Drowned out by yet another busy news cycle last week were Acting Comptroller of the Currency Keith Noreika’s remarks at a fintech conference held at the Federal Reserve Bank of Philadelphia. However, these comments should not be overlooked, as they have the potential to upend the banking industry in this country by tearing down the long-standing wall separating banking and commerce. If this happens, expect to see a Bank of Amazon, or Google Bank, coming to a browser near you.
Noreika was referring specifically to the OCCs proposal to issue special purpose national bank charters to fintech companies (the fintech charter). Originally proposed last December by then Comptroller Thomas Curry, the charter has yet to get off the ground due to ongoing legal challenges by state bank regulators, who claim the OCC does not have the statutory authority to grant such a charter. While Noreika has previously expressed support for the fintech charter, he significantly raised the stakes last Thursday when he noted that the principle of separating banking and commerce had become “religious” and should be re-evaluated. Noreika’s comments seemingly confirmed the fears of many fintech charter opponents, who consider the charter to be a pathway for commercial firms like Wal-Mart, Google, or Amazon to open a bank.
Separation of Banking and Commerce
The separation of banking and commerce has long been sacrosanct in this country, born of the fear that banks had accumulated too much economic power in the early 20th century. Policymakers from both parties have largely supported this separation, due to concerns that if allowed to control a bank, commercial entities would simply use it to provide subsidized funding to their non-bank subsidiaries, thereby creating an uneven playing field for those commercial firms that do not own a bank. In addition, because banks receive FDIC deposit insurance which lowers their overall cost of funding, taxpayers would in effect be subsidizing the operations of the commercial entity. Finally, if a commercial entity which owned a bank were to ever find itself in financial distress, the government may be forced to bail out the company for fear of what might happen to the bank subsidiary if the parent entity were allowed to fail.
The principal statute enforcing the separation of banking and commerce is the Bank Holding Company Act (BHCA) of 1956. The law, which has been amended several times, prevented bank holding companies from owning any firms engaged in nonbank activities and gave the Federal Reserve broad powers to supervise the activities of a bank holding company and all its subsidiaries. When the fintech charter was first introduced last year, it was uncertain if the charter recipient would be considered a bank for purposes of the BHCA, meaning the bank’s parent entity – provided it had one – would be subject to consolidated supervision by the Federal Reserve. The OCC white paper outlining the fintech charter indicates the BHCA “could apply” to a fintech charter recipient that is controlled by a holding company. Noreika undermined this position on Thursday when he said that a recipient of the fintech charter “wouldn’t be a bank for purposes of the Bank Holding Company Act” and therefore would not be subject to consolidated supervision by the Federal Reserve. However, there is no discretion on the matter when it comes to marketplace lenders, as the statute makes clear that a “national bank is a “bank” for purposes of the BHCA if (A) it is either (i) an FDIC-insured bank or (ii) a bank that both accepts demand deposits and engages in the business of making commercial loans and (B) it does not qualify for any of the exceptions from the definition of “bank” in the BHCA.”
It is easy to see why a marketplace lender would want a bank charter. Like any financial institution, it is critical for marketplace lenders to diversify their funding sources so that they do not become overly reliant on any one channel and can maintain the provision of credit during any kind of market environment. By becoming a bank, a marketplace lender gains access to FDIC insured deposits – provided the FDIC approves their application – and insured deposits are the cheapest funding available – just think about how much interest you are earning on your checking account. Access to insured deposits is especially critical for balance sheet lenders – lenders that retain loans on their books, which they fund through a mix of debt and equity – as these lenders may currently face substantial interest rate risk given the maturity mismatch between their assets and liabilities.
