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The New and Unanticipated Dynamics of the Marketplace

With the implosion experienced in the global capital markets in 2008 and the resultant freezing of many traditional sources of both debt and equity financing among institutions searching for credit and liquidity, it has become increasingly apparent that, in the US and elsewhere, government-sponsored financial assistance has become the most significant source of new capital and funding.

Yet the constraints on these funds and the programs’ limitation, in many cases, to banks and thrifts pose an unavoidable quandary for many financial institutions that do not, at present, possess a banking or thrift charter.

At the same time, the financial services industry has come to understand that retail commercial bank deposits also afford more stable funding.

These two new factors have caused an unparalleled transformation within the financial services industry. There are now many reasons for entities to adopt commercial banking and savings institution status.

A Multitude of Bank Holding Company Applications. Recently, prominent investment banks Goldman Sachs and Morgan Stanley and diverse financial services firms, such as CIT Group, American Express Company and General Motors Acceptance Corporation (GMAC), have successfully applied to become bank holding companies regulated by the Board of Governors of the Federal Reserve System (the Federal Reserve).

Their example raises a critical question: Should investment vehicles, such as private equity, venture capital, mezzanine lender and other registered or unregistered funds, also consider obtaining this status? Often such entities may hold or be affiliated with business units registered as investment advisers or other companies registered as broker/dealers under the Investment Advisers Act and the Securities Exchange Act, respectively. These vehicles may also be part of corporate structures that may even own, directly or indirectly, a nationally chartered bank with limited trust powers, or an industrial loan bank, which may be regulated by the Office of the Comptroller of the Currency (OCC) or by a state banking department in conjunction with the Federal Reserve. For the ultimate corporate holding company in question, these limited banking vehicles typically are structured to avoid bank holding company status.

Constraints Under New Law. Such entities, along with licensed insurance vehicles, registered mutual funds and other regulated finance entities, may constitute a “financial institution” for purposes of the application of the Emergency Economic Stabilization Act of 2008 (EESA). The US Treasury has limited the applicability of the initial $350 billion of funding available under this legislation to capital infusions through the issuance of preferred stock by banks or thrifts that have full banking or thrift institution powers and that are supervised by a federal banking regulator--be it the Federal Reserve, the OCC, the Federal Deposit Insurance Corporation (FDIC), or the Office of Thrift Supervision (OTS). A company may have already successfully applied for the program announced by the US Treasury that temporarily guarantees investments made by money market funds (that is, mutual funds organized in accordance with the requirements of Rule 2a-7 of the Investment Company Act); but that entity may find that other programs established under EESA are, at present, not available for it.

A Brief Review of the Landscape

Facing the panoply of programs that are in existence, investors and executives alike must ask themselves: Are my ultimate strategic objectives better served by gaining access to federal relief programs?

Some Programs Are Available to Non-Banks. At present, certain existing programs are available to institutions that do not have a banking or thrift license and that do not possess full banking or thrift institution powers. These include:

• Commercial Paper Funding Facility (CPFF). The Federal Reserve announced the creation of CPFF to provide a liquidity backstop to US issuers of highly rated commercial paper through a special purpose vehicle that will purchase three-month unsecured and asset-backed commercial paper. A fee of 10 basis points is paid at the time of registration, calculated on the maximum amount of an issuer’s commercial paper that may be owned under the facility. The commercial paper to be purchased will be discounted based on a rate equal to a spread over the three-month overnight index swap rate, with a spread of 100 basis points per annum in the case of unsecured commercial paper, and a 300 basis points per annum spread for secured paper. CPFF would continue to be available whether the issuer was affiliated with a bank holding company or not.
• Term Asset-Backed Securities Loan Facility (TALF). Under TALF, the Federal Reserve Bank of New York will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated asset backed securities collateralized by newly and recently originated small business loans. Such loans include student loans, auto loans, credit card loans and loans guaranteed by the Small Business Administration. While TALF is of potential significance in expressly extending the relief provided by this facility to loans originated by institutions other than banking entities, it focuses on providing liquidity in the context of new issuances of highly rated asset-backed securities. However, it does not address the investment community’s concerns about strengthening investors’ ability to sell these securities in secondary market transactions on terms and conditions that are viable.

