The term “fintech” is used to describe the application of new technology to improve the delivery and use of financial services and products in a more cost-effective way than is available in the traditional financial marketplace. The fintech industry is growing by leaps and bounds with an explosion of new products and services. While most fintechs are regulated by a variety of state and federal regulators, increasingly fintechs are considering the advantages of regulation by traditional banking authorities, a simplifying approach that consolidates regulatory oversight in one agency.
This emerging trend offers opportunities and potential pitfalls for fintechs and requires careful planning and implementation. However, the Federal Deposit Insurance Corporation (FDIC) took a big step toward providing some clarity for fintechs that are considering this path with its March 17, 2020 “Proposed Rule: Parent Companies of Industrial Banks and Industrial Loan Companies.” If adopted, this proposal would provide a transparent roadmap for a non-depository financial entity to either acquire an existing industrial loan company (ILC) or to apply for deposit insurance for a newly chartered ILC, ensuring federal regulation by the FDIC.
What is an ILC?
An ILC is a type of state-chartered bank that is insured by the FDIC, but its parent holding company is statutorily excluded from supervision and regulation by the Federal Reserve Board. ILCs generally have the same lending powers as traditional commercial banks. However, the parent of an ILC has an advantage over traditional banks because it can engage in commercial activities, while the parent of a traditional bank -- a bank holding company regulated by the Federal Reserve -- is prohibited from doing so. Over half of the current ILCs are chartered in Utah, but they also exist in California, Hawaii, Minnesota, and Nevada. No ILCs have been established since 2008, largely due to moratoria imposed by the FDIC and Congress. Now, however, the situation is changing.
Why is an ILC Charter Useful for an Online Lender?
An ILC is regulated by one federal entity (the FDIC) and one state regulator that granted its charter. Consolidating regulatory oversight saves time and money by avoiding the need to comply with several state licensing laws and regulations, as banks must do. Also, the ILC does not have to submit to multi-state examinations of its operations. Another significant advantage is that insured deposits provide a much lower cost of funds than other sources of funding. A lower funding cost would still allow reasonable profits, but would make lending more competitive with traditional bank lending rates. A further benefit is that an FDIC insured ILC can rely on interest rates of the state in which it is chartered instead of having to comply with the usury laws of several states.
What are the Requirements to Become an FDIC Approved ILC?
The purpose of the proposed rule is to codify existing practices utilized by the FDIC to supervise ILCs and their parent companies. It is designed (1) to mitigate undue risk to the FDIC insurance fund that may otherwise be present due to the absence of consolidated supervision of an industrial bank and its parent company, and (2) to ensure that the parent company that owns or controls an industrial bank serves as a source of financial strength for the industrial bank.
For typical state-chartered banks, the FDIC would be the primary federal regulator of the bank and the Federal Reserve would be the primary federal regulator of its parent holding company. Because the Federal Reserve does not regulate the activities of the parent of an ILC, the proposed rule provides that the FDIC, the ILC, and its parent enter into a written agreement to ensure that the ILC and the parent are operating in a safe and sound manner.
The proposed rule requires that written agreements must contain specific elements. However, depending on the type of applicant and its business plan, the elements contained in the agreement can be expanded. These requirements are in addition to the standard information that an ILC applicant for deposit insurance must provide to the FDIC.
The following are some of the requirements in the proposed rule that a parent holding company must agree to as part of a written agreement.
- The parent holding company of the ILC must consent to be examined by the FDIC, necessitating an understanding of and compliance with extensive FDIC laws and regulations.
- Annual reports regarding risk assessment, monitoring and control, as well as describing transactions with the bank subsidiary, will be required.
- There must be an annual audit of the ILC.
- The parent’s representation on the board of the ILC is limited to not more than 25% of the ILC’s board membership.
- The capital and liquidity of the ILC must be maintained by the parent at a level satisfactory to the FDIC, but this will be higher than that required for new bank applicants that are not ILCs. The recently approved application for deposit insurance for an ILC by Nelnet Bank (Nelnet) and Square Financial Services, Inc. (Square) illustrate this point.
- Where the parent of the ILC is controlled by a shareholder who owns 25% or more of the parent, the FDIC could require additional financial commitments by that individual.
The approvals for deposit insurance submitted by Square and Nelnet were implemented under existing FDIC policies and procedures. These were important breakthroughs because for the first time in 12 years, the FDIC approved deposit insurance for ILCs. The FDIC’s move to codify these procedures in the proposed rule means that other fintechs will have clearer guidelines for obtaining the same results, which is an important takeaway. While there is no question that fulfilling the FDIC’s requirements will take careful planning and execution, the steps laid out in the proposal will simplify the process and enable more fintechs to take advantage of these new opportunities.
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