized to own shares of a company that: 1843(c)
1. Owns and operates bank premises
2. Performs services for the BHCs banks
3. Conducts a safe deposit business
4. Temporarily owns shares acquired in satisfaction of a debt
5. Owns shares of the very limited types in which a NB can invest
6. Owns shares of any company as long as they do not include more than 5% of any
class of voting securities
7. Owns shares of an investment company, as longs as the investment company does
not own more than 5% of any companies voting shares
8. Does business in the US only as an incident of its international or foreign business
(OR)
9. Engages in export trade
ii. Activities that a BJC can invest in as a BHC: List closed due to GLB Act:
1. Making, acquiring, brokering, or servicing loans and other extensions of credit
2. Activities that relate to extending credit, i.e., any activity usually in connection w/
making, acquiring, brokering or servicing loans or other extensions of credit
3. Leasing personal or real property w/o operating or serving leased property during
the lease term
4. Operating nonbank depository institutions—industrial banking and savings
associations
5. Acting as a trust company
6. Providing financial and investment advisory activities including serving as
investment adviser to an investment co
7. Acting as a securities broker
8. Underwriting and dealing in gov/ securities and other debt obligations that a state
member bank may underwrite and deal in
9. Management consulting, employee benefits consulting and career counseling
10. Providing courier services for checks, docs and written instruments exchanged
among financial institutions and printing and selling checks and related docs.
11. Acting as an insurance agent under narrowly limited circumstances
12. Community development
13. Issuing and selling money orders, savings bonds and travelers checks
14. Processing banking, economic and financial data
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15. Administrative services for mutual funds
16. Owning share son an exchange
17. Certifying digital signatures
18. Providing employment histories for credit decisions
19. Cashing checks and transmitting money and
20. Acting as a notary public
3. Approval requirements:
a. A BHC must get approval b/f:
i. Prior Fed approval to acquire a bank and become a BHC (discussed previously)
ii. Prior Fed approval to acquire additional banks
1. Or more than 5% of the bank
iii. Restriction on nonbank activities
iv. Must give notice of activities and acquisition
v. Must make reports
vi. Must undergo examinations
vii. Must comply w/ capital requirements
viii. Are subject to enforcement actions
b. A BHC must give notice of activities and acquisitions:
i. Give Fed 60 days notice b/f: Commencing a non-banking activity or acquiring a share of
a nonbanking company:
1. If the bank does not hear back from the Fed: The bank may proceed with the
activity (note that FHCs only need 30 days notice)
ii. Must give 10 days notice b/f: Undergoing non-banking activity or 12 days notice for an
acquisition if they meet certain management and capital criteria
1. Criteria:
a. The bank is well managed and well capitalized
b. The BHC’s lead insured depository institution is well capitalized and well
managed
c. The BHC controls no insured depository institution that is
undercapitalized or has a poor examination rating for management
d. At least 80% of the risk weighted assets of the BHC’s FDIC insured banks
are in well capitalized banks and at least 90% are well-managed
e. No formal administrative enforcement actions have been commenced or
taken during the past year or is currently pending against the BHC or its
depository institution
f. The Fed has not specifically required the BHC to file a notice for the
activity or acquisition (AND)
g. Any acquisition would cost more than 15% of the BHCs consolidated their
1 capital or increased consolidated risk-weighted assets by more than
10%. 1843(j)(3)-(5).
iii. Acquisitions of non-banking depository institutions: The BHC must follow the notice
procedures governing non-bank activities w/ one exception:
1. Even if the BHC otherwise qualifies to commence activities closely related to
banking w/o prior notice, the BHC must obtain the Feds prior approval to acquire
an FDICs insured institution.
X. FINANCIAL HOLDING COMPANY
1. Overview of FHCs:
a. FHCs can:
i. Engage in (directly or through subs) in “financial” activities and activities “incidental” or
complementary to financial activities.
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b. Companies held under a FHC:
i. FHCs may own: Bank, securities broker-dealers, insurance companies, a commodities
dealer, other financial incidental or complimentary related companies, and can participate
in merchant banking.
ii. Note: Cannot operate a money market or hedge fund but there can be 3% ownership in
these funds.
2. Requirements to become a FHC:
a. There are 3 requirements to be eligible to be a FHC:
i. FHC and each one of its FDIC insured subs must be well capitalized and well managed:
Being well capitalized requires at least a satisfactory composite rating for management
1. Dodd-Frank: Requires that the entire FHC, not just the banks be well captilized
and well managed.
ii. Each of these institutions must have a satisfactory review under the CRA; 12 USC
2903(c)(2): Even if it does not meet the CRA requirement it will be ok if it has a plan to
meet the requirement that is adequate
iii. Must file a declaration with the Fed that it elects to become a FHC: 1843(1)(l),
2903(c)(1)
b. If a FHC becomes deficient in any one of these categories:
i. 180 days to correct: If the FHC does not correct w/ in 180 days then it will be required to
cease the activity that is impressible and may have to divest the sub
ii. Cannot engage in any new activity: If any of its subs has an unsatisfactory CRA ratings
3. Permissible activities, i.e., activities that are financial:
a. Permissible activities that the FHC may engage in or acquire the shares of or engage in are:
i. Financial in nature
ii. Incidental to such financial activity
iii. Complementary to a financial activity
iv. Posing no substantial risk to the safety and soundness of depository institutions or the
financial system generally. 1843(k)(1).
v. BUT KEEP EYE OUT FOR VOLKER RULE:
1. Enacted as part of Dodd-Frank prohibits FHCs and any other affiliated of a FIDC
insured bank from engaging in proprietary trading and from owning a hedge fund
or private equity firm.
b. Generally there are no pre-notice requirements for engaging in activities except when:
i. Must give notice 30 days after: Engaging in permissible activity
ii. Except when acquiring a thrift
c. Activities that are financial under 1843(k):
i. Lending $, transferring $, exchanging $, investing $ for others, transferring securities, or
safeguarding $ or securities
ii. Underwriting, brokering, selling any kind of insurance guarantee, or indemnity
iii. Providing financial, investment or economic advice, including acting as an investment
adviser to an investment company
iv. Securitizing loans or other assets that a bank could hold directly
v. Underwriting in, dealing in, or making a market in securities
vi. Engaging in activities that the Fed had b/f GLB-determined to be closely related to
banking under 5(c)(8)
vii. Merchant banking-acquiring shares in any company w/ certain requirement
viii. Investing in any company through an insurance company in the ordinary course of the
insurance companies business w. relevant state law and w/o routinely managing or
operating that entity except as necessary to obtain a reasonably return on investment.
ix. Lending, exchanging, transferring, investing for others, or safeguarding financial assets
other than money or securities
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x. Arranging, effecting or facilitating financial transactions or the account of third parties
4. Merchant Banking Provisions Expands List of Permissible Activities:
a. Allows bank to: Engage in nonfinancial affiliations
b. Merchant banking activities:
i. May engage in limited private equity like investments: Under this rubric the FHC an own
non-financial firms
ii. There are four main constraints on owning them; 1843(k)(4)(h):
1. The FHC must acquire the shares as part of a bonafide underwriting or
merchant or investing banking activity: Includes investment activities engaged
in for purpose of appreciation and ultimate resale or disposition of the investment.