But Most Programs Are Only Available to Banks or Thrifts. The principal program established under EESA is, at the present time, limited in its applicability to banking or thrift institutions. For this and other reasons set forth in this Alert, we recommend that any company or vehicle seeking these benefits should consider approaching the Federal Reserve or the OTS to determine whether, for purposes of either the Bank Holding Company Act (the BHCA), or the Savings and Loan Holding Company Act (the SLHCA), adoption of bank or thrift holding company status under the BHCA or the SLHCA, respectively, would permit access to additional programs established under EESA, and thereby implement certain funding and regulatory advantages.

A number of significant programs exist under current law; to be eligible for these, it is necessary to be a bank or a savings and loan holding company.

These programs are:

• The Troubled Asset Relief Program (TARP). The cornerstone of efforts by the US government to restore stability to the national financial system consists of the recently adopted EESA and the TARP launched pursuant to this statute. Despite language in the original statutory provisions emphasizing the anticipated role of the Treasury in purchasing troubled assets from affected financial institutions, almost immediately after its passage the focus of the Treasury’s efforts under EESA shifted from acquiring mortgage-related assets to infusing new capital into troubled banks or thrift entities. Although both EESA and TARP expressly are applicable to any financial institution having a significant business presence in the US (including a registered investment adviser and a broker/dealer), the Treasury has chosen to concentrate the vast majority of the $350 billion initial authorization of funds designated by EESA to facilitate the contribution of new capital to banks or savings institutions pursuant to the terms of the Capital Purchase Program (CPP). Under conditions imposed by the Treasury, applicants for participation in CPP have been limited to regulated banking and thrift entities, and the application process is commenced by the relevant bank or thrift that is seeking CPP funding applying to the appropriate banking or savings institution regulator with jurisdiction over such vehicle’s operations.
• The Temporary Liquidity Guarantee Program. The FDIC recently announced the creation of this program as part of a larger government effort to strengthen confidence and encourage liquidity in the nation’s banking system. Subject to certain amount limitations and the payment of requisite guarantee fees (75 basis points in the case of the debt portion of this facility), the program makes available two components. One guarantees newly issued senior unsecured debt of the participating banking organizations issued between October 14, 2008 and June 30, 2009, and provides such guarantee until June 30, 2012. The second part provides full coverage for non-interest bearing transaction deposit accounts held at the participating bank or thrift in question, regardless of dollar amount, until December 31, 2009. Eligible entities include any FDIC-insured depository institution, any US bank holding company and certain US savings and loan holding companies (in essence, consisting of those entities whose activities conform to the requirements for financial holding companies). This guarantee program is the one under which Goldman Sachs, Morgan Stanley and JP Morgan issued a combined amount of $17 billion of new obligations in November 2008 at very attractive funding rates. In addition to facilitating issuance of these securities, the program further enhances potential funding benefits derived from deposits available at the constituent bank level.
• Availability of the Federal Reserve's Discount Window. As a member of the Federal Reserve, a bank holding company, through its constituent bank, is eligible to obtain additional funding and liquidity through use of the Federal Reserve’s Discount Window. This program has also been made available to investment banking institutions that are not bank holding companies, but access to it and its mechanics of lending favors banks and bank holding companies over eligible non-banking entities. It does not typically require the use of pledged assets as security for the extensions of credit in question.

Possible New Programs. While the initial $350 billion authorized by EESA has already been utilized by the Treasury, primarily in support of CPP, the remaining $350 billion remains to be implemented in accordance with the recommendations of Treasury, and subject to Congressional objection.

