Executive summary
Many non-banks consider acquiring a bank, or establishing a de novo bank, to serve their customers and capture the benefits afforded to a bank. Before embarking on this strategy, one dimension that should be well understood is the regulatory limitations applied to the affiliated businesses of an institution, or its investors, which owns a bank. This overview is not a comprehensive review of those restrictions, nor a substitute for legal advice. Given their importance, however, a general overview provides a foundation for more detailed discussions with attorneys intimately acquainted with banking law.
Regulation W limits transactions between a bank and its affiliates. Any company or individual within the same corporate family or under common control is deemed an affiliate. Restrictions include limits on lending, payments, and other transactions between a bank and its affiliates. Affiliates will also face heightened risk and compliance requirements. Myriad regulations, administration costs, and compliance with changes to the rules, usually brought about by a crisis, can affect a strategic plan. When considering transactions with affiliates, including lending to an affiliate, a bank must first take into account what is in the best interest of the depositors, not customers, shareholders, or employees.
Non-banks can capture the value of providing financial services directly by acquiring, or converting to, a bank. A non-bank that can transfer loan receivables to a bank, for example the loan pipeline of a mortgage bank or loans made by a non-bank finance company, can shift these assets and benefit from a lower cost of funds. Payments business, including wires, ACH, debit card, and credit card, can flow through the bank, ensuring fees remain in the consolidated group. Intercompany derivatives, management fees, leases, and other transactions can be used to obtain financial benefits for the group. For some businesses, the benefits of bringing banking services in house more than cover the cost of tighter risk and compliance controls.
Many banks opt not to lend to affiliates, but where they do, loans to affiliates are capped at 10 percent of the bank's capital. Payments business that runs through the bank must be subject to the same service level agreements and pricing as non-affiliated customers. The same is true for derivatives and other transactions. These are allowed, but only on market terms for similar transactions, and this must be well documented.
Risk and compliance
Limitations on transactions with affiliates are designed to limit risk at the bank. Regulation W was promulgated by the Federal Reserve in 2003 to implement Sections 23A and 23B of the Federal Reserve Act. These sections establish requirements and limitations on transactions between member banks and their nonbank affiliates to prevent two things: losses to the bank arising from transactions between it and its nonbank affiliates, and the transferring to a nonbank affiliate of any of the bank's benefits derived through access to the federal deposit insurance safety net.
Regulation W is conceptually straightforward, but implementation can be more challenging, especially as organizational complexity increases. In response to the number of exceptions authorized during the financial crisis, regulatory complexity increased further with the Dodd-Frank Act.
The regulation carries both quantitative and qualitative limits: quantitative limits per affiliate and in aggregate, qualitative limits on the types of assets that can be purchased from affiliates, collateral requirements, requirements that transactions be consistent with safe and sound banking practices, and requirements that pricing be at arm's-length terms.
Bank compliance requirements can be daunting for non-banks. Beyond the legal advice needed, the bank's risk, compliance, and operational teams need programs in place to ensure adherence. The key areas of focus are:
- Development and integration of an enterprise-wide compliance program
- Structured corporate governance to ensure accountability
- Creation and maintenance of a complete Regulation W information repository
- Implementation of a complete set of controls, testing, and compliance reporting processes
With fintech firms, mortgage companies, insurance companies, and others exploring expansion into banking, Regulation W needs to be understood, managed, and mitigated in the context of the specific circumstances, products, and service offerings involved.
Extensions of credit
The extension of credit to an affiliate, including loans, letters of credit, and guarantees, is governed by Regulation W. Section 23A of the Federal Reserve Act is the primary statute governing transactions between affiliates. The guiding principle is to protect the depositors of member banks, and the deposits insured by the FDIC, from the actions and activities of affiliates that are not FDIC insured.
Covered transactions under Section 23A are loans and extensions of credit to an affiliate, investments in an affiliate, purchase of assets from an affiliate, and transactions that can put a bank at risk through an affiliate.
Section 23A prohibits a bank from entering into a covered transaction if the transaction would exceed 10 percent of the bank's capital stock and surplus, or if the aggregate amount of the bank's covered transactions with all affiliates would exceed 10 percent of capital stock and surplus.
