Square’s and SoFi’s applications for industrial bank charters and Varo Money’s application for a national bank charter directly bring to the forefront these lingering questions: What is a bank? Who should own a bank? And how should banks and their owners be regulated? (Note: On Oct. 12, 2017, SoFi announced it was withdrawing its application for an industrial bank charter.)
For almost 13 years, regulators have avoided these questions. The Federal Deposit Insurance Corporation (FDIC) first instituted a moratorium on granting insurance to industrial-loan banks in 2005, after an application by Wal-Mart for an industrial bank charter. Although the moratorium technically expired in 2008, the FDIC continued the moratorium in practice. The Dodd-Frank Act created its own moratorium in 2010 and mandated a study of industrial banks. The Dodd-Frank moratorium expired four years ago, and the study is now gathering dust. And although the FDIC recently made a series of pronouncements designed to encourage applications for new bank charters, there has been no movement at the FDIC to address issues associated with industrial bank charters. The silence is telling. In a very real sense, these applications are designed to put an end to the long strategy of kicking the can down the road. The SoFi and Square applications put the issue squarely, so to speak, before the agency.
These applications raise critical strategic business issues regarding who will own the customer relationship – the technology company or the bank?
To add to the mix, the Office of the Comptroller of the Currency (OCC) continues to toy with the concept of a special FinTech charter, where a company engaged in the business of accepting deposits, making loans, or paying checks (very broadly defined) could obtain a national bank charter. The OCC proposal holds open the possibility that a company might obtain a charter without obtaining deposit insurance and avoiding the strictures of the Bank Holding Company Act (BHCA). However, because all national banks must be members of the Federal Reserve System, any FinTech application will require the Federal Reserve to evaluate how and to what extent limited-purpose institutions should have access to core services.
As one might expect, these developments have drawn substantial opposition. Community banks and state bank supervisors have been the most vocal opponents. Litigation already has been filed against the OCC on its FinTech charter proposal, and opposition is assured with respect to the SoFi, Square, and Varo applications. The Independent Community Bankers of America has written the FDIC, asking for yet another moratorium on granting deposit insurance to industrial banks, presumably to give Congress yet more time to act to close further opportunities to obtain industrial bank charters.
The Varo application poses slightly different issues than those posed by SoFi and Square, as Varo seeks a full national bank charter with the full array of deposit-taking and lending powers. And unlike SoFi and Square, Varo will deal with BHCA issues posed by its ownership structure. Each of these applications will make their way to the FDIC, and each poses particular concerns and problems for the FDIC because it determines whether to grant deposit insurance. Each will be relatively narrowly focused. None will operate a traditional bank model. Each will require the FDIC to decide what is really required to be a bank for deposit insurance purposes.
There are, of course, much broader questions raised by these applications beyond those listed earlier. These applications raise critical strategic business issues regarding who will own the customer relationship – the technology company or the bank. Even without a bank charter, FinTech companies are fighting to supplant banks and become the first stop for financial services, relegating banks to providing utility-like back-office services. Banks start with substantial advantages in this fight, because they have capital and extensive customer relationships and have been able to conform to the complex regulatory environment. But the technology firms likewise come to the battle with formidable weapons.
The Applicants, the Rationale, and the Obstacles
SoFi, while primarily focusing on student loans, is an online lender founded in 2011. It has funded over $20 billion in loans to more than 350,000 borrowers. Although some loans are retained on its balance sheet, most of its funding appears to come from third-party investors and its own captive hedge fund.
Square, on the other hand, is a payments company designed to assist merchants at the point of sale. A critical component of the business is its merchant advance business that provides cash advances to merchants using Square’s point-of-sale services. Last year, Square expanded into the online lending space, making loans to small businesses. To fund its loans, Square has been using its own money plus funds from Utah’s Celtic Bank. Loans are then sold to investors such as hedge funds.
It is apparent that the lack of parent company regulation and supervision creates some discomfort at the FDIC.
Varo Money offers online bank accounts, coupled with debit cards, using The Bancorp Bank as its back-end partner to perform the banking services. Varo then serves as the front end of the customer relationship, offering a wide variety of personal financial management tools to its customers.
It is easy to see why each might want a bank charter. For SoFi and Square, the access to federally insured deposits as a funding source for loans is a tremendous advantage. For Varo, being able to offer deposit products directly, rather than through Bancorp, puts Varo exclusively in control of the customer relationship. And, importantly, a bank charter avoids nagging questions regarding state money transmitters or consumer or commercial lending licenses. Banks can export interest rates and fees from the state where their loans are deemed to have been made, preempting the interest and usury laws of the various states. The complex overlay of the varying regulatory requirements of the 50 states and the District of Columbia present daunting (and expensive) challenges to non-bank companies attempting to operate in the financial services space.
