Banking Law Notes

BANKING LAW NOTES

This will not only be about banking regulation but also how banks work. A scrivener is someone who goes to meetings and takes notes, this is all you’ll be unless you learn the business side of banking. You will hear lots of acronyms, ROI return on investment and how it’s calculated, and ROE return on equity.

St Banking Regulators, OCC, FDIC, SEC, IRS, all regulated banks bf “deregulation.” But actually there is more regulation now and before the crisis than there ever has been before.

Some of the class will taught w the Financial Times (FT), it is a pink paper and essential for bankers or investors.

Find an article that is of current interest to banking. Copy the article, attach 1.5-2 page analysis, double space, 12 point font. (12% of grade). Each month by the end of the month, you must turn in an article and an analysis of why it’s important. Can always turn it in early. Busi section of NY Times, and Wall Street Journal are good. The Economist is the other publication (British publication). Nobody reads the whole paper. The American Banker is online and has good articles on banking, but it’s pretty dull. Cong is doing a lot of talking about banking right now.

History of BankingAmerican Revolution: needed to fund war, cong issued paper money, never heard of on this continent. Value was uncertain, cong had no power to tax, so term came about “not worth a continental.” Const auth cong to “coin Money and regulate the Value thereof” and “regulate Commerce among the several sts.” This was making coins from precious metals. Const also forbid states to coin money. Const says nothing about banks.

Hamilton v. Jefferson: competing views. Hamilton: strong central govt, banks would be a commercial aristocracy and would promote economic growth. Jefferson: favored weak govt, suspicious of banks, concentration of power was bad.

New fed govt began in 1789, deeply in debt, regarded as a doubtful credit risk, very unpopular. Hamilton: we need to remove doubt about its creditworthiness, create a favorable investment climate to increase the number of investor classes. His plan included the US issuing bonds, used proceeds of that to repay old bonds that were issued by the old colonies and pay off debts of individual states in the war. It established the govt’s credit. First US Bank: lasted 20 yrs from 1791, charter expired in 1811, privately owned, federally chartered, conducted normal banking busi, helped govt pay bills and collect taxes, evolved into a central bank regulating st banks and credit by deciding how quickly to redeem bank notes for gold or silver (species).

First US Bank failure, first one happened in 1809, had paid-in capital, notes or IOUs from the directors of the bank, issued 800k in notes to customers, had $86 left in cash when it failed, so those notes were worthless, no insurance yet.

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This failure inspired 2nd US bank: 1816, for 20 yrs. Maculloch v. MD, const case upholding the 2nd US bank’s charter. Andrew Jackson, lawyer, depicted himself as a champion of ordinary people. He thought const prohibited bank charters and paper money, only gold and silver is ok. 2nd Bank charter cam up for renewal, Jackson vetoed it. Jackson removed all deposits from 2nd Bank, so bank failed, when deposits disappear, the bank almost always fails.

Banks: when prof talks about banks, usually talking only about commercial banks. Commercial banks: usually in the busi of taking deposits and making loans. Investment banks: do not take deposits but do loan money, they get their money from sale of shares and from borrowing. IR Spread: borrow money at one rate and lend the same money at a higher rate, make money on the spread.

Bc of the panic of 1837, we enter into new era, No central bank, Sts enacted general bank-chartering statutes, facilitated entry into the banking industry. How did location of the bank have something to do w its value? Carpetbaggers: If you are in NY to buy goods and the bank that issued the notes is in the rugged west, the note may not be worth the face value of the note, almost always worth less bc no way to know how much the note was worth (how good that bank was doing or whether it still existed). You could buy bank notes from Midwestern banks at a real discount price and travel the distance and redeem them for face value for gold.

Only 7 of 31 banks had no banks by 1852, no st const made it a crime to be a banker. No central bank to function as the Fed Reserve functions today. Macroeconomic spikes and valleys could not modify those swings.

Civil war created financial crisis bc fed spending soared, so issued paper money again to fund the war, controversy over whether it was constitutional. Inflation went up. Cong in response created the National Bank Charter: required member banks to back bank notes w US fed securities in US bonds. This was really not to benefit the banks by securing them but to help the govt itself w an influx of money from the bond sales.

St Banks: cong enacted punitive tax on st banks that issued notes, so st banks issued checking accounts, like loans/notes but avoided the tax. This lead to the Dual Banking System. Panic of 1907, depositors withdrawing money, stock mkt crash, loan rates reached 150%, higher than mafia.Banks squeezed for cash refused to allow withdrawals from customers, in some major cities, employers paid their govtl employees in scrip, IOUs from the city govt, some busis would take it as paper money.

Who stepped in? JP Morgan and other several individuals who had amassed fortunes significant enough to bail out the govt. Nobody could do that nowadays.

Need for a Central Bank:

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Big banks: wanted to be banker-owned and controlled, like a local clearinghouse.Progressives: wanted it to be a govt agency.

What came out was a Federal Reserve: hybrid of proposals: 12 regional Fed Reserve banks, member banks owned stock and elected majority of directors.

Fed Res Board: controls policy, reps from the regional banks, chairman appointed by pres and confirmed by senate.

1929, stock mkt crash, the big rich cos (Rockefeller, Morgan, Carnegie) anticipated it and converted to cash. Created bank holidays: unpaid holidays in banks and other govt entities.1932-33, Senate Banking Committee hearings highlighted abuses by big banks, they had failed to disclose known weaknesses in securities underwritten (backed financially and accepting the risk of the venture) by the banks. Commercial banks were issuing securities and underwriting them.

Banking Act of 1933, separated commercial and investment banking, established FDIC, supported by small banks, opposed by big banks. If smaller banks are insured, customers have no reason not to go to them anymore, more convenient/local. Big banks kept busi bc people thought they were more stable, so they didn’t like this insur.

Compartmentalization, deposit IR regulation and other mechanisms used to separate the functions of commercial and investment banking. ??

Disintermediation: movement of money from one form or instrument to a diff kind of instrument for certain advantages such as IR, people are moving savings from commercial banks to other places. ??

Thrifts: commercial banks historically had little interest in doing busi w people of modest means, Thrifts filled this void by making small loans to average people.

Clearinghouse: entity that takes checks, there has to be some way of getting the money back to the bank to cash the check. If I write a check to LL Bean, it won’t get deposited locally, but will at their headquarter’s bank, their bank takes it to a clearinghouse that clears it w my bank in Atl. Bookkeeping entries: is the way it’s done now.

S&Ls: mortgage loans and sometimes car loans; homebuilders, appraisers, and brokers were on the board. Generated tons of legal work, law firms did a lot of the morts and loans.

Deposit interest caps were eased by cong, originally banks were not allowed to pay interest on demand deposits, S&Ls allowed more interest to attract more savings, abolished: mkt IR on jumbo CDs (certificates of deposits in excess of 100k), NOW (notice of withdrawal) accounts, Sweep accounts (overnight any cash can be swept out of one account and put into a diff account w higher IR), Money-mkt mutual funds (pooled money that is invested, some allow you to write checks), w check-writing.

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In 1979-80, fed sharply increased mkt IRs to combat inflation. Thrift industry: money-losing and mkt value insolvent, earned low rates on old morts they gave, but had to pay high rates to customers to keep deposits in the bank, get into a negative spread. Potential for massive disintermediation: can move accounts to earn more on a rate, if you are a corp you may move it for 5 basis points, if you are individual prob doesn’t make sense unless it’s closer to 100 basis points.

A basis point is a unit relating to interest rates that is equal to 1/100th of a percentage point per annum (pa). It is frequently but not exclusively used to express differences in interest rates of less than 1% pa. It avoids the ambiguity between relative and absolute discussions about rates. For example, a "1% increase" from a 10% interest rate could refer to an increase either from 10% to 10.1% (relative), or from 10% to 11% (absolute). It is common practice in the financial industry to use basis points to denote a rate change in a financial instrument, or the difference (spread) between two interest rates, including the yields of fixed-income securities. Since certain loans and bonds may commonly be quoted in relation to some index or underlying security, they will often be quoted as a spread over (or under) the index. For example, a loan that bears interest of 0.50% per annum above LIBOR is said to be 50 basis points over LIBOR, which is commonly expressed as "L+50bps" or simply "L+50".

Let Thrifts and S&Ls do things competitive w com banks, doing loans on commercial prop now. Lacked the requisite expertise, higher returns reflected higher risks. Resulted in IR mismatch, borrowed money from depositors, demand deposits are short term loans bc can be withdrawn at any time, but morts are long term, if IR go down, then you have high IR morts, but if they go up you have to pay depositors the higher rate while you have the low rate morts.

Moral hazard: Insurance tends to change behavior of the person insured. Think through this history and see how politics have been involved in the past and see how anything that happens in banking today is primarily the result of politics.

[[[[See written banking law notes]]]]

• Entry into banking business– Chartering– Change in control

• Interaction between federal & state law

Charter

• Gives bank separate legal existence– Like corporate “articles of incorporation” or “certificate of incorporation”

• We’ll consider:– Formal legal chartering criteria

• Letter of law– Standards & process for judicial review

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• Administrative law

Gives bank basic legal existence of the entity.

Many banks aren’t chartered under st law.

Bank v. Busi Corp

You can get a name and reserve it on the web until you submit a charter wi certain time. Can do anything that a general corp is auth to do. But it’s diff when it is a bank. Dual system: fed and st charters

-Discretionary charter: Regulators have substantial auth over whether chartering can occur. OCC or FDCI may have the ability to say if you can charter or not. Why? Bc if bank goes under you can lose tp’s money bc FDIC insures deposits. Whereas if corp goes under shs will lose and there is no fed insur. FDIC is an arrangement bw the bank and FDIC and customer is just 3rd party beneficiary so no direct relationship but FDIC is good about paying. Reasons: 1. Fed reg should have some say so since they are backing it with Treasury and US taxpayers. 2. Depositors can’t protect themselves. 3. Financial statements are snapshots of current condition, the longer ago it was, the less accurate it may be. Regulators are historians who look at what happened in past. But banks can change a lot over a few months, not required to show loans that are over 60 days old, must only show ones that are 90 days old, so in a month, the loans can be shown for the first time and they are already 90 days old. 4. Macro economic interest in healthy banking system (this is what bailout was for). 5. Govt has legitimate interest in restricting competition (is this thin ice?). No interest in ensuring that McD’s and Wendys stay healthy so let them build beside each other, but not same w banks bc tp backs them.

-Specialized charter: limit the bank’s activities to those that are auth by st banking act or banking auth.

Discretion: Why should business corporations obtain charters as a matter of right, while bank regulators have broad discretion to deny charters?

Some community banks make much of their money on overdraft fees (NSF No Sufficient Funds). These are often done by poor people. Now, must be concerned about Community Reinvestment, lend to poor, lend to community groups and make rooms available for them to meet.

Must find a CEO, attract management, produce a busi plan, do we now file an application? No, need to call bank regulator/auth and ask for a meeting and show busi plan, must be very sensitive to the banking auth so that you know what they’re problems are so you can change it, don’t file an application until you know it’s going to be approved. Must decide where location will be, need to have land tied up, at least w an option to purch or option to rent.

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Need to raise so capital for operating expenses, and banking auth will want more financial stability. Then you can file application.

Chartering Discretion Reg wanted themselves to have broad discretion and prevent lawyers from suing saying there is a rt to receive a charter.What incentives does reg have to grant or deny charter. If bank can go to state or OCC, st bank commissioner will want to get a lot of banks so can ask general assembly (st cong) to get more money for budget next yr. But St Insur commissioner will not want banking commissioner to approve just any bank, so there are pros and cons. Factors: 1. financial history of bank (little to none bc not even chartered yet!) 2. Capital adequacy of bank, must have 15m or more today or it’s highly unlikely. 3. Future earnings prospects of new bank (this is most important), in busi plan (pushing it to predict 5 yrs out, even hard to predict 10 yrs out, but they will want you to), look at banks in similar geographic areas and how they performed in their first years out, will be skeptical if you show that you will perform a lot better than them and don’t have a reason why, must be realistic (bc if pro forma financial statements are too good, your investors will sue you for selling shares based on unlikely projections). 4. Character of management (sec of st doesn’t check character of corp’s board/officers, but again banks are diff bc of tps). 5. Need and convenience of community, does community need another bank? 6. Corp documents consistent w the statute under which they’ve been submitted (not important bc easy to do).

Future earnings prospects is the most important factor, if it’s not going to earn money then there is no point in building a bank.

Camp v. Pitts: early challenge to OCC charter denial. US S Ct: OCC says it was an unfavorable location, that is enough (sub deference to OCC, FDIC or whoever reg is), won’t have a de novo hearing, will just look at what’s in file. Lawyer will tell OCC not to keep a lot of files on their decision bc don’t want them subpoenaed. Just want a paper saying the application is insufficient. they are on blackboard.

• Early challenge to OCC charter denial• Plaintiffs applied for national bank charter• OCC denied charter

– Evidently didn’t believe locality needed another bk• Plaintiffs asked court to review denial under Administrative Procedure Act

– General statute governing judicial review of administrative decisionsNat Banking Act 5 USC §706:

The reviewing court shall—(1) compel agency action unlawfully withheld or unreasonably delayed; and(2) hold unlawful and set aside agency action, findings, and conclusions found to be—(A) arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law; …(D) without observance of procedure required by law;

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(E) unsupported by substantial evidence in a case … reviewed on the record of an agency hearing provided by statute; or(F) unwarranted by the facts to the extent that the facts are subject to trial de novo by the reviewing court

Character of Mgmt: (s not very helpful)

BCCI bank w complex structure:• Two banks, each in countries with strong secrecy laws & weak supervisors

– Luxembourg bank: 47 branches in 13 countries– Cayman Islands bank: 63 branches in 28 countries– Separate accounting firms

• No country felt responsible– Luxembourg holding company– Operated from London– No banking in Luxembourg

–Response to scandal: International agreement to require “consolidated comprehensive supervision” by bank’s home country. Each country agreed it would have comprehensive supervision of any bank chartered in the country, even if it conducted no busi there. Comprehensive Supervision: Bank’s home-country supervisor

gets enough information about bank’s worldwide operations(including bank’s relationships with affiliates)

to assess bank’s overall financial condition & compliance with law

Would want enough to know what overall financial condition was, or will not allow it to operate in our country.