2. The shares must be held by a securities affiliate, e.g., a registered broker
dealer: Cannot reside in their banking sub, but another one of the entities in the
holding company
3. Has to be held for a period of time to enable the sale or disposition on a
reasonable basis consistent w/ the financial viability of the activities involved,
i.e., to turn a profit: A FHC may actually satisfy this by holding the shares until
it is the right time to sell.
4. The FHC must not routinely manage or operate the company: Only manage
the company as necessary in order to obtain a reasonable return on their
investment
iii. While not a real constraint, these provisions attempt to limit the routine management:
1. Can only hold for 10 years if held directly or 15 years if by private equity:
Investment generally cannot exceed 10 years if held directly and 15 years if held
through private equity
2. The FHC cannot have an officer, director or employee interlocking with the
company in which it has invested unless the company:
a. Has its own officers and employees responsible for routinely managing the
company
b. The holding company does not routinely manage the company
i. Note: If these two requirements are met the holding company can
name the entire board of directors for the company
3. The FHC’s officers, directors, or employees generally cannot supervise and
officer, director, or employee of the portfolio company: In that the companies
day to day operations
a. But in can manage the day-to-day operations when: Intervention is
required to obtain a reasonable return on the FHCs investment upon resale
or other disposition of the investment to avoid loss.
4. The FHC CANNOT contractually restrict the portfolio company’s routine
business decisions: The holding company cannot contractually restrict the
portfolio company’ routine business decision but can contractually require the
holding company’s approval for actions outside the ordinary course of business
a. Non-routine activities include:
i. Issuing or redeeming securities
ii. Removing or replacing executive officers, independent
accountants, auditor, or investment bankers
iii. Amending bylaws or articles of incorporation
iv. Making significant acquisitions
v. Selling a significant acquisition
vi. Selling a significant sub or
vii. Significantly changing the company’s business plan or accounting
methods or policies.
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5. To facilitate monitoring of holding company involvement in managing the
portfolio the FHC: Must document any such involvement and reason for it.
c. Further limitations are placed on these activities by the Volker rule:
i. The Volker rule: Enacted as part of Dodd-Frank prohibits FHCs and any other affiliate of
an FDIC-insured bank from engaging in proprietary trading and from owning a hedge
fund or private equity fund
1. But there are exceptions: Banking entity may engage in risk mitigating hedging
activities and it may buy and sell instruments in connection w/ underwriting or
market making.
a. Market making: The Volker rule interferes with the banks ability to
market make b/c they must have an inventory of securities
b. To avail themselves to the Volker rule market making firms must:
i. Must have an internal compliance program
ii. The market making must be designed to not exceed the reasonably
expected near term demands of customers and counterparties
iii. Must engage in bonafide market making that is not a subterfuge
iv. Must register or be exempt from registration from the securities
laws
v. Profit must be from market making and not from appreciation as a
result of the trades
vi. Profits must reward for performing market making services and
not risk taking
vii. Market making must comply with regulation
c. Note that these regulation are all nearly impossible to comply with.
5. Extensions of these rules to the FHCs subs:
a. Operating subs, i.e., 23A:
i. May only engage in activity in which NB can directly: An operating sub can engage as
principle in activities impermissible for a sub of a national bank only if the sate bank is
adequately capitalized and the FDCI has found that the activity is not a threat to the FDIC
fund.
b. Financial Subs, i.e., 23B:
i. Engage in one or more actively that bank cannot act in directly
ii. Can engage in activity that is not insurance underwriting, issuing annuities, and merchant
banking
iii. Bank must remain well capitalized and well managed and must have a good CRA record
iv. Must deduct from its reg. cap every dollar of the banks equity invested int eh sub and stay
well capitalized after the deduction.
v. The total assets that FHC can have in its sub cannot be over 50 Billion or 45% of the
banks consolidated assets
vi. Bank cannot do any real estate development.
XI. FEDERAL REGULATOR’S ENFORCEMENT ARSENAL
1. Parties Covered by 1818u which is the key enforcement statute for FDIC depository institutions:
a. Institutions affiliated parties:
i. Management or agent of FDIC insured depository institutions: Any director, officer,
employee, or controlling shareholder of an FDIC insured depository institution, any agent
for such a bank or any person acquiring control of such a bank.
ii. People who participate in the company: Any shareholder (other than a BHC), consultant,
joint venture partner and any other person determine by the appropriate Federal Banking
agency who participate in the conduct to of the banks affairs.
21
iii. The tree As: An independent contractor (attorney, appraiser, accountant) who knowingly
or recklessly participates (mere negligence is not enough) in:
1. A violation of any law or regulation,
2. Breach of fiduciary duty, or
3. An unsafe or unsound practice
2. Conditional Approvals; 1818(b), (e), (i)(2):
a. The agency may condition approval activities on compliance w/ some restriction or
requirement: When a bank or a BHC applies to a Fed banking agency for approval to acquire a
bank, engage in a new activity or open a new branch, or the like the agency may seek to
condition the approval on the applications compliance with some restriction or requirement.
b. These conditional approvals can serve as a potent enforcement tool:
i. Banks may need formal agency approval to engage in a variety of activities: Even to take
such apparently routine steps as opening a new branch or commencing a new line of
business in which many other banks already engage.
ii. If a bank violates the condition it could lead to other disciplinary action: If the bank
subsequently violates such condition the agency can punish the violation by issuing a
cease and desist order, imposing civil money penalties and removing the persons
responsible.