That being said, however, obtaining a bank charter will not be easy for any of the applicants, putting aside the political and almost metaphysical issues surrounding these applications. There will be careful scrutiny of the business plans, the capital and financial components, and the qualities and capabilities of proposed management. The applicants will each be required to address Community Reinvestment Act obligations. The agencies will focus on 23A, 23B, and Regulation W issues, closely scrutinizing relationships with affiliated companies.
The SoFi and Square proposals would avoid Bank Holding Company Act issues, because the Utah industrial bank falls outside the definition of “bank” under the BHCA. For Square, this is particularly important because it also operates a point-of-sale hardware appliance business and a fast-food delivery service. It also isn’t clear whether SoFi’s and Square’s ownership structures would lend themselves to BHCA restrictions, which may be a driving force behind seeking the industrial bank charters. Varo, seeking a full national bank charter, will have to deal directly with BHCA’s restrictions, because the company that controls Varo’s bank, and any company that controls that company, will become a bank holding company and must register with the Federal Reserve and be subject to Federal Reserve supervision, and it must conform its activities to those permissible under the BHCA.
The FDIC will no doubt consider the lack of Federal Reserve oversight and regulation of SoFi and Square as it evaluates the applications. It is apparent that the lack of parent company regulation and supervision creates some discomfort at the FDIC. It remains to be seen whether the FDIC can get comfortable with unregulated holding companies, or whether it will attempt to use techniques similar to the OCC’s capital and liquidity maintenance agreements to provide assurances of financial support to the bank.
Litigation already has been filed against the OCC on its FinTech charter proposal, and opposition is assured with respect to the SoFi, Square, and Varo applications.
There was an interesting period at the FDIC in 2007, during the early stages of its moratorium on dealing with industrial banks, where it published a proposed rule dealing with applications to establish industrial banks. The proposed rule would have required parent companies to consent to FDIC examination, submit reports of operations, limit representation on the board to 25%, and agree to limit activities only to those that were financial in nature. The proposed rule, which was never adopted, would have precluded non-financial companies from owning industrial banks and imposed BHCA-like supervision on parent companies. The proposed regulation may provide some insight as to how the FDIC may address the current applications.
There is a long tradition that new entrants to the banking sector draw substantial opposition. These applications will be no exception. No sooner had SoFi filed its application than the Independent Community Bankers of America decried the proposal as inappropriately intermixing banking and commerce. Bankers also have expressed the fear that were these applications to be granted, it would open the door to larger technology companies seeking bank charters without being subject to the same comprehensive supervisory framework applicable to traditional banks and bank holding companies. The fear may not be SoFi or Square but, rather, Apple, Amazon, Facebook, or Google.
The rhetoric surrounding the OCC’s public deliberations regarding a proposed FinTech charter illustrate both the sources and the motivation of the opponents. The Conference of State Bank Supervisors called the OCC’s actions “a dangerous precedent” and “an unprecedented, unlawful expansion of the chartering authority given to it by Congress for national banks.” A group of state regulators sued the OCC, arguing that such charters were beyond its powers and, if granted, would deprive the states of the ability to protect the consumers in their respective states. The fact that the OCC has yet to accept a single application for a FinTech charter has not lessened the opposition.
So, what is a bank? Is it the institution operating from a physical branch that accepts deposits from a teller window and makes personal and business loans in the community where it is located? It certainly seems as if the FDIC has that view of the type of bank it should insure. While many banks have moved away from this traditional model, the power of that model lives on. What about a bank that is structured in such a way to avoid bank holding company regulation of its owners? There is clearly some discomfort as well with respect to such institutions. These applications will force a serious evaluation of these issues.
In 1987, the FDIC published a provocative booklet, “Mandate for Change: Restructuring the Banking Industry.” In it, the FDIC argued that holding company regulation was unnecessary and contributed little to overall bank safety and soundness. It asserted that focusing regulation on the banks and their activities, and imposing strict and appropriate limits on transactions with affiliates, would provide for a more resilient banking system and serve to enhance the flow of credit into our economy. It may be hard to find copies of that booklet at the FDIC today.
It will be fascinating to see how these various applications fare at the agencies. Although we can see philosophical acceptance at the OCC, and probably philosophical opposition at the FDIC (at least under current leadership), these and other similar applications will likely play out over several years. One suspects that it is about time for the agencies to engage directly and fully on both the broader philosophical concerns as well as the peculiar questions posed by these applications. These particular applications may not move the needle much in the struggle over customer ownership, but they are harbingers of much more to come.