So, You Want to Be a Bank? Benefits of Operating Through a Bank Charter and Charter Choice Considerations

Like last year, 2018 is shaping up to be a busy year for de novo bank charters, with signs suggesting that we will continue to see strong interest in bank formation. The Federal Deposit Insurance Corporation (FDIC) has already approved seven applications for deposit insurance for de novo institutions through September, and it approved eight during 2017, which was the most since 2010. While many bank chartering proposals are likely to originate from groups proposing to conduct a traditional community banking business, the last few years have seen increasing interest among nonbank financial services providers, including technology enabled firms engaged in payments, crypto currency and lending businesses, in exploring whether to operate through a depository institution charter.

Although some Fintech firms may decide to pursue the new, non-depository, special purpose national bank charter being promoted by the Office of the Comptroller of the Currency (OCC)—often called the Fintech charter—others may decide they would be better off chartering or acquiring a so-called “full service” depository institution for a variety of reasons, including lower funding costs, access to traditional payments systems, and market credibility. The decision to charter or acquire a depository institution involves many important regulatory consequences.

This article is the first in a series of articles that will address key considerations to keep in mind when deciding whether to operate through a bank charter. This installment will address some important potential benefits of operating through a bank charter and the types of charters available. Subsequent installments will address the consequences of operating through a bank charter and the process for forming or acquiring a bank. Like many things, “the devil is in the details,” so please do not hesitate to follow up with us or join us at our November 1st Fintech Frenzy panel discussion where we will be addressing the major points summarized in this discussion.

Reasons for Establishing or Acquiring a Depository Institution

It is certainly possible for non-bank entities to provide a variety of financial services, but there are some very significant advantages to operating through a bank charter. In particular, while nonbank competitors of banks offer a variety of products that are not deposits but function like them, such as cash management accounts tied to mutual funds or part of a brokerage account, only banks are permitted to take FDIC-insured deposits from the public and have access to deposits as a source of funding.

Operating through a bank charter also provides access to the payments system operated by the Board of Governors of the Federal Reserve System (Federal Reserve) and access to wholesale funding, such as the Federal Reserve discount window, Federal Home Loan Bank advances, and the federal funds market. Further, in many jurisdictions, banks and trust companies are the only type of corporate entities permitted to act as a trustee.

Operating through a bank charter also confers significant advantages on lenders, since insured depository institutions are permitted to “export” interest and fees that are components of interest from the state where the bank is located to borrowers in other states, thereby eliminating the need to comply with various state usury laws. Federally chartered depository institutions generally benefit from federal preemption of state banking laws, and are not subject to state licensing and compliance requirements that may apply to nonbank lenders or other nonbank financial services businesses, such as money transmitters. State chartered depository institutions are often exempt from licensing requirements as well.

Types of Charters Available

One of the key considerations in forming or acquiring a depository institution is the type of charter through which it is to operate. In the United States, banking institutions may be organized under federal law or state law, and within each system there are various types of charters available, which may include commercial banks, savings banks, and trust companies, among others.

Any group considering forming or acquiring a bank should review the available charter options, taking into account variations in the formation process (including initial capital requirements), as well as the authorized activities and powers of the charter and any associated limitations, including limitations on the types or concentrations of permissible assets. For example, under federal law it is still possible to charter either a national bank or a federal savings association. The national bank charter provides a great deal of flexibility in terms of authorized commercial banking powers. The federal savings association charter, however, is subject to qualified thrift lender requirements and other limitations that make it more appropriate for a business that will focus on mortgage lending. The federal savings association charter historically provided certain advantages, notably the fact that a unitary savings and loan holding company that controlled only a single savings association that met certain requirements was not subject to any restrictions on its activities. However, this advantage was eliminated for all but certain grandfathered companies by the Gramm-Leach Bliley Act in 1999, and the Dodd-Frank Act imposed additional limitations on activities of companies that control any insured depository institution, including a savings association. Details on such changes are beyond the scope of this discussion, but the consequences of controlling a depository institution will be addressed in a subsequent installment of this series of articles.

Although certain specifics are currently being litigated in the federal courts, as noted above, an important advantage of banking institutions chartered under federal law, such as a national bank or a federal savings association, is preemption of state law. Federally chartered depository institutions are generally not subject to state laws that conflict with their authorized powers under federal law. As a consequence, federally chartered institutions are not subject to state licensing and certain other regulations, which allows them to avoid complying with a patchwork of state laws and operate uniformly on a nationwide basis.

