On Friday, December 2, 2016, the Office of the Comptroller of the Currency (OCC) released a paper on a proposed limited purpose national bank charter for FinTech companies. The proposal should be of interest not only to FinTech companies but also to investors in both the banking and the technology sectors. The OCC is accepting comments on the proposal until Jan. 15, 2017. In the meantime FinTech companies – and other constituencies – interested in the charter should begin to consider their options, either as commenters or as applicants.
The proposal raises several questions:
- What is the limited purpose FinTech charter?
- What is the cost-benefit analysis for a limited purpose FinTech national bank?
- What FinTech companies are eligible or ineligible for the charter?
- How would a company apply for a charter?
- What are the regulatory challenges for a limited purpose FinTech national bank?
- How should an investor evaluate a limited purpose FinTech national bank?
We have for decades represented traditional banks in obtaining de novo charters and in conducting their business under the multi-faceted bank regulatory framework, including OCC supervision. We also represent many technology companies active in the shadow banking sector. Herewith our thoughts:
What is the limited purpose FinTech charter?
The OCC has been working to take the lead among U.S. financial regulatory agencies in addressing the entry of FinTech companies into the banking industry. The agency is a gatekeeper by virtue of its exclusive authority to grant national bank charters, and it is the sole regulator of national banks. Although most national banks fit a traditional bank model – financial intermediation by lending money with the proceeds of deposits – the OCC has the power to grant limited purpose charters to banks engaged in only a narrow range of banking activities. The agency has exercised this authority by issuing limited purpose national bank charters to companies conducting solely a trust business or a credit card business. The common theme for these charters is that the banks do not take deposits and instead obtain funding on a wholesale basis.
The limited purpose FinTech charter follows in these footsteps. It is important to understand the contours of the charter. The proposal does not define "FinTech" or any comparable term; there are no specific technology requirements for the charter. The basic statutory prerequisite is that the institution engages in at least one of three core banking functions: (i) receiving deposits, (ii) paying checks, or (iii) lending money. Even though the charter is for a limited purpose, an institution that obtains such a charter is a national bank and subject to all of the laws and regulations that apply to national banks, with the exception of those covering banks that take insured deposits. A limited purpose national bank would, of course, be subject to supervision by the OCC but also, depending on the company's specific characteristics, by the Consumer Financial Protection Bureau (CFPB) with respect to any consumer-facing operations, and conceivably by the Federal Reserve Board (the "Board") with respect to any companies that control the bank.
What is the cost-benefit analysis for a limited purpose FinTech national bank?
The charter provides two basic advantages: preemption and credibility. The benefits of the former are specific and even quantifiable; those of the latter are more amorphous but nevertheless important. Neither advantage is unalloyed.
As to preemption, a national bank is exempt from usury and certain fee limits except in the bank's "home state." A national bank can "export" the most favorable home-state limits to loans to borrowers in all other states. The home state of a national bank without physical branches is the state identified in the bank's organization certificate. Separately, a national bank is exempt from state licensing and many other regulatory requirements. The proposed policy, as well as the Comptroller himself, states, however, that several state laws will continue to apply, including those relating to anti-discrimination, fair lending, and debt collection.
Credibility is the result of OCC supervision. The capital markets typically treat national banks as more stable than their nonbank competitors because of continuing OCC oversight and certain legal requirements, notably capital and liquidity standards. Indeed, certain investors limit themselves to banking organizations. The limited purpose charter would enlarge the group of institutions attractive to these investors. Additionally, customers tend to view banks as more established entities.
In return for these advantages, there are several regulatory costs, some of which will vary by institution and by the terms of the operating agreement that the OCC seems likely to require from newly established limited purpose FinTech banks. We describe the regulatory framework for limited purpose national banks and corresponding costs in detail below, but two easily quantifiable costs are immediately apparent.
