Thoughts on the Close the ILC Loophole Act
Plus, another interesting FDIC-related bank merger development
Thoughts on the Close the ILC Loophole Act
An industrial bank or industrial loan company (ILC) is a state-chartered bank that, like an ordinary commercial bank, has the power to take deposits, make loans and engage in other banking activities. Despite this, if an ILC meets certain criteria it does not count as a “bank” for purposes of the Bank Holding Company Act.1 Among other consequences, this means that the ILC’s holding company is not subject to the same activities restrictions that otherwise prevent companies that own banks from also engaging in commercial activities.
ILCs have their supporters, but in general this is a rare issue where various stakeholder groups which are frequently locked in combat find themselves in violent agreement: it does not make sense for the BHC Act to exclude ILCs from the definition of bank.2
Regulators and many members of Congress are also uneasy about, or outright opposed to, the ILC exemption. Over the past two decades this has manifested itself in various moratoria on new ILC approvals (both self-imposed by the FDIC and mandated by Congress) as well as various pushes in Congress to amend the BHC Act to remove the exclusion. So far, the closest this latter effort has come to finding success was in 2007, when the House of Representatives by a vote of 371-16 passed the Industrial Bank Holding Company Act of 2007. That bill died in the Senate, however.
Momentum is building to try again. This time, the vehicle being backed by public interest groups and the banking industry is a bill sponsored by Rep. Jesus Garcia called the Close the ILC Loophole Act.3
This post is intended to describe three key issues that an effort to remove the ILC exception must address and explore how the proposed bill would address them.
What Happens to Existing ILCs?
The FFIEC’s National Information Center currently lists 25 ILCs.4 Of these, many are small institutions to which the proposed bill would not make much of a difference, either because the ILC in question does not have a parent company at all or because the parent company and its non-bank affiliates are engaged in activities that would be permissible for a bank holding company. There are a few ILCs, however, with parent companies engaged in activities that clearly would be impermissible under the BHC Act,5 and a few other ILCs with parent companies engaged in a mix of financial and non-financial activities.
Most agree that it would be unfair to such companies to pass a bill effectively forcing them to quickly sell their ILCs or else have their non-banking activities become illegal. The proposed bill would address this by adding another condition to the ILC exemption: to be eligible for the exemption the industrial bank in question must have been granted deposit insurance (or have a pending application for deposit insurance) before September 23, 2021.6
The supervision of grandfathered companies would not be completely unchanged, however. Another section of the bill would give the Federal Reserve Board the authority to supervise and examine such companies.
So no required change in non-banking activities, but an additional degree of federal bank regulatory oversight. This seems like a reasonable enough result, but the questions get harder as we go on.
What Happens to Companies with ILC Applications Pending?
The FDIC’s website currently shows four pending ILC charter applications, two from companies that are at least vaguely financial companies and two from firms squarely engaged in commercial activities.7 The most notable of these is an application from Rakuten, a Japanese e-commerce company, which has drawn significant opposition, again from across the spectrum.
For these pending applications, the bill would require the FDIC to (re-)open the applications for public comment and hold a public hearing on each application. After receiving this public input, the FDIC would have until September 23, 2023 to approve the application, otherwise the application would be denied.
Were Congress to enact this proposed bill, I do not expect that there would be a lot of dramatic tension about what the FDIC would choose to do with the Rakuten application, but maybe one or more of the other applications would squeeze through.
The most interesting thing about this section of the bill is likely a product of the time at which it was drafted: the bill would say that the FDIC could approve an application only by a two-thirds vote of its board of directors. The context for this provision is that the FDIC’s five-member board may by law have no more than three members who are of the same political party. In other words, if there is a full FDIC board of directors,8 a bipartisan vote of at least 4-1 would be required to approve one of the currently pending ILC applications.9
What about M&A Involving a Grandfathered ILC or its Parent Company?
Even if the path to acquiring a BHC Act exemption eligible ILC through a de novo charter application is effectively cut off, a commercial company could attempt to acquire such an ILC from an existing ILC owner. To address this, the bill would direct the federal banking agencies to disapprove a change of control of an ILC under the Change in Bank Control Act unless one of four exceptions applies: (1) the ILC is in danger of default, (2) the acquisition is part of a qualifying internal reorganization, (3) the change in control is the result of an acquisition of a publicly traded company that controls an ILC, provided that after the acquisition, the acquirer holds less than 25 percent of any class of voting shares of the company or (4) the ILC will be controlled by a bank holding company, savings and loan holding company or foreign bank treated as a bank holding company.
The prohibition and the exceptions described above mean that, in essence, if a commercial company were to seek to sell its ILC charter, it would only be able to sell the ILC to another bank or to a company that is already subject to consolidated Federal Reserve Board supervision and already subject to the restrictions on commercial activities to which most banking organizations in the United States are subject. In other words, a car manufacturer that currently owns an ILC could not sell that ILC to another car manufacturer, or a home improvement retailer, or a social media company, etc. That seems fair enough - this will narrow the universe of potential acquirers, but not dramatically so, while still allowing companies to exit the banking business in a non-fire sale fashion should they choose to do so.
Not everyone agrees. The Bank Policy Institute this week reported that “this ‘change in control’ section has become the latest point of contention with this legislation as some parent companies of ILCs have fought vigorously to retain the ability to sell their ILCs to any company.” I would be interested to see the alternative language these ILC parent companies are proposing, but if BPI’s characterization is accurate I agree with BPI’s conclusion that this would undermine the goals of the bill.