While preemption of state law is an important advantage of operating through a federal charter, it may be less significant in the context of a community-based or regional institution that plans to operate in one or only a few states. Further, state regulators are known for fostering strong relationships with the institutions they supervise—many of which are significant economic contributors in the states where they do business—and operating through a state charter can mean easier access to regulators. In addition, as will be addressed in a subsequent installment of this series of articles, some states, such as Utah and California, offer an industrial bank or industrial loan company charter that is not treated as a bank for Bank Holding Company Act purposes if it meets certain requirements. As a result, if an organization or its investors are engaged in activities that are not permissible for a bank holding company, it may make sense to consider operating through this type of charter. The FDIC has not recently approved a de novo deposit insurance application or change in control filing for an industrial bank, but there are signs that the agency may be open to doing so. In addition, both federally chartered institutions and FDIC-insured state chartered banking institutions are permitted to “export” interest from the state where they are located to borrowers in other states. These are all compelling reasons to consider operating through a state chartered institution.

OCC Special Purpose National Bank Charter

The OCC’s announcement this summer that it would begin accepting applications for special purpose national bank charters means that there is another potential option available to Fintech companies that wish to operate through a bank charter. The Fintech charter would be a national bank and, as such, would generally be permitted to engage in any activities permissible for a national bank, including lending and functions related to facilitating payments. However, since it would not be FDIC-insured, it would not be permitted to accept deposits. This limitation offers a potential advantage because acquiring control of a Fintech charter should not cause a company to be regulated under the Bank Holding Company Act.

The special purpose national bank charter has been seen as a potentially game changing option for non-bank lenders and payments businesses because it offers the benefits of federal preemption described above. A Fintech charter would also be able to export interest to borrowers in any state. Since many non-bank marketplace lenders currently make loans through an arrangement with a bank partner that originates the loans and performs certain key functions, operating through a Fintech charter may allow a firm to reduce its dependence on third parties and mitigate the risk that its bank partner may not be seen as the “true lender.” 

While the OCC’s Fintech charter offers many attractive benefits, it is not a silver bullet solution. Applicants for a Fintech charter will need to demonstrate their ability to operate the bank in a safe and sound fashion, and it is widely anticipated that the OCC will require significant initial capital for these charters. The OCC has also said that it will expect applications for a Fintech charter to demonstrate a commitment to financial inclusion by providing or supporting fair access to financial services and fair treatment of customers. The charter is also not without controversy. The New York Department of Financial Services recently renewed its litigation challenging the OCC’s legal authority to issue special purpose national bank charters, and the Conference of State Bank Supervisors has signaled it is prepared to do so as well. As a result, there is some uncertainty about whether and when this charter will actually become available.

De Novo Formation Versus Acquiring an Existing Charter

Any party considering operating through a depository institution charter should consider whether to form the charter de novo or acquire an existing institution. Formation of a de novo institution in some respects is more complex than acquiring an existing institution and involves an application to a chartering authority such as the OCC or a state regulator, an application to the FDIC seeking approval of deposit insurance and, often, an application to the Federal Reserve seeking approval of any bank holding company or savings and loan holding company that will be formed to control the new institution. This process can take up to a year (and sometimes even more) to complete and is preceded by one or more pre-filing discussions with regulators.

In contrast, groups seeking to acquire an existing institution can often complete the transaction with only the necessity of obtaining Federal Reserve approval of any holding company that will be formed to acquire the target institution or a Change in Bank Control Act clearance and similar change in control approvals required under state law. And the time required to obtain approval to acquire an existing institution, absent any significant supervisory concerns, is typically shorter—often as short as a few months. In some cases, groups seeking to acquire a bank may be interested in maintaining the bank’s existing management team or its existing business. In the context of an acquisition transaction, it is typically possible to convert the target institution to another charter type (for example, from state to federal) if desired.

That said, there are some advantages to forming a depository institution on a de novo basis, chief among them the fact that organizers of a new institution need not spend time or effort performing diligence on an existing business, negotiating and closing a transaction or conforming or disposing of unwanted assets and businesses after the deal has been completed. Further, formation of a de novo institution avoids searching for an appropriate target and potentially paying a premium and other transaction costs to acquire an existing business. The recent run up in bank stock prices could potentially make a de novo charter attractive. Finally, the capital required to be raised to acquire and operate an existing target bank may significantly exceed the capital required to form a de novo bank.

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Goodwin’s Financial Institutions practice is recognized as a leading provider of banking and consumer financial services legal advice. We counsel our clients on all aspects of bank regulatory and consumer financial services law, including bank chartering proposals and bank mergers and acquisitions. Our attorneys also work with entrepreneurs seeking to establish non-bank financial services providers, including Fintech businesses, and with venture capital and private equity firms that invest in these businesses.