Investors that own large stakes in a bank can trigger the Federal Reserve’s oversight if they have “controlling influence” over the bank. Rules for determining control, and thereby the subjection of the controlling party to extensive Federal Reserve supervision, were developed gradually, in the form of public and private interpretations, to help banks and their investors comply with regulatory requirements. The resulting schema, according to Federal Reserve Vice Chair for Supervision Randal Quarles, is both “Delphic” and “hermetic.”

Any lack of clarity in this area is problematic; it could unnecessarily hinder provision of capital to banks from investors fearful of being caught up in a regulatory web or lead to unintended compliance failures. The Department of the Treasury recommended that the Fed review its current approach for determining control, which the Department found “not sufficiently transparent.” In particular, Treasury feared that opacity could discourage investment in fintechs.

The Fed’s proposal: New factors and thresholds

Currently, under the Bank Holding Company Act, the threshold for control is 25% ownership of any class of the bank’s voting securities, or the ability to elect a majority of the bank’s board of directors. Additionally, control is present when the investor “exercises a controlling influence over” how the bank is run. This rule has been the most difficult to interpret, because its principles were never collected in a single place, instead developing over decades in the form of guidance and interpretive letters.

To bring more clarity to the control rules and to promote investment, the Fed is now seeking public feedback on a proposal that would both streamline the rules and impose a differing level of presumptions based on the level of ownership of voting stock of the controlled company by the investing entity. The proposal includes a matrix of tiered factors and thresholds that the Fed would use to determine whether investors in a banking entity have control. Specifically, the triggers differ depending on whether voting equity is less than 5%, from 5% to 9.99%, from 10% to 14.99% or from 15% to 24.99%. An investor would be entitled to a (rebuttable) presumption of noncontrol if it controls less than 10% of every class of voting securities and does not trigger any of the control presumptions for its applicable tier.

The criteria that are tested for each level of ownership involve:

  • Board representation: What percentage of the board of the banking entity does the investor have power over? Counterintuitively, the less voting power the investor has, the higher the percentage of the board it can direct (the equivalent is true for the other criteria as well). For example, if the owning company has from 5% to 25% of the voting securities, it must hold less than 25% of the board seats, but if it has less than 5% of the vote, it can have rights to anything less than 50% of the board.
  • Board governance: What positions do the investor’s board representatives hold? For example, if the owner has 15% or more voting equity, it will be deemed to control if its representative is board chair (whereas no imputation exists if the investor has less than 15% percent voting equity). Further, control is implicated if an owner having 10% or more voting power is represented by more than one-quarter of the audit committee (or other committee with power to bind the company), or if it solicits proxies to replace more than its permitted percentage of directors.
  • Officer-employee interlocks.
  • Total equity ownership, including nonvoting.
  • Restrictions on management discretion.
  • Business arrangements providing more than a specified percentage of revenues or expenses or on other than market terms.

The Fed published a chart showing how different combinations of those factors could result in a presumption of control.

Potential benefits of the proposal

The control rules shape investment decisions in, and by, banks. One benefit of the updated rules could be that private equity firms considering investment in a bank could find it is easier and simpler to take a noncontrolling stake. Another, as anticipated by the Department of the Treasury, is that banks could be encouraged to invest in fintech firms. If the banks acquire noncontrolling stakes in fintech startups, these firms would remain free to conduct nonfinancial activities. Even beyond fintechs, the current framework could facilitate bank investments in other sectors.

The consultation period on the Fed’s proposal is open for 60 days after publication in the Federal Register. Specifically, the Fed is seeking feedback on certain technical questions on how to calibrate the control thresholds.