4000 - Advisory Opinions
Application of Regulation O to Formula for Calculation of Interest Rate
August 4, 1982
Pamela E. F. LeCren, Senior Attorney
At your request, I have reviewed the attached June 22, 1982 opinion concerning *** written by Honors Attorney Robert Feldman in which you concurred. The opinion concerns a formula used by *** to calculate interest on loans. The formula, which is used for loans to all bank customers, establishes a sliding scale that lowers the interest rate on a loan in proportion to the size of the customer's compensating balance. For example, if customer X has no compensating balance, the interest rate on X's loan is prime plus five percent. Prime equals the money market certificate rate plus 31/2 percent. The scale tops off at a 150 percent compensating balance which carries an interest rate of prime minus 12 percent. The bank has established a minimum rate of 71/2 percent. A customer's compensating balance is equal to the sum total of that customer's demand deposits, the total book value of his or her stock in the bank, and 50 percent of his or her savings deposits held by the bank.
Attorney Feldman concluded that although the same formula was used to calculate the interest rate on loans to all bank customers, use of the formula would entail a violation of section 215.4(a) of Regulation O which requires that loans to bank insiders be made on substantially the same terms (including interest rate and collateral) as those made available to persons not employed by the bank or covered by Regulation O. After reviewing Mr. Feldman's memorandum and the regulation, we are in agreement with the conclusion expressed in that memorandum.
The formula necessarily treats similarly creditworthy individuals differently based upon their stock ownership in the lending bank. For example, customer X who has the same demand deposits and savings accounts as customer Y but who holds stock in *** will be accorded a better interest rate on a loan than Y who holds stock of equal book value in another institution but holds no stock in ***. The formula thus may result in an extension of credit to a principal shareholder that is not made on substantially the same terms as those made available for comparable transactions with persons not subject to the regulation.
Our conclusion is not altered by the fact that it may be possible under the formula for a nonshareholder to obtain as good a rate or a better rate than a shareholder who has no demand deposits or savings accounts. The fact that the formula places a premium on shareholder status and does not treat shareholder status within the broader context of creditworthiness (i.e., the customer's overall financial status) causes us to conclude that the formula is improper. Where the formula results in terms more favorable to principal shareholders of the bank, the loans to the principal shareholders will be in violation of section 215.4(a).
Not only do we find to include book value of a customer's stock as part of a formula to determine the interest rate on loans to present a problem under § 215.4(a), we find it somewhat incongruous that *** would consider stock ownership to have some function as a compensating balance.
By requiring a compensating balance when extending a loan, a bank is in a position to set the interest rate on that loan at a lesser rate than it might otherwise make available to any particular customer. As the compensating balance serves as a cheap source of funds, the bank is "compensated" on its loss of interest income from the loan. In fact, a bank will often come out ahead due to the spread between the interest (if any) it pays on the deposit and the income it can draw when the funds are invested. The compensating balance can also serve as a form of collateral, i.e., the funds could be used as set-off against the debt owed to the bank. Compensating balances are normally restricted to demand deposits. While considering a debtor's assets (including bank stock) in assessing his or her creditworthiness is normal banking practice, to consider the customer's stock in the lending bank to somehow be a "compensating balance" is, as indicated above, somewhat incongruous. Inasmuch as the instant formula was developed after the Regulation O violations were cited, including stock ownership as part of that formula tends to confirm the appearance of the bank adopting the formula simply to explain away preferential loans to bank insiders.