3. Written Agreements, 12 U.S.C. 1818(b):
a. Regulator may enter into an agreement with a bank: The banking agency may seek to
negotiate a written agreement
b. This agreement has 2 advantages over formal enforcement mechanisms:
i. The written agreement gets the attention of top bank managers
ii. They provide independent grounds for cease-and-desist orders, civil money penalties and
removal
c. The statute provides express authority to base an enforcement action off of breach of these
agreements: Breaching one of these statues may be the basis of an agency cease-and-desist
order.
d. May be more strict than the formal enforcement sanctions: Written agreements, like
conditional approvals, may include restrictions and requirements more stringent and intrusive
than the agency could have imposed through formal enforcement proceedings.
4. Cease-and-desist orders:
a. The grounds for a cease-and-desist proceedings: The agency must show that an insured bank
or institution affiliated party:
i. Unsafe and unsound practice: Has engaged, is engaged, or is about to engage in an unsafe
or unsound practice, OR
1. Embraces: Any action, or lack of action which is contrary to generally accepted
standards of prudent operation, the possible consequences of which if continued
would be an abnormal risk or less or damage to an institution, its shareholders, or
the insurance fund.
ii. Violation of law Has violated or is about to violate of a statute, or regulation
iii. Agreement with agency: A condition imposed in writing by the agency or a written
agreement with the agency.
b. Notice on temporary cease-and-desist orders:
i. The agency has the option of issuing a temporary cease-and-desist order: In order to do
this it must satisfy two requirements:
1. Notice: It must have served notice of charges seeking a regular cease-and-desist
order
a. Does not require a hearing: The agency may then issue a temporary ceaseand desist order ex parte of a hearing
22
2. Misconduct must be determined to have the potential to harm the institution:
The agency must determine that the misconduct specified in that notice is likely to
render the bank insolvent, significantly dissipate its assets or earning weaken its
condition, or otherwise prejudice the internet of its depositors. 12 U.S.C. 1818(c).
5. Suspension, Removal, and Prohibition:
a. Gives the Fed Regulatory Agency Broad Sway over the banks by giving them powers to:
i. Can withhold charter or deposit insurance: If they do not want someone to be involved in
the bank
ii. Can prevent someone from being a executive: The agency can prevent an existing bank
form making someone a director or executive.
iii. They can also remove the person from office: They can remove someone form officer
and prohibit them for life form participating in a federally insured depository institution
b. Removal v. Prohibition:
i. The agency removes a respondent from office: But prohibits them form participating in
the affairs of a depository institution.
ii. Prohibition may encompass a wide variety of people: Not only officers and directors but
anyone who participates in conducting the banks affiliates and may even extend to
independent contractors who fall with in the definition of institution affiliated party.
c. PREREQUISTIES FOR REMOVAL
i. The pre-requisites for removal: To remove an institution an institution-affiliated party,
the agency must establish three substantive parts (misconduct, effect, and culpability):
1. Must demonstrate that 1 to 3 types of misconduct is present:
a. Violation of law or agreement: Violating a statue, regulation, final ceaseand-desist order, condition imposed in writing, or written agreement;
b. Engaging in unsafe or unsound practice: Engaging or participating in an
unsafe or unsound practice, OR
c. Breach of fiduciary duty
2. Effect that resulted in:
a. Loss or damage to the bank: Actual or probable loss or other damage to
the bank
b. Prejudice to the bank’s depositors: Actual or probable prejudice to the
interest of the bank’s depositors
c. Benefit to the respondent: Financial or other benefit to the respondent
3. Culpability (beyond mere negligence):
a. Involved personal dishonesty
b. Demonstrated willful or continuing disregard for the bank’s safety and
soundness. 12 USC 1818(e)(1).
d. There are other provisions that allow to suspend a person:
i. Authorizes the agencies to suspend persons charged w/ federal felonies involving
dishonesty or breach of trust if the individual continued service or participation may pose
a threat to the interest of the depository institutions. 12 U.S.C. 1818(g).
e. Industry wide bar:
i. The effect of an industry wide bar: Respondent cannot hold any office in any FDICinsured bank, any federally insured credit union, certain other federally regulated
financial institutions, or nay depository institution regulatory agency.
ii. The Fed Agency has to show that the D acted w/ Scienter: The level of culpability has
to be beyond negligence, it has to be proven that the defendant acted with knowing or a
reckless disregard.
6. Civil Money Penalties:
a. There are three types of civil money penalties and most of them are per se
23
i. Unlike criminal fines, civil penalties can be imposed administratively, w/o most of the
procedural protections in criminal cases and unlike compensatory damages they are not
limited to the amount of actual harm.
b. There are 3 tiers of fines under 12 U.S.C. 18(j)(2):
Tier 1
Tier 2
Tier 3
Minor violations;
1 of 3 types of
The respondent
Types of Conduct
namely any violation misconduct:
knowingly
of a statute or
1. Committing a
committed 1 of the 3
regulating, ceaseviolation of the
types of misconduct:
and-desist order,
type that would
1. A violation of the
suspension, removal,
support tier 1
type that would
or prohibition order,
penalties
support tier 1
prompt corrective
2. Recklessly
penalties
action order,
engaging in an
2. An unsafe or
condition imposed in
unsafe or
unsound practice
writing, or written
unsound practice, 3. A breach of
agreement.
or
fiduciary duty
3. Breaching a
fiduciary duty
5k per day
25k per day
1 Million per day
$ Amt in fines
Damages
Do not need to show N/A
Knowingly or
Intent
intent
recklessly
Do not need to show Must involve a
The respondent
Effect
effect
certain pattern or
knowingly or
effect
recklessly caused one
or two substantial
effects:
1. A substantial loss
to the bank
2. A substantial
pecuniary gain or
other benefit to
the respondent.
7. The FDIC’s back-up enforcement Authority:
a. If the primary regulator does not take action for an insured bank the FDIC can: It may
suspend insurance and can also take enforcement action on its own.
b. Exercising back up authority is a two-step process:
i. The FDIC must recommend in writing that the other agency take specific enforcement
action: Give 60 days for the agency to act or provide a plan of action. Period can be
shortened if needed
ii. If the problems remain unresolved, the FDIC’s BOD must determine that:
1. The bank is unsafe and unsound
2. The bank or institution-affiliated party is engaging I unsafe/unsound practices
3. The conduct in Q poses a risk to the deposit insurance fund or may prejudice the
interest of the bank’s depositors
a. The FDIC may itself then take the recommended enforcement action. 12
U.S.C. 1818(t).
