Introduction

Bank directors who have the desire and stamina are welcome to delve through the intricacies of the new, 400+ page Financial Services Modernization Act.

Perhaps more important to bank directors than the details of the new law's provisions expanding the powers of bank subsidiaries and bank holding companies is an understanding of how the new law affects the strategic planning process and the future of their institution.

Both the new law and existing law allow banks to offer a wide array of products - many are nonbanking in nature - which can produce noninterest fee income. Which fee income-producing products will community banks offer, and how? What corporate structure will be most suitable for community banks to engage in these activities?

This will be my focus for this short article. I will not address other subjects of the new law, including important changes in laws affecting CRA, privacy, and Federal Home Loan Bank borrowings. I also acknowledge the possibility that my reading of some of the provisions of the new law may be found to be in error. The new law will be subject to an interpretive process in the coming months as the federal banking agencies develop regulations.

Why should community banks care about activities that produce fee income?

Many community banks rely heavily on the traditional banking business - accepting deposits, making loans, and living off the net interest margin. Although some banks may continue to thrive just on this business, many others will be forced or will want to expand their business into fee income activities such as insurance agency activities, broker-dealer activities, and investment advisory services.

Many large banks have already made the transformation from banking to financial services. In 1998, 50% of the total revenues of bank holding companies with other $50 billion in assets represented noninterest income, up from 39% in 1994.

In contrast, for banks and bank holding companies with assets of between $100 million and $2 billion, only 20% of total revenues represented noninterest income, up from 16% in 1994.

Most community banks still rely heavily on net interest spreads. In 1998, the net interest income of banks with assets of between $100 million and $2 billion was 4.13% of average assets, while banks and bank holding companies with over $50 billion in assets had net interest income of 2.92% of average assets. Because large banks do not rely as much on net interest spreads, they can offer higher rates on deposits and lower rates on loans.

As customers increase their use of off-premises facilities to conduct their banking business, such as ATMs and the Internet, many community banks should seek ways to more fully utilize their investment in their branch systems. Personal service products such as insurance and investment advisory services can be offered through branch offices, which can also facilitate cross-selling opportunities.

Increase in competition

One obvious byproduct of the new law is the increase in competition from those who were not previously direct competitors.

Under prior law, investment firms and insurance companies could not own banks. Now they can. The Allstates and Merrill Lynches of the world can turn each of their insurance agency or brokerage offices into commercial bank branches, state law permitting.

Larger bank competitors will also be able to offer a wider array of products to your customers. Customers will be able to visit a branch of a large bank and take care of all of their banking, investment, and insurance needs. The large banks will no longer be required to share their profits with insurance companies and investment firms because they will also be the insurance company and investment firm.

New activities authorized by the new law

Community bank subsidiaries or their holding companies can engage in the same new activities that large bank subsidiaries and their holding companies can engage in under the new law. But, practically speaking, will they?

What are the new activities? Those enumerated in the new law include underwriting insurance and annuities; underwriting, dealing in or making a market in securities; acquiring and controlling companies engaged in activities not authorized for holding companies or banks, as part of a bona fide underwriting or merchant or investment banking activity; and underwriting and dealing in municipal revenue bonds. All but underwriting and dealing in municipal revenue bonds must be conducted at the holding company level.

How many community banks will purchase or establish insurance companies and investment firms? How many will be in a position to underwrite the sale of securities? Very few will have the financial capacity and skills to engage in these activities actively and directly.

The neutrality of laws in the face of inequality reminds me of a quote from Anatole France: "The law, in its majestic equality, forbids the rich as well as the poor, to sleep under bridges, to beg in the streets and to steal bread."

Of course, the new law does more than enumerate some new activities. It creates a new standard for the Federal Reserve (subject to the Secretary of Treasury's veto) to measure whether a bank holding company (or the new financial holding company) may engage in a particular activity. The old standard was whether the activity was closely related to banking. The new standard is whether the activity is financial in nature, or incidental or complementary to an activity that is financial in nature.

The new law also creates a new standard by which the Secretary of the Treasury (subject to a Fed veto) decides whether a national bank financial subsidiary may engage in a particular activity. The new standard is whether the activity is financial in nature or incidental to an activity that is financial in nature (but not complimentary to an authorized activity). However, the statute provides that certain activities, even though they may be considered financial in nature, cannot be performed by a national bank subsidiary. These include real estate development and investment, insurance underwriting and merchant banking.