Fed Bank Control Act slides we are skipping.

Preemption Analysis: No simple rules, but there are some guidelines:

• Question of statutory interpretation– What did Congress intend?

(assuming Congress can legislate on this subject)• No simple rules• More uncertainty than under

many other legal systems

• Types of preemption: • Express: cong intent express, then preempts state. • Field: cong intended to occupy the field and preclude st reg, preempts st. • Conflict: if st law interferes w policy of fed law, preempts st.

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Barnett v. Nelson and St v. Wachovia cases:1---Building Code:

• State requires that doors open outward from any room used by retail business customers if more than 50 persons can occupy room

• National bank’s lobby can hold more than 50 persons, but doors open inward• Assume no federal law:

– applies similar safety precautions to nat’l banks; or – deals with application of state building codes

• Must bank comply with state law? No preemption, so it has to comply. • What if fed law says: no st building code shall apply to fed banks? will be litigated, turn on if there is a valid fed interest in doing this, prob would say no.

2—Deposit-Taking• State prohibits anyone from taking deposits in state without state license.• Can national bank with branches in state take deposits at those branches? St prob can’t

enf this law against fed bank, though not specific preemption, intended this to be a field preemption probably

Sup Clause: “This Constitution, and the Laws of the United States which shall be made in Pursuance thereof . . . shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding”

– U.S. Constitution, art. VI, § 2.

#3—Selling Insurance• National banks can sell insurance if located in town with population ≤ 5,000. 12 U.S.C. §

92• This bank is in town of 3,500• State law prohibits any firm from selling insurance in state unless all officers, directors &

employees have insurance licenses– Assume federal law is silent about applying such a state law to national banks

• Can bank sell insurance if some of its employees lack the state-required licenses?

This would be very likely to be litigated. St insur cos don’t want nat banks selling insur. What will ct look at?: no express preemption. implicit field preemption? Legit nat interest in having this preemption? (this is harder argument to make).

Look at cost benefit: how much will it cost to litigate v. complying w license requirement? Does it say you can only sell insur in the small town, or can you do it on the web and still make money? If there is likelihood of significant busi, then advise that they start selling anyway.

#4—Capital Requirement• State requires each state bank to have equity worth at least 6% of bank’s total assets

– Bank’s liabilities cannot exceed 94% of assets

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• Assume federal law sets 4% standard– Silent about validity of stricter state standards

• May state require FDIC-insured state banks to comply with 6% state standard?– What if 4% federal standard is key part of capital-based federal regulatory

system?

Can an FDIC insur bank be required to comply w nat bank standards. If it’s a nat bank, then don’t have to comply, if St FDIC insur bank, it’s less clear but will prob have to comply bc chartered by the st, even though it is insur by FDIC. What if the st law required 3% (more flexible than nat standard), FDIC may require more for it’s insur and so may lose coverage and go out of busi if don’t comply.

#5—Loans to Insiders• Under federal law, FDIC-insured bank’s total loans to an executive officer cannot exceed

15% of bank’s capital• Under state law, state bank’s total loans to executive officer cannot exceed 20% of capital• How much can state-chartered,

FDIC-insured bank lend to executive officer?

St bank would be limited to 15%

#6—Late-Payment Penalty• State limits late-payment penalties

to $1 per day• Assume no federal law deals with:

– Late-payment penalties– Application of state limits to national banks

• Does $1-per-day state limit bind national bank in that state?This is not clear even though it seems no preemption, st prevails; but ct will look to see if there is a specific st interest then st limit can apply.

Chevron Deference If Congress has made clear its intent

regarding the precise question at issue,that is conclusive

If statute is silent or ambiguous,court will uphold agency interpretation

that fills a gap or defines a termin a way consistent withCongress’s revealed design

Express PowersSt banks have limited power to give more auth than nat banks. Express or Enumerated powers of nat banks: 1. can adopt a corp seal2. can have succession (continued existence, no specific term, reelect directors)

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3. make contracts4. can sue and be sued. 5. elect directors, dir may appoint officers, define their duties6. dirs can adopt bylaws 7. exercise all such incidental powers as shall be necessary to carry on the busi banking ***Very important: banks: if doesn’t say we can’t do it (such as invest in com RE investments), then ought to be able to do it. ---Others that have been added---8. banks can contribute to charitable activities, issue and sell Gennie Maes (secs guaranteed by govt nat mort assc.)10. may possess tangible commercial property and lease it, so long as investment doesn’t exceed 10% of assets (not cap stock or equity) of the bank (equipment, machinery)11. make investments to promote gen public welfare.

Incidental powers1. the busi of banking strictly construed2. powers necessary to carry on busi of banking*Are these granted in the 19th century when statute was adopted or are they evolving?

Barnett Bank v. Nelson,p. 95• Federal statute empowered national bank in town of 5,000 or fewer people to act as

insurance agent• State law allowed bank to sell insurance in such a town only if bank had no holding

company• How did Court resolve conflict?

Watters v. Wachovia Nat’l Bank, p. 98• What was dispute here?• What did Court hold?• Why did Justice Stevens dissent?

Operating Subsidiary• Why does conducting activity through a subsidiary present a more difficult legal issue

than conducting it in parent bank?– Is difference simply one of form? – Or should it make a policy difference?

Watters• According to majority opinion, what preempted state law?

– OCC regulation?– Or federal statute itself, without need for implementing regulation?

• To what extent should preemption analysis differ if agency, not statute itself, is preempting state law?

•Cuomo v. Clearing House

• What was dispute here?• What did Court hold?• What did Justice Thomas argue in dissent?

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• How does limiting state enforcement authority under § 484(A) differ from preempting laws the state seeks to enforce?

• How much difference would you expect distinction to make in practice?• Does majority persuasively distinguish Watters? • Who has better of statutory-construction argument: majority or Justice Thomas?

Policy• Does Cuomo make good policy sense?

– Advantages of letting states sue national banks to enforce wide range of state laws?

– Disadvantages? Justices’ Votes

National Bank PreemptionSupreme Court Justice Watters (2007) Cuomo (2009)

Alito, Samuel Preemption PreemptionBreyer, Stephen Preemption No preemption

Ginsburg, Ruth Bader Preemption No preemptionKennedy, Anthony Preemption Preemption

Roberts, John No preemption PreemptionScalia, Antonin No preemption No preemptionSouter, David Preemption No preemption

Stevens, John Paul No preemption No preemptionThomas, Clarence — Preemption

Obama:• Reaffirmed basic federalism principles in Clinton executive order

– E.g., agency should preempt state law only:• to deal with problem of national significance; &• if agency has strong legal basis

• Why no preemption statement in Federal Register preamble unless text of regulation preempts?

Rulemaking• Process by which administrative agency develops & promulgates rules• Key steps:

– Agency publishes notice of proposed rulemaking in Federal Register– Interested persons submit comments– Agency analyzes comments– Agency promulgates final rule in Federal Register

Federal Register• Notice of proposed rulemaking

– Preamble• Explains what agency seeks to accomplish & why

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• Poses questions– Proposed text of rule

• Final rule – Preamble

• Analyzes comments & explains rule– Text of final rule

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Incidental PowersTours v. Camp: banks wanting to act as travel agents, OCC approves, necessary for busi of banking means established activities that are necessary or can be “convenient or useful” in perf of those activities, but here ct says travel agency not useful. Expand the definition of the nat banking act by adding this 3rd category but even it doesn’t pick up travel agencies.

M&M Leasing v. Seattle First National: nat statute: doesn’t give banks power to loan money for personal prop. If you lease a car, bank holds title, make payments, get title back at end w lien portion paid or satisfied, if you default. If you default, bank repos the car. Car dropped 10% of value when you drove off lot, you are underwater right away given your loan (underwater is now used in RE as well). Bank has car they can auction at 85k but loan is 100k. So bank had risk the entire time until the loan caught up w value, and if you wrecked it the car would be only worth 2k. This case: leases, if you lease a car, banks own the title, if you make 24 lease payments, you can give them the car back. Closed end lease: bank assumes risk of value fluctuation, lessee can turn in keys and walk away, lessee has no risk, if bank did calculations correctly then car would be worth at least as much as what a loan would be worth for the same car, so bank can release or sell it w a loan. Open end lease: lessee assumes risk of value fluctuation, if car is worth more than the agreed upon residual value, then lessee can buy the car at the residual value price if he wants (but prob have to borrower money from bank to buy it). But if agreed residual value is worth more than current value of car, then lessee must not only give back keys but must give check to make up difference. But neither of these are very diff in the economic effect, either way the lessee has the risk of value fluctuation. They are basically the same thing. Leasing equipment and loaning money secured by the prop, they are doing basically the same thing. Ct was taking a step to determine incidental powers of banking.

NationsBank v. Variable Annuity (important case): OCC: bank acting as agent for sale of annuities is part of busi of banking. Insur co: 5 activities listed in busi of banking statute are exclusive list. Ct: used chevron test, rule for OCC, annuity is making initial payments for future income stream, deferring consumption is like putting money in a bank account. Busi of banking is not limited to enumerated powers as long as OCC uses reasonableness. Deference to regulator. Interpretations of §24 Seventh regarding leases are dynamic, not fixed in time.

Banks are prohibited from:1. Owning RE, except to the extent necessary for operations (building to operate, but does not have to be limited in size to what you need immediately, can instead expand into that space and

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lease the space in the meantime, renting the space at more than it costs to build (to e.g. law firms); and except for OREO meaning banks can own other real estate owned (this is on the asset side but replaced a prop that had a loan, so bank foreclosed on it, so not good bc RE prob not worth more than loan). Why can’t banks own RE? 1. RE is volatile but is it any riskier than loaning money on RE? Bank will loan 80% of value of apts, so bank will produce a pro forma (docs that are formalities). 80% of 20m is 16m dollars. Pro forma value of apts is 20m, 80% is 16m, costs 16m to build, so bank has risk, but builder has to sign guarantee but assumes builder is not judg proof, so bank takes risk. So very little diff bw owning and lending as far as risk. 2. RE is also illiquid, can’t turn it into cash in a short period of time, can’t sell until find a buyer. 3. No experience, no exp in mging and operating RE, perhaps offices bc they manage an office themselves, but mging shopping centers is diff. 2. Glass Steagal separated commercial from investment banking, com banks can’t own equity securities. Except can hold stock in subsidiaries, can own all that stock, can own equities in its own subsidiary, except can own stock in small private busi investment cos, so can own stock in private busi (though not less risky, just politically desired), except can broker securities. Why? is a loan riskier than a stock share?

SecuritiesWhen we are talking about this, we are not generally talking about a bank as a subsidiary of a holding that deals in secs, we are talking about a bank as a bank that tries to deal with secs.

Security BrokerageSecs Industry v. Comptroller: OCC allowed banks to have subsidiaries that buy and sell securities solely as an agent but not buy or sell for its own account, will not underwrite, or give investment advice. Insur Assc: violates Glass Steagal Act which permits banks to act as agents only for preexisting customers, cong intended to separate commercial and investment banks. Ct: no mention of brokers in legis history other than it saying that will permit buying and selling “to the same extent as before,” Even bf the mtk crash and the Act banks had brokering services for both existing customers and the gen public. Act just wanted to distinguish buying/selling for com bank’s own account but brokering for customers by holding co subsidiary, not the bank itself, is ok.

Bank already has customers, so can buy and sell for its own customers and can own subsidiaries that engage in brokering services to customers and gen public.

Security UnderwritingInvestment Co. v. Camp: bank was engaging in buying and selling of stocks for customers. Can banks offer customers to invest in a stock fund created and maintained by bank? Risks: 1. bank is taking risk that is backed by tps 2. bank may encourage investment in its securities affiliate in favor over other investments, to help its affiliate, even if the investment is sound. 3. If bank bought stock that goes down in value, can hurt bank’s reputation and prudence 4. risk that bank makes inappropriate loans to its customers to enable customers to buy secs from its secs affiliate. Ct: operation of an investment fund that involves a bank underwriting, issuing, selling and distributing of securities violates Glass Steagall.

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Govt doesn’t want to pony up FDIC money in a bank that was taking unnecessary risk. But investment banks are not com banks, not FDIC insur; but tps are still at risk if a bail out is necessary, if there is a risk to the entire financial system. Clawback: A dividend clawback is an arrangement whereby the equity owners commit to use dividends they have received in the past to finance the cash needs of the project or corporation in the future. Clawback has a more general definition. For example, premiums paid on an insurance policy may be refunded (or clawed back) if the policy is cancelled in a certain time frame. Such an arrangement is specified in the contract and referred to as a clawback provision. SIA (Secs Industry Assc) v. Board of Govs of Fed Reserve (1984): is buying and selling commercial paper prohibited by Glass Steagall? Commercial Paper: a document issued by a corp entity saying, give me $X and I will pay you back in 90 days, it is a short term note. Usually institutional transaction. Is it a promissory note or security? If you buy the com paper, then you are underwriting bc you take the risk of chaning in value (buy and sell to somebody else, hopefully for more than you paid), if you just set up your customer w a buyer of com paper, then you are just brokering. Ct: underwriting com paper is investment banking and prohibited by Glass Steagall for com banks.