8. Terminating or suspending deposit insurance:
a. May terminate deposit insurance on 3 different grounds:
24
i. (1) If the bank is in an unsafe and unsound condition to continue operations
ii. (2) If the bank or its directors have engaged or are engaging in unsafe/unsound practices
in conducting the bank’s business
iii. (3) If the bank or its directors have violated any statute, regulation, order condition
imposed in writing by the FDIC, or written agreement with the FDIC
b. The FDIC will also put in place safety measures in place for 6 months after suspension to
prevent runs: To reduce the likelihood of a rune, existing deposits retain insurance for at least 6
months after the order takes effect. But insurance does not apply to new deposits.
c. Suspension: Of deposit insurance is an interim remedy, once the suspension takes effect,
insurance applies to existing deposits, but no longer to any new deposits.
XII. BANK FAILURES
2. Receivership vs. Conservatorship:
a. Receivership:
i. Receiver liquidates the bank and sells its assets: The old corporation ceases to exist
ii. Can maintain deposits: A different corporation may take the banks business at the same
location, and have many of the same assets and liabilities
b. Conservatorship:
i. Take control of the troubled institution: conservator operate a bank as a going concern and
unlike receiver, lack the authority to liquidate the bank.
ii. In a conservator process they try to rehabilitate the troubled bank: Regulators can use
conservatorships to wrest control of a bank from management or seek to rehabilitee that
troubled bank
iii. OLA is a process of conservatorship: Where the FDIC creates a bridge financial company
in which a too big to fail institution can be taken care of four 5-8 years only
a. Problem is that liquidation is not really an option in these types of situations.
3. Grounds for Receivership:
a. FDIC serves as a receiver for all failed NBs and failed thrifts: In practice the FDIC serves as
a receiver to all failed FDIC insured state banks and thrift institutions.
b. Grounds for receivership; 12 U.S.C. 1821(c)(5):
i. Bank has obligations that are greater than their assets
ii. Bank cannot/ probably cannot meet its obligations in the normal course of business
iii. Bank is unsafe and unsound condition to transact businesses
iv. Bank incurs/likely to incur loses depleting its capital and no reasonable prospect of
becoming adequately capitalized
v. Bank is critically under capitalized or has substantially insufficient capital (PCA issues)
vi. Bank is undercapitalized and (a) has no reasonable prospect of becoming adequately
capitalized, (b) fails to recapitalize when ordered to do so under the prompt corrective
action statute, 12 USC 1931o(f)(2)(A),(c) fails to submit a timely and acceptable capital
restoration plan, (d) materially fails to implement such a plan.
vii. Bank substantially dissipates assets or earning through a violation of a statute or regulation
or thorough an unsafe/unsound practice
viii. The bank conceals records or assets or refuses to let authorized examiners inspect records
ix. The bank willfully violates a cease-and-desist order
x. The bank commits any violation of a law or regulation, or unsafe unsound practice or
condition that is likely to cause insolvency or substantial dissipation of assets or earnings,
weaken the bank’s condition or otherwise seriously prejudice the interest of the deposit
insurance fund
xi. The bank is convicted of money laundering
xii. The bank looses its FDIC insurance—this is virtually a death sentence
xiii. The bank consents to receivership/conservatorship
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4. Marshaling assets:
a. A receiver may Marshall a bank’s assets: by identifying all of the items of potential value of
the bank and turning them into cash
b. The four main powers of a receiver:
i. Avoiding Fraudulent transfers: Debtor and creditor law has long prohibited a debtor from
transferring property to hinder, delay or defraud a creditor. 12 U.S.C. 1821(d)(17)(A).
By providing these transactions fraudulent, the receiver may obtain a judgment
invalidating them. 1821(d)(17)(A)-(B).
ii. Pursuing claims against failed bank directors and officers: claims include:
1. Breach of fiduciary duty
2. Intentional wrong-doing or
3. Other actionable misconduct
4. When receiver identifies a credible claim it will consider whether the bank or
insiders has insurance to pay the claim
iii. Terminating K’s and leases
5. TERMINATING FAILED BANK’S K’S AND LEASES
Type of
Consequences if Receiver Terminates Agreement
Agreement
Agreement
Receiver is liable only for an “actual direct compensatory damages” determined as of date bank
not w/ in any entered into receivership. Receiver is not liable for punitive damages or damages for lost
category
profits, opportunities, or pain and suffering.
Lease under
Lessor can recover only rent accrued b/f termination. Lessor has no claim for damages under
which bank
any acceleration clause or penalty provision.
is the lessee
Lease under
Lessee, if not in default when receiver terminates lease, may either treat lease as terminated or
which bank
remain in possession of property for remainder of lease term. If lessee remains in possession,
is the lessor
lessee must continue to pay rent, and if receiver fails to perform bank’s duties under lease,
lessee may deduct any resulting damages from rent due to receiver.
K for sale of If purchase has possession of property and is not in default when receiver terminates K,
real property purchaser may either treated K as terminate or remain in possession of property. The following
rules apply if purchaser elects to remain in possession: Purchaser must continue to make
payments; if receiver fails to perform bank’s duties under K, purchaser may offset resulting
damages against payments due to receiver; receiver shall deliver title as provided in K and
reliever has no other duty or liability.
Service K
If receiver accepts services under K b/f terminating K, receiver shall pay under K for those
services and treat payment as administrative expense. Receiver can terminate K even if receiver
has accepted services under K
QFC
Receiver must terminate either all or non of a party’s qualified financial Ks w/ the bank. If
receiver terminates QFC, other party may recover reasonable cost of cover
XIII. PAYING VALID CLAIMS IN ORDER OF PRIORITY:
1. Creditors must petition the receiver in order to get claims
a. The receiver determines which claims are valid: All creditors must provide proof of claims
and then the receiver decides which claims are valid, creditors who are dissatisfied may seek
payment of the claims in court
b. Claims priority: Pays secured claims first, i.e., those backed by collateral and then pays the
unsecured claims
2. Calculating how to pay secured claims:
a. If collateral worth less then claim, the secured claim is only paid up to the collateral: The
remainder constitutes an unsecured claim, 12 U.S.C. 1821(d)(5)(D)(ii), if a creditor has not
protected its security interest the receiver treats the claim as unsecured.
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3. Unsecured Claims
a. Paid in the following order:
i. The cost of the receivership (administrative expenses)
ii. Deposits—insured and uninsured
iii. General liabilities, i.e., bonds and most unpaid bills and wages incurred b/f
receivership—a residual category for liabilities that do not fit into any other category
iv. Subordinated debt
v. Cross-guarantee liability to the FDIC
vi. The ownership interest of the bank’s shareholder equity
b. Pay claims in the category completely b/f moving onto the next: However, the FDIC as
receiver has leeway to deviate from these priorities as long as each claimant receives no less than
it would have received in a straight liquidation. 1821(i).