Once the Federal Reserve and the Secretary of the Treasury promulgate rules on which activities qualify under the new law as financial in nature, etc., we will know which new activities community banks, given their resources, may engage in under the new law.

Activities authorized under existing law

The new law, with a few exceptions, leaves intact the activities that banks, their subsidiaries, and holding companies and their subsidiaries could engage in prior to the effectiveness of the new law.

For example, holding companies and their nonbank subsidiaries can engage in activities that are closely related to banking, as determined by the Federal Reserve by regulation or order prior to the enactment of the new law. This is an extensive list. I doubt that most community bank holding companies have even scratched the surface in taking advantage of many of these activities.

Under existing law, national banks directly and through operating subsidiaries may engage in activities that are a part of the business of banking and are incidental to the business of banking. Under this authority, the courts and the Comptroller of the Currency have authorized an extensive and exceedingly broad list of activities. The new law leaves this authority intact; national banks can continue to engage in activities which are part of the business of banking and that are incidental to the business of banks.

In the past, the Comptroller has authorized activities such as the sale of software and hardware to customers to communicate with the bank through electronic means; acting as finder in a variety of contexts; real estate development and investment where the bank will use a part of the premises for bank use; privately placing stock or other equity of others, and taking equity interests in the form of warrants or sharing in profits in entities which borrow from the bank.

The new law hardly touches the authority of state banks and state bank subsidiaries to engage in activities that state law permits them to engage in. Under existing law, where a state bank or state bank subsidiary acts as principal in an activity that national banks cannot engage in, the state bank must obtain the approval of the FDIC before it may engage in the activity.

Activities that community banks are most interested in

From our experience, the nonbanking activities that community banks are most interested in engaging in are those that they may already engage in under existing law.

They include mortgage company, small loan company, insurance agency (including title insurance and annuities), personal property leasing, investment advisory, trust and broker-dealer activities through third party broker-dealers. The new law does lift the requirement that national bank subsidiary insurance agencies must be located in towns with populations of 5,000 or less. However, national bank parents that function as insurance agencies remain under the geographic restriction. The new law prohibits national banks from selling title insurance unless they sold title insurance before enactment of the new law, or unless state law in a state where the national bank wants to sell the title insurance allows state banks to sell title insurance. However, national bank subsidiaries are not restricted in selling title insurance.

National vs. state banks

Does the new law tilt the balance between state and national banks? In other words, is there anything in the new law that would entice state banks to become national banks or national banks to convert to state banks?

In terms of the activities in which banks may engage, the new law seems to maintain the status quo. Each bank should evaluate those activities in which it wishes to engage. The Comptroller of the Currency has historically sought to expand the powers of national banks and their subsidiaries aggressively. We can expect the Comptroller to continue to seek ways for national banks and their subsidiaries to expand their activities under the new standard (activities that are financial in nature) as well as the old standard (part of the business of banking and incidental to the business of banking). State laws vary, but many now have "wild card" statutes, that allow state banks to engage in the same activities in which national banks engage. Some states go beyond what national banks can engage in, and allow activities such as real estate development and venture capital investments.

Do thrifts have any advantages over commercial banks?

Prior to enactment of the new law, savings institutions could be owned by unitary thrift holding companies, which could engage in virtually any nonbanking business. However, the new law repealed that authority, except as to those who were grandfathered. Congress thus took away one of the most attractive attributes of being a savings institution.

Another power of savings institutions that commercial banks do not have is the authority to branch nationwide regardless of state law. The new law left this power alone. For banks that have a game plan to establish branches in many states, a thrift charter may be attractive.

What are the strings attached to the new powers?

The new authority to engage in activities that are financial in nature through bank subsidiaries and holding companies and their subsidiaries is encumbered by a number of regulatory restrictions.The new authority to engage in activities that are financial in nature through bank subsidiaries and holding companies and their subsidiaries is encumbered by a number of regulatory restrictions.

Bank subsidiaries or affiliates must be and maintain their status as well capitalized and well managed. Bank subsidiaries and bank affiliates must have at least a satisfactory CRA rating at the time a new activity is begun. Financial subsidiaries of banks cannot have assets exceeding, in the aggregate, 45% of the bank parent's assets. Investments in the equity of financial subsidiaries are deducted from a bank's regulatory capital. Financial subsidiaries of banks are also made subject to most of the restrictions on transactions with affiliates in Section 23A and 23B of the Federal Reserve Act.

