The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) was signed into law on July 21, 2010. Like other recently enacted “reform” legislation, the Act is immense (over 2,300 pages) and leaves much of the details to federal regulators to fill in through the rulemaking process. Almost a dozen federal agencies will be required to engage in a massive amount of rulemaking in the next one to two years to implement the requirements of the Act.
The Act significantly reshapes the regulatory environment for depository institutions and their holding companies. Some of the more significant provisions include: changes to the regulatory capital requirements for regulatory institutions and holding companies, repealing certain provisions of Gramm-Leach-Bliley which limited Fed power to engage in rule making in certain areas, further restrictions on transactions between insured depository institutions and their affiliates, new limits on bank mergers and acquisitions and new restrictions on proprietary trading by banks and their affiliates.
This Client Alert focuses on those provisions of the Act’s reform of financial institution and holding company supervision which will likely have the most effect on our clients.
Repeal of Prohibition on Paying Interest on Demand Deposit Accounts
The Act repeals the provision of the Federal Reserve Act which bans the payment of interest on demand deposit accounts. Because demand deposit accounts are the only transaction accounts available to businesses, the effect of this change will be to permit banks to pay interest to businesses on their transaction accounts. This change will be effective one year after the Act becomes law.
Permanent Increase in Deposit Insurance Limit
The Act makes permanent the current standard maximum deposit insurance amount (SMDIA) of $250,000. The FDIC coverage limit applies per depositor, per insured depository institution, for each account ownership category.
Capital Requirements (the “Collins Amendment”)
The regulation of capital ratio requirements for bank holding companies will be significantly revised by the Act. The so-called Collins Amendment subjects depository institution holding companies to the same leverage and risk-based capital standards currently applicable to insured depository institutions.
Minimum Leverage Capital and Risk Based Capital Requirements. In conjunction with input from the newly created Financial Stability Oversight Council, federal banking agencies will establish minimum leverage and risk based capital requirements, on a consolidated basis, for insured depository institutions and holding companies. The established minimum ratios for holding companies will not be less than the minimum ratios established under the Prompt Corrective Action principles for insured depository institutions in effect at the time of the enactment of the bill. Simply put, holding companies will now be required to meet the capital requirements already established by the FDIC for insured depository institutions. This provision effectively means that holding companies will no longer be permitted to include hybrid capital instruments (i.e., trust preferred securities) in their calculation of Tier 1 Capital.
Effective Dates and Phase-In Periods. The leverage and risk-based capital requirements will become effective immediately once the applicable federal agencies have implemented the proper regulations, which are required to be established within 18 months of the enactment of the bill. However, the bill will phase in the exclusion of hybrid capital instruments from Tier 1 Capital as follows: (i) holding companies with $15 billion or more in total assets will have three years as of January 1, 2013 to deduct hybrid capital instruments issued before May 19, 2010 from Tier 1 Capital; (ii) for holding companies with total consolidated assets of less than $15 billion as of December 31, 2009 will be permitted to continue to count hybrids as Tier 1 Capital as long as they were issued before May 19, 2010; and (iii) all holding companies must deduct any hybrid capital instruments issued on or after May 19, 2010 from Tier 1 Capital immediately upon enactment of the bill. Intermediate U.S. holding companies of foreign banks, thrift holding companies and large “covered financial companies” regulated by the new Financial Stability Oversight Council will be subject to different phase in rules.
Capital Requirements to Address Risks to the Financial System. In addition to setting forth requirements for both leverage and risk-based capital, the Collins Amendment also authorizes the appropriate federal banking agencies, with input from the Financial Stability Oversight Council, to establish capital requirements to address risks that specific practices and activities pose, not only to the institution engaging in the activity or practice, but to other public and private stakeholders in the event of adverse performance, disruption, or failure of the institution or the activity.
Exceptions to the Capital Requirements. Finally, in a move which will further separate the regulatory regimes between large and small financial institutions, the enhanced capital requirements prescribed under the Collins Amendment do not apply to any small bank holding company (i.e., a bank holding company with less than $500 million in assets). These institutions will be permitted to continue including hybrid capital instruments as a portion of their Tier 1 Capital.
Countercyclical Adjustment of Capital Requirements. The Act also mandates that the capital requirements for bank and thrift holding companies (including small bank holding companies) and depository institutions be “countercyclical.” Thus, the capital requirements should ease in times of recession and be tightened during economic expansion. It is unclear how these provisions can be reconciled with the hard floor for capital requirements that is mandated by the Collins amendment.