4. Determining the validity of claims:
a. Applying the same rules as if there were no receivership when determining value of claims:
But four special rules apply to receivership:
i. The claim must arise form a legal obligation that existed b/f the receivership and its value
must be certain or promptly ascertainable.
ii. If no assets remain to pay a claim, nether the receiver nor a court need determine the
validity of the claim.
iii. The receiver can make payments (dividends) on properly provide claims at any time—
thus the claimant would go unpaid b/c it had no provide its claim b/f the dividend. 12
U.S.C. 1221(d)(10)(B).
iv. The so-called ide agreement rule can invalidate a claim that depends on an agreement w/
the failed bank, if the agreement is adverse to the FDICs interests as receiver or insurer
and the banks records do not adequately evidence the agreement.
b. Set offs:
i. Courts have long allowed a failed bank’s to setoff: Deduct what the banks owes them to
what they owe to the bank.
c. Subrogation: When the FDIC as insurer pays a failed bank’s insured deposits it becomes
subrogated to their claims against the bank, 12 USC 1821(g).
i. The FDIC in effect steps in those depositors’ shoes, becoming entitled to receive
whatever share of the bank’s assets would otherwise have gone to those depositors.
5. Structuring the resolution:
a. How receivership and deposit insurance intertwines:
i. The FDIC as receiver has a lot of different options: It can try to find a white knight or it
could sell off the assets in a piecemeal fashion.
b. Pays depositors off immediately:
i. May pay depositors off immediately w/o paying off banks assets: It can retain or credibly
guarantee doubtful assets and it does not have to dump them when it is not a good time to
make a profit off of them.
ii. After immediately paying off depositors: After immediately paying off depositors claims
it replenishes the insurance fund ocean the receiver pays off these claims.
c. There are four options that the FDIC uses to resolve a failed FDIC institutions:
i. In a deposit payoff (straight liquidation) the FDIC liquidates the bank’s assets and pays
the bank’s liabilities
ii. In an insured deposit transfer the FDIC pays a healthy bank to assume the failed bank’s
insured deposits
iii. In a purchase and assumption the FDIC arranges for an acquirer to purchase some or all
of the failed bank’s assets or all of the bank’s liabilities.
27
iv. If the FDIC plans to sell the failed bank as a going concern but odes not find and acquirer
it can form a bridge financial bank, transfer assets to the bank and have the bridge bank
carry on the failed Bank’s business until the FDIC lines up an acquirer.
6. Least-cost resolution requirement:
a. Least-Cost Resolution Requirement:
i. General rule: In dealing w/ a particular bank the FDIC must adopt the resolution method
that is “least costly to the insurance fund” 12 U.S.C. 1823(c)(4).
1. How to identify this: To identify the least cost approach the FDIC must
“evaluate alternatives on a present value basis, using a realistic discount rate and a
document that evaluation and the assumption on which the evaluation are based
b. Systematic risk exception: A narrow systematic exception exists for cases in which least-cost
resolution of a particular bank “would have serious adverse effects on economic conditions or
financial stability.” 12 U.S.C. 1823(c)(4)(G).
i. Defining systematic risk: Refers to a possibility of a sudden, usually unexpected event the
disrupts the financial markets, and thus the efficient channeling of resources quickly
enough on a large enough scale to cause a significant loss to the real economy.
28
POLICY ATTACK OUTLINE
1. Systemic Risk:
a. Bailouts:
i. 1984 FDIC bailed out all creditors of Continental Illinois
1. Allowing the bank to fail and its uninsured depositors to suffer loss would cause
incalculable damage to the U.S. financial system
a. This bail out established the notion that some banks are too big to fail(TBTF).
i. This is largely defined by the financial systems exposure to each other
2. Problems with TBTF logic:
a. It can create a moral hazard b/c it promptes complacency and increases the
potential for a big firms failure to cause panic among invesotrs
2. The Market and Financial Disasters:
a. Alan Greenspan(Pre-financial collapse):
i. Believes in the virtues of the free market
1. Greenspan believes in the benefits of free market capitalism and criticizes the
regulation of the 70s which created inflation.
2. Believes that flexibility in the economy has made it more resilient to shocks and more
stable that it has been in the decades
3. Thinks that the regulators are poor controllers of the economy and the firms/business
are a much stronger alternative
4. Not concerned with the changing function of banks and that derivatives and complex
financial products are unregulated and are changing the function of banks and does
not recognize that the industry is highly regulated and bolstered up by bailouts.
ii. Pre-write:
1. Alan Greenspan in a speech b/f the financial crisis highlighted a reliance on the free
market and his ideology while at the Fed that the industry was the best mitigator of
risk. In many ways Greenspan’s speech demonstrates a dogmatic outlook of the
economy which may have lead to the financial crisis. Greenspan believed that the
banking industry was the best mitigator of risk, and that by their use of complex
financial products they could resist down swings in the economy.
2. In reflection, his view is quite absurd. He ignores the fact that these industries are
profit driven entities that pose a systematic risk to the U.S. economy and will not act
in the best interest of the economy as a whole, but only look at short term profits even
if it increases the risk of a failure.
b. Posner—Excerpt—A Failure of Capitalism:
i. Posner’s argument is contrary to Greenspan’s. Posner argues that the financial crisis was the
result of too little regulation and the government should have been more aggressive at
curving the risky lending practices of banks that resulted in the housing market bubble and
ultimately the financial crisis.
ii. He criticizes the regulatory agencies for not being able to gather intelligence that could have
allowed them to predict the crisis and their failure to have any sort of intelligence about the
financial system.
iii. Posner also criticizes laissez faire capitalism saying that the polices of that put reliance in
industry and the free market allowed for the recession and for the damages that it put onto the
economy.
iv. Posner also sees danger in the governments response, that the massive bailouts running up
the deficient will lead to inflation and that banking should not be a free market industry but
should be highly regulated.