SIA v. Board of Govs (1986): whether selling com paper to small numbers of institutional investors is impermissible underwriting? Here it is Private placement: selling to private entities. But are you buying then selling or just arranging sale to 3rd party? What if inv bank says, we will sell to public and use best efforts to sell at the price we paid or greater (to show not taking a risk). But issuer would rather have more of a commitment, want the inv bank to say we will go ahead and buy it and then try to sell it at whatever we can (guaranteed underwriting), so inv bank takes all the risk; but this creates a conflict of interest bw inv advisor (inv bank) and the issuer, inv bank wants the lowest price so it can make a big profit and issuer wants the highest price for its stock; so best efforts causes inv bank to lose lot of incentive to buy low. Arguably public is better off by having more competitors in the mkt in dealing w these secs bc lowers sec buying prices. Ct: buying and selling com paper to few institutional investors (private offering) is not underwriting bc no public offering. Brokering: don’t own the asset, but simply put buyer and seller together.Underwriting: buy asset and resell to someone else, creates an investment risk.

What if bank wants a co to underwrite: should you set it up as a subsidiary of the bank or the bank’s holding co. Better to do it as holding co, not much of a legal diff, but psychologically the parent may have to stand for the co’s liabilities and bank will not have to bail out the co directly. From regulatory standpoint, it is less likely that a bank would do something imprudent in bailing out its sister co (as a sub of the holding co) than if the co was the bank’s own subsidiary. Banks prob will never be auth to underwrite securities.

InsuranceBroker: taking policies underwritten by a 3rd party and selling to a customer/insured (little risk).Underwriter: buying policies and issuing it directly to the customer/insured.

-Life Insur: If insured a lot of lives in Haiti, you would be in big trouble right now. Life insur odds generally are getting better bc of better health care. Mortality tables today say 25 yr old

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will die around 75, so insur co can know won’t have to pay until then and set aside a small portion for accidental deaths, pretty safe bet. But if life span turned out to be 85, then co gets extra 10 yr of premiums bf it must pay. So can invest and get a return over same period of time. Doesn’t make massive amt of money but make good return over long period of time. -Casualty Insur is diff: homer owners insur, can’t start out nationwide so choose limited geographical area, good decision to start out in S. Fla? No bc of hurricanes, though most home owners insur doesn’t cover water. Casualty insur is much riskier. May ask for earth quake insur and get it for a few extra bucks (GA is due an earthquake), may also get flood insur esp if live in flood plane and it also causes little more. Total cost may be $200.

Brokering12 USC §92: permitted nat banks to act as insur agents provided that was in a town w population not exceeding 5,000 people. (someone had a good lobby). How can innovative lawyers use these statutes to help banks?

-AnnuitiesNationsBank of NC v. Variable Annuity Life Insur Co: whether nat bank may serve as agents in sale of annuities. Ct: OCC interpretation correct, brokerage is an incidental power necessary to carry on busi, annuities are not insur so can broker annuity regardless of town size. (ct dodge question about whether statute directly prohibits brokering in larger towns, or whether just allows brokering in smaller towns; statute just says nat bank can do it in smaller town).

Annuity: pay premiums to receive later payouts during a set period (for retirement, estate/beneficiary, college): if fixed: then payouts will be same overtime; if variable: payouts will be fixed for short time then variable based on return over remaining period (seller of annuity is taking little risk here bc pay based on performance of investment). Isn’t this a lot like insur? Yes, but what if you die bf annuity payouts end? Must have a survivorship clause that says payments must transfer to estate/beneficiary. If no clause, then seller will hope that something bad happens to buyer bf payouts end.

Generally as long as you are a broker, only the insur co is taking a risk and bc bkr is just taking a fee.

-Geographic restraints on sellingLudwig: can cos in small towns of less than 5k, sell to customers outside of town? Ct: defer to OCC, satisfied Chevron standard, cong expressly permit small town banks to sell insur and Comptroller didn’t impose a geographic limt on insur cos wi small towns of less than 5k, so can sell to customers outside of the town (circumvent rule). -Casualty insur (busi of banking/incidental)Hawke: whether incidental powers includes power of banks to sell crop insur? Bank want to insur crops if giving loans for crops. OCC: all banks can sell casualty insur to protect against crop loss (fire/hail insur etc), bc under §24(7th) it is in the busi of banking or is incidental power. Ct: nat can sell casualty insur, including crop insur, if they meet the requirements of Gramm-Leach-Bliley (must be well capitalized and managed) or under §92 (must be small town less than

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5k); but they do not have power to sell crop insur solely under §24 as busi of banking or incidental power. If they did, then why did they create GLB act and §92 to narrow the banks that could? If we let them sell crop insur, what is to stop them from selling any other kind of insur?

-Retirement CDsBlackfeet: can bank sell CDs as retirement CDs and circumvent insur statute? OCC authorized it. Ct: retirement CDs are insur and prohibited if they work as such and there is no exception to allow bank to sell insur, Comptroller’s decision was unreas, this makes banks take additional risk that is not compensated by predictable income stream. Ct is asked to reign in regulator when reg gets too much in the pocket of the industry.

Geographic Expansion of Banks

Mid 1800s, few branches bc cities weren’t that big yet, didn’t need several banks on diff sides of town. Many sts limited banks to one office only, and couldn’t even branch wi the county. Overtime, NC changed and other states too: allowed st wide branching. GA prohibited branching but allowed 5 percenters. Once they allowed branching, these 5 percenters merged and then grew rapidly. Over 1980s and 90s, were worried about expansion, but now those distinctions have disappeared.

Now if it is a holding co, it can operated just about anywhere it wants, subj to MacFadden act, st law restrictions, and antitrust regulation.

Drawbacks from geographic restrictions:

1. These restrictions stymied competition, aren’t really in competition in banks in adjoining county bf bc couldn’t branch, but once you could branch, banks might consider things such as county lines. Like a liquor store on the county line. 2. These restrictions also stymied consumer convenience, traveling but no branch of your bank around. Now all the majors have branches wherever you travel usually, all major cities. 3. Interfered w efficient transfer of funds to the most efficient users. 4. Prevent banks from growing such that they couldn’t easily take advantage of economies of scale. 5. Impaired safety and soundness of entire system, independent geographic non-diversified manner.

Positives: 1. Prevented concentration in certain areas bc outside banks couldn’t come in. 2. arguably enhanced competition bc harder to move branches around and take over others. 3. allowed local control by citizens, little inv interests in community banks by non-locals. 4. local institutions are more likely to extend credit to local community, particularly small businesses. 5. discourages growth of very large banking institutions (too big to fail). 6. improved safety and soundness of banking system bc it discouraged competition in various ways.

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Mkt shares: China has only 8 domestic chartered banks. US has about 13,000. Some argue that US should retain control of local banking to maintain the spirit of small towns and small busi. Is this banking regulators’ job? There is a bell curve for banks as far as mkt share, many small ones and many large ones but few in the middle. Suntrust is a rare mid-size bank that has a good bit of mkt share. Large banks look for commercial customers. Small banks look for individuals and small busis. Prof. thinks there is no reason to fear that small banks are disappearing bc they retain this mkt share; bc large banks have no interest in retaining these small types of customers.

From a banking standpoint, they don’t like customers who pay on time bc they don’t make money, they only get a discount from the merchant that you bought something from, but that’s it.

Lewis: Bank wanted to start investment mgmt subsidiary in FL, state statute: no out of st corp could come in. Ct: violates com clause, undue burden on interstate commerce, FL statute is unconst, no ev that there is risk to local mkts and consumers, essentially ignore st’s local interest argument. Cts beginning to look at favor on non-bank inv mgmt firms.

McFadden Act: if concentration of more than 10% of national deposits or more than 30% in any given state, then can’t merge. (this was the rule for a long time).

Intrastate bankingPlant City v. Dickinson: St law against branching. 1st nat bank got approval to start armored truck messenger service and allowed to take deposits from outside to home bank in FL and make deliveries. This is innovative lawyering and businessing, can’t branch so buy mobile armored cars and run around to various sites in counties/citites on Fridays, people who just got paid can make a deposit, benefit to customers, particularly if their bank closes early on Fridays. Could argue that car wasn’t taking deposits, they were just picking up the paper and making the deposit only when they got back to the bank. OCC: approved but deposits received couldn’t become bank liabilities until in hands of bank, not when left the customer’s hand to go to the truck. Ct: armored truck service constitutes branch banking, carrying out same functions as branching by allowing them to conduct busi outside. St law prohibits geographical expansion, these are in effect mobile branches, prohibited by st law. This is a very restrictive case (rare), cts began to loosen up afterward due to politics.

Secs Industry Assc: Πs secs bkr association filed suit against OCC bc allowed discount brokerage offices in banks. Ct: zone of interest test, discount brokerage offices wi the bank, bc not the core busi of banking, so allowed discount brokerage houses.

This is up through the end of 1960s and 1970s.

Interstate Branching and AcquisitionsEarly on, there were regional compacts where if you were a bank in that region, you could acquire or merge or branch de novo into other states wi that region. If you were in New

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Hampshire, you could acquire or set up a bank in Vermont. In Southeast, you could do the same thing. This was a midway step to interstate banking.

S&L debacle of early 80s. Banks were getting into serious financial trouble, S&Ls were allowed to get into new risky busis after deregulation, banks had problems in loan concentrations in particular industries. One Dallas bank had huge loans in petroleum industry, but oil price dropped, wildcatters weren’t making much money and couldn’t pay loans. Also lending in agriculture and real problems there too. FDIC came in and took over public bank, then decided to find a buyer, could find a Dallas based bank (but would impact competition). So who else is big enough to take over, money center banks in NY were dying to get into Texas bc it’s so large and have big cities, once you got in you could branch around wi the st. Whichever NY bank is chosen will make one happy and the rest furious. Banking regulator didn’t want the public flack. Avoided that by finding a bank not in a money center but is big enough, found banks in Charlotte that were big bc had been branching wi st for a while. Found one named NC Nat Bank. Regs allowed this bank to come in, get all deposits and assets, no time for real due diligence in looking at loans, so reg gave NC bank a put option (option to sell the at a certain price/time), the ones they didn’t want, they put to the FDIC, the ones they didn’t want to keep, they simply kept. Bank takes over deposits, cash, all assets and ability to turn those assets into cash by forcing FDIC to buy. Regulators can approve mergers that would otherwise not exist or violate antitrust laws. NC bank makes offer to C&S in GA, agmt to merge was made on the beach, so now NC bank has branch in TX and GA, changed the name to Nations Bank. Press release always says it is a merger of equals, but this is never the case in reality, this is just to pacify customers and employees.

McFadden Act: The Act sought to give national banks competitive equality with state-chartered banks by letting national banks branch to the extent permitted by state law. The McFadden Act specifically prohibited interstate branching by allowing each national bank to branch only within the state in which it is situated. Although the Riegel-Neal Interstate Banking and Branching Efficiency Act of 1994 [1] repealed this provision of the McFadden Act, it specified that state law continues to control intrastate branching, or branching within a state's borders, for both state and national banks.Now: if fed bank, must have approval of OCC to branch, need of community; if st bank, must get approval from banking commissioner to branch (they almost never turn down).

Now antitrust laws are really the only obstacle to a merger. p. 204, good review of bank merger statutes, prior approval or notice required in each of them. Normal antitrust laws don’t apply to banks, they apply only to bank holding cos (dept of justice).Banking antitrust statutes apply to banks and contain a convenience of needs and public interest defense that is not available to ordinary entities, require prior regulatory approval, also have safe harbors: if get approval from regulator, any objectors have limited period (30 days) to file formal objection, then it’s closed.

Antitrust Mkts: 1. Product mkt2. Geographic mkt

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US v. Nat Bank (important, may be on exam): OCC decided to allow merger bw Phil. Bank and Gerard Trust, some of the largest banks in Phil. Ct: Must look at 4 county mkt area, resulting mkt share would be 30% of assets and deposits, the two largest banks would have 60%, 4 largest would have 80%, §7 of Clayton Act says this is inherently suspect area, reject defenses regarding convenience and econ development. A certain of “cluster of services” are included in commercial banking, if have more than 30% in this product mkt, then merger is suspect. What if you looked at broader definition of banking, rather than specific clusters of services? Then it may have been ok bc more competition, etc.

US v. Connecticutt Nat Bank: savings & loans bank provide competition for com banks. Not sufficient competition bw com bank (commercial customers) and S&Ls (individuals), not the same enough to be considered competition. Prof thinks this doesn’t make sense, they say banks are a broad group of services, S&Ls provide deposit and indiv residential loans; but prof says s&ls have large impact, didn’t look at commercial reality.

Board ruling: looked at number of offices and number of services, mark every place there is a branch that offers those services, and draw a circle. How do you analyze this? Look at four firm determination of mkt, look at 3 diff mkts. Mkt 1: four banks all have 20% each, 80% total; mkt 2: one bank w 77% and three banks w 1% each, 80% total, mkt 3: four banks have 20% and many more have 1%, but still top 4 banks would have 80% mkt share. [see slides]

HHI (Herfandoll-Hershman Index): squaring of mkt shares. Mkt 1: if each has 20% of mkt, 5(20)2=2,000. [s]

If you merge top two banks, subtract post and pre HHI to get increase in concentration. [s]

p. 248, problem 1.

