The Office of the Comptroller of the Currency (“OCC”) and the state banking regulators are locked in an acrimonious battle over which agency or agencies will have primary regulatory jurisdiction over the increasingly significant financial technology (“FinTech”) sector, each citing its bona fides for encouraging innovation and protecting consumers. Neither is being totally forthright in its arguments.
Primarily at issue are non-bank FinTech lenders and mobile payment providers, both of which are subject solely to state licensing. The OCC has proposed a FinTech national bank charter that would not require deposit-taking. This would allow such banks to avoid state-by-state licensing and preempt some state consumer protection laws.
The state banking regulators have strongly objected to this proposed charter and to other OCC initiatives that would diminish, or eliminate, the states’ jurisdiction over these FinTech companies. At the same time, the state banking regulators have cast a blind eye to FinTech companies engaging in traditional banking activities, such as deposit-taking, permitting them to operate without a banking license.
This battle for regulatory jurisdiction is redefining what it means to be a bank in the United States. At stake, among other things, is whether FinTech companies can offer basic banking services to the public without providing the protection of Federal Deposit Insurance Corporation (“FDIC”) insurance and oversight by a federal prudential regulator, including examination for compliance with federal consumer protection laws.
This Client Alert describes these recent developments and provides some context to assist in understanding their significance.
- In 2016, the OCC proposed a FinTech national bank charter that would permit banks with that charter to engage in lending and other banking activities without engaging in deposit-taking.
- The states have challenged the OCC’s FinTech national bank charter on the grounds that deposit-taking is a necessary condition for the business of banking, and that the OCC does not have the authority to implement a charter that does not require deposit-taking. The states also argue that a FinTech national bank charter would permit FinTech lenders to preempt state usury laws by “exporting” the higher usury limits from the state in which they do business, and that FinTech lenders should not be permitted to export interest rates.
- The states’ arguments about the OCC’s authority are grounded in a reasonable reading of the National Bank Act (“NBA”), and one lower court has enjoined the OCC from granting FinTech charters, pending appeal.
- Significantly, the NBA requires a national bank to become a member of the Federal Reserve System and obtain deposit insurance from the FDIC. Neither the Federal Reserve Board nor the FDIC have publicly commented on the FinTech national bank charter proposal.
- The states’ legal arguments are ironic. No state has required mobile payment providers, such as PayPal/Venmo, that accept and hold deposits (up to $31 billion as of June 30, 2020) from customers, to obtain a banking license even though virtually every state requires a banking license in order to accept deposits. The enforcement of those laws would likely drive the mobile payment providers to obtain a national bank charter and eliminate state jurisdiction over this large sector of