3. The Financial Crisis of 2008:
a. Timeline of financial crisis:
29
i. 2008 housing crisis that began in 2008
1. This was after a fundamental run up in housing prices in the Us which was a bubble
a. One of the reasons that this was caused was b/c of the loose monetary poice
during this period and low interest rates to a near historic lows, making credit
both cheap and readily avaliable for households and business alike.
b. Banks began to ignore underwriting standards for lending
c. The originators took the originate and distribute model where they would
originate it and then sell it quickly
d. A lot of these loans were of poor quality and poor credit so defaults began to
sky rocket, especially w/ the subprime mortgages
e. The process of securitization fed off and fed into the housing bubble.
f. The mortgages were put into ppols were they were securitized into asset back
securities and then they were formed with exotic products likes CDOS and
SPVs and CDS, so they could get a triple AAA rating.
g. They were thought of having been a safe investment but since their value
depended on the housing market, when the housing market went so did the
mrotages
h. When the forclsoure crisis hit it began to erode the value of these products that
were on the books of almost every bank in the world
i. Banks in Europe began to carsh firth and the govenrments had to take
steps to stem a run
i. Soon after the American banking sytem started to implde were the big firms
Lehman Borthers and Bear Sterns begin to collapse and
i. Feddie Mae and Freddi Mac also began distressed and had to be bailed
out
j. In the midst of the bail out Aigb egan to fail b/c it had backed all of the bonds
with CDS and could not raise the funds to pay them off
k. The government had to resuce it
ii. The fed response
1. The fed had to take extraordinary steps and they had to come in and bail out the bnaks
and the nonbank situtions
2. They had to nearly nationalize all of the big banks
3. The
b. Kenneth Scott: Summarizes the financial crisis
i. There was not a singular cause of the financial crisis. In many ways, it was the perfect storm.
It started with poorly chosen mortgages and reckless lending. Then there were the issue of
poorly crafted financial products RMBs which were comprised of these poorly chosen
mortgages. Then in addition there was the derivatives, which insured these mortgages and
gave them a boost in their credit ratings. Then there were the banks that invested in the
RMBs who thought that they we were a secure financial product. When in reality the
derivatives and the RMBs helped create an interlink age between the major financial
intuitions, which led to a cascade. Where one bank failed, the next bank would fail or if there
was a wide spread failure in the RMBs then the derivative contracts would bankrupt the
insurers. Essentially, there was the perfect storm, unregulated products that were on the
balance sheet of every major bank, and linked to almost every major financial instituions.
When the underlying products began to fail the entire system came crashing down.
ii. The government played a large role in the subprime mortgage crisis and the major banks
were also complicit. The Fed, under the supervision of Alan Greenspan made the decision to
stimulate the housing market. It did this in 2001 by cutting interest rates on loans. This
allowed people to afford loans easily and get mortgages for houses that they would never be
able to pay off. Also many of these mortgages were made to low income individuals who
30
were never able to pay off the loans. This financial industry was complicit in this and lent to
people w/o properly vetting them.
iii. The GSE’s Fannie, Freddie, etc guaranteed these loans and helped make securitizing the
mortgages attractive. Backing the loan, the government made the securities seem like a safe
investment.
iv. The fiancnail industry and the banks began to develop asset backed securities pools with the
residential mortgages referred to as RMBs and they were divided into tranches that had
different levels of seniority. In essence, the seniority was allowed for each level to provide a
better credit rating and to be a more attractive investiment. With the lower wouns being
subprime. The lower pools were hard to seel, so they were put into new pools to create
CMOs. Then the processes was repeated and the farther you went along the less of a
connection there was with the original loan.
v. In addition, these products were assured by large insurance agencies like AIG through the
use of CDSs.
vi. Financial collapse became result largely of the lower loans going underwater and the
foreclosure crisis. When the lower tranches started to go the tranches with the better credit
ratings became more risky. The banks also began to not to be able to identify which loans
were still good and which ones were bad. In essence, the RMBs and CMOs had become toxic
and they became worthless. When these products began to fail this caused the insurance
policies to be triggered, and AIG had over insured and could not pay out on its investments.
This led to a chain of failures through out the financial system and led to the global financial
collapse.
c. Regulatory Failures:
i. Gaps in the US regulatory structure were at least partly responsible for the crisis but
specifically the fragmented structure of regulation, with specialized regulatory agencies
operating across articifically segregated lines of servies sucha s banking isnruance, securities
and futures.
d. There are multiple lessons that were learnt from the financial crisis.
i. The danger of defects in financial products:
1. The CDSs were not necessarily the problem with the financial products. While the
CDS and derivatives are risky investment the problem during the financial crisis was
the bundling of subprime loans into RMBSs which magnified the impact of the crisis
by making large defective products.
ii. Firm Risk Management:
1. The originators of the mortgages retained very little risks on the loans that they made,
they just received fees or the origination of the loans and immediately sold them. In
addition, the GSE’s failed to effectively monitor the underwriting of the loans that
they backed. Furthermore, deposit insurance provided a government safety net for
banks that made debt cheaper and gave and allowed for banks to leverage and led
bank management to take excessive risk, regardless of its compensation structure.
iii. Government Regulation:
1. There was ample authority for US regs to have addressed these issues, provided they
had perceived the need and acted on it
e. Shelia Blair Speech—FDIC on the causes of the current state of the Financial Crisis 2010:
i. It was estimated that half of all financial services were conducted in institutions that were not
subject to regulation and supervision. The crisis demonstrate that many of the financial
institutions that were not subject to prudential regulations had grown to large and complex to
resolve under the existing bankruptcy law and currently they cannot be wound down under
the FDIC’s receivership authorities.
31
ii. There was a failure of market discipline and regulation. This was demonstrated by the
shadow banking system that were incorporating products and services into their own more
lightly regulated affiliates and subs.
iii. In the years leading up to the financial crisis there was a failure of market discipline. The
consumers and business had access to easy credit and there was a lack of sound underwriting
by the institutions who were issuing credit.
iv. The banks and thrifts in the 1980s-90s began securitizing a major share of their mortgage
loans with the GSEs and started to focus on originating rather then holding onto the
mortgages.
1. This allowed uniformed consumers to be subject to predatory terms that were not
readily transparent to many borrowers.
f. Reforms after the Financial Crisis:
i. Housing and Economic Recovery Act of 2008:
ii. TARP Program—to initiate some of the bail outs
iii. American Recovery and Reinvestment Act of 2009—Which was a economic stimulus
package
iv. Dodd-Frank Wall Street Reform Act of 2010—
1. Created the FSOC in order to regulate non-bank SIFIs by allowing them to come
under prudential rules
2. Created stress testing of organizations
3. Get rid of the office of thrift supervision
4. Creation of the CFPB which consolidated the consumer protection laws
5. Creation of the a swap clearance process w/ in the CFTC
a. Title VI
b. Title IX
6. Orderly Liquidation process to try to save the good aspects of a FHCs, but this model
is flawed b/c it essentially creates a bail out process
4. Problems/Policies with FDIC insurance:
a. Congress created the FDIC in order to:
i. Congress’s purpose in creating the FDIC: Banking Act of 1933
1. Faced w/ virtual panic after the great depression Congress wanted to find a way to
protect people’s earnings against bank failures, which could deplete their savings.
