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The FDIC's Supervision of Industrial Loan Companies: A Historical Perspective
Industrial loan companies and industrial banks (collectively, ILCs) are FDIC-supervised financial institutions whose distinct features include the fact that they can be owned by commercial firms that are not regulated by a federal banking agency.1 Some observers question whether current arrangements for overseeing the relationship between an ILC and its parent would provide sufficient safeguards if more extensive mixing of banking and commerce were permitted. This article describes the FDIC's approach to supervising ILCs and its historical experience with the ILC charter. Because Utah is home to by far the majority of the commercially owned ILCs, we highlight the supervisory practices Utah and the FDIC have employed with respect to the ILC-parent relationship. Our purpose is not to address the broader banking and commerce debate, but to provide a factual and historical context to policy discussions about how supervisors protect FDIC-insured entities that are part of larger organizations.
Strategies to monitor and control a bank's relationship with affiliated and controlling entities are fundamental to effective bank supervision under any organizational form that banks adopt. This principle is enshrined in U.S. banking legislation, bank regulation, and supervisory practice. Stand-alone banks, savings associations, bank and thrift holding company subsidiaries, industrial loan companies, and other FDIC-insured entities are subject to Sections 23A and 23B of the Federal Reserve Act, which limits bank transactions with affiliates, including the parent company.2 Federal Reserve Regulation O places limitations on loans to bank insiders and applies to all insured banks.3 The Prompt Corrective Action regulations required under the Federal Deposit Insurance Act (FDI Act) mandate progressively severe sanctions against any insured bank whose owners fail to maintain adequate capitalization in that bank.4 These and other safeguards described in this article constrain the degree to which a parent company or its subsidiaries can undertake transactions with, or divert capital from, an insured institution.
This array of safeguards reflects the importance Congress and the banking agencies attach to containing the potential cost of bank failures. The bank failures listed in Table 1 were caused by various factors, including weak economic conditions, failed business strategies, insufficient oversight by boards of directors, fraud perpetrated by bank insiders, and the nature of the influence exerted by a holding company or other controlling entity. Table 1 shows that the problems that can cause a bank to fail strike democratically across charter types and regulatory structures. More specifically, the table reinforces the observation that appropriate safeguards over inter-affiliate transactions are important under any charter type.
Depending on the organizational form a banking company adopts, federal oversight of the relationship between an insured bank and its affiliates may occur in two ways: bank supervision and holding company supervision. Bank supervision does not involve extensive federal banking agency oversight of controlling entities and their related interests. For example, if the controlling shareholder of a community bank also owns an automobile dealership, that dealership is not supervised by a federal banking agency. The statutory, regulatory, and supervisory safeguards alluded to at the outset of this article are designed to prevent abuse of the bank by the owner, and the owner may be required to produce documents and financial records that detail the bank's relationship with the dealership.
As of year-end 2003, 7,769 insured commercial banks were in operation. Of these, about 1,370 stand-alone commercial insured banks, 56 ILCs, and 40 Competitive Equality Banking Act (CEBA) credit card banks and other non-BHCA banks interacted with the federal banking agencies primarily by virtue of the agencies' bank supervision powers.5 Another 6,303 insured institutions were bank holding company subsidiaries. Each of these institutions was directly regulated, as a bank, by the relevant federal banking agency, and the parent companies of these institutions were subject to an additional layer of Federal Reserve supervision.6
In addition to supervising bank holding companies, the Federal Reserve, under the Gramm-Leach-Bliley Act of 1999 (GLBA), has umbrella supervision powers with respect to financial holding companies.7 Where a subsidiary of a bank holding company or financial holding company is regulated directly by another agency, GLBA directs the Federal Reserve to rely on work performed by that agency (the "functional regulator") to the extent practical for purposes of exercising its umbrella supervision responsibilities.