Resulting bank is fed, so needs OCC approval. Bank Merger Act Pine 22% (484 HHI)Maple 2% (4 HHI)

Oak 19% (361 HHI)Ivy 30% (900 HHI)Kudzu 26% (676 HHI)Total HHI: 2425 (over 1800 is suspect for highly concentrated)

Pine Maple merger would increase HHI by 88. 22*2*2=88. Resulting firm would have shared HHI of 575. Small increase of 88 HHI would have little impact and thus likely would not face an antitrust challenge. Agency should approve merger. [Might could have counted thrifts at ½ deposits bc can’t compete as well with actual banks (Fed’s First Hawaiian Order), but not always best way to do it].

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Safety and SoundnessCapital reduces the risk of failure, more able to sustain a bad period than one with lesser capital, if you have no capital then you have no risk, so you might be really risky bc no consequences. FDIC likes it bc creates a buffer bw FDIC and depositors in that must look to equity of bank bf FDIC comes in.

Leverage limit is pretty straightforward, but risk adjusted limits are more complicated.

Leverage ratio does not take into account differences in risk so not good enough: one bank has all cash as assets, other has 2nd morts on residential RE and credit card debt from college students. Same equity but no question that the all cash bank is more sound. Also doesn’t take into account off-balance-sheet items.

What is an off-balance-sheet item? Not clearly risks until the economy tightens, these items can become risky, investor can pull balance sheet on 10 banks and look at balance sheets and not footnotes (where off balance sheet items are), the banks could vary greatly depending on footnote items. If bank issues a lot of letters of credit that they think they will never have to make payments on, just made a maintenance fee, can have it indefinitely, in good times the bank won’t have to make a payment. But if bank builds high rise condo in ATL, contractor requires standby letter of credit to ensure payment even though there is no income coming in bc can’t rent them, so contractor will look to owner’s letter of credit from his bank to get paid, so it goes instantly from an off balance sheet item to cash flow. AIG issued many insur policies many times what it’s corp net worth was and so long as people paid obligations then they could make money, all of the sudden people wanted to get paid off bc the underlying indebtedness was not making what it should.

Delta Problem: Sorted risk weighted assets, calculated off-balance-sheet items to get credit equivalent amount (multiply 100 mil standby letters of credit guaranteeing commercial cos by 100%, 6m in standby letters of credit backing performance of subcontractors and suppliers by 50%). Multiplied total for each risk weight category by relevant percentage (Cash and US treas secs at 0% and CA gen obligation bonds at 20%, 1st morts on 1-4 family housing at 50%, everything else at 100%), added the total of all categories to get risk weighted assets (4073m risk weighted assets).

Ascertain which capital categories are tier 1 or 2 (common sh equity is T1, rest is T2) add both tiers for total capital (160+160=320m total capital).

Total risk based capital ratio (total capital 320)/risk weighted assets 4073)= 7.8%, not > or equal 8% so doesn’t comply w capital requirements. Leverage ratio (T1 capital 160/total assets 5000)= 3%, not > or equal 4% so doesn’t comply w capital requirements.

The problems on the final will be much more like Minoan bank and Beta bank.

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p. 274, Major Types of Banking Risks: Credit, market, interest rate, operational, liquidity, concentration, reputational, compliance, strategic.

Prompt Corrective ActionPrompt Corrective Action statue refers to a capital based set of restrictions governing supervision of FDIC insured banks, classifies banks into five categories according to their capital.p. 279, read this over from time to time. Capital Categories:

Leverage Ratio Total RBCR Well Capitalized: >_ (greater than or equal) 5% >_ 10%Adequately Capitalized >_ 4% >_ 8%Undercapitalized < 4% < 8%Significantly Undercapitalized < 3% < 6%Critically Undercapitalized < 2% N/A

p. 294, chart on How Deposit Insur Inhibits Mkt Discipline, need to be able to follow this. Deposit insur indirectly props up a bank bc it gives it an artificially low cost of funds. Most likely to choose bank bc of location rather than on how risky the bank’s loan portfolio is and they don’t worry about it bc of deposit insur.

Theory: if you don’t have limitations on number of capital backing loans to one borrower. Loans into RE and loans to one particular borrower in RE. GA is thinking about allowing certain borrowers to exceed capital expenses. Bc bank’s capital has dropped they have to raise capital in bad market to meet capital limits, or otherwise not renew loans w these borrowers. GA thought it was easier to just allow banks to exceed limits w certain borrowers (your WSJ article is about this).

Insider Lending: most banks are careful about this, look at the definition of “insiders,” bottom of p. 304 Basic Rules on Lending to Insiders: 1. prohibits preferential terms 2. requires prior board approval for extentison of credit exceeding certain thresholds 3. limits total exensiosn of credit to any one insider 4. limits aggregate extension of credit to all insiders; and 5. restricts overdrafts by executive officers and directors. Supplemental rules reinforce and prevent evasion of basic rules: 6. treat loans to an insider’s own ventures as loans to the insider; 7. treat insiders of a bank’s affiliates as insiders of the bank 8. prohibit knowing receipt of an improper extension of credit, 9. prohibit preferential lending to a correspondent bank’s insiders; and 10. further restrict extensions of credit to executive officers.

Correspondent Banks: banks that are correspondents may be close geographically, they can clear checks on each other, but there are limitations on insider lending, can’t do on preferential terms, there is pressure to look kindly on loans to other bank’s directors if they do the same, they can’t make them on preferential terms, must have someone watching over this, monitor loans to own employees, board members, and officers and directors of other banks.

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p. 2941. Can’t use prompt corrective actions statute bc it doesn’t regulate management of bank, can’t tell them not to do séances. Can only do so under discretionary safeguards if it is an excessive risk to bank such as if person is a CEO. OCC can come in and help the person develop mgmt skills, or lower their capitalization rating. 2. 25m T1/500m total assets= 5% leverage ratio, subtract 7m dividend from sh equity and total assets. 18m T1/493 total assets = 3.6% leverage ratio so undercapitalized, so can’t pay dividend25 T1+25 T2=50 total capital. 50/500= 10%, well capitalized. Subtract 7m from 25. 18m T1 + 18m T2= 36 total capital. 36 total cap/493m = 7% RBCR so undercapitalized, can’t do it. 3. a. capital restoration plans must be realistic, probably can’t accept this bc airplane business is more of a way to diverting resources from more pressing or unpleasant busi of confronting the real problems, can’t commit to new lines of business wo getting them approved. . b. Controlling corp must guarantee the plan, can’t have new lines of business. c. Bank must get the plan approved by agency bf it can implement it.

4. a. Theta bank, agency has power to compel Theta to accept the offer. b. Agency can remove him, at a hearing, Growel can appeal, has burden of proof it is in banks best interest for him to stay, bc he has been there for over 180 days (25 yrs) he meets the threshold under which agency can remove a manager. Agency wants to encourage new managers to recognize embedded losses. 5. Agency can close bank.

p. 300 problems. [Need to go over these problems to make sure you understand]1. a. 15% of 9m= 1.35mb. morts don’t count as regularly mktable, not liquid1. 500k silver bullion can secure a loan up to amt, mktabl.2. rare gem not readily mktable, so not qualified. 3. Bentley not readily mktable.4. security that is volatile on NASDAQ, still readily mktble.5. Com shares of sparke software, most volatile security trade mkt value of 700k, you could legally make this loan, but it could easily turn into a nonconforming one. What if bank made loan at 700k value collateral, then value of collateral declined to 500k, it becomes a nonconforming loan, bank could make the borrower: 1. provide additional security 2. repay 200k to get back into conformity.

Participation Agmt: bank makes loan and sells other bank a participation, originator gets 5%, particpaters get 5%. This helps banks make loans to bwrs that would otherwise exceed banks’ lending limits. Run into problems when participater wants a preference for 1st 5m that comes in for repayment of pr comes to participater. Preferences affect compliance and risk bc bank is essentially risking 10m bc won’t see their 5m return until the 1st 5m is given to the other bank.

2. Lamda Nat Bank, 20m in tier and 25m in tier 2, can make loan up to 40m, can only count tier 2 to extent of tier 1. What if you had 9m of loan loss reserves, 6m of which is counted in tier 2 capital, so have excess of 3m in cash. Must look at capital adequacy formulas to see what you can do w loan-loss reserves. Can add this increase your lending limits. You can include loan

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loss reserves in capital so you have another 3m. 15% of 3m is 450,000. Questions like this will be on the final.

3. Bank is making 6 $10m loans to 6 individuals, 220m in tier 1 and 100m in tier 2. Base lending limit will be 15% of 320m=48m. This is less than the 60m it’s trying to loan and these look like common enterprises. Mining co, we don’t know if it’s closely held, if it is then can’t count them, must know where their shares are traded and if it is on a recognized exchange. Can only loan $4.8m each.

4. Bank has 205m capital, lending limit is 15% 30.75m. a. Loan is 30m so under lending limit. This is barely under the lending limit. Seeking additional 5m loan secured by 2nd mort. Bank lawyer would argue it fits wi exception that it’s in bank’s best interest to make additional 5m loan. Regulator would say could loan 750k but not 5m. b. 3 start up businesses, can make a loan up to the 750k for the lease, still under limit. c. additional money for waterproofing may fall under exception, 30m in the building (, taxes due, if you don’t owe them money to pay the taxes, tax liens fall first in line on RE, taxing authority could come in and foreclose on the tax lien, takes priority on your 30m loan, it is prudential to bank to protect 30m loan interest. Previous owner has rt to redeem at amt paid at tax sale plus additional interest at 10 or 15%. Exceptions to Lending Limits: 1) drawing on uncolledcted funds that are in normal process of collection 2) renewing or restructuring a loan, so long as don’t advance new money, after making reasonable efforts to bring loan into conformity 3) advancing additional money to pay Tax, Insurance, Utilities, Security and Maintenance and Operating expences to preserve the value of real property securing a loan, but only if doing so to protect bank’s own interest in the collateral. 4) financing the ale of the bank’s own assets, including property acquired by foreclosure, so long as financing leaves bank no worse off than when the bank owned the assets. Insurance co acknowledges lender in policy, agrees to notify and allow a cure from bank if there is a monetary default on the policy, bank wants ability to pay insur premium if borrower doesn’t pay it. Even if loans are for cutting grass or security services, bank makes argument that this protects bank’s value, can advance beyond the lending limits.

d. So long as you don’t advance additional money and use reasonable efforts to bring loan into conformity, you can restructure the loan and even reduce the payments and not violate. If the bank has made reas efforts to come into conformity, goes back to bwr and asks him to reduce principle, this is reas efforts to bring into conformity. Bank argues: bwr knows more about building and how to run it, change payments but say bank gets any additional cash flow.

e. This loan would put bank over lending limit, 30m loan on books, want to sell for 8.5m and loan the money to the new purchaser. Exception: financing bank-owned property (OREO), bank is better off by giving this loan, assume building is not worth more than 8.5m, so will get this money out, so that’s better off and they will finally get payments on a monthly basis.

5. Owner needs additional 1m of loan, wants bank to loan the money to him individually come wi limits. Regulator would aggregate those loans to show that bwr exceeded limits.

6. Regulator: you are not on parity w the participant, participant gets a priority, so can’t do it.

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Bank: has good argument, when you put the 120m back in you are still under your lending limits.

7. Wildrose county, 8m in capital, employer wants another 10m, normally employer would be grouped, but there is a company town exception that makes an exception for this and makes it ok.

Interbank LiabilitiesInsiders need clear limits in addition to the other limits. Additional limits if you qualify as an insider.

5 Basic Rules p. 304: 1. prohibits preferential terms; 2. requires board approval for extensions of credit exceeding certain thresholds 3. limits total extension of credit to any one insider 4. limits aggregate extensions of credit to all insiders and 5. restricts overdrafts by executive officers and directors. 5 other supplemental rules too....

This is a place where small banks often screw up.

p.307 problem. p. 305-306. 1. Neptune owns all voting shares of several banks, one bank CEO wants:a. 1m mort loan, has to be approved by board, but can go ahead and make the loan. b. loan to pres of bank’s son to post his bail for drug charge, it is ok so long as there are no preferential rates, you can technically make the loan so long as you would do it for a 3rd person, valid credit risk now but may change when gets put behind bars. c. This is a director, so is an insider too, morts are not liquid, can make it up to 4.5m, but not the full 5m. d. 5m line of credit to CEO of bank for gubernatorial candidacy, cannot do.

FDIC Insurance CoverageDefinition of Deposit

FDIC v. Philadelphia: whether a standby letter of credit backed by a contingent promissory note is an insured “deposit” under the FDIC program. Standby letter of credit: bank will standby, if primary obligor doesn’t meet a condition, then bank will pay it off. A promissory note was signed, so looks like a deposit. Ct: though it looks and acts like a note, it is not, there is no deposit, thus there is no insurance. Note: this is at the end of the S&L crisis when they were doing bad economically, when this happens, the cts are more influenced by what is going on in the world than applying the law as written, they had to stretch here. There is a ct mandated oxymoron, the non-note note.

Brokered Deposits: You can split your deposits among several banks then you can get 100% coverage of 100k in each bank, just don’t put more than 100k in each bank. Can deposit in banks with better interest rates on CDs, etc. Regulators did not like broker deposits on balance sheets, but they began to realized that they were efficient, if bank needed deposits, why not let them come in from out of state. The risk is the volatility, as IR change, then out of state brokered deposits are moved; this is why regulators prefer local deposits.