It is unlikely that a significant portion of these funds will be allocated for use prior to the arrival of the new Administration in Washington. Doubt exists whether any future plans may include a long-delayed role for Treasury to purchase significant sums of troubled assets, including mortgage-backed securities held in existing structured investment vehicles. It is also unclear whether such purchases may be limited, as was CPP, to buying assets held by banks supervised by federal banking and thrift regulators, or whether such a new program might return to the broader concept of “financial institution” as originally set forth in EESA. Finally, these decisions will all be taken in the light of significant Congressional pressure to provide mortgage relief to individual homeowners.

Any company interested in these funding alternatives should consider consulting with the Treasury to express its views on the importance of having any new programs under EESA address the concerns of “financial institutions” beyond regulated banks and thrift entities.

However, the most likely way of assuring that a financial institution is eligible for these programs is for it to adopt bank or savings and loan holding company status under the BHCA or the SLHCA.

Consequences of Status as a Bank Holding Company

The most immediate and significant considerations to be judged in the event of obtaining bank holding company status are concentrated in the following key areas:

• Capital requirements at the bank and bank holding company levels;

• Activity limitations at the parent and subsidiary level;

• Role of the bank holding company as a “source of strength”; and

• Oversight and regulatory supervision attributable to bank holding company status.

Capital: Under bank capitalization requirements established by US bank regulators, in order to be deemed “well-capitalized” a bank or bank holding company must maintain capital (consisting of both Tier 1 and Tier 2 components) equal to not less than 10 percent of its risk-adjusted assets.

In principle, Tier 1 capital, sometimes referred to as core capital, must constitute not less than 50 percent of the total amount of such capital amounts; it consists of common stockholders’ equity, qualifying noncumulative and cumulative perpetual preferred stock, and any minority interests in equity accounts of consolidated subsidiaries. Deducted from the calculation of Tier 1 capital are amounts attributable to goodwill, other intangible assets, credit-enhancing interest-only strips and non-financial equity investments required to be deducted from capital.

Tier 2 capital, or supplementary capital, is limited to 100 percent of Tier 1 capital amounts, and consists of allowances for loan and lease losses, other “non-qualifying” perpetual preferred stock, hybrid capital instruments and equity notes, and certain amounts of subordinated debt and intermediate term preferred stock.

From these aggregate amounts of Tier 1 and Tier 2 capital are deducted amounts of investments in unconsolidated subsidiaries, reciprocal holdings of banking organizations’ capital securities and other deductions (such as other investment vehicles and joint ventures) as determined by the pertinent supervisory authority. As noted in the recent approval by the Federal Reserve of GMAC’s application to acquire bank holding company status, this requirement may trigger a need to raise significant additional capital, potentially at both the bank subsidiary and the parent bank holding company levels. While GMAC, by virtue of its bank holding company status, was able to qualify for $5 billion in funding under CPP established under TARP, this amount did not completely satisfy its requirements for additional capital, requiring GMAC to engage in a lengthy and complex exchange of debt for equity positions.

Activities: Under the BHCA, the areas of business operation undertaken by the bank holding company, directly and through its subsidiaries (including its banking vehicles), must be financial in nature, and not consist, except under certain limited exceptions, of commercial activities. The BHCA provides precise statutory detail on which activities are sufficiently closely related to the business of banking as to be permissible for a bank holding company, acting directly or through one of its subsidiaries, to undertake without specific notification to, or approval from, the Federal Reserve.

Conversely, the BHCA also provides express procedures for obtaining the requisite approval of the Federal Reserve in those cases when the activity is not closely related to the business of banking or not of a financial nature. In these instances, the Federal Reserve may impose restrictions and conditions on the ownership and operation of the vehicle in question, or may deny the relevant bank holding company the permission to proceed with the specified acquisition.

Source of Strength Doctrine: The BHCA incorporates provisions designed to assure that the bank holding company will maintain sufficient resources to support its banking subsidiaries with the requisite capital and managerial resources necessary to operate the business efficiently and effectively. To this end, amendments to the BHCA enacted after the savings and loan crisis of the 1990s make clear that a bank holding company will guarantee any losses that the FDIC may incur as a result of any shortfall in amounts caused by payments it has made to depositors after the assets of any insolvent bank held by that bank holding company have been marshaled and applied to satisfy those claims.