In the context of this regulatory landscape, an ILC is an insured bank operating under a specific charter whose controlling shareholder may be a nonfinancial corporation. The ILC is subject to oversight by federal and state bank regulators; however, the controlling company in many cases is not.8 Table 2 compares key features of the ILC charter with those of a bank charter. The remainder of this article discusses the supervisory approach and framework that have evolved with respect to ILCs and concludes with a brief chronology of ILC failures.
A Historical Perspective on ILC Supervision
Stepping back, industrial loan companies and industrial banks have existed since the turn of the 20th century. In 1910, Arthur J. Morris established the Fidelity Savings and Trust Company of Norfolk, Virginia. This was the first of the Morris Plan Companies, which were also known as industrials, industrial banks (borrowers were industrial workers), or thrift and loans. In the beginning, these entities were not subject to supervision by any federal banking regulator but rather were state-chartered and supervised by the states. These early industrials operated more or less like finance companies, providing loans (at a high interest rate) to wage earners who could not otherwise obtain credit. The loans were not collateralized but were based on endorsements from two creditworthy individuals who knew the borrower. Some ILCs operating today continue to serve as small financing companies; however, they have expanded their operations to include some commercial and collateralized real estate lending.
State law prevented some of the early Morris Plan banks from receiving deposits. Instead, they issued certificates of investment or indebtedness (thrift certificates) and avoided the use of the term "deposit." Because some state laws did not permit these entities to accept deposits, the FDIC determined that they were not eligible for federal deposit insurance.9 This policy eventually changed, and at least six banks received federal deposit insurance from 1958 through 1979. In addition, as state law permitted industrial banks to include "bank" in their name, these entities applied for and received deposit insurance.
Because thrift certificates were exempt from Regulation Q interest rate restrictions, the ILCs tended to pay higher interest rates on their thrift certificates than insured banks paid on their deposits. Even given the high interest rates, some investors were reluctant to purchase the thrift certificates, as they were not federally insured. In 1975, Utah formed an insurance fund, the Industrial Loan Guaranty Corporation (ILGC), to help ILCs remain competitive with federally insured banks. California organized a similar state insurance fund. Both insurance funds were financed not as part of the state budgets but rather built up reserves through modest assessments on ILCs. After only two ILC failures in 1978 and 1980, the Utah ILGC fund was depleted. The California fund also was depleted following a large ILC failure. These problems were compounded in 1980 when Regulation Q was repealed, allowing banks to pay higher interest rates and forcing ILCs to accept narrower margins to remain competitive.
This situation posed significant challenges for the onset of federal supervision in the early 1980s. The FDIC's involvement with industrial loan companies began in earnest in 1982, when the Garn-St Germain Depository Institutions Act authorized federal deposit insurance for thrift certificates, a funding source used by industrial loan companies. Provisions of this legislation allowed ILCs that were regulated in a manner similar to commercial banks to apply for federal deposit insurance. Reinforcing this development, some states changed their laws to require their ILCs to obtain FDIC insurance as a condition of keeping their charters. The determination of eligibility for federal deposit insurance came as ILCs were experiencing significant deterioration in credit quality and the economy was entering a recession. Several ILCs that applied for federal deposit insurance required the infusion of additional capital, and other applications were denied. As a result, those entities had to be sold or liquidated.
The FDIC subsequently amended its Statement of Policy Concerning Applications for Deposit Insurance to clarify that ILCs would be eligible for deposit insurance if they met certain requirements. These requirements addressed problems that had characterized the previously uninsured ILCs. If the eligibility requirements were met, the FDIC Board of Directors would then evaluate an applicant based on the factors set forth in Section 6 of the FDI Act: the financial history and condition of the applicant; the adequacy of the applicant's capital structure, future earnings prospects, and character of management; the convenience and needs of the community; and whether the applicant's corporate powers were consistent with the FDI Act.