Congress wanted to make sure that the sums of money deposited in the banks were
not tied up and also wanted to make sure that people’s assets were protected from
bank faulres
b. They are intended to:
i. B/F FDICIA system of Fed deposit insurance and depository institutions regulation
encourage the banks and managers to act in ways that could harm the FDIC insurance fund.
But the prompt corrective provisions, risk based deposit insurance premiums, and least-cost
resolution attempt to try to limit the moral hazard issues with deposit insurance.
1. How this changes the behavior of owners and managers: Deposit insurance has
changed the behavior of bank managers and owners in two distinct ways. First, banks
do not have to make a choice between being risk adverse and attracting depositors.
Depositors, due to insurance, will have their funds secure at banks that take risks and
ones which are conservative. Second, contingent on their capitalization requirement,
banks that take risks and those that do not will pay the same deposit premiums. So,
this encourages institutions to take greater risks than they would otherwise, or
effectively they are subsidizing other institutions risk taking.
2. Regulators: Regulators also face perverse incentives due to deposit insurance, which
are forbearance, i.e., failing to take appropriate action to reduce the risk of a
unhealthy institution poses the deposit insurance fund; and over extending the federal
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safety net –needlessly shielding an insured depository institution from market
discipline.
c. FDICA is intended to better align the owners and managers and regulators with that of the deposit
insurance found. By forcing prompt corrective action from the bank owners and managers or face
remove and by mandating regulator action in order to prevent forbearance. However, the
overextension of the federal safety net, as seen during the 2008 financial crisis, has not been
something that the FDICIA has seemed to have curtailed
i. FDICIA:
1. Includes a series of provisions intended to improve supervision of insured depository
institutions, with a signifcant emphasis on capital supervision as a primary tool.
5. The purpose of deposit insurance:
a. Shifts risks of runs form the private sector to the Government by reducing the borrowers costs and
enabling banks to operate w/ higher leverage than they otherwise would, DI may give banks an
advantage over competitors that fund themselves on market terms. By conferring on banks a benefit
unavailable to ordinary business firms, deposit insurance offers a possible rationale for subjecting
banks to duties not imposed by other firms.
b. The effect of deposit insurance is that it has reduced deposit insurance bank capitalization rates were
much higher, the banks had to hold more capital to protect itself form large unforeseen customer
with draws.
c. The main idea of deposit insurance was to prevent runs when the public believed that the bank was
at risk.
6. Justification for deposit insurance: Milton Friedman
a. FDIC was created b/c in the Great Depression the Fed was unable to prevent bank failures. This was
not the only problem with FDIC insured institutions. In the 1970s problems developed with the
deposit insurance fund due to inflation which destroyed the net worth of some financial enterprises.
b. According to Friedman in order for deposit insurance to work, there has to be some private personal
incentive for safe banking.
7. Reforms to FDIC insurance: Blinder and Westcott, Reform of DI:
a. Blinder and Westcott put fourth seven principles that should guide reform to the deposit insurance
fund
i. DI should enhance macroeconomic stability and financial stability
ii. DI should prevent most bank runs—first, by guaranteeing depositors that they will not suffer
losses if the bank fails, DI also reduces incentive for a rational DI to run his or her bank.
Second, the existence of Deposit insurance should reduce the risk of contaigen
iii. Di should be designed to minimize moral hazard problem of excessive risk taking
iv. Public funded DI should neither subsidize nor tax the banking system. It should be void as a
cost of doing business.
v. Deposit insurance should minimize the risk to the tax payer
vi. Di should relive small depositors of burden of monitoring their banks
vii. If the deposit system is not broken there is no need to fix it.
b. Reforming FDI:
i. Analogy to private insurance:
1. The problem with FDIC insurance is the same as other insurance, it presents a moral
hard problem.
a. Banks may exploit DI insurance by taking greater risks then they would
otherwise
2. Deposit insurance does not have the risk reducing mechanisms of private insurance. It
has no deductible or other coinsurance and insurance depositors have little incentive
to monitor their bank’s financial health. However, the safeguards in place, such as
capital standards, prompt corrective actions, self dealing restrictions, examination,
supervision and enforcement do help restrain risk taking.
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c. Narrow Banks may help reduce the risk to the deposit insurance fund:
i. A narrow bank is:
1. Permits FDIC insured banks to only invest in short-time, high quality, readily
marketable assets
2. Would hold deposits and provide payment services
3. Other banking activities must take place in an uninsured affiliates.
8. Separating finance and commerce:
a. Policy for and against non-financial affiliations:
i. Against non-financial affiliations:
1. The separation of banking from commerce helps ensure that banks allocate credit
impartially and without conflict of interest
2. If allowed, if a nonbank bank’s apparent or affiliates encounter financial difficulties,
the public will tend to perceive the bank as suffering from the same difficulties which
could lead to a run on the bank.
3. The nonbank loophole threatens the nation’s payment system by giving large
diversified firms access to that system.
a. A bank cannot resist the parents orders to make payments that would create
overdrafts on the bank.
ii. Non financial affiliations:
1. The US has never had a complete separation of banking and commerce
2. The arguments are too attenuated when they implicitly deny the feasibility of
maintaining corp. separateness between banks and their affiliates
3. Experience does not suggest that non financial affiliations as particularly prone to
conflicts of interest competitive inequalities
4. Any concerns about access to payment system can and should be resolved by
properly pricing and controlling the use of the system rather than arbitrarily limiting
the affiliations permissible for bans.
b. Statements by Corrigan 91’ President of Fed Reserve Bank of NY:
i. The main issue presented:
1. The core issue is whether a business entity (non-financial) should be permitted to own
and control financial institutions, that have direct or indirect access to the federal
safety net associated w/ banking institutions.
a. It follows that there must be clear conception of:
i. Control—presumed to existed when ownership is >24.9% and may
exist when there is far lest Does not exist however when there is less
than 5%.
ii. Access to safety net:
1. Financial firm as access when it directly or indirectly has
deposit insurance, has access to the discount window of the
central bank has access to the account and pay to official
supervision.
ii. Opposed to the combinations of commercial banking orgs b/c:
1. Firewalls are ineffective:
a. When they are needed most firewalls fail to work
2. Safety nets get over extended:
a. It is inevitable that at least parts of the safety net will not be extended to
commercial owners
3. Risk of concentration of power
4. The potential benefits that might grow out of banking-commercial combinations are
remote at best and illusory at worse under present circumstances.