- Capital requirements. At a minimum the OCC will expect a national bank to maintain capital above the four "well capitalized" standards: (i) a common equity tier 1 risk-based capital ratio of 6.5 percent, (ii) a tier 1 risk-based capital ratio of 8.0 percent, (iii) a total risk-based capital ratio of 10.0 percent, and (iv) a leverage ratio of 5.0 percent. Additional common equity tier 1 capital, that is, common equity on top of the common equity used to meet the 6.5 percent standard, is a prerequisite for discretionary capital distributions or certain other payouts. The risk-based ratio for this capital, known as the capital conservation buffer, is still phasing in; for 2017, the minimum ratio to avoid any restrictions on distributions or payouts is 1.25 percent. The risk-based ratios are based on a bank's assets that have been adjusted to reflect perceived credit risk, and they also take account of the credit risk associated with off-balance sheet items. The leverage ratio is based on assets as they appear on the balance sheet.If a limited purpose bank has off-balance sheet activities, additional capital will be necessary, although the proposal does not provide any quantitative guidance.
- Assessments. The OCC is industry-funded rather than taxpayer-funded. To support its operations, the agency assesses national banks on a semi-annual basis. Assessments vary by asset size and bank condition. Every national bank pays a general fee, and additional fees are imposed on existing limited purpose national banks – trust banks and credit card banks. A limited purpose FinTech national bank should expect a supplemental assessment beyond the general one although the proposal does not speak to this issue.
What FinTech companies are eligible or ineligible for the charter?
The threshold statutory requirement for any national bank charter is that the applicant engage in at least one of three core banking functions: lending money, paying checks, or receiving deposits. For many FinTech companies, this bar is easy to pass: alternative lenders by definition lend money; and, given the OCC's broad interpretation of paying checks, payment processors and money transmitters would meet the second of the initial requirements. A FinTech company that wishes to accept deposits would have to obtain a full-blown national bank charter, which has several regulatory consequences beyond those presented by the proposed limited purpose charter.
A second inverse requirement is that a company may not engage in activities that are impermissible for national banks. The core operations of many FinTech companies, lending and payment process, are unlikely to include prohibited businesses, but related operations might be problematic. Many real estate-related activities, for example, are not available to a national bank, including acting as a real estate broker or owning real estate other than property necessary for the business. To the extent the FinTech company makes equity investments, these investments may also be restricted.
How would a company apply for a charter?
The application process involves the same four phases as the application process for full-service national banks – (i) prefiling discussions, (ii) preparation and filing of the application, (iii) OCC review and evaluation of the application, and (iv) agency approval.
An applicant must have at least one prefiling meeting with the OCC to discuss the prospective business of the bank and the agency's regulatory considerations. Limited purpose FinTech banks should anticipate at least two meetings: one with the OCC's newly established Office of Innovation located in San Francisco and one with office of the district in which the bank will be headquartered. Special licensing or legal issues may require a meeting with appropriate personnel in Washington, D.C.
Preparation of the application
The centerpiece of any national bank application is the business plan for the first three years. The plan is an extensive document that requires information on several subjects. In preparing an application, an applicant should be guided by the policy considerations in the OCC's regulation on new charters: whether the proposed bank (i) has organizers familiar with the relevant laws and regulations; (ii) has competent management, including a board of directors, with ability and experience relevant to the proposed services to be provided; (iii) has capital sufficient to support the projected volume and type of business; (iv) can reasonably be expected to achieve and maintain profitability; (v) will be operated in a safe and sound manner; and (vi) does not have a misrepresentative title.
The proposal explains the application as containing seven key elements:
- Robust, well-developed business plan. The business plan has two functions. First, it is the document that will (or will not) persuade the OCC to grant a charter. The OCC expects a detailed discussion of the plans for the bank. If the applicant is an operating FinTech company, the plan should have a thorough description of the company's operations and results to date. Second, the OCC will use the business plan as the baseline for examining the bank. Virtually any changes to the plan, even if only marginally strategic, typically will require prior OCC approval. Performance that lags the business plan will receive negative marks. Accordingly, an applicant must commit to the implementation of each detail of the plan and present a realistic, obtainable set of goals.
- Governance structure. The OCC views a clear governance regime as critical to the success of the bank. To the OCC, "structure" involves not just an organization chart and reporting lines, but policies and procedures that ensure that the board of directors and senior management take an active role in guiding the activities of a bank. The OCC looks for the board to set a "tone at the top" that encourages compliance with laws and regulations and that prevents inordinate risk taking. A satisfactory governance structure would include, among other things, an audit committee that reviews independent audits, and chief risk and compliance officers with direct access to the CEO and the board.