How to avoid the strings

It appears that banks and their holding companies can engage in a wide range of activities without becoming subject to the regulatory restrictions described in the last section.

National banks may engage directly or through subsidiaries in activities that are part of or incidental to the business of banking. These powers are not subject to the new law's restrictions on financial subsidiaries of banks. In addition, state banks may, subject to state law, engage directly or through subsidiaries in activities which the states authorize and which are permitted to national banks under the incidental powers provisions of existing law, without becoming subject to the new law's restrictions.

Holding companies may engage in activities that the Fed found to be closely related to banking prior to the enactment of the new law. These powers also are not subject to the new law's restrictions on activities performed at the holding company level that are financial in nature.

As mentioned previously, most activities in which community banks would want to engage are authorized under existing law. For the most part, community banks should be able to avoid the "strings" if they properly structure their activities.

Does our bank need a bank holding company or a financial holding company?

The holding companies of many community banks have been shells, devoid of any activity other than use as leverage and for corporate governance. To the extent community banks have engaged in nonbanking activities, those activities have generally been conducted by the bank or a subsidiary of the bank

The new law will change the use of holding companies for those community banks that want to engage in at least one of the activities that the new law authorizes holding companies, but not financial subsidiaries of banks, to engage in. Those community banks will need holding companies to engage in those activities, unless national banks are permitted by the OCC to engage in the activity because it is a part of banking or incidental to the business of banking, or the states allow state banks to engage in the activity. Under the new law, holding companies that will engage in financial activities need to become certified as "financial holding companies".

Should the financial activity be lodged at the bank, a bank subsidiary or a holding company subsidiary?

This will depend on whether the activity can legally be engaged in by the particular entity and on traditional business considerations.

As discussed in the last section, certain activities can be legally justified on grounds other than the fact that the activity is financial in nature.

Traditional business considerations include sources of funding for the activity, limitation of liability on the parent bank, state licensing issues and management, co-branding and marketing issues.

Can your bank or bank subsidiary make minority investments in entities engaged in financial activities?

The new law allows national banks to control or "hold an interest" in a financial subsidiary. "Financial subsidiary" is defined as a subsidiary that is controlled by one or more insured depository institutions. It appears that national banks will be able to hold a minority interest in a financial subsidiary if there are other banks that have invested in the subsidiary that represent, in the aggregate, control over the subsidiary.

Under OCC interpretations of existing law, national banks may hold minority interests in entities that engage in activities that are a part of the business of banking or are incidental to the business of banking, under certain circumstances. This authority was unaffected by the new law.

Many community banks have entered into joint ventures and other arrangements to engage in activities that they may not have engaged in because of lack of expertise or resources. These arrangements and investments should continue to be available to community banks under the new law.

Financial Subsidiaries vs. operating subsidiaries

As mentioned previously, the new law appears to leave untouched the OCC's authority to approve the establishment and operation of operating subsidiaries, which can engage in only those activities that are part of or incidental to the business of banking.

The possibility exists that the OCC may find certain activities to be incidental to the business of banking that would not even be considered to be financial in nature.

Statutory subsidiaries - SBIC's bank premises subsidiaries, etc.

National banks also have authority, independent of the "incidental powers" provision, to make investments in entities conducting activities that the Congress has authorized in separate sections of federal law. Among those investments are Small Business Investment Corporations (SBICs) and bank premises subsidiaries. The new law does not affect the authority of national banks to make these investments.

SBICs are a particularly interesting investment for community banks. SBICs are licensed by the Small Business Administration, and have wide latitude to invest in debt and equity of small businesses. SBICs allow banks to engage in venture capital activities, even though the new law otherwise prohibits banks from establishing financial subsidiaries to engage in merchant banking activities.

Summary

The new law may not be particularly useful for community banks that wish to expand their nonbanking activities; the existing law already gave them wide latitude to engage in an array of fee income-generating activities

What the new law does is change how banks may engage in a new activity, and adds to the strategic choices available to community banks. It also produces a wider range of competitors and a wider range of potential acquirors.

With any legislative change as sweeping as the new law, the effects will not be known for some time.

For community banks directors, however, the new law is confirmation that the new world of financial services is about to happen and that it is time to consider how their institutions will fit into it.

If you have any questions about this article or other director related issues, please write the article's author.