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Analogy to Private Insurance: Reinsurance: insure the insurance, secondary liable bc only has to pay if first insurer does not pay. Co-insurance: usually a fixed deductible or percentage cost the insured, covers a part of the cost of the insurance; here the second co is equally liable. Deductible: studies show that less likely to take advantage of insur if you pay a deductible, can negotiate to pay higher deductible and lower premium. FDIC does not have a premium. The premium that made sense in January may make no sense as time changes bc the risk of the bank always changes, not like predictable lives or driving record. Banking history is examined but not as often and is a lot more cumbersome. So risk based premiums don’t work as good.Exclusions for certain risks: exclusion for arson in home owners insur, not obligated to pay; like suicide exclusions in life insur policies. Mkt Risks: Shareholders: have the most risk, they have much to lose and lose everything bf anybody else gets something. There is a lot of transparency for shs, they can read SEC filings. Depositors: can review SEC filing but can’t access bank regulator info. Depositors don’t have much incentive to look at safety and soundness bc they are worried about convenience and location. Debt holders: Senior debt holders don’t have to worry bc they are at top of food chain. Subordinated debt have to worry but most banks don’t use a lot of these types of debt to raise money (bold holders etc). RE developers: can be attracted to a bank by making better loans w less interest. May do good for a while but RE mkt always turns down, it is a given. They go up or down regularly.

Consumer Protection and Basic Financial ServicesUsuryState law concept and varies among states.Corporations: many sts say usury doesn’t apply to corporations.

Section 85 Usury Limits: permits nat banks to charge the greater of 3 rates: 1. rate allowed by the laws of the st where the nat bank is located, except that where a st sets a diff rate for st chartered banks, this rate is allowed for nat banks (case law: nat banks have “preferred lender” status, can get highest rate of any lender in st). 2. 1% above the discount rate on 90 day commercial paper in effect as the fed reserve bank in the district where bank is located 3. 7% if no interest rate is fixed by st law.

Section 85: Fed bank can charge same interest in st where bank is “located.” Except where st alws diff rate Tiffany v. Nat Bank of Missouri: national bank enjoys the same limits as “the most favored lender” status under the state law, can take advantage of the highest rate allowed to lenders under st law even if st-chartered banks are restricted lower rates. Other lenders may have more favorable rates and nat banks are entitled to receive that rate.

Marquette: whether nat bank act authorizes a nat bank based in one state to charge its out of state credit card customers an interest rate on unpaid balances allowed by its home st when the rate is greater than that permitted by the st of the bank’s nonresident customers. Ct: nat bank can charge its home st’s higher IR to out-of-st customers despite the fact that out-of-st law prohibits

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it so long as the st law applies in same way to all in-state customers. Π argued that IR was usurious bc the credit card program was “located” in the other st. Ct: can’t say bank is relocated just bc does busi out of st, money is paid to the home st bank, that is where it is “located.”

Smiley: late payment fees are “interest,” doesn’t have to be a time or percentage figure, can be any fee, applies the same way as IR limits, fed bank can charge interest in st where located.

p. 351-353Truth in Lending Act (TILA): requires disclosure about loan terms.Consumer Leasing Act: disclose terms of consumer leases such as automobile. RESPA: real estate settlement procedures act, HUD defined annual percentage rates (APR), this can be found in RE or for automobile. Discloses info to consumers. Fed Fair Credit Reporting Act: regulates how 3 reporting agencies distribute credit reports. Fair Debt Collection Act: can’t harass etc. See other Acts on these pages.

RedliningEqual Credit Opportunity Act: prohibits disc of any credit w respect to any aspect of credit transaction on the basis of: race, color, religion, national origin, sex, marital status, or age. Creditors are anyone who regularly extends, renews, or continues credit.

Chevy Chase Consent Decree: fed govt came in and sued bank based on aggregate number of loans in communities, weren’t many in low income and minority areas. Bank didn’t want to put branch bank in depressed area bc if they did and didn’t loan any money out of it, then might get in trouble. Bank agreed to comply but didn’t admit any wrongdoing. There was no ev that any loans were denied.

Community Reinvestment Act: 1. lending test of ability to meet needs of loans for small busi and home morts, etc made to local area. 2., investment test of needs apart from lending, 3. service test for bank’s extending retail services. If you can’t show compliance, then can’t merge, est new branches, etc. Critics: the act discourages the very thing it tries to help, makes bank stay far away from these areas; creates risky investments; discourages diversification of loan portfolios bc local loans will be same; reduces profitability; local community leaders may extort banks by threatening a complaint, can delay mergers and squeeze settlement money out of bank. Graham-Beech-Bliley: there is no longer an automatic holdup of these mergers. Now, even small banks have at least one officer ensuring that the bank complies w CRA.

Predatory Lending/Subprime Mort CrisisPay day lenders: most are around young people, usually around military bases, customers get paid some money regularly but often have money problems, charge high interest rate on short term loans so that customers can pay car bill, etc. Roof repair: can talk people to contract w roof repair, signing a note and mort secuirty, if she can’t pay bank will sue and bank has a perfect defense bc bank was a holder in due course, can’t find the contractor, now have a mort on it that she can’t pay.

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Subprime Mortgages: commitment fees, close the loan and immediately sell the loan to the wholesaler, keep the commitment fee even though had hardly any risk. Wholesaler packages the morts and puts them out for auction, diff investment banks buy them, sometimes for their own account, sometimes to split them up and resale in traunches, sell one group the income from it and one the principal paid on the note, this creates a question of who exactly owns the note bc it has been sliced and diced so much. Foreclosure defense lawyers often ask the bank to present the note if they are the owners, but nobody can find it often. If loan is not that big, originator can make it larger to increase percentage of broker fee, will do this even if bwr can’t pay loan, this is

Community Reinvestment Act: banks were concerned about opening up in zip codes where they worry about them not being repaid.

LTV 95% or more

Mortgage Fraud: lender wants to flip, buy a piece of real estate at 100k, then transfers to wholly owned corp for 150k, then transfer it to another wholly owned corp for 250k, then 400k, this takes place over a month or so. The RE that is really worth 150k, is now on the books at 450k, now you can get another loan for 350k and secure it with the RE. For this to work, you need a good mort bkr who will look the other way, and get a good appraiser who will appraise it at 450k for the lender. Can entice the lender into doing this. It would be nice to have someone in house at the lender, but this is more difficult. But lender’s general counsel can be bribed, though they have a duty to report this to their client. Compensation scheme that encourages mort bkrs to make bad loans.

Financial PrivacyYou basically don’t have any, many people can get this information.

Lender Liability1. liability toward bwr for actions taken by lender during your relationship.2. to 3rd parties, no direct relationship but harm caused to them by your borrower.

Brown: Lender had acceleration clause w owner of airplane, other buyers offered money for plane but lenders wouldn’t take it, foreclosed on and repossessed the plane and sold it in another state for larger profit. Usually ldrs are only entitled to get money back and give bwr the excess, here ldr was just worried bc bwr didn’t have any insur on plane and new buyer probably was going to put insur on it. 2 types of acceleration: lender can F bc 1. feels insecure or 2. bwr defaulted. Ct: bwr signed an agmt, ldr had rt to accelerate, but must imply an obligation of reasonableness, must act in good faith.*Be careful when you negotiate so that you don’t modify the loan inadvertently by accepting late payments, etc, you will lose your ability to foreclose immediately, must at least give notice that you will strictly construe the payment date, even then ct may say you still independently modified the loan.

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Kham: bwr is trying to get more financing from bank bf chapter 11 bkrp, but bank doesn’t want to sit behind tax lien, so bank wants to avoid letting loan become into bkrpy, so debtor agrees to a line of credit, bank suddenly stops line of credit, this was done to increase its priority under an earlier letter of credit. Ct: equitable subordination cannot subordinate bank’s interest to allow it to become an unsecured creditor, bank did not break any promise, it just made a clean break that it was allowed to do.

Connor: real estate developer obtains financing from ldr, developer made mistakes w the foundation, rain storms caused soil to expand, Πs home buyers sued both developer and ldr.Two theories of bank liability to 3rd parties: 1. liable for bwr’s negligence under joint venture w bwr (bwr violated duty to 3rd party and ldr also liable) 2. liability for bank’s own negligence in violating independent duty to 3rd party. Joint venture test: agmt bw parties under which have a community of interest or joint interest in a common busi undertaking and understanding of sharing of profits an losses and rt of joint control. Ct: there is no ev of a joint venture, even though ldr had some control other than just financing, their incentives and profits were completely independent of one another, their payments were coming from diff money w diff risks. Otherwise all ldrs would be in joint venture w bwrs. So not liable under joint venture theory of liability. So must be liable if at all for independent duty to 3d party, but was there a duty? 3rd party duty balancing factors: 1. extent to which transaction was intended to affect Π 2. foreseeability of harm 3. degree of certainty of injury 4. closeness of connection bw conduct and injury 5. moral blame attached to conduct 6. policy of preventing future harm.Here, Δ ldr met these standards, so can be liable to 3rd party, even though not liable under joint enterprise liability.

As a bank, you will get a claim of lender liability virtually every time you are ready to foreclose. As a bwr’s lawyer, you must find any issues that could raise lender liability. Most lender liability cases are directly bw the bwr and ldr, only a small percentage are bw 3rd parties and bwr.

Note: read the tying section so that you will know what a lending tie in. Tie ins are illegal and banking statutes prohibit them. When you are involved with your bwr, you must not require bwr to do certain things that will tie products together: 1. require bwr to buy/use another service (of bank, affiliate, holding co, etc) 2. require bwr to provide certain services to bank 3. preclude bwr from doing some service w a competitor.

Affiliate Restrictions

You don’t have to remember all of these rules word for word for the final exam. Just know how to do the problems if given the information.

Need to allow banks to affiliate and have dealings with other company while meeting the goal of maintaining a meaningful economic separation bw banks and various affiliates.

Section23A

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Quantitative: can’t have transaction w one affiliate that exceeds 10% of bank’s capital, and can’t have a transactions in the aggregate that exceed 20% of bank’s capital.

Qualitative: Collateral limitations: 100% for govt securities and bankers’ acceptatnes; 110% for st and municipal securities; 120% for debt instruments not wi the 100%, 110% and 130% categories; and 130% for stock, leases, or other real or personal prop. Low Quality Assets: can’t use bank as FDIC member as a vehicle for purchasing low quality assts, defined by on p. 429.

Exemptions: Sister Bank exemption: more than one bank as a subsidiary of a holding co.

Subsidiaries of banks: Diff bw: operating subsidiaries: engages only in activities that a nat bank can conduct directly (originatinga and servicing morts)financial subsidiaries: activities that bank cannot conduct directly (underwriting corp securities). p. 31 collateral requirementsSection 23B on p. 31.

Bank Holding Company BasicsOriginally had to own 2 or more banks, but this creates a loophole, could organize a holding co for every bank and could never be regulated by the holding co act.

Important definitions:Company: any corp, ptrp, busi trust, association, or similar org, or any other trust unless by its terms it must terminate wi 25 yrs. Excludes individuals, qualifiying family trusts, qualified family ptrps, and corps owned by the fed or st govt.

Control: owns, controls, or has power to vote 25% or more of any one class of the bank’s voting securities. Or if th eco controls in any manner the election of a majority of the bank’s directors. If the fed reserve board determines after notice and opp for hearing, that the co directly or indirectly exercises controlling influence over the mgmt or policies of the bank.

Bank: any institution which 1. accepts deposits that the depositor has a legal rt to withdraw on demand and 2. engages in the busi of making commercial loans.

Prior approval requirement to 1. become a bank holding co or; 2. to acquire 5% or more of the voting shares or substantially all of a bank’s assets.

Bank Holding Co can conduct directly or through nonblank subsidiaries: 1. banking or managing and controlling banks and other subsidiaries authorized under this Act or furninghin services to or performing services for its subsidiaries or 2. activities that the fed reserve board had bf enactment of Graham Bleach Bliley Act determined to be “so closely related to banking as to be proper incident thereto.”

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Reg Y: can do things that are deemed for the “public benefit.” (fed has already determined that things on reg Y are closely related). Must give 60 day notice to fed. Still must be identified by fed to be in the public interest, even if listed in Reg Y. This is all on p. 442.

Next we will talk about regulation of bank holding cos and the diff bw them and financing holding cos.

Once you have become a bank holding co., you have taken on a new regulator by the fed, you have already gotten prior approval by them if you have a holding co, but you also must make reports, for the most part the fed has to rely on the reports that the HC prepared for other regulators. Also must have periodic examinations.

For BHC, must have: 1. Must have prior approval to be HC and give notice of all activities or acquisitions. 2. submit reports, fed usually must rely on reports submitted to other regulators3. subject to examinations4. capital requirements of hc and individual subs, as well as consolidated balance sheets of all subs and HC taken together.

BHC Rating System, p. 458CAMELs system is similar to RFICD: Risk managmentFinancial conditionImpact, on BHCComposite, overall evaluationDepository institutions and reg structure related to those.

Enforcement: Fed has regulatory auth over BHC and only non-banking subs, the banking subs continued to be regulated by fed or st (charter) and FDIC.

Financial Holding CosGraham Leach Bliley: effectively removed the distinction bw commercial and investment banking, a financial holding co has much broader powers in terms of what its subs can do, allowed banks to be involved with a broad range of financial activities.

BHC can become an FHC; requirements: 1. each BHC’s subs that are FDIC insured depository institutions must be well capitalized and managed. 2. satisfactory examination rating under Community Reinvestment Act, good community investment rating. 3. BHC must file with the Fed reserve a declaration and election to become a FHC.