- Capital. At the outset, an applicant must show that it will, taking into account expected growth, have sufficient capital to meet the standards identified above throughout the first three years of operation. Plans to raise additional capital in the future to meet the standards would not pass muster. If an applicant has off-balance sheet activities, the OCC expects the applicant to propose a minimum level of capital that will cover the risks of those activities. What that amount might be the proposal does not say. However, the proposal observes that limited purpose trust national banks typically must hold capital often in excess of the amount that the capital ratios would require for a full-service bank. The proposal also states that the agency "would consider" adopting specific capital rules for FinTech banks.
- Liquidity. The OCC's general standard is that a national bank should have capacity to "readily and efficiently meet expected and unexpected cash flows and collateral needs at a reasonable cost, without adversely affecting either daily operations or the financial condition of the bank." To the OCC, liquidity is a function both of access to funds and of a bank's cost of funding. Unlike the capital standards, there is no uniform quantitative liquidity requirement.
- Compliance risk management. This element requires an extensive set of policies and procedures – and qualified personnel to implement them – to ensure compliance with the wide range of laws and regulations that apply to a national bank. Of special importance to the OCC currently are fair lending laws and Bank Secrecy Act and related requirements. A bank should have a chief compliance officer with both authority and accountability for implementation of the policies. While compliance personnel necessarily will be embedded in each operating unit, these personnel should report to the chief compliance officer who in turn reports to senior management and not to the managers of the operating units.
- Financial inclusion. This element should be a selling point for most FinTech companies. The OCC and the other federal banking agencies have, over the years, expressed concern about the number of unbanked and underbanked households in the country and have urged banks to broaden their offerings to meet the financial needs of these households. The regulators have considered mobile banking an important and successful means of reaching out to traditionally underserved communities, including the un-banked and under-banked.
- Recovery and exit strategies; resolution planning and authority. This Plan B element of the business plan is a relatively recent development largely in light of the financial crisis. An inadequate discussion of how a bank will handle serious adversity – that is, if the OCC believes it could be taking on what could turn out as a difficult problem – might be enough to torpedo an application regardless of the other elements.
OCC evaluation and review
This phase of the application process is largely for the OCC rather than the applicant, but it will involve at least one round, and perhaps several, of written questions from the OCC for which written responses will be necessary. The responses may require significant work, including re-doing pro forma financials. National bank applicants typically are not operating nonbank companies, but in the case of the limited purpose FinTech charter, they may well be. The OCC might require on an onsite visit or other in-person discussion about the particulars of the business.
Even in the best of circumstances, the review process can take months. In the case of novel applications, such as those for the limited purpose charter, applicants should plan for a year-long process.
Approval or issuance of a charter is more than a single yes/no decision. For all charters, the OCC will grant preliminary conditional approval, after which the applicant can organize the bank. The preliminary conditional approval will specify standard requirements and enforceable supervisory conditions, including minimum policies and procedures. The approval also may impose institution-specific conditions, a likely event in the case of limited purpose FinTech national banks. After receipt of the approval, the organizers must raise at least the amount of capital stated in the application within twelve months. Organizational activities include the organizers' execution of the articles of association and organization certificate and appointment and meeting of the board. The OCC requires all directors to take oaths.
The preliminary conditional approval will expire within eighteen months. Before a bank can open, it must comply with the conditions set forth in the approval and must otherwise prepare to open. The OCC will conduct a pre-opening examination shortly before the bank plans to open. If the examination is satisfactory, the agency will issue final approval, and the bank may then commence business.
In some cases in the past, the OCC has required that as part of the final approval the new national bank enter into an operating agreement with the agency. The agreement covers any operations that the OCC may have concerns about, and often will involve supplemental reports and require prior OCC approval for certain actions. The proposal is clear that operating agreements for limited purpose FinTech national banks are a strong likelihood, rather than an unusual feature as they are for other national banks.
What are the regulatory challenges for a limited purpose FinTech national bank?