Lending and all extensions of credit to an affiliate, and acceptances issued on behalf of an affiliate, must be secured by a statutorily defined amount of collateral ranging from 100 percent to 130 percent of the covered transaction amount. Securities issued by an affiliate, and low-quality assets, are not acceptable collateral for any credit transaction with an affiliate.
Of critical importance is Section 23B, which requires certain transactions, including all covered transactions, to be on market terms and conditions.
Lending to a customer of an affiliate is acceptable, but the customer, transaction type, risk, and profitability must meet the existing standards and policies of the bank. Profitability, revenue, and relationship implications derived from the affiliate cannot be considered. All decisions must be on market terms and at arm's length.
Payments transactions
Payments transactions and flows between the bank and its affiliates are also subject to Regulation W. The flow and processing of deposited items and outgoing payments between affiliates and the parent company need additional scrutiny in two areas: service levels and pricing.
Service level agreements. Agreements must be in place to document the level of service to be provided by the bank and the affiliate respectively, and to establish the standards by which performance is measured. An agreement also establishes clear lines of accountability for both parties and generally includes key performance metrics and a timeline for the resolution of issues. The strongest banks create an agreement with the affiliate defining deposit deadlines and payment cut-off times, the availability of funds for deposited items, and the price for creating and posting payments transactions. The bank-affiliate agreement must be on the same terms as agreements with other customers. Establishing a process for reviewing these agreements on a regular schedule ensures they stay current and aligned with services provided to external customers.
Pricing methodology. Several payment methods should be priced on a per-item basis to the affiliate, and pricing should be similar to what the bank provides commercial customers. Examples include an inbound wire transfer, an outbound wire transfer, the clearing of paper checks, the clearing of remote deposit capture images, the origination of ACH transactions, the receipt of ACH transactions, and accepting or providing coin and currency. To comply with Regulation W, the bank should charge fees for these services based on the volumes of similar commercial customers. The funds availability schedule used for inbound deposits should be similar to the schedule provided to commercial customers, and any earnings credit provided to the affiliate for deposited balances should be similar to the earnings credit offered to commercial clients.
Derivatives, hedging, and other transactions
All derivatives and other transactions between bank and affiliate must also be on market terms. As with loans and payments, all trades between the bank and its affiliates must be on the same terms the bank would execute for a similar trade with a non-affiliated entity.
In the mortgage business, the interest rate risk associated with servicing, where rates down means servicing value down, moves in the opposite direction from the value of the mortgage pipeline, where rates down means pipeline value up. Servicing done by an affiliate is therefore a natural hedge for the mortgage production of a bank. If the organization executes an interest rate swap between the bank and the affiliate, it moderates income volatility at both entities without changing the interest rate exposure of the consolidated enterprise. Bank regulators acknowledge that affiliates often use each other as derivative counterparties to maximize profits while still managing risk, but the swap must be executed on fair market terms covering rate, collateral, and credit monitoring.
Derivatives that shift default risk to the bank face the same limits as a loan. Credit derivatives and other trades can protect the affiliate from loss by transferring the risk to the bank, and guarantees work similarly. Any of these are considered covered transactions and fall in the same bucket as a loan to the affiliate.
Purchases of assets or transfers of businesses within the corporate family must also be on market terms. It is fairly common for banks to buy or sell loans and other assets to affiliates, and when businesses are moved the bank must pay or receive fair value. Some banks transfer distressed loans or foreclosed property to an affiliate for workout. Such transfers are allowed but must be on fair market terms. Notably, Regulation W does not allow a bank to buy low-quality assets, so the distressed asset transaction cannot go the other way. Banks can also only purchase assets that fit within their charter limitations.
Affiliates may charge the bank management fees provided the fees are reasonable given the services provided. It is common for IT, HR, and other administrative services to be performed at the holding company and allocated to subsidiaries via a management fee. This is allowed, but the fee must not exceed the market value of similar services provided by a third party, and should be supported by written agreements describing the service and the basis for the charge. Affiliates can lease facilities to the bank, but only at or below fair market rates.
Conclusion
A non-bank becoming a bank, or owning a bank, is a significant undertaking. Obtaining regulatory approval is difficult, affiliates face several intercompany limitations, and it triggers heightened risk and compliance controls. Endurance Advisory consults with banks and other institutions to identify the value of alternative strategies, and assists with implementing the systems and controls necessary to gain regulatory approval and manage the bank.