Merchant Banking

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Same thing as investment banking, private equity, venture capital. It involves lending but not deposit making like commercial banking. Keeps an investment account and invests in equities. Also advises and invests 3rd party monies in equity investments.

p. 474 problems1. Can have 3 diff possibilities. Probably will have to the 2 yr divestiture provision that you will have to get rig of it. But can try the grandfather or merchant banking exception. When Oldman Sachs acquires a bank, it becomes a BHC, so must look to BHC activities. 2. To be a BHC, must be well capitalized and managed, one seems to be well capitalized and ne is adequately capitalized. Must have satisfactory examination under Community Re-investment Act, and one bank does not. But there is a 12 month window in which it can file a plan for improvement, so has 2 months left to do so. So what can we recommend? Can merge the banks and then the bank will be well capitalized. Can go to regulator and argue that the smaller bank has the CRA problem and when the big bank takes over, and the combined bank will be in compliance once big bank takes over. 3. Manufacturing and leasing armored cars is incidental and complementary to a financial activity. Under Section 1843K(4)’s first permissible activity, it involves the transfer of money from one account to another. It is at least a “potential” permissible activity under subsection K(5) in that it Provides a device or other instrumentality for transferring money or other financial assets or Arranging effecting or facilitating financial transactions for account of third parties. Looking at the factors for classifying additional activities: It is needed to compete effectively with other financial institutions that offer broader services, particularly overseas, who may have greater access or control over armored car services. Poses no substantial risk to the safety and soundness of the institutions.4. You don’t meet the capital requirements, so what could you do to cure this problem? Could help if you sold certain assets, sell the 100% risk weighted assets in exchange for cash which have no risk. Could persuade the Fed to ease the 25% of revenue restrictions, this is just persuasion. Go back to p. 478. Know the Holding Co Regulation Chart (ignore the Unitary Thrift HC). You deal w fed for bhc and fhc. But bhc must be closely related to banking. For fhc, must be financial or incidental or complimentary.

March 17, 2010Banking Law

What has Senator Dodd suggested?

(1) A consumer financial protection agency. House wants it to be independent, Senate wants it under the authority of the Fed.

(2) It attempts to end TBTF by trying to provide an agency with the ability to break up institutions that pose a systemic risk for the economy

(3) Set up a single federal bank regulator

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(4) dealing with executive compensation and corporate governance (in theory adds more transparency for investors)

This agency is supposed to put the financial consumer protection in one place. It will have a five member board and an independent director. It will have authority over “shadow banking” industries…things that provide quasi banking functions like mortgage brokers & pay day lenders.[With over-lapping regulatory agencies, it’s easy for things to fall between the cracks. This agency seeks to cover all consumer financial protection.]

It will allow the states to enact tougher regulatory laws, and these laws will apply to federal institutions!

This agency is largely targeting the biggest financial companies.

This agency will also be able to promulgate regs to target companies that aren’t currently regulated, like hedge funds.

On the whole, they’re trying to make risk more transparent by collecting data, analyzing data, and identifying risks.

How are we going to discourage excessive growth? How do we get things from being TBTF? As the institution grows larger or more complex (interconnected), what about saying that your leverage ratio must drop, your liquidity must go up, and your capital must go up…this makes it harder for them to grow and also makes them safer!

These large institutions are also going to have to file their own “funeral plans” with this agency, describing how to disassemble the company most efficiently if the company fails.

The single federal bank regulator- Independent - Chairman appointed by Pres- Board that includes FDIC, FED, and 2 other independent members- Funding will come from the banking industry

This leaves the FDIC to focus on its role as a deposit insurer & a resolver of failed institutions along with back-up regulatory power.

Fed will be able to focus on financial stability and allow it to get information about these financial institutions.

How do we deal with the derivatives market? Most of them are currently unregulated. The volume of unregulated derivatives in 2008 was $592 trillion…a huge, huge part of the world’s

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economic system. This is definitely a complicated issue dealing with complex financial instruments.

The SEC will try to look at unregulated derivatives. Basically they’re trying to establish a central clearing-house for these derivatives, which will be regulated. This won’t make a difference to the ordinary person directly anyway. The SEC is getting more authority here.

What about insurance?- New office within the Treasury department- Insurance is already regulated by state insurance commissioners, so they are really

going to object to this proposal- But it probably makes some sense to have some national uniformity with insurance

Also new agency within the SEC to have its own staff and authority to de-frock credit companies that has been putting out bad credit ratings.

How about checking executive compensation & corporate governance?- Allow shareholders to vote on golden parachute packages

Clawbacks: require public companies (not just banks) to establish policies to recover compensation previously paid to executives when it is determined that those bonuses were based on inaccurate financial information (Enron and Lehman would be good examples).

All of these proposals are not going to eliminate the chances of a financial meltdown, but it will probably be an improvement over what we currently have.

3/22/10

Monitoring and Enforcementp.633, 636 charts, good to know

Monitoring and Examiners:Fed banks: OCC, FDIC, and Fed reserve.St banks: St Banking Commissioner, FDIC and Fed reserve has reg auth over st banks that are members of the fed reserve (but do not reg very often, mostly just share reports.

Call report: banks file balance sheet for regulators on a quarterly basis, detailed, either internally or externally produced. These are looked at most often by all regulators. Agencies tend to try to coordinate these so regulators are not coming back to back or all at once. Banks always cooperate bc would be suspicious if try to delay or avoid. For large banks (BoA), the examination goes on continuously bc the work is so huge and takes so long, could not do it periodically, so have people working on them everyday. Loan administration is important, suing on notes if you have to, though it’s looked down upon by mgmt. Must have note to sue on and collateral must be maintained.Teller must be available for review, die packs put in stolen money turns skin and everything orange. Die packs are required, each teller must have them in the cash drawer. Examiner checks

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for this and that tellers are trained to use them. Also want to make sure the cash drawers balance every day. Want to go through safety deposit boxes and make sure no one has accessed the vault for these boxes without first signing in. Loan files will be examined to make sure they are all signed and executed properly, guaranties, modifications.

Examiner will then right up a preliminary report and set up meeting w Board of Directors to talk about report and what they found. Will look to see if Board and mgmt is cooperative and not flippant.

The public cannot access examination reports. If the OCC conducts a report, it does not have to give it to you. Rationalization: If it were public, mgmt would not be as candid w examiners; also examiner would be more likely to conduct favorable examinations if they were public and banks could use them for advertising, and govt might be held liable for the impression made by its examination. If report is negative and made public, then depositors would act irrationally and withdraw. A buyer of a bank can obtain a copy of the examination report from the seller, but in theory the regulators have no obligation to give the report to the buyer. But they understand that buyer will not buyer unless it sees the report.

What is on the report? CAMELS analysis, score of 1-5 (1 being best, 5 being worst, so the lower the better). -Capital adequacy-required ratios; even if you meet statutory minimum requirements, if you have risky assets/loans, then will need more than minimum requirements). -Asset quality-concentration of assets, whether they are performing, risky.Management-officers and board of directors, more subjective, must be cordial and cooperative w examiners; impression of examiners of quality of mgmt, risk and personnel policy, morale. -Earnings-return on assets, return on equity, compare ratios and similarly situated banks, are the trends positive or negative, like to see a sight upward trend. -Liquidity-percentage of cash and cash equivalents (liquid securities), can be adequate in good times and inadequate in downturn; tied into capital adequacy and assets too. -Sensitivity-shock test, reprice assets at giving time; cash reprices instantly, buildings are relatively fixed; loans reprice on maturity or IR change at diff times, categorize them into ones that reprice 1-30 days, 31-70 days, 91-180 days, 1 yr, 2 yrs., 3-5 yrs. Demand deposits reprice instantly. Savings accounts and other immediate accounts reprice instantly. So all of these are in the 1-30 day category. CDs reprice on whatever the specified maturity date is, however bank will usually give money back on a CD anytime you ask for it bc bank wants to keep your business. Subordinated debt, depends on when it matures and you have to pay it off.

Assume you have 100m of assets in 1-30 day category, how much liquidity do you want to have in that category? 100. Bc want to balance out your IR risk, your assets and liabilities reprice at the same time so there is no risk on IR changes. So your ratio is 1:1 or just 1.

What if you have 100 assets (loans, collecting interest payments) and 50 in liabilities (deposits mostly, paying interest), so ratio is .5. If IR goes up you have loans that were 6% that reprice

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and are now 8%. IR on deposits go up too but you don’t have as many so you win bc the rate on your loans are higher so the spread is greater. But if rates go down, those 6% loans go down to 4% and the interest on your deposits go down too but you don’t have that many so the amt you save doesn’t make much of a difference. So you lose on the spread.

If you are asset heavy, then IR increases are to your benefit bc you can collect a lot of interest. If you are liability heavy, then IR increases are to your detriment bc must pay more interest out.

REITs. RE Investment Trusts, independent busi, not owned by bank or holding co, has long term K w bank who sells shares to customers and charge them for mgmt fees, they were very profitable in the 1980s. Bought property, could be specialized and bought apartments. Mortgage REITs loaned money, got some capital from stockholder investors, can borrow more cap from bank (but bank could be considered an affiliate bc major source of income, so needed to find another way). Bank could sell commercial paper to REIT as bwr, matures in 90 days, and bwr pays back pr and interest, short term debt. REIT gets construction K from another lender that advances money over 3 yrs, pays off commercial paper debt every 90 days, REIT pays interest and then refinances construction K, bwr can pay off loan.

1 is the best CAMELS rating. 5% of banks get a 1 CAMELS rating, 80% get rated 2. Why would a bank not want to be #1, bc it means has a lot of capital sitting there, playing it safe but not making much money, a #1 rating is only good in a downturn. #2 is good bc earning money and adequate capital. #3 is bad bc get put on lists w a bunch of regulators, get examined about every 6 months. If you have any component rating of a 5 you will be a 5 Many regulators started doing examinations off-site in their own offices by looking at call reports sent by banks, cheaper and more convenient.

p. 640

3. On which CAMELS component would you rate the bank most favorably, how about least favorably? Leverage ratio of 5%, total risk cap ratio of 18.5%. Mkt sensitivity is the least favored probably, long term bonds, all the deposits are demand deposits. Would probably rate the asset qualities low (good), and sensitivity high (bad). Major liquidity problems too. You got 4m in cash, even if you sell the other stuff, the 61m in bonds will take you 40-60 days to liquidate.

4. What part of the CAMELS component would be least favorable.

Enforcementp.642When banks are closed, they have a big impact on a lot of people.

Types of EnforcementApart from general grievances, prompt corrective action, capital directives, formal or informal criticisms by supervisors, Enforcement Actions include: 1. conditional approvals2. written agreements

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3. CDOs, cease and desist orders4. suspension and removal of officers and directors.5. controls over personnel6. civil penalties7. civil litigation8. suspension/termination of FDIC insur. 9. criminal prosecution10. conservatorship and receivership.

FIRREA’s list of persons subject to enforcement action: 1. Institution affiliated parties: directors, officers, empees, and controlling shs..2. any sh who participated in the conduct or affairs of the bank.3. independent contractors (mostly auditors/CPAs, and lawyers): personal liability if knowingly or recklessly participate in: a. a violation of any law or reg b. a breach of a fiduciary duty or c. an unsafe or unsound practice.

Conditional approvals: when bank wants to do something may do so if gets prior approval (mergers/acquisitions, engage in new activity, new branch). Most informal type of corrective action, if they have real concerns they will come see you, here if they are waiting until bank needs something. May have concerns about capital ratio. What is Texas ratio?

Written agreements: Advantages for regulators: 1. gets attention of top bank mgmt and regulators can be invited to its signing, 2. also provides independent grounds for giving a CDO, civil money penalties, and removal if the bank breaches; but bank can enforce agmt directly in ct, must issue CDO or some other action and enforce that. Advantages for bank: 1. cheaper than fighting a CDO 2. less public than CDO or appeal. 3. easier to control language, creates more certainty. It happens infrequently but here bank has recognized it has a problem and wants to meet with regulators.

CDO: 1. determine grounds (unsound practice; violated statute, reg, condition imposed for approval, or written agmt. 2. give notice of charges, can be immediately challenged by bank but must be challenged in ct so becomes public. 3. will tell bank to start or stop doing something (can demand to sell off assets to raise cash for cap req). Ag may save time by issuing CDO first wo written agmt. Bank is better to take it and obey. Can contest it and file an appeal, will be filed in civil ct but this will make it public. May suspend enforcement to give a time to come into compliance.

In re Seidman: for a CDO to be necessary, there has to be some activity that produces an abnormal risk on the safety and soundness of the bank. Test: 1. was ag action arbitrary and capricious? (rare) 2. did it violate const rights of party? (rare) 3. exceed statutory juris of ag involved? (not unless ag was careless) 4. did ag fail to observe required procedures? (these are their own internal procedures) 5. was the CDO supported by substantial ev on the record? (most likely to challenge it here; but substantial here means: if ag already has or can put together enough ev so that ag’s actions look acceptable).

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Must be related to safety and soundness: what if bank has big house boat for entertaining bank customers? Ag probably can’t order them to sell it just bc they are irritated. But if cap ratio is bad enough, can order them to sell non-producing assets, may get more specific and tell them to sell boat if it gets bad enough.

Suspension, Removal and Prohibition: can remove officers/directors/shs and can so far as bar them from life from being involved w a bank of any kind. Not frequently used, other than as a threat. Powerful but may be subject to faulty implementation. Requisites for Removal:To remove or prohibit an institution-affiliated party, the ag must est: 1. Misconduct: a. violated statute, reg, CDO, written agmt b. unsafe or unsound practices c. breach of fiduciary duty 2. Effect: a. actual or probable financial loss or other dmg to the bank b. actual or possible prejudice to the interests of the bank’s depositors c. financial gain or other benefit to the respondent and 3. Culpability: involved personal dishonesty b. willful or continuing disregard for safety and soundness. Look at p. 659, next paragraphs after this one!