The central challenges are cultural: while many FinTech companies come out of a culture of innovation, risk-taking and (sometimes) frequent failures, banks and their regulators are highly risk-averse. A bank failure is a traumatic event. A variety of adverse consequences will flow from a failure, including an investigation and possible enforcement actions against individual directors and officers. To avoid failures – as well as to promote several other public policies – the OCC examines the operations of a national bank every 12 to 18 months, and in the interim keeps close watch on the bank. Many business decisions will require OCC review and approval before they can be implemented.
The OCC may not be the only federal regulator of a limited purpose national bank; the Board and the CFPB may also have roles to play.
The OCC's power to oversee and regulate national banks is far-reaching. By statute, the agency's central responsibilities are to assure "the safety and soundness of, and compliance with laws and regulations, fair access to financial services, and fair treatment of customers by" national banks. More detail on each of these functions is as follows:
- Safety and soundness. The OCC's oversight here falls under the rubric of "prudential supervision" and covers any operation, activity, or event that could affect the health of the institution. The agency has identified eight types of risk that it expects a national bank to manage: credit, interest rate, liquidity, price, operational, compliance, strategic, and reputation.The OCC examines each national bank for safety and soundness periodically; a newly chartered national bank can expect an examination at least every twelve months and reporting requirements beyond those imposed on more established national banks. The examination covers the gamut of a bank's activities, divided into components referred to collectively by the acronym CAMELS: capital adequacy, asset quality (e.g., whether the bank is underwriting loans that will perform), management (including management of the eight risks), earnings, liquidity, and sensitivity to market risk. The OCC typically treats a problem found in any component of the exam as a weakness in management. An examination report will follow, with each component rated on a scale of one to five and a composite score of one to five. (The composite score is not an arithmetical average or median.) Any rating of three or higher is a cause for concern and could lead to some type of enforcement action. OCC examiners will meet with management and the board to discuss their findings. If there are any deficiencies, or "matters requiring attention," the OCC expects the board to respond promptly. If the same failure appears in later examinations, more serious enforcement actions will follow.In the event of a violation of a law or regulation or even an unsafe or unsound practice that is not technically a violation of a specific rule, the OCC may take one of a wide variety of enforcement actions. These actions range from, on one end of the spectrum, a nonpublic commitment from the board to take remedial action to, on the other end, a public cease and desist order that requires specific actions and civil money penalties. Actions against particular officers or directors also are possible. In an extreme instance, the OCC may bar an individual from the banking industry. In addition, by statute, the OCC must take certain actions to limit the activities of a bank if the bank falls to meet regulatory capital requirements.
- Compliance with laws and regulations. In addition to running a bank safely, management and the board must be alert to compliance with several laws and regulations, even if compliance is not directly related to the safety and soundness of the bank. These laws and regulations include restrictions on transactions with affiliates and insiders, requirements for the delivery of bank products to consumers (including disclosures under such statutes as the Truth in Lending Act and the Electronic Funds Transfer Act), and privacy laws and protections governed by the Gramm-Leach-Bliley Act. The bank's activities and programs are the subject of a separate compliance exam, although the OCC may conduct this exam simultaneously with the safety-and-soundness exam.
- BSA/AML/OFAC. This acronym refers to compliance with the sets of laws that prohibit transactions by a bank that would facilitate criminal activity (even if the bank's actions are entirely permissible or even necessary for other clients) or that could support terrorists or other enemies of the United States. Any default is likely to result in a harsher rather than lighter enforcement action, and the OCC may suspend its review of other applications by a bank until the BSA/AML/OFAC issues are resolved. Payment processors and money transmitters likely are familiar with BSA/AML/OFAC requirements, but all technology companies that receive a limited purpose charter will have to have a compliance program.
- Fair access. Traditionally, this category encompasses fair lending laws and a bank's performance under the Community Reinvestment Act (CRA) in providing products and services to low- to moderate-income individuals or communities in the bank's assessment area. Although CRA does not technically apply to banks that do not take insured deposits, which would include limited purpose FinTech national banks, the OCC has said that it will impose CRA-like conditions on approval orders. Fair access is one area in which technology companies in the banking sector may have a regulatory advantage over traditional, full-service national banks insofar as the technology services may bring banking services to the un-banked or the under-banked.
- Fair treatment. In this area, the OCC enforces the consumer financial protection statutes, including some, such as the Truth in Lending Act, that already apply to online lenders. A national bank, whether limited purpose or full-service, engaged in consumer activities must have an extensive compliance program.
