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03.19.2020 | Legal Advisory

On March 18, the Board of Directors of the FDIC approved the deposit insurance applications of Square, Inc. and Nelnet, Inc. to create two de novo industrial loan companies (“ILCs”). The approvals come a day after Jelena McWilliams, Chairman of the FDIC, signaled the FDIC was considering two pending deposit insurance applications for ILCs. Both companies still need to obtain the approval of the Utah Department of Financial Institutions to obtain an ILC charter.

The approvals are significant for several reasons for fintechs and other non-bank companies. Most notably, they are the first of their kind since 2008, when the FDIC approved a single application for deposit insurance for an ILC. It also establishes a viable path forward for fintechs and other non-bank companies seeking a banking charter to allow them to offer their own proprietary products and services directly to customers and operate independently and more efficiently across the country. ILCs also are attractive to fintechs and other non-bank companies because, for the time being, their parent companies do not become subject to the activities and investment restrictions of the Bank Holding Company Act and the supervision and regulation of the Federal Reserve on a consolidated basis. In other words, ILCs technically can be owned and controlled by commercial companies. Finally, the approvals closely follow in time the FDIC’s February approval of Varo Bank’s application for deposit insurance. Ultimately, the approvals demonstrate that “non-traditional” entities can satisfy the rigorous statutory and regulatory requirements to enter the industry and validate the viability of their respective business models.

The conditions in the FDIC’s approval orders are generally consistent with approval orders for traditional insured depository institutions. Expectedly, they require higher capital requirements, including a tier 1 leverage ratio of 20% in the case of Square and 12% in the case of Nelnet (Varo Bank is required to maintain a tier 1 leverage ratio of 10%). Likewise, both parent companies and controlling shareholders are required to enter into customary capital and liquidity maintenance agreements (“CALMA”) and parent company agreements.

FDIC Director Martin Gruenberg opposed Square’s application on the grounds that it did not meet the statutory requirements under the Federal Deposit Insurance Act, including source of financial strength. In that connection, he cited several concerns, including that Square has never been profitable since it formed in 2009, was reliant on a business model that is “highly vulnerable to an economic downturn”, and the viability of the proposed ILC would be entirely reliant on the parent company. In his separate statement, he also cited “extraordinary conditions” included in Square’s CALMA, including maintaining the 20% tier 1 leverage ratio at the proposed ILC and establishing a $50 million emergency fund in the event Square, Inc. failed to provide sufficient funds to the proposed ILC. He opined the conditions were “reflective of the underlying weakness of the application.” He also described the conditions in the parent company agreement, several of which were described in the FDIC’s March 17 proposed rule for ILCs and their parent companies. Gruenberg voted to approve Nelnet’s application, though he did issue a separate statement discussing his opinions.

The ILC charter has garnered significant opposition from community banks, community groups, trade associations, and others. This longstanding opposition stems from the fact that an ILC charter allows a commercial firm to own and control an FDIC-insured depository institution. Opponents argue this mixing of banking and commerce results in an uneven regulatory playing field, increases the risk of consumer harm, poses conflicts of interest and privacy concerns, and threatens the stability of the U.S. financial system, among other things. Opponents also have expressed concern that granting any fintech FDIC-insured ILC charter is a slippery slope toward allowing large U.S. “Big Tech” giants such as Apple, Google, and Amazon to enter banking.

The attention now shifts to pending deposit insurance applications for ILCs that are not predominantly financial in nature. In her statement accompanying the proposed rule, Chairman McWilliams noted that “some industrial banks today are owned by nonfinancial commercial firms, and the FDIC has received applications from groups seeking to establish new banks owned by commercial parents. Questions about the mixing of banking and commerce, and the ability of banks to affiliate with nonfinancial firms, involve complicated policy trade-offs that are best addressed by Congress.”

Rakuten, a Japanese e-commerce company akin to Amazon, currently has an application pending. Its application promises to focus renewed attention on large tech firms, fintechs, and other non-bank companies seeking U.S. banking charters and the mixing of banking and commerce. Deposit insurance applications for commercially owned ILCs may be forced to wait to receive approval for federal deposit insurance until the FDIC adopts a final rule for ILCs and their parent companies. That process could take a long time.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

Previous Fintech in Brief Advisories:
FDIC Signals Pending Decisions on ILC Applications and Proposes New Rules for ILCs and their Parent Companies
FDIC Approves First Fintech Application for Federal Deposit Insurance