Civil money penalties: can be $5k-$1m a day, don’t need to bear any relationship to the amount of harm or the type of harm inflicted by bank (don’t want penalty to throw bank into bankruptcy or receivership. Can be issued administratively, unlike compensatory dmgs and criminal penalties in litigation. $5k/day is nothing to a bank, just embarrassing. $1m/day is not bad for a big bank but is huge to a small bank.

***OCC has primary auth to put national bank/thrift into a receivership, if bank is insured by FDIC (almost all are), FDIC has back up auth to come in. FDIC’s auth to terminate or suspend deposit insur: FDIC can refuse to provide insur (this is the A bomb, almost never happens), will cause bank runs, no deposits, and thus bank goes bankrupt almost instantly. Can delay the action so that run will occur more slowly over time as word gets out and allows bank to be bought out by another bank.

Civil Litigation: shs and third parties can sue the entity as well as board of dirs, officers, lawyers, accountants, their firms, appraisers; Govt regulators can also enforce actions against the board of dirs and officers directly St law can impose stricter duties than imposed by fed law. Directors of banks are targets for litigation, and being a dir on the audit committee makes you become an even larger target.

(side note): Floor plans: bank loans money to car dealerships so they can buy from mfr and sell to customers. Also want banks as back ups to finance cars that the mfr refuses to finance (virtually anybody can finance a car).

Fed cts: we won’t make up fed laws (like the no-note note), there is no such thing as federal common law in banking, so will look to states to see what conduct is necessary for officers and dirs.

Kaye, Sholer case: OTS came in and froze the bank account of the law firms that represented the bank. Attys wanted paychecks but firm couldn’t pay, also attempted to freeze the ptr’s

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individual accts (hard to make expenditures beyond necessities, i.e., mort and kid’s tuition). Never a ct filing by the Δ law firm bc it settled in 6 days. Why did they settle? Bc they didn’t have time to do anything else, accts were frozen and credit was ruined. Nothing happened to the OTS but academics thought OTS’ actions were an abuse of power, so OTS never tried it again. They simply made allegations, didn’t prove anything, but essentially shut down the firm’s business. Fed govt could strip them of their power so OTS had to back down due to the response or risk losing power.

Can use regulatory malpractice as a defense against a reg action. (p.686). When a bank/institution-affiliated party is sued for dmgs by FDIC, they often respond w affirmative defenses such as that reg was contributorily negligent, ailed to mitigate dmgs, assumed the risk, had unclean hands, is estopped from complaining, and intruded itself as an independent intervening cause in the bank’s failure.

Criminal Penalties: last resort bf closing the bank. Can charge bank executives w conspiracy, mail fraud, false statements to fed officials, RICO violations, interstte transportation of prop obtained by frauds. Will have severe sentences if crime substantially jeopardized safety and soundness or affected a financial institution and derived more than $1m gross receipts from crime.

Conservatorship, Receivership. Last resort, regulators don’t like to do this bc looks like they haven’t done their job.

p. 689 problems1. a. assumed they are FDIC insured, loan officer is not checking credit history for loans: something informal first, use conditional approvals if they are applying for something, or written agmt or CDO.b. Guy makes loans based on character alone: try written agmt or CDO, maybe request they be excluded from the loan committee. c. officer has bank buy a speedboat but uses it for his own purposes: issue CDO asking them to sell boat, if bank gets lees, officer will make up diff. d. FDIC uncovers info that officer is in mafia and did crime and escaped bank by speedboat: CDO ordering bank to fire bank, criminal actions. e. officer sends postcard warning govt not to take enforcement action, resigning at bank, and donating stock to a library: can still enforce, can use civil/criminal liability to reach him. f. 20 yrs later, GBI finds out that officer is serving at another bank: US attorney can take criminal actions bc officer violated past CDOs, etc. 2. CEO wants to bring dangerous rattlesnake to officer, tells examiner that it is gentle. Bank is a state nonmember bank but is controlled by a holding co. So, fed can regulate, but there is no specific statute or reg that says fed can come in if officer is acting crazy. But customers wouldn’t want this snake roaming around the bank: can issue CDO or written agmt w bank. 3. Fed savings bank, accountant covered up shortfall by letting officers manipulate statements to overstate earnings, accountant approved this. FDIC can enf actions against professionals as well as executive officers, may be hard to enf in ct, but fed could get professional to sign a written consent to bar this outside accountant from doing any sort of accounting services. This saves time, money, risk at trial.

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4. Did the officer advanced money for payments on nonperforming loans (refinancing) so that their books looked good. And then the records were lost in floods bc they kept them on first floor and bank was by a river: Did officer take reasonable steps in refinancing and locating these files? If so, then no action.5. Leverage ratio is 10% (good), loans are underperforming so they are on bottom of list of performing banks, but officers aren’t changing anything: fed can’t do anything if bank aren’t doing anything illegal or negligent, but they just aren’t making money. 6. Earthquake destroys building, kills some empees and customers; empees are later kidnapped by terrorists; CEO contracts bad disease and always works in back away from the public; CEO’s friends are spreading rumors: regs don’t account for misfortune, will matter only if they built it on a fault line or not up to code; may worry about the friends spreading rumors if the friends were officers at other banks. 7. Maybe OCC may use CDO to stop them from issuing such loans in future but nothing illegal was really done, but FDIC would probably not get involved.

Bank Failure

Fed can appoint a Receiver: liquidates bank and sells it off; or Conservator: takes over and runs the bank (this is rare). Major player w dog in the fight is FDIC bc it insures the depositors. If bank goes under, what happens to the other guys, other creditors and uninsured depositors? Shs won’t get anything. Uninsured depositors will become creditors, FDIC will pay them only any excess amts available.

Bankruptcy acts don’t apply to banks and don’t have jurisdiction over banks themselves (have to look at bank acts), but do have juris over bank holding cos.

FDIC is often the receiver, steps on bank rights? No bank is going to say anything bc they are in a big enough mess and don’t want to deal w it at that point.

Receivership process: 1. regulators appoint a receiver to take control 2. receiver marshals ban’s assets 3. determines validity and priority of claims. Govt agency that issued the bank’s charter appoints the receiver (OCC for national bank, OTS for thrift, state supervisor for st bank or thrift); if the charter agency balks, FDIC can step in and appoint a receiver but usually just acts as receiver itself. By law FDIC serves as receiver for all failed national banks and fed thrifts, in practice FDIC also serves as receiver for all failed FDIC insured state banks and thrifts.

Grounds for Receivership: 1. bank has obligations exceeding assets2. cannot or probably can’t meet obligations in normal course of busi3. unsafe or unsound condition4. incurs or is likely to incur losses depleting sub all of bank’s capital and has no reas prospect of becoming adequately capitalized5. critically undercapitalized or has sub insufficient cap6. undercapitalized and: a. no reas prospect of becoming adequate b. fails to recapitalized when ordered under prompt corrective action statute (§1831) c. fails to submit timely and acceptable cap restoration plan or d. materially fails to implement such a plan

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7. bank sub dissipates assets or earnings through a violation of statute or regulation or through unsafe or unsound practice.8. bank conceals records or assets, or refuses to let examiners inspect.9. willfully violates a CDO10. bank commits any violation of law or regulation or any unsafe or unsound practice or condition that is likely to cause insolvency or sub dissipation of assets or earnings, weaken the bank’s condition or otherwise seriously prejudice the interests of deposit insur11. convicted of money laundering crimes12. loses FDIC insur13. bank consents to the receivership or conservatorship (they usually don’t fight it).

Marshalling AssetsReceiver is almost always going to be FDIC bc they have the biggest dog in the fight. Receiver looks at value of assets. Is the loan paying and current? if so then probably close to par value. If not current, then can package the loans and put them out for bids at other banks (usually nearby banks). Competitive bank nearby is more likely to pay a higher price for these loans than a big bank miles away bc it is a way to get new local customers. Now that you liquidate all assets and have cash from the sale, will now have to pay off creditors by priority. Shs don’t get anything bc they are at the bottom. Priorities (p.718)1. Administrative costs of receiver are paid first2. then depositors are first creditors paid, insured depositors get paid by FDIC insur fund, then FDIC has a first priority claim against the bank to get back the money, so FDIC gets its money back from bank. FDIC has auth to pay even uninsured depositors, if they determine that will prevent major runs on other major banks (but this is rare). If so, then FDIC has claim against bank for repayment of insur money for these uninsured creditors too. 3. General liabilities, any creditors including any unpaid depositors, pay off by priority, then pay pro rata (if owed 10m but only have 5m left, then pay creditors pro rata at 50c on the dollar). Landlords, get paid for the time the bank occupies the lease with whatever money they have, not good for LL bc his mortgagee loaned money only bc of the lease w the specific tenant (the bank). Bank also probably has maintenance Ks and leases on bank automobiles, will simply have to return the cars and pay whatever it can. What about developers who have construction loans and the project is 1/3 complete, developer is entitled to the rest of the money but cannot get the rest bc bank doesn’t have anymore, bank will simply vacant the obligation and if developer is lucky it will find another bank to pick up the rest of the financing obligation. 4. You never get to repay shs bc there is never enough money. Set off rights: when bank owes bwr money under a loan K but doesn’t have money, bwr has given lender bank security on its prop or development it’s building, better to get another bank to give you a loan so you can pay off old bank and get all of your collateral back. But as last resort, most cts say can say that bwr can off set any financial obligations bwr owes the insolvent lender bank (such as deposits in the insolvent bank drawn on bwr’s other bank or entity and visa versa, can clear accounts and offset the excess owed to lender if any), if offset enough then can get collateral back.

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Structuring Resolutions (p.729)Resolution options: If another bank agrees to buy assets, if you represent the insolvent bank, you want put options and buying bank wants a long period of time to do due diligence and put option to sell to FDIC at a certain price (this is same thing as guaranteeing the buyer’s loss on the asset).

Least Cost Resolution requirement: congress gave FDIC obligation to figure out resolution option that will result in the smallest hit for the FDIC’s insurance fund: 1. liquidating bank, selling whole bank to one buyer; or 2. sell it off as partial banks, diff assets and liabilities going to diff buyers, the complexity for FDIC goes up dramatically. FDIC prefers whole bank transfers.

Systemic Risks: there is an exception to the least cost resolution requirement when such a resolution would have serious adverse effects on economic conditions or financial stability. Sec of Treasury in consultation w Pres can make such an exception only if recommended by 2/3 majority of both Fed Reserve board and FDIC board. Gen Accounting Office must review and report on the exception including the potential for it to increase moral hazard. FDIC must levy a special assessment to recopur the additional cost of deviating from least cost resolutions. Such an assessment applies not only to insured banks’ domestic deposits (as in the case of regular FDIC premiums) but to their foreign deposits and most of their nondeposit liabilities. Big bank and insurance firms risk on the financial system.

International Bankingp.739. There will be at least 2 questions on the exam and people get them wrong often. So need to read the chapter.

You won’t be asked who regulates US branches of foreign banks.

Foreign Bank Activity Here in USInternational banking was of little interest to US until early 1900s. Fed Bank Act: gave fed banks auth to be involved w international banking. WWI gave US power on the world horizon. Money center banks (mostly in NY) began getting involved, on into WWII. Huge increase in intl banking at this time.

Intl Banking: US banks doing busi abroad and non-US banks doing busi here (totally diff)

Economic and financial mkts are increasingly global, stronger intl banks help financial producers mkt abroad. Money is fungible and can move easily by bookkeeping entries. Prior to 1978, foreign banks could operate in US, across st lines, no capital requirements, so had a huge advantage over home banks.1978 Intl Banking Act: Fed Res reg foreign bank reserve requirements, approval of offices, examinations, agencies; OCC reg and approves foreign bank branches here.1991 Foreign Bank Supervisions Enhancement Act: holding co owned all shares of the nat. bank of ga. Borrowed the money to buy the stock of the holding co. Needed to liquidate to pay debts.

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Washington lawyers were involved. Gave Fed right to examine foreign banks themselves, not just their branches/offices here. OCC does hands on regulation of foreign bank activity here. International Monetary Fund: banks making loans to foreign countries, this is a moral hazard, it helps underdeveloped countries but about 90% of time the money ends up back into US banks. Loan 100s of billions to S. American countries and other places. US banks can make their own loans wo regard to whether country defaulted, if they defaulted, the IMF would loan the country money to repay the bank’s loan (moral hazard).

International Activity of US Banksp. 753, Reg by the Fed Reserve: member banks, export trading agmts, Edge Act corporations, intl banking facilities. US co wants to sell products abroad, must worry about the exchange rate risk. If the spot rate is 1, then US$ equals foreign$

1. Spot mkt: immediate settlements at existing exchange rate (spot).2. Futures: delivery of settlement at a later time but at an agreed upon exchange rate. 3. Currency options: contingent claims that allow you to hedge your bet w puts and calls.

If delivery will be in 6 mos, how can you be assured that you will get $6m in 10 mos or set forward K at the current exchange rate. Or easier just to denominate payment in US dollars. If you want a currency option, you will buy either a put or call. Want to make sure the dollar is strengthens, want to by calls on dollars (buy) or puts on euros (sell). If euro drops then you can’t by $10m with it, but if you buy a put to sell $10m euros at $10m dollars, then you get your profit. If euro goes up so that you get more than your $10m dollars, then you just let the put expire.