Federal Reserve Board
The Board may enter into the life of a limited purpose bank in two ways: it may or may not regulate any company that controls the bank as a bank holding company, and the bank will be required (like every other national bank) to become a member of a Federal Reserve Bank.
- Bank holding company status. An interesting question implicit in the OCC's proposal, but which the OCC lacks jurisdiction to answer, is whether a company that controls the proposed limited purpose FinTech national bank is a bank holding company. It seems that such a company would not become a bank holding company because the proposed limited purpose FinTech bank does not appear to be a "bank" under the Bank Holding Company Act (BHCA). Banks covered by the BHCA are only those with FDIC deposit insurance or that both accept deposits and make commercial loans. The proposal envisions banks that do not take deposits and therefore would not have deposit insurance. However, the other limited purpose national banks that the OCC has chartered and that are not banks under the BHCA are explicitly excepted from the definition of "bank." Since no similar statutory exception exists for FinTech banks, it is difficult to say with certainty whether the Board might seek to treat a FinTech bank as a bank for the purpose of the BHCA. If a FinTech bank were a bank under the BHCA, then a controlling company would likely be regulated as a bank holding company, an entity subject to the same kind of oversight and regulation by the Board that the OCC exercises over national banks. The same capital requirements apply. Like a national bank, the activities of a bank holding company are strictly limited. Separately, because the Board's definition of control is complicated, investors intending to take minority, passive positions in the stock of a bank holding company typically must consult with the Board to confirm that the investment will not be deemed controlling. For example, while a holding of 25 percent or more of any class of voting stock is defined as control, the Board typically expects an investor planning to take 10 percent or more of any class of voting security to enter into passivity commitments that ensure that the investor could not exercise control. If a group of investors intends to invest in a bank or bank holding company, the investment process must be carefully managed to ensure that the group is not treated as a single, controlling investor.
- Federal Reserve Bank membership. By statute, every national bank must be a member of the Federal Reserve Bank for the district in which the bank is located. (There are twelve districts.) A member bank is required to purchase non-transferable stock in its Reserve Bank for which the bank receives a six percent coupon (the six percent may be adjusted downward for banks with more than $10 billion in assets). A member bank also has access to the discount window.
Consumer Financial Protection Bureau
The CFPB has authority to write, amend, and implement virtually all consumer financial protection statutes, authority it took over from the Board in 2011. As many FinTech companies know, the CFPB's jurisdiction extends to nonbanks engaged in consumer-facing activities. A shift to a national bank charter could mean a shift in oversight of these activities from the CFPB to the OCC, which is often (although not necessarily accurately) seen as a somewhat less aggressive regulator than the CFPB. Perhaps a better way to put the difference is that the OCC has far greater experience in examinations than the CFPB and is in contact with its national banks on a continuous basis, as opposed to the often discrete intervention of the CFPB with the institutions it regulates.
The CFPB has principal examination and enforcement authority over banks with more than $10 billion in assets. For banks below that ceiling, the primary federal regulator (in this case, the OCC) has examination and enforcement authority, but the CFPB has back-up authority over issues of consumer compliance. To date, the OCC alone has taken any consumer-related enforcement actions against smaller national banks. The CFPB and the OCC jointly have initiated actions against or entered into consent agreements with larger national banks.
The CFPB has begun to take an interest in FinTech, an interest that is unlikely to be affected by a limited purpose national bank charter. It has taken a variety of enforcement actions against online lenders and providers of other technology-driven financial services. The bureau recently published an advance notice of proposed rulemaking on the needs of FinTech companies for confidential consumer information held by banks. As between FinTech companies and banks, the CFPB seems to favor the former.
How should an investor evaluate a limited purpose FinTech national bank?
The returns on an investment in a limited purpose FinTech national bank are likely to be along the lines of a traditional national bank rather than a technology company that is active in the financial services sector. Supervision by the OCC will reduce the risk of failure but, for a variety of reasons, not least capital and liquidity requirements, potential earnings will be reduced. By contrast, nonbanks engaged in the same business, notably online lenders, may well achieve greater returns; however, with limited regulatory oversight, the risk of failure is greater.