Marketplace lenders who utilize a peer-to-peer model would also benefit from access to insured deposits. In this model, the marketplace lender serves as a digital platform, where prospective borrowers go to apply for a loan and third party investors can choose which loans to fund. The marketplace lender simply collects a fee when loans are funded, while avoiding the associated risks of maintaining the loan on their balance sheet. The peer-to-peer model can be volatile however, as the marketplace lender is entirely reliant on having access to a steady stream of investors willing to fund loans. As an example of what can go wrong, look no further than LendingClub, who last year fired their founder and CEO after it was discovered that the firm sold $22 million in loans to an investor that violated the investor’s “express instructions” for loan quality. Had LendingClub also had access to insured deposits, they would have felt less pressure to falsify loan characteristics to satisfy investor demands because they would have been able to fund the loans themselves.
The third type of marketplace lending model that would benefit from access to insured deposits is known as the notary model, or rent-a-charter model. Here, the marketplace lender still serves as a platform matching service, but the loan is originated by a partnering bank and after a few days is sold to the marketplace lender, or directly to an investor through the marketplace lender. This approach allows the marketplace lender to circumvent state usury (interest rate) restrictions, which apply to non-bank lenders because the loan was originated by a chartered bank. Banking law has historically maintained that as long as a loan is validly originated by a state or nationally chartered bank, the loan will remain valid for the remainder of its term regardless of who owns the loan. Of course, if the marketplace lender were itself a chartered bank, there would be no need for it to collaborate with another bank and it could originate loans on their own.
Other Benefits of Becoming a Bank
The benefits of obtaining the fintech charter extend beyond access to cheap and stable deposit funding. As alluded to above, non-bank lenders are subject to state-by-state restrictions on the maximum level of interest they can charge. A national or state chartered bank on the other hand, is free to charge the maximum amount of interest permitted by the state in which they are headquartered. In addition, a fintech charter recipient would benefit from national bank preemption, meaning they would be subject to a uniform set of standards established by the OCC and therefore exempt from many state laws governing lending activities. Finally, a fintech charter recipient would not have to go through the burdensome process of applying for a license in each state in which they seek to do business.
Criticism of the Fintech Charter
Critics of the fintech charter point to the language in the OCC’s whitepaper as being overly broad and creating an opening for any type of entity – not just fintechs– to apply for a charter, provided they are engaged in “the business of banking;” traditionally defined as receiving deposits, paying checks, or lending money. The then Comptroller of the Currency, Thomas Curry, tried to allay these concerns in a speech he gave this past March, when he said: “Proposals that would mix banking and commerce are inconsistent with the OCC’s chartering standards and would not be approved.”
There is a new sheriff in town however, and Noreika’s comments last week made it perfectly clear that he sees things differently from his predecessor. For proponents of the charter, Noreika’s comments will likely prove unhelpful, for they give fuel to the argument that the fintech charter could lead to the mixing of banking and commerce, something which most Americans are opposed to.
Even if the OCC were to proceed with offering the fintech charter, it is unclear if any fintech would actually apply for it given the rigorous application process and the accompanying supervisory expectations. For instance, applicants are expected to outline plans for initial and future capital contributions, as well as provide specific information on how they will maintain and monitor appropriate capital levels. In addition, fintech charter applicants must develop a living will, which articulates specific financial or other risk triggers that would prompt the Board and management’s determination to unwind the operation in an organized manner. These are not typical considerations for your average tech startup.
Alternative to the Fintech Charter – Industrial Loan Company
Fintech companies interested in becoming a bank are not waiting around passively while the OCC gets their house in order. Several have identified an alternative route to accessing the holy grail of insured deposits – a Utah-based Industrial Loan Company (ILC) charter. This past June, marketplace lender SoFi became the first fintech to apply for an ILC charter and they were followed last month by payments processor Square. Begun over 100 years ago, ILCs were originally “small, state-chartered institutions that made uncollateralized loans to low- and moderate-income workers who couldn’t get such loans from banks.” Originally forbidden to accept deposits, ILCs eventually became eligible for FDIC insurance with passage of the Garn-St. Germain Depository Institutions Act of 1982.
The most enticing feature for those seeking an ILC charter is the fact that ILCs are exempt from “bank” status under the Bank Holding Company Act. This means that the parent company of an ILC is not subject to consolidated supervision by the Federal Reserve, which is a big reason why companies like Harley-Davidson, Toyota, and Target all control an ILC.