One area where I am more sympathetic to the grandfathered ILCs and their parent companies, though, is with respect to the narrowness of the third exception above. As I read this, it would mean that in a hypothetical scenario where a commercial company that owns an ILC merges with or is acquired by another commercial company, the ILC could not be retained by the post-closing company following the merger.
In theory, crafting the exception this narrowly would prevent mergers of commercial companies motivated by a desire to gain control over a subsidiary ILC of the target company. Fair enough, I guess, but how realistic is this scenario? For example, if someone is going to acquire Harley-Davidson, is it really likely that they would be doing so because they want to own a tiny Nevada industrial bank? It seems more likely that such a merger involving commercial companies would be driven by reasons unrelated to the ILC, in which case inserting a mandatory ILC divestiture into the transaction would add a lot of unnecessary friction.10 If that is so, would it be better to impose post-merger restrictions on the ILC’s size or activities, along with a required post-merger divestiture on a long enough timeline (say 5-10 years) to allow for an orderly disposition?
Another interesting FDIC-related bank merger development
On Wednesday morning, New York Community Bancorp announced that it had amended its merger agreement with Flagstar Bancorp (first signed in April 2021) to extend the termination date for the agreement to October 31, 2022. In addition, the parties announced that they would be revising the structure of the merger of their subsidiary banks such that FDIC approval of the transaction would no longer be required.11
In a press release, the companies explained that this change was being made because the companies “each believe that a national bank charter is an appropriate charter for the combined company’s banking operations, especially taking into account Flagstar’s national mortgage banking business, which Flagstar has operated successfully for many years under the supervision of the Office of the Comptroller of the Currency.”
On NYCB’s earnings call, analysts asked the obvious questions:
Operator
Thank you. Our next question comes from Steven Alexopoulos with JPMorgan. Please proceed with your question.
Steven Alexopoulos
Hey, good morning, everyone. Can you give more color on the decision to go the route of the national bank charter? And you said, you received NYS [DFS] approval. Was the FDIC a roadblock in getting this deal approved?
Thomas Cangemi
Well, I'm not going to comment on any agency. I will tell you that we truly believe that with the National Banking platform and where we're heading in the bank in the future that the OCC charter is the way to go. So clearly, we're very much appreciative of [DFS] approval, and I'm not going to comment on any other regulatory discussions there.
Steven Alexopoulos
Okay. But what -- can you go into the decision to switch to the national charter?
Thomas Cangemi
I just did. As we -- I do appreciate the question and it can be sensitive on the commentary, but we went to a journey through this process. It's now a year through the approval process, and as we went through this process, we feel very confident that the business model is focused on a national mortgage banking platform and a national commercial banking platform that will be more inclined for an OCC Charter.
Maybe the full story is the story presented in public. Maybe the parties really did, three years after first starting to explore this deal,12 organically come to realize that it would be better for the bank to have a national bank charter.
It does seem like a flaw in the opaque bank supervision and bank merger review process, though, that we may never be able to say for sure.
To oversimplify slightly, to benefit from this exclusion the ILC must either (i) have total assets less than $100 million, (ii) have not have had a change in control after August 10, 1987 or (iii) not accept “demand deposits that the depositor may withdraw by check or other similar means for payment to third parties.” This third condition is the condition upon which most ILCs rely. For bank accounts owned by individuals, this is not nearly as restrictive as it sounds because these banks may offer NOW accounts that effectively function as demand deposit accounts. In addition, trade groups have raised concerns that recent changes to the definition of savings deposit may have further blurred the distinction between demand deposits and other types of deposits.
Obligatory disclaimer for the rest of this post: the ILC issue is an area where I find myself in agreement with the public interest groups and the trade associations. You can raise semantic quibbles about whether it is right to characterize the ILC exclusion as a “loophole,” given that the statute clearly says what it says, but on the question of whether the statute should as a policy matter say what it says, I have never heard a convincing rationale for the exception. For example, this letter from the Conference of State Bank Supervisors, though framed as addressing “misperceptions regarding ILCs,” quickly devolves into a litany of complaints about the OCC’s fintech charter without ever coming around to defending the ILC exemption on the merits.
The bill has three co-sponsors, one Democrat and two Republicans.
The National Information Center breaks down their location as follows: Utah (15), Nevada (4), California (3), Minnesota (2) and Hawaii (1).
This marks a change from the discussion draft of this bill introduced by Rep. Garcia during the last Congress which would have taken a much harsher approach to grandfathering.
In addition to the four pending de novo charter applications, the FDIC’s website also shows a pending conversion application.
The FDIC is currently headed by an Acting Chairman who was last confirmed by the Senate in 2012 and whose term expired in 2017 (he is permitted by law to serve until a successor is appointed and qualified). This might make you skeptical as to the odds of the FDIC having a full board of directors any time soon.
This provision would also have the effect of requiring ILC deposit insurance applications to be approved at the board level, rather than being acted on by FDIC staff under delegated authority. This would codify the FDIC’s current approach, which reserves decisions on ILC deposit insurance applications to the board.
I suppose the counterargument is that you could imagine a scenario where a giant company that really, really wants to own a bank might be willing to acquire one of the smaller commercial companies that own ILCs, and would be willing to bear the costs of acquiring the commercial business of the target even if that commercial business is irrelevant to the acquirer’s line(s) of business.
FDIC and New York Department of Financial Services approval would have been required because the parties planned for Flagstar’s bank to merge into NYCB’s bank, which is a New York state savings bank. The revised agreement would have Flagstar’s bank, which currently operates a federal savings bank charter, convert to a national bank charter and then NYCB’s bank would merge into the national bank.
The Background of the Merger section of the parties’ S-4 states that between April and June of 2019 the parties had preliminary discussions regarding a potential transaction. Discussions picked up again in January 2021.