Oversight and Regulatory Supervision: Banks and bank holding companies are highly regulated entities that need to maintain a significant internal compliance, legal, credit and risk-management infrastructure to comply with established policies and procedures required to assure the safe and effective operation of the banking entity in question. For example, approvals for the payment of dividends may be required before a specific bank may effectuate its payment of such sums to its shareholders. In addition, the BHCA imposes strict limitations on extensions of credit, sales of assets and other transactions arising between a bank holding company and its affiliates, including any constituent banks. These restrictions generally limit the amount of credit that may be extended by a bank to its bank holding company and to that holding company’s subsidiaries to amounts that are fully collateralized by cash or high quality securities.

Further, as a fiduciary, a bank will be held to the highest standard of duty in dealing with its depositors and customers. Entities should expect to dedicate significant management and personnel resources to complying with lengthy periodic examinations by Federal Reserve, OCC, FDIC and possibly state banking regulators.

Addressing the Consequences of Bank Holding Company Status

Greater Access to New Capital Sources. Bank holding company status brings consolidated capital requirements that may be burdensome in certain cases, or may ultimately prove to be unworkable given the earnings per share dilution that may result from achieving capital compliance. However, investment programs under EESA may become available to banks and bank holding companies. In addition, the tangible benefits of the FDIC’s Liquidity Guarantee Program and of the Federal Reserve’s Discount Window, described above, are also likely to be available once bank holding company status is obtained. Eligibility for such programs should make it easier for a bank holding company to raise the necessary additional capital that it will require as a result of its new status under the BHCA, although some shortfalls may still be possible, as seen in the case of GMAC.

Regulatory Alternatives Concerning Activities. Similarly, while the activity limitations may be difficult to satisfy for an entity engaged primarily in commercial activities, many companies focused principally in a financial business should be able to continue their existing operations (such as sponsoring and distributing hedge and mutual fund products, as well as providing private wealth and banking services to clients) through their existing networks of advisers, broker/dealers and banks, should they determine that bank holding company status is otherwise advantageous. These activities will likely fall within the ambit of activities that are permissible under Regulation Y as promulgated by the Federal Reserve under the BHCA.

In addition, investments in equity securities that may not conform to the requirements of Regulation Y may well be allowable under the Merchant Banking Regulations adopted as a result of the enactment of the Gramm-Leach-Bliley Act in 1999, and the requisite designation of a bank holding company, or one of its subsidiaries, as a financial holding company. This was the path extended to Goldman Sachs and Morgan Stanley when they were approved to become bank holding companies. In connection with their actual or anticipated applications to register as financial holding companies, the Federal Reserve extended to these institutions the opportunity to avail themselves of these Merchant Banking Regulations in order to hold operations and activities that would not otherwise conform to the requirements of being financial in nature under the standards of Regulation Y. While imposing a maximum ten-year holding period for these investments, and limiting the ability of the parent entities to control directly the active management of these non-conforming vehicles, this alternative allowed both Morgan Stanley and Goldman Sachs, as well as other applicants for bank holding company status, a minimum of two years, and a maximum of five, to restructure their operations so as to meet the activity requirements set forth in the BHCA.

Advantages of Savings and Loan Holding Company Status. In addition to the benefit of being able to qualify for TARP programs administered by the US Treasury, as well as the Temporary Liquidity Guaranty Program described above, a savings and loan holding company has another significant advantage: it is not generally subject to any quantitative capital guidelines or leverage limitations, and thus does not calculate risk-based assets, and the resultant capital requirements, on a consolidated basis at the holding company level. Capital adequacy is typically measured at the level of the actual subsidiary engaged in the savings and loan activities. This difference may mean that significant amounts of capital will not have to be raised at the savings and loan holding company level—a situation significantly different from the requirements for bank holding companies.