In the mid-1980s, commercial firms became increasingly interested in nonbank bank charters (including ILCs) because they were exempt from the Bank Holding Company Act.10 As a result, more than 40 nonbank banks were organized that were owned by commercial firms, and several hundred more applications were anticipated. These applications were not filed, however, because in 1987 CEBA was enacted. CEBA generally made all banks that were insured by the FDIC "banks" under the BHCA. Therefore, with certain exceptions, all existing nonbank banks that were insured became "banks" under the BHCA. CEBA also grandfathered the exclusion from the BHCA of the parent companies of existing nonbank banks, provided they operated within certain restrictions. Interest increased in the ILC charter, and, in 1988, the first commercially owned ILC applied for FDIC insurance. Once the precedent had been set, more applications followed.
Tasked with supervising the ILCs that had obtained federal deposit insurance, the early FDIC and state examinations of those ILCs with commercial parents proved challenging. Examiners encountered management unaccustomed to regulatory oversight and sometimes unwilling to provide information. For example, examiners frequently could not identify local officers with decision-making authority or find records, including loan documentation, on site. These entities operated as an extension of the parent, not as autonomous, federally insured and regulated banks. It became apparent that such ILCs needed to be introduced to and helped to understand the specifics of banking regulation and corporate governance of the separate ILC entity.
Specifically, just as for all other insured banks, ILC management (senior officers and directors) must be held accountable for ensuring that all bank operations and business functions are performed in compliance with banking regulations and in a safe and sound manner. To guarantee sufficient autonomy and insulate the bank from the parent, the state authority, the FDIC, or both typically impose certain controls. One example of proactive state supervision is the Utah Department of Financial Institutions, which imposes conditions for approval of new industrial bank charters, giving considerable weight to the following factors:
The FDIC has developed conditions that may be imposed when approving deposit insurance applications for institutions that will be owned by or significantly involved in transactions with commercial or financial companies.12 Some of the nonstandard conditions that may be imposed include the following:
As with any bank-level review of an institution with affiliates, examination procedures include an assessment of the bank's corporate structure and how the bank interacts with the affiliates (including a review of intercompany transactions and interdependencies) as well as an evaluation of any financial risks that may be inherent in the relationship. Examiners review the current written business plan and evaluate any changes. Examiners also review any arrangements involving shared management or employees. In the latter case, referred to as "dual employees," agreements should be in place that define compensation arrangements, specify how to avoid conflicts of interest, establish reporting lines, and assign authority for managing the dual-employee relationship.
All services provided to or purchased from an affiliate must be on the same terms and conditions as would be applied to nonaffiliated entities. All service relationships must be governed by a written agreement, and the bank should have a contingency plan for all critical business functions performed by affiliated companies.
In examining any insured depository institution, the FDIC has the authority (under Section 10(b) of the FDI Act) to examine any affiliate of the institution, including the parent company, for purposes of determining (i) the relationship between the ILC and its parent and (ii) the effect of such a relationship on the ILC.13 Further, Section 10(c) of the FDI Act empowers the FDIC, in the course of its supervisory activities, to issue subpoenas and to take and preserve testimony under oath, so long as the documentation or information sought relates to the affairs or ownership of the insured institution.14 Accordingly, individuals, corporations, partnerships, or other entities that in any way affect the institution's affairs or ownership may be subpoenaed and required to produce documents. In addition, the states of Utah, California, and Nevada have direct authority to conduct examinations of parents and affiliates.15
ILC Failures: A Brief Chronology
The narrative above indicates that ILCs' entry into the federal regulatory arena and FDIC insurance was precipitated by financial difficulties the ILCs were experiencing. Recollections of FDIC examination staff are that a number of the newly insured ILCs were essentially small finance company operations that paid high rates to thrift certificate holders and made higher-risk loans. The post-1985 history of ILC failures is dominated by these smaller ILCs.