Expansion of Federal Reserve Supervisory and Examination Powers
The Act expands the Federal Reserve’s authority to require reports, examine, supervise or otherwise regulate any subsidy of a bank holding company, including “functionally regulated subsidiaries” which include broker-dealers, investment advisers or insurance companies. Previously, the Federal Reserve was required by the Bank Holding Company Act (BHCA) to coordinate and defer to other regulatory agencies when examining such subsidiaries. Further, Section 10A of the BHCA had specifically limited the Federal Reserve’s ability to regulate these entities. This section of the BHCA is being repealed and the Federal Reserve’s examination authority now covers both the bank holding company (BHC) and its subsidiaries. The Federal Reserve is also now empowered to monitor compliance, not only with laws that the Federal Reserve has specific jurisdiction to enforce, but with all other laws (other than those laws policed by the new Bureau of Consumer Financial Protection).
In evaluating bank acquisitions by holding companies, the Federal Reserve must now consider the extent to which a proposed transaction would result in greater or more concentrated risks to the stability of the U.S. financial system.
Previously financial holding companies were exempt from notice or approval requirements in acquiring businesses engaged in certain financial activities. Financial holding companies must now provide prior notice to the Federal Reserve before acquiring a financial business with more than $10 billion in assets. These acquisitions will no longer be exempt from Hart Scott Rodino anti-trust provisions either.
The standards for interstate bank transactions have been raised. Interstate acquisitions of institutions by bank holding companies subject to Federal Reserve approval will now require that the holding company be well capitalized and well managed, rather than just adequately capitalized and adequately managed. Similarly, interstate bank mergers requiring supervisory agency approval will now require that both institutions be well capitalized and well managed.
On the other hand, the Act liberalizes interstate branching through de novo charters. So long as a state permits branching by banks chartered in that state, interstate branching into that state must also be permitted. Previously, states had the ability to “opt in” or “opt out” of interstate branching. Since most states did not opt in, acquiring a bank was often the price of admission to a new state. Henceforth, de novo interstate branching will no longer be subject state regulations discriminating against out of state charters. This provision takes effect immediately.
Prohibition on Proprietary Trading (the “Volcker Rule”)
Referred to as the “Volcker Rule,” the Act adds a new section to the Bank Holding Company Act prohibiting proprietary trading by depository institutions and their holding companies and other affiliates. Banks and their affiliates are also prohibited from holding any equity, partnership, or other ownership interest in or sponsoring a hedge fund or a private equity fund. Proprietary trading is defined as engaging as a principal in any transaction in any security, any derivative, futures contracts, any option on any such security, derivative, or contract, or any other security or financial instrument that is covered in a rulemaking.
There are numerous exceptions to this prohibitions, including transactions in connection with (i) transactions in U.S. government securities or securities of “government sponsored entities” such as Fannie Mae, Freddie Mac, Farmer Mac, Federal Home Loan Corporation and Federal Home Loan Banks, (ii) underwriting activities, (iii) bona fide hedging, (iv) investments in “small business investment companies,” (v) transactions through a regulated insurance subsidiary and (vi) limited exemptions for subsidiaries in the business of sponsoring investment or hedge funds and the sponsorship of investment or hedge funds.
There will be a study by the GAO of the best manner to implement rules to achieve the objectives specified in the statute. Following the study, there will be a period of rulemaking involving multiple agencies. The effective date of the rules will be the earlier of twelve months after rules are issued or two years from the date of the Act’s signing by into law. There will also be a grace period for illiquid funds. If you have investments in private equity funds, you will need to pay close attention to the Act and to the rulemaking process for guidance on what action is required.
Moratorium and Study Related to Credit Card Banks, Industrial Banks and Trust Banks
The Act imposes a three year moratorium, commencing immediately, on FDIC insurance of any credit card bank, industrial bank or trust bank which submitted an application after November 23, 2009. Further, the Act prohibits transactions which would result in a company which derives more than 85% of its gross revenue from non-financial activities having direct or indirect control over any credit card bank, industrial bank or trust bank, except in certain narrow circumstances. The Comptroller General is directed to conduct a study on the effects of exemptions in the BHCA which allowed companies controlling thrifts, industrial loan companies, credit card banks, trust companies, and grandfathered “nonbank banks” to avoid regulation as a BHC. This is aimed at closing loopholes that allowed companies to use industrial loan company or similar charters in states such as Utah to acquire depository institutions while avoiding BHC designation.
Financial Holding Company Capital and Management Requirement
Financial holding companies, and not just their depository subsidiaries, will now be required to be well capitalized and well managed to continue to engage in non-bank financial activities.
Transactions with Bank Affiliates
Existing restrictions on banks’ transactions with their affiliates have been expanded. Investment funds which are advised by the bank or its affiliates are now included as affiliates, whether the advisor is registered or not. The scope of covered transactions has also been expanded to include a number of new transactions, such as repurchase agreements, swaps and derivative transactions, among others. These amendments will take effect approximately two years after the date the Act becomes law.