This consideration may have motivated Hartford Financial Services Group, Transamerica Corp., Genworth Financial and The Phoenix Companies to apply for registration as savings and loan holding companies when they acquired—or launched plans to acquire—a thrift institution. Although insurance enterprises by principal nature, when these entities applied for such registration, they became eligible for participation in the CPP equity infusion program established under TARP, as well as for the liquidity advantages provided by the Temporary Liquidity Guaranty Program.

Steps to Achieving Bank Holding Company Status

Procedures. As a general matter, three distinct routes are available to attain bank holding company status:

• Convert an existing bank possessing limited powers, such as a limited purpose trust company or an industrial loan bank, into a bank with full banking powers and chartered under the auspices of the OCC or a state banking regulator;
• Acquire an existing bank with full banking powers, taking advantage of the OCC’s new “shelf-charter” application process; or
• Organize and operate a newly established bank de novo.

In each of these cases, an application could be made to the Federal Reserve for the parent entity that owns the bank in question to be registered as a bank holding company. Here is additional information about each of these approaches:

Conversion of Existing Limited Purpose Bank. This was the path chosen by Goldman Sachs, Morgan Stanley and CIT Group in their successful applications to obtain bank holding company status. Each of the applicants owned an industrial loan bank, with restricted banking powers, originally established precisely to avoid bank holding company status. The applicants undertook to convert their respective bank entities into full purpose banks under state law, and were given an initial term of two years, with a total of three additional one-year extensions, to conform their operations to the activity requirements of the BHCA. A similar approach could be taken with respect to a limited purpose trust company, in converting it to a full purpose bank.

Acquisition Pursuant to New “Shelf-Charter” Provisions. The OCC has adopted a new procedure for a novel national bank shelf-charter, designed to facilitate new equity investments in troubled depository institutions (read the OCC’s press release about shelf-charters here). While focusing on the acquisition of banks that are under duress, this procedure may be used to demonstrate a proposed investor group’s readiness to move forward quickly in the context of other banking acquisitions. The new procedure, as announced by the OCC, involves granting preliminary approval to investors for purposes of obtaining a national bank charter. The charter remains inactive, or “on the shelf,” until the investor group is in a position to acquire a troubled institution.

It should be noted that additional approvals are required if any further organizers, executive officers or directors are appointed to the applicant’s management group. Final approval by the OCC would also be required to be granted to a specific acquisition the first time the FDIC accepts a bid to acquire a failed institution by that group.

The process involves the following steps:

• The OCC reviews the application for a shelf-charter, evaluating the qualifications of the proposed management team, the sources and amount of capital that would be available to invest in the troubled bank and a streamlined business plan concerning the operation of the bank;
• If the review is positive, the OCC provides conditional preliminary approval of a national bank charter, subject to more formal and detailed operating plans being prepared once a specific institution is targeted for acquisition;
• The pre-approved investor group is cleared to view the list of failing or troubled institutions maintained by the FDIC--the group is entitled to submit bids for those institutions;
• If a bid is submitted and found to be acceptable, the FDIC is expected to approve the bid, and the bank would thereafter be acquired pursuant to the terms of the proposal;
• The charter remains on the shelf for a period of up to 18 months, and the charter may be used for multiple bids during that time period.

Organization of a De Novo Bank. Finally, as previously noted, application may be made to either the OCC or a state banking authority to organize and establish a new banking institution. The entity making this application needs to demonstrate its financial solidity, dedicate a specified amount of capital necessary to maintain appropriate capital ratios in light of the assets to be acquired by the new bank and prove it has appropriate managerial expertise and commitment. In addition, a plan to demonstrate capital adequacy at the parent level and to deal with the entity’s non-conforming activities (through the operation of a financial holding company as indicated above) also must to be delivered to the regulator in question, along with business plans and projected budgets for a designated series of years.

Steps to Achieving Savings and Loan Holding Company Status

Procedures. Establishing savings and loan holding company status follows a course that is in many ways analogous to that for bank holding companies. Application is made to the OTS to acquire or to organize, on a de novo basis, a thrift institution. At the same time, application is made to register with the OTS as a savings and loan holding company.

The OTS has discretion to impose any conditions during the approval process, including capitalization requirements at the holding company level. However, we expect that such required capital ratios will be set at the subsidiary thrift level rather than at the holding company level. As is true of banks regulated by the Federal Reserve, the OCC or state banking authorities, a thrift institution chartered by the OTS will be subject to the capital, activity and prudential operation requirements that the SLHCA establishes; it will also need to file periodic reports and submit to examination by OTS staff. In this regard, the OTS, much like the Federal Reserve, may be influenced by the desire to establish the savings and loan holding company as a source of strength for the constituent thrift organization that it holds; thus, it may require the holding company to maintain sufficient capital to support the activities and businesses of the savings and loan institution in question. A savings and loan holding company will also be subject to restrictions similar to those imposed on a bank holding company in its dealings with its affiliates, particularly its savings and loan institution.

The World Turned Upside Down

Regulators May Be Receptive to Granting Bank or Thrift Holding Company Status. Until the recent events relating to the global credit crisis, many financial institutions, to the extent possible, had taken every effort to avoid bank or thrift holding company status. When investments in banking institutions were considered necessary from a strategic perspective, these acquisitions were often carefully structured to be limited purpose vehicles to avoid the consequences that would arise if the parent entity were to become a registered bank or savings and loan holding company.

As a result, the investment banking model gave rise to powerful competitors to the traditional commercial banking sector, unfettered by the burdens of commercial banking regulation and able through high levels of leverage to earn greater returns on their capital and investments. This reliance on greater leverage and the absence of significant regulatory oversight proved to be the investment banks’ ultimate undoing.

To a degree heretofore unexpected, the need for more stable funding afforded by retail commercial bank deposits, coupled with the importance of access to the liquidity and relief programs offered by the government to regulated banking and thrift entities, has caused an unparalleled transformation within the financial services industry. The adoption of commercial banking and savings institution status no longer is a thing to avoid. Growing numbers of entities are swiftly moving into this once shunned area; we are seeing a remarkable rise in the registration of new bank and savings and loan holding companies.

Regulators have supported these initiatives, allowing prominent investment banking and diversified lending entities to transform themselves rapidly into bank and savings and loan holding companies. We have seen significant regulatory accommodation to the needs of financial services entities in this process. Regulators may be acting out of an understanding that significant numbers of nationally chartered and other banks will face insolvency or liquidation if they are not acquired by well-capitalized investor groups. The OCC, and other such regulators, may also have concluded that existing financial institutions may not be the only purchasers able or ready to acquire these troubled banks.

The Time to Act is Now. The new procedures established by the OCC, and the practices recognized by other regulators, make more possible the involvement of potential acquirers that may not have made previous investments in the banking field. For example, the Federal Reserve also has amended its interpretations of what may constitute a “passive” investment in a bank or a bank holding company to make it more probable that a potential investor need not apply to federal banking regulators to acquire an investment in the banking entity in question. These new provisions may allow the acquiring group, whether it is a private equity group, an investment fund or another institutional investor, to obtain up to 33 percent of the total amount of equity in the banking institution, and up to two representatives on the board of directors of the pertinent bank.

Such recent regulatory actions evidence a greater willingness to encourage acquisitions, even of healthy banking entities, by new investor groups that may add liquidity and capital to the overall banking sector. The Federal Reserve has demonstrated flexibility in allowing additional time to investors in bank holding companies to conform their activities in accordance with limitations under the BHCA. The uniquely conducive current setting permits a broad array of investor groups not registered as bank holding companies to act. Through the operation of a fully licensed bank and an application to the Federal Reserve, or through the acquisition of a thrift institution and an application to the OTS, they may take the steps to qualify for bank or savings and loan holding company status and take advantage of the funding benefits available through existing and contemplated governmental programs that such status engenders.

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