From 1985 through year-end 2003, 21 ILCs failed (Table 3). Of those, 19 were operated as finance companies, and the average total assets of these 19 failed ILCs were $23 million. Most of the failures were small California Thrift and Loans that did not fare well in the banking crisis of the late 1980s and early 1990s.16 Eight of the 21 ILC failures occurred within five years of the institutions' receiving FDIC insurance. Another ten failures occurred within six to eight years of receiving insurance.
The two largest ILC failures are also the most recentPacific Thrift and Loan and Southern Pacific Bank (SPB). Both were part of a holding company structure when they failed; one, SPB, was a vestige of the old system of uninsured ILCs. SPB, the largest failure, was originally chartered in 1982 as Southern Pacific Thrift and Loan and was insured in 1987 with a name change to Southern Pacific Bank. Pacific Thrift and Loan was chartered and received federal deposit insurance in 1988. Both failures were the result of ineffective risk management and poor credit quality.
It is difficult to make definitive, "all other things equal" comparisons of historical failure rates of ILCs with failure rates for other charter types. Failed ILCs generally were small Thrift and Loan companies (except for Southern Pacific and Pacific Thrift and Loan) and, during a significant part of the period we are considering, were relative newcomers to federal supervision. Also, as noted above, a number of them may have entered the insured arena with an above-average risk profile and, soon after their entry, experienced deteriorating local economic conditions and a severe real estate downturn. These factors contributed to a relatively high incidence of failure.17
A review of Table 3 raises an interesting question: Why have no Utah-based insured ILCs failed? One plausible answer is that only eight of the original Utah state-insured ILCs were subsequently insured by the FDIC. The state of Utah tried to either sell or liquidate the poorer-performing ILCs. Recently, an essentially new ILC industry has been born in Utah, with commercial companies either buying ILC charters or organizing de novo institutions. The supervisory strategies and standards the FDIC and the state of Utah applied to this new breed of ILCs, outlined in the preceding section of this article, have been tailored to fit the profiles of individual institutions. While details of supervisory approaches may differ across institutions, the approaches share one overriding principle that permeates both state and federal bank supervision: protection of the insured entity.
Monitoring and controlling the relationship between an insured entity and its parent company is an important part of the banking agencies' approach to supervision. This is true under any organizational form banks adopt, including the limited number of banks now operating as subsidiaries of a commercial firm or other nonbank entity. Because Utah is home to a number of commercially owned ILCs, the evolving supervisory strategies developed by that state and the FDIC provide a window into the processes and procedures that are important to consider in any discussion of insulating an insured entity from potential abuses and conflicts of interest by a nonfederally supervised parent. Cooperation between regulators from the state authorities and the FDIC's San Francisco Region and ILC management has resulted in critical controls, including requirements for local management, boards of directors, and files, as well as definitive business plans for the ILCs. More broadly, experience with the ILC charter reinforces the conclusion derived from other charter types that effective bank-level supervision is a key ingredient in safeguarding insured institutions from risks posed by parent companies.
The author acknowledges the significant contributions made to this article by
Robert C. Fick, Counsel
Callister, Louis H., and George Sutton, "Industrial Banks," Consumer Finance Law Quarterly Report, Salt Lake City, Utah, Spring 2002.
Comizio, V. Gerard, "Bank Chartering Issues in the New MillenniumComparing Deposit Holding Companies and Bank Charters," Consumer Finance Law Quarterly Report, Spring 2002.
Federal Deposit Insurance Corporation, History of the EightiesLessons for the Future, Washington, DC, FDIC, 1997.
Ross, Yan M., and George Sutton, "Utah ILCs: A Fresh Look Backward and Forward," Quarterly Report, November 17, 1992.
Sutton, George, "Industrial Banks," Consumer Finance Law Quarterly Report, Spring 2002.