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iii. History of banking and commerce in the US—shows that there has been a public policy
against such corps. Arguments for combining banking and commerce.
1. In the face of the concerns about conflicts of interest, unfair competition, and
concentration and the extension of the safety net, the argument is made that allowing
such combinations will provide important public benefits that—given appropriate
safeguards and fire walls more than compensate for the risks.
iv. The risks associated with combining banking and commerce:
1. COI unfair competition and concentration
2. Contagion risk—it is inconceivable that any major bank would walk away from any
subs of its holding co. If your name is on the door all of your capital funds are going
to behind it in the real world. Lawyers can say you have separation but the market
forces are persuasive and it would not see it nay that way.
3. The risks surrounding the potential extension of the safety net to the firms that control
the banking orgs.
v. Favors combining banking and securities firms b/c:
1. Unlike banking and commerce, combinations of banking and securities firms are the
rule not the exception through the industrial view.
2. Combinations of banking and securities cos strike Corrigan as while in keeping w/ the
sprit of congeneric financial corps
3. BHCs are and should be subject to official supervision at the level of the holding co.
4. While there is something to be said for the so-called limited universal bank model,
Corrigan believes that securities activities of banking firms houdl be organized
similarly.
9. Safety and Soundness:
a. History of Basil:
i. Precursors
1. Basil originated in an effort to correct for some of the leverage limit’s blind spots,
notably failures to account for credit risk and off-balance sheet items.
2. In the 1980, US bank regulators seeking to reverse decades of decline in bank captail
levels—tightened enforcing of the leverage limit
3. Many banks responded by exposing themselves to greater credit risk and took more
off-balance sheet liabilities such as contingent liabilities
ii. The regulators response:
1. The Federal Banking agencies began to develop risk-based capital standards to help
control the differing risks of the assets and take into account some of the different
risks.
2. The banking institutions complained that the agreement would place American banks
at a competitive disadvantage , and that there should be some approach that places
banks on a equal footing with foreign banks.
3. The Basil committee was designed to establish a frame work where the regulators
from the leading industrialized could work together to establish risk based standards
frame work
iii. Pre Basil:
1. They were subject to two main kind of restrictions
a. Activitiy
b. Examination—seeing if the underwriting of loans were being reasonable
being well down.
b. Basil I
i. In 1988:
1. 12 leading industrialized countries met and they were to adopt risk based standards.
a. Established the proposition that there are ought to be internatlion standards
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2. The US would only apply them to FDIC insured banks
3. From the very outset these international outcomes have always had an interest in:
a. The safety and soundness of the financial system,
b. Relative economic position
i. How our banks are compared to foreign banks
4. Most important:
a. Risk weighted capital requirements are going to be essential to banking
regulation
i. This is more important than all other types of regulation like
controlling activity b/c it is hard to circumvent.
ii. Avalaible to buffer losses no longer WHERE they come from
iii. If well captilizaes the equity is still there to absorb the loss regardless
of the actvity
ii. The standards:
1. Risk based capital standards achieved acceptance.
a. But they had major limitations:
i. Took account of only credit risk and this measurement was crude
ii. Banks were able to game the system and did
iii. The agreement gave the banks very little credit for taking risk
mitigating techniques such as hedging or obtaining collateral
guarantees
iv. The banks risk management techniques were becoming much more
sophisticated and the banks were not doing anything to mitigate the
risk.
b. Fell short:
i. In some sense it was a static template or structure, it made the buckets
and put things in the bucket
ii. So it created a lot of room of regulator arbitrage so not as well aligned
with the risk of the firms as it should be.
1. This led to a revised Basil accord.
c. Basil II
i. Goal of Basel II:
1. Sought to take a broader and more nuanced view of banking risks
2. It keyed risk weights to credit ratings.
3. IT dealt with market risk and interest rate risk
4. It made use of banks internal risk management models
ii. Short falls:
1. It did not increase required capital levels
2. By reduce risk weights for securities and borrowers with high credit ratings, it
facilitated the decline in capital levels
iii. Expected to make banks more safe but was mistaken:
1. The credit ratings on which regulators had set such stored proved unreliable, most
notable concerning RMBs in the U.S.
iv. These failures by a large part led to Basil III.
v. Preverse effects of Basil II:
1. Have regulatory capital being set by the people who are being regulated in effect
a. If your loans are set by your internal model, it has incentive to manipulate its
risk rates
2. It is very hard to understand a risk model, they are standardized for the most part but
the big banks have there own teams of quants that are very complex and hard to
penetrate
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a. The models are problematic when there is discontinuity with the financial
market then the internal models do not reflect it.
3. If Basil II had been fully implemented
a. If Basil II would have been fully implemented then the financial crisis would
have been much work
i. Northern Rock in the UK and was on Basil II and was pro-cicycle and
it resulted in the bank going insolvent.
vi. Basil II:
1. While Basil I was about raising capital Basil II stated purpose that as a whole capital
should be about the same after Basil II was put into place.
a. In the industry there was a notion that there may be a reduction in the amt of
capital held by the banks by implementing these models.
d. Basil III
i. General
1. The creation of capital conservation buffers and at keeping bank’s capital well above
the required minim levels during good times to that banks can better withstand the
stress of band times.
2. Added buffers for distribution of dividends
ii. Highlight’s of three
1. About increasing the amount and quality of capital but did not come to grips with the
methodology
a. Raised the leverage ratio:
i. Changes the way that this is calculated, put all of the assets in the
demoninator
ii. Takes a broad view
b. Has risk based standards that change the way that Risk Based ratios are
calculated.
i. Tries to be risk sensitive
1. Looks more closely at the riskiness and the risk of loss
10. Stress Testing:
a. To evaluate the adequacy of the banks capital
i. The Fed did so b/c there was enormous problems with the stability of those firms.
ii. Wanted to ensure confidence in the 19 biggest financial firms in the U.S.
b. Suggests three types of test by Truillo
i. Simple Leverage Ratio
1. Very blunt
ii. Bucket Tests
1. Intermediate
iii. A stress testing regime
1. Sophistacated and focused on supervisory and not on the banks own model
c. Thinks that this is essential to stress testing.
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