Letter of Credit: guarantor promise to perform or other party can get paid by this letter of credit (not guaranteed by bank itself). Standby Letter of Credit: almost a guarantee from bank issuing it, bank standbys obligors promise to pay/performance. If they don’t build it, we will pay X dollars. Banks do not ever expect to be called on these.

Euro Dollars: a dollar liability of banks located outside the US. There are no colored bills for euro dollars, just an accounting mechanism, a euro dollar book. Funds in these books are usually CD or other fixed rate deposits bw banks that are illiquid, although there is a secondary mkt for these. They are usually priced at a spread over LIBOR. Eurobank loans, unlike deposits, are floating rate loans at a spread at so many basis points over whatever LIBOR is at the time. CDs maturity periods are fixed term intervals and so you can easily match or mismatch intervals. You might mismatch intentionally if you want to speculate on something you are doing short term and you think you might profit from it. You will simply match maturities at the time if you are more conservative.

At end of WWII, US was a net outbound investor under the Marshall plan, private businesses were buying busi in other countries at fire sale rates, we were the only country that came out on top after the war. During the 70s-80s, US interest rates were very high, and somewhat

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worldwide. Now it’s at 3-4%, Carter yrs had rates at 24%. Made goods/services expensive but results in huge flow of money bc foreign investors invest at our high rates, wealthy people and sovereigns kept reserves in dollars, it is still the world’s most popular reserve currency. The euro is competing but hasn’t been quite as stable. Huge budget deficits at the time, a lot of countries loan us money bc our economy is so good, we keep borrowing. We doubled national debt each time w Reagan, Bush, & Obama; Clinton balanced the budget and had a surplus. Japanese are much more savings conscience than US, only recently changing in US by reducing personal debt rather than saving. So US debt is rising but US personal debt is slightly dropping. Trade deficits are high now and usually are, so long as foreign countries lend us money and other countries produce quality goods at a cheaper price, we keep buying them. The hugest imbalance is w China, we buy so much stuff from China bc it’s so cheap to make. Since early 90s, US position in world economy has weakened, mostly to continuing trade deficits and budget imbalances. If this doesn’t change, there will be a huge impact on interest rates. If China moves its reserves from dollars to euros, then there will be a money shortage for loans, so interest rates will soar to try to attract other investors.

Collejo case: read and pay attention to Sovereign Immunity and the Act of State Doctrine.

British bank model: their security firms/merchant banks can accept deposits. German model: similar to British. Japanese: entities have auth to be involved in lots of things, Mitsubishi makes TVs, cars, oil tankers; very vertically and horizontally integrated. Japanese economy has been booming like crazy but struggling now bc of its banking industry. Their banks have a lot of bad loans on the books bc their govt is so intertwined w them, many of them are technically insolvent though the govt tries to keep bolstering the banks and not recognizing losses. Many RE and corporate loans that have far less than par value, if most of your assets are bad loans then bank doesn’t have a lot to lend out.

We have only covered the basics of international banking.

Side note: must know what reg 28a and b related to.

Insurance IndustryDiff from banking industry, insur is an old idea, trade beginning to flourish around time of code of Hammurabi, caravans were risky bc of pirates/animals, so hedge against risk by lowering profits some (risk/reward analysis), run 2 caravans on diff routes, reduce risk by half but cut profits some bc transportation costs, then insur cos decided to take risk on these by selling coverage and covering losses.

Modern insur cos began with Lloyds’s in London. Lloyd’s-group of individuals, get together and underwrite ventures, not huge reserve requirements bc all assets of the individuals are on the line, good profits.

Insur in US began w marine insur for ships. 1800s, life insur began and life expectancy was low at the time so more risky, now very profitable bc returns are paid much later and premiums are paid longer. Easy to predict life expectancy based on demographic statistics, so conservative investment.

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Widow Act: life insur policies went directly to widows and children and could not be obtained by creditors of the deceased.Insur is still largely St regulated institution: Late 1800s, Sts began to set up insur regulating agencies, varied dramatically from st to st, but stayed a st regulated under taking. Sct: insur was not interstate commerce (Elliott says this makes no sense). So became a st regulated institution and still is, have all the diff sts regulating the same large national insur institutions. 1940: insur is considered interstate commerce, cong has auth to regulate.

ERISA, employment retirees insur act, Fed law: written by insur co lobbyists: If insur claim for disability: can’t get atty fees, no punitive dmgs, have to try in fed ct, where criminal trials have priority. Insur cos know it will take a long time to settle, so cos often offer a lower settlement payment, if insured turns it down and later wins at trial, then co only has to pay payments it would have owed anyway. So easy for insur cos to win either way.

Other types of insur.Home owners’ insur: policy can exclude water dmg, must prove wind caused it. E&O coverage (malpractice, errors and omissions, must be neg can’t be intentional or won’t pay) D&O coverage (officers and directors), retail busi has liability coverage (slip and fall).Fidelity bonds: form of insurance protection that covers policyholders for losses that they incur as a result of fraudulent acts by specified individuals. It usually insures a business for losses caused by the dishonest acts of its employees (Elliott thinks lawyers should have fidelity and E&O insur).Health insur: how to make profit by paying out claims, premiums have risen twice the rate of inflation in 20 yrs bc healthcare costs are so high. Busi end of hospitals think new health care bill is great bc emergency room costs treat uninsured, so hospitals add costs on top of paying customers, thus insur cos pay these costs, and then charge customers w higher premiums. Requiring everyone to buy health insur will help.Opposition argument: if everyone has insur coverage, insur co will pay out many more claims and so rates will go up even further. They say emergency room cost savings won’t equal costs of increased risk by adding the current uninsured.

Insur cos are still regulated by the states. Key states, NY, CA are more important bc of high populations, trade groups and insur commissioners have impact on policies. St Reg: 1. Require certain capital and reserves. With banks we have standard measures but insur cap adequacy differs w type of insur (life, property, liability). 2. Restrict investments: want to make sure co can pay all claims but want them to be profitable. 3. Premium control: st insur commissioner represents the people as elected official but insur cos pay for their elections, conflict of interest.4. Require filing of financial statements: depending on st law, may have auth to examine books and have some auth to close the co if become insolvent.

Insur co has influence on the regulatory process and it is somewhat unhealthy. Sct recently: corps are people under 1st amd and can give campaign contributions to officials regulating them.

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p. 554Banks themselves can do fewer things than bank holding co. Bank subs can only do what bank itself can do essentially.Bank holding cos can do fewer things than financial holding cos. Financial holding cos were created to access to investment banking and insur cos. Govt reg: don’t want bank funds to prop up sister co in the holding co, bc don’t want FDIC to bail out bank that has bailed out its sister corp.

When insur co was not interstate commerce, so no antitrust or dept of justice regulation. 1940 Sct: insur cos are interstate commerce and subject to antitrust regulation.McCaren Act: insur cos are exempt from fed antitrust sts, only subject to st antitrust laws (small staff and seldom enforced.

Socialized Insurance (insured by taxpayers). Social Security has insurance aspects, it is basically socialized insurance for disability. Govt employee pensions: contribution plan: you get back only what you pay in and interest on investment but can’t guarantee it (no longer like some benefit plan where you get back same amt no matter what you pay in or how long you’ve worked, even auto unions can’t offer these anymore). Military benefits: tp backed plans. FDIC: tps backed if bank goes broke. Pension benefit guarantee corporation: insur pensions if the co goes broke. Govt flood insur: can get it from govt if no one else will write it when insured lives on the beach. Cong determined that too many voters/contributors that live in flood planes/lakes/beaches. Add flood and earthquake insur no matter where you live bc it’s really cheap, this might blow your insur agent’s mind but they will insur you bc it’s so rare. Flood is about $100/yr, earthquake is about $48/yr.

Co-pays: self or co-insurer by paying deductible and co-insurer by paying part of it over certain maximums. Reinsurance: insur co can access other insur co for excess loss, even though reinsurer has no obligation to insured bc of K privity.

Umbrella insur (covers all parties involved in accident when you’re liable): auto insur 10/20 (max in thousands for bodily injury of one person; total bodily injury for one accident). Umbrella insur will not be on the final exam, but some of the other concepts will be in mind.

Investment Management

April 12, 2010Banking Law

Securities, Stock Exchanges, etc. Starting with the Howey Case on p. 496

In the 1980s, small regional stock exchanges began to emerge that were using electronic devices for trades. This was easily a more efficient way to make trades.

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Congress seized on the fact that commercial banks and investment banks were one in the same when looking to the cause of the Great Depression. This was partially true, but the true cause was overspeculation in equities. Congress adopted the 1933 Act, the 1934 Act, and Glass Steagal (which called for the divestiture of investment banking functions from commercial banks)

33 act was looking at initial offerings of stock. Offering circulars are VERY detailed and very complicated.

An underlying portion of securities regulation is to ensure that the public has information sufficient to allow it to make an informed decisions about whether to buy that particular security.

Fee arrangements:- Let’s say Merrill Lynch will agree to buy the initial offering from the company. The

company likes it because they get a chunk of money minus any commission paid to Merrill. (Best efforts) the underwriter wants to do this! They are taking essentially no risk…you deliver your 10 million shares and we’ll hawk them on the market. Merrill has no obligation to maintain the stock price after the first day. The market is likely to go UP the day after the initial offering. So Merrill earns a big commission & makes all of its customers happy.

What are some of the thing brokers can do for their customers that are problems?- Churning (p. 522)- Suitability of the investment to that particular customer- Boiler rooms - Scalping/pump & dumping

SIPC sort of like the FDIC for securities…this fund went to $0 in a hurry in the 1960s after a brief downturn. We still have it, but

What a margin requirement is is you borrow money to buy stocks! Margin rules are dealt with by the FED, not the SEC…this basically lays out what banks can loan you when buying on the margin, say like 50% of the potential portfolio can be borrowed. Just like any other leverage, it works great on the way up, but it sucks for you if the stock drops in price!

What about net capital rules? We have them for the same reasons we have them for banks.

Let’s go back to Glass-Steagal- Banks have a spotty history as investment advisors- It is difficult to put together an investment bank and a commercial bank together just

as far as compensation schemes are concerned.

What about risks from the investment banking side?- Commercial bank might have a closer relationship with clients and may take business

away from investment bank

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- If we let banks into securities business, this increases competition, which drives down compensation in the whole industry.

****Keep in mind that financial holding companies have investment banking arms, and those that were bank holding companies converted to FHC so that they could have investment arms!!!!************

Risk Assessment:

Choose underwriter and agree to pay them a fee for efforts they will make and risks they are taking.

Two kinds of fee arrangements: 1. underwriter agrees to buy the % of initial offering from you, so issuer knows it will get a certain amount on offering day (co favorable) 2. best efforts (underwriter favorable), no obligation to try to maintain that stock price after the first day.

ConflictsIf your broke is touting only stocks that his firm is underwriting, they may not be the best shares for you.

Churning: broker trades freely just to make a commission, doesn’t hold stock for a long time. If you opened an account and gave your broker trading authority, then you basically dumped cash on his desk and told him to do what he wants with it. If broker’s trading is slow, he may just sell one stock and buy another just to make a decision.

Suitability: know your customer. If bkr’s customer is elderly and all their net worth is tied up, need to be in something stable and income producing, not something speculative. As a bkr dealer, you should know your customer, the investments you’re recommending must be suitable to the customer. Is this investment looked at to produce current income or capital appreciation?

Boiler Rooms: bkrs are told to churn stocks, but only a set few specific stocks.

Pump and Dump: bkr buy stocks at low price, then tell customers to buy it bc it looks good, so demand goes up and price goes up, then bkr dumps the stock and makes a nice profit. Proposal to stop bkr’s from recommending stock they own, but security industry prohibited this bc it was un-American, even though it’s a huge conflict of interest.

FIPC: security investment deposit corp, like for private deposits, little capital, small crash in 1960s broke it then they put more money in it. Restrictions: do not insure more than $100,000 in cash and 500k or 800k in securities, not like FDIC where you get money immediately, the process to get the money back is very time consuming.

Margin Rules: a margin requirement allows you to borrow money to buy stock. If there were no margin rules, you could pledge $1m to borrow another $1m, the stock broker will loan you $1m and will retain $1m as collateral and can sell them immediately to pay off the loan. This was a big cause of the stock mkt crash. People did this w $1k, put it up to borrow $10k. When stock

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went down, they could not pay. Margin rules are set by Fed Reserve, not the SEC, bc it sets what the bank or bkr can loan you.

Margin Call: If you borrow $500k w $1m stock portfolio, then your stock portfolio goes down in value, then brk/bank can call your loan bc your collateral isn’t worth as much as it used to be, have little time to pay (2 busi days), if not, then bkr will sell the stock quick to get as much money as it can. This leverage works great on the way up but hurts coming down.

Capital rules: required to keep net worth of $250k or 1500% (15x).

Glass Stegel Act: what is the risk of allowing the commercial bank if it does investment banking too? 1. capital requirement, not much of a risk2. expertise, it’s a busi they don’t really understand. 3. advice may not be good, history as investment advisors is spotty (bank trusts tend not to perform well compared w other investments)4. Compensation schemes of commercial loan officers are salary-based, w small bonuses; Trading bkrs make big bonuses for big sales/profts and make big commissions on the side. How can bank keep loan officers happy bc they perform an important function of the commercial bank.5. Conflicts, competition based on compensation, bank may use bank funds to shore up a shaky investment banking operation, commercial bank could have a closer relationship w clients than investment bank, may take business away from investment bank, and increasing competition in investment industry so prices will go down (fees will go down, and stock prices will go down).

Jargon is importantKnow the Howey rule, 33 Act, 34 Act and the problems that can arise under them.

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