1 ILCs are state-chartered institutions (currently operating in California, Colorado, Hawaii, Indiana, Minnesota, Nevada, and Utah) that under certain circumstances are not "banks" under the Bank Holding Company Act (BHCA). A company controlling an institution that is not a BHCA bank is not required to register as a bank holding company with the Federal Reserve Board and, therefore, is not subject to regulation and supervision by the Federal Reserve Board. Generally, an ILC will not be a BHCA bank as long as it satisfies at least one of the following conditions: (1) the institution does not accept demand deposits, (2) the institution's total assets are less than $100,000,000, or (3) control of the institution has not been acquired by any company after August 10, 1987.
2 Sections 23A and 23B, 12 U.S.C. §§ 371c & 371c-1, by their terms, apply only to state member banks and national banks. However, section 18(j) of the Federal Deposit Insurance Act, 12 U.S.C. § 1828(j) makes Sections 23A and 23B applicable to state nonmember banks, and 12 U.S.C. § 1468 makes sections 23A and 23B applicable to savings associations.
3 Regulation O (loans to insiders), 12 C.F.R. Part 215. FDIC regulations (12 C.F.R. § 337.3) make the Regulation O prohibitions and limitations on loans to insiders applicable to all insured nonmember banks.
4 See, for example, 12 C.F.R. Part 325 (with respect to nonmember banks).
5 The Competitive Equality Banking Act of 1987, Pub. L. No. 100-86, § 101(a)(1), 101 Stat. 554, 562 redefined "bank" for purposes of the Bank Holding Company Act to include any bank insured by the FDIC but specifically excepted certain classes of banks from the BHCA, including CEBA credit card banks and certain ILCs.
6 By comparison, both federal savings associations and savings and loan holding companies are regulated by the Office of Thrift Supervision.
7 Gramm-Leach-Bliley Act of 1999 (GLBA), Pub. L. No. 106-102. Title I, 113 Stat. 1338.
8 Under a proposed rule, broker-dealers who own ILCs may soon be able to choose consolidated supervision by the Securities and Exchange Commission. See "Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities," 62 Fed. Reg. 62872 (proposed November 6, 2003, to be codified at 17 C.F.R. Part 240). An ILC can be owned by a bank holding company, in which case the parent company is subject to Federal Reserve supervision.
9 Where state law permitted the use of "bank" in the name, 45 industrial banks became federally insured before the enactment of the Garn-St Germain Depository Institutions Act of 1982, Pub. L. 97-320, 96 Stat. 1469.
10 At that time, the BHCA defined a bank as an entity that both made commercial loans and accepted demand deposits. If an entity performed only one of these tasks, it was not a bank under the BHCA. Such an entity became known as a nonbank bank because it was not a bank for BHCA purposes, yet it was a bank for other purposes, including, for example, deposit insurance. As a result, a company that controlled a nonbank bank was not subject to regulation and supervision as a bank holding company.
11 These requirements are outlined in Utah's Department of Financial Institutions website at https://dfi.utah.gov/financial-institutions/industrial-banks/.
12 Regional Director memo, transmittal number 2004-011, "Imposition of Prudential Conditions in Approvals of Applications for Deposit Insurance."
15 The Utah Department of Financial Institutions ("DFI") requires all parent companies to register with the state under Section 7-8-16 of the Utah Code and has authority to examine such companies under Section 7-1-510. The California DFI has authority to examine parent organizations through Chapter 21, Section 3700 (specifically Section 3704) of the California Financial Code and to require reports and information through Section 3703. In the state of Nevada, holding companies are required to register with the Secretary of State. The Financial Institutions Department for the State of Nevada has the authority to conduct examinations of parent organizations under Section 658.185.
16 As the operations of industrial banks based in California grew larger and more complex, the California Department of Financial Institutions reorganized and enhanced its oversight of ILCs. In October 2000, California state laws and regulations governing the oversight of ILCs (specific to capital standards, lending authority, loan limits, permissible investments, branching requirements, transactions with affiliates, dividend restriction, and holding company examinations) were revised to parallel those of other charter types.
17 For more general information on the regional banking crises of the 1980s and early 1990s, see FDIC, History of the EightiesLessons for the Future.
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