Clearly, ILCs have outgrown their simple beginnings, and they have garnered significant criticism along the way. By the time of the financial crisis, financial services firms owned most ILCs, and a handful of them were quite large. ILCs owned by Merrill Lynch, American Express, Morgan Stanley and Goldman Sachs averaged $30.5 billion in assets at year-end 2006.
Major controversy around ILCs erupted in 2005 after Wal-Mart filed an application for a Utah-based ILC, which was going to be called Wal-Mart Bank. The FDIC received over 10,000 comment letters pertaining to the application, most of them opposed to granting Wal-Mart Bank deposit insurance, and “98 members of Congress wrote a letter to the FDIC requesting a moratorium on approvals for new, commercially owned ILCs.” The FDIC responded by issuing a temporary moratorium on deposit insurance applications by ILCs, and the Dodd-Frank Act imposed a three-year moratorium on new ILCs, which expired in 2013.
Square and SoFi’s Big Gamble
Square and SoFi are gambling on the fact that the public outcry that followed Wal-Mart’s ILC application will not await them – thus far, it appears they are correct. The fact that both these companies are already providing some form of financial service likely helps deflect criticism. Square and SoFi may also be trying to take advantage of the public’s continued distrust of large banks. In fact, in their deposit insurance application, SoFi attempts to draw a clear distinction between themselves and Well Fargo:
“SoFi recognizes that cross selling can involve illegitimate practices, and SoFi and SoFi Bank will take thorough precautions to protect its members. There will be no incentive fee paid to employees based on number of products sold or fees generated. Both the NOW account and credit card product will be carefully monitored to assure that these products are requested by and used by the member.”
While SoFi may not defraud their customers a la Wells Fargo, rampant sexual harassment throughout the company, which led to the CEO’s ouster last month, is sure to doom their application.
By applying for a Utah-based ILC charter, Square and SoFi have implicitly revealed their belief that going the ILC route is an easier way to achieve “bank” status as compared to waiting and applying for the OCC’s fintech charter. While it is true that the Utah Department of Financial Institutions is more likely to grant a state banking charter than the OCC is to grant a national bank charter, no one can be sure how the FDIC will react. Regardless of whether a fintech applies for a state or national charter, if they want to hold deposits, they must get approval from the FDIC. Given the FDIC’s recent reluctance to grant deposit insurance to ILCs – only one ILC has been granted deposit insurance since 2008 – it seems as though an application for deposit insurance would be looked upon more favorably if it were coming from a national bank.
Unlike the OCC, the FDIC has had little to say on the topic of fintech besides generic platitudes about how the agency welcomes applications for deposit insurance. Current FDIC chairman Martin Gruenberg’s term expires next month, and he will likely refrain from making any significant decisions in his remaining month or so on the job. This means that fintechs looking for regulatory clarity will not find any until President Trump’s nominee for FDIC chair is confirmed by the Senate. However, the President has yet to nominate anyone after his original choice withdrew from consideration back in July. Whomever the President eventually nominates, they will surely be asked about granting deposit insurance to fintechs during their confirmation hearing. Amazon, Wal-Mart, and Google will be listening closely to their answer.
 See 12 USC 1841.
 This is known as the “Valid-When-Made Doctrine.”
 Some state laws would still apply. Examples of state laws that would generally apply to national banks include state laws on anti-discrimination, fair lending, debt collection, taxation, zoning, criminal laws, and torts.
 These definitions have evolved over time to incorporate new technologies. For instance, debit cards are considered to fall under the “paying checks” category.
 Many ILCs had obtained deposit insurance prior to this through one-off applications.
 These firms were forced to convert to Bank Holding Companies during the crisis so they could access emergency Federal Reserve liquidity assistance.
 Only a few states are authorized to charter ILCs and Utah is a popular home for ILCs due to their relaxed regulatory climate and relatively high cap on interest rates.