Bank Report
October 2005

Headlines

1.  Federal Reserve Proposes To Ease Rules for Small Bank Acquisitions
2.  FDIC Considers Parity for State Banks Conducting Interstate Business
3.  Banks May Offer Special Savings Accounts Without Trust Powers
4.  Agencies Issue Guidance on Authentication Techniques
5.  Other Developments: Ethics Policies and Risk-Based Capital

Full Reports

1.  Federal Reserve Proposes To Ease Rules for Small Bank Acquisitions

The Federal Reserve has proposed to raise the asset size threshold and relax other criteria for determining when a bank holding company qualifies as a small bank holding company.  Under the Federal Reserve’s rules, qualifying small bank holding companies may use debt to finance up to 75 percent of the purchase price of an acquisition, resulting in a debt-to-equity ratio of up to 3:1.  The proposal would increase the asset size threshold from $150 million to $500 million in consolidated assets for determining when a bank holding company qualifies under the Small Bank Holding Company Policy Statement.  The proposal would also clarify the treatment under the Policy Statement of subordinated debt associated with trust preferred securities.  The proposal would exclude from debt an amount of subordinated debt associated with trust preferred securities equaling up to 25 percent of a small bank holding company’s equity, less parent company goodwill.  In addition, during a five-year transition period, subordinated debt associated with trust preferred securities issued before publication of the proposed rule would not be considered debt under the Policy Statement.  Comments are due by November 7.

Nutter Notes:  While the Federal Reserve generally has discouraged the use of debt by bank holding companies to finance the acquisition of banks or other companies because high levels of debt can impair the ability of a bank holding company to serve as a source of strength to its subsidiary banks, the Federal Reserve has recognized that small bank holding companies have less access to equity financing than larger bank holding companies and that, as a result, the transfer of ownership of small banks often requires the use of acquisition debt.  For those reasons, the Federal Reserve adopted the Policy Statement in 1980 to permit the formation and expansion of small bank holding companies with debt levels that are higher than those that would be permitted for larger bank holding companies.  The Policy Statement contains several conditions and restrictions that are designed to ensure that small bank holding companies that operate with higher levels of debt permitted by the Policy Statement do not present an undue risk to the safety and soundness of their subsidiary banks.  Among other restrictions, a small bank holding company does not qualify if it is engaged in significant non-bank activities or conducts significant off-balance sheet activities.

2.  FDIC Considers Parity for State Banks Conducting Interstate Business

 The FDIC has released advance notice of a proposed rule to create parity between state-chartered banks and national banks in their interstate activities and operations.  The Advance Notice of Proposed Rulemaking, published in the Federal Register on October 14, was issued at the request of the Financial Services Roundtable, a trade association of integrated financial services companies.  Generally, the rules would provide that the home state law of a state bank applies to the interstate activities of the bank and its operating subsidiaries to the same extent as the National Bank Act applies to the interstate activities of a national bank and its operating subsidiaries.  The FDIC on May 24 held a public hearing on the petition by the Financial Services Roundtable.  The Roundtable argued that the FDIC should adopt rules to permit state banks operating on an interstate basis to be governed by a single framework of laws and regulations to the same extent as national banks.  Those opposed to the rulemaking generally argued that the petition was an ill-conceived response to the competitive imbalance created by sweeping preemption regulations the OCC issued in 2004.  They argued that the proper cure for the imbalance is for Congress to roll back the OCC regulations, not to use them as a model for the state banking system.  Comments must be submitted on or before December 13.

Nutter Notes:  The Roundtable argued that, over the last decade, national banks and federal thrifts, with the support of the federal courts, increasingly have been allowed to disregard state laws that apply to the activities and operations of banks, including federally chartered banks.  The result, the Roundtable argued, is that national banks and federal savings associations now can do business across the country under a single set of federal rules.  In contrast, there is widespread confusion and uncertainty with respect to the law applicable to state banks engaged in interstate banking activities.  Furthermore, the Roundtable argued, this uncertainty produces the potential for litigation and enforcement actions, deters state banks from pursuing profitable business opportunities, and causes substantial expense to state banks that decide to convert to national banks or federal thrifts in order to gain greater legal certainty.  Several members of Congress, state attorneys general, state bank regulators and industry officials have voiced concern over, or opposition to, the proposed rule on the grounds it would deprive the states of much of their authority to regulate banking business conducted within their states, including their authority to enforce consumer protection laws.

3.  Banks May Offer Special Savings Accounts Without Trust Powers

The FDIC has amended its rules to allow banks without trust powers to offer Coverdell Education Savings Accounts, Roth Individual Retirement Accounts, Health Savings Accounts, and other similar accounts without the prior written consent of the FDIC.  The FDIC’s rules already provide that banks that do not have trust powers may offer self-directed traditional IRA and Keogh Plan accounts without the prior written consent of the FDIC.  FDIC regulations generally prohibit a state non-member bank from changing the general character of its business without the prior written consent of the FDIC.  Exercising trust powers constitutes a change in the general character of the business of a state non-member bank that requires the prior written consent of the FDIC.  As a result, the FDIC previously amended its rules to clarify that a state non-member bank that does not have trust powers may nevertheless act as trustee or custodian of specified retirement accounts as long as the bank does not exercise investment discretion or provide any investment advice with respect to the accounts.  Those rules have now been further amended to cover these additional types of accounts.  Although the amendments went into effect on October 18, the FDIC is requesting comments on the changes.  Comments are due on or before January 17, 2006.

Nutter Notes:  Prior to 1985, the FDIC’s rules had provided that state non-member banks could act as trustee or custodian of traditional IRAs and Keogh Plan accounts.  However, banks were permitted to invest funds held in these accounts only in the banks’ own time or savings deposits.  The 1985 amendments revised the rules to provide that customers could direct the bank to invest the funds from such plans in assets other than the bank’s own deposits.  The investments were required to be made “at the direction of the customer provided the bank does not exercise any investment discretion or provide any investment advice with respect to such account assets.”  Since 1985, Congress has introduced new accounts with tax-incentive features similar to traditional IRAs and Keogh Plan accounts.  For those reasons, the FDIC determined that further amendments were necessary.  The new rules retain the requirements that the bank’s duties be custodial or ministerial, and that the acceptance of such accounts without trust powers be consistent with the applicable state law.

4.  Agencies Issue Guidance on Authentication Techniques

The federal banking agencies have issued guidance on authentication techniques that banks should use in Internet banking transactions.  The October 12 guidance identifies enhanced methods that regulators expect banks to use when authenticating the identity of customers using Internet-based financial services.  Examiners will be assessing banks’ progress in complying with the new guidance during upcoming examinations.  Banks will be expected to achieve compliance with the guidance no later than December 31, 2006.  Among other things, the guidance states that single-factor authentication methods may not provide sufficient protection for Internet-based financial services.  The agencies “consider single-factor authentication, when used as the only control mechanism, to be inadequate for high-risk transactions involving access to customer information or the movement of funds to other parties.”  Banks should conduct risk assessments which in turn should provide the basis for determining an effective authentication strategy according to the risks associated with the various products and services available to on-line customers.  Customer awareness and education should continue to be emphasized because they are effective deterrents to the on-line theft of assets and sensitive information.

Nutter Notes:  On August 8, 2001, the agencies issued guidance entitled Authentication in an Electronic Banking Environment.  The 2001 guidance focused on risk management controls necessary to authenticate the identity of retail and commercial customers accessing Internet-based financial services.  Since 2001, there have been increasing incidents of fraud, including identity theft, and the introduction of improved authentication technologies.  The new guidance replaces the 2001 guidance and specifically addresses why banks should conduct risk-based assessments, evaluate customer awareness programs, and develop security measures to reliably authenticate customers remotely accessing their Internet-based financial services.  The new guidance applies to both retail and commercial customers and does not endorse any particular technology.  Financial institutions should use the new guidance when evaluating and implementing authentication systems and practices whether they are provided internally or by a service provider.  Although the new guidance is focused on the risks and risk management techniques associated with the Internet delivery channel, the principles are applicable to all forms of electronic banking activities.

5.  Other Developments: Ethics Policies and Risk-Based Capital

• FDIC Emphasizes Ethics Policies

The FDIC has recently emphasized the importance of maintaining appropriate codes of conduct or ethics policies to promote honest and ethical conduct, compliance with applicable laws and regulations, and accountability.  In Financial Institutions Letter 105-2005 issued on October 21, the FDIC said that a bank’s board of directors should establish “clear expectations” on acceptable business practices and prohibited conflicts of interest.

Nutter Notes:  In addition to rules on self-dealing and acceptance of gifts or favors, codes of conduct or ethics policies should contain rules requiring appropriate background checks, mechanisms to report questionable activity, policies and procedures to safeguard confidential information and ensure the integrity of records, and strong internal controls over assets.  Banks are encouraged to develop a risk-focused approach in determining when pre-employment background screening is necessary.  In addition, contractors should be subject to screening procedures.

• Possible Changes to Risk-Based Capital Rules

The federal banking agencies have issued advance notice of a proposed rule that would modify the risk-based capital standards for all banks and holding companies.  The modifications under consideration are intended to modernize the risk-based capital rules to ensure that the capital framework remains a reliable measure of risks present in the banking system, and minimize material differences in capital requirements that may arise between banks that adopt Basel II and banks that remain under the existing risk-based capital rules.

Nutter Notes:  The modifications are designed to use currently available data to implement any required changes, with the intention of minimizing the burden associated with compliance.  The Advance Notice of Proposed Rulemaking also solicits comments on any outdated, unnecessary or unduly burdensome requirements in the regulatory capital rules.  Comments are due by January 18, 2006.

Nutter Bank Report

Nutter Bank Report is a monthly electronic publication of the Banking and Financial Services Group of the law firm of Nutter McClennen & Fish LLP.  Chambers and Partners, the international law firm rating service, has ranked Nutter’s Banking and Financial Services practice among the top banking practices in the nation in the 2005 Chambers and Partners U.S. rankings.  Visit the 2005 U.S. rankings at ChambersandPartners.com.  Assistance in the preparation of this issue was provided by Jennifer A. Irvine and Melissa A. Maichle.  The information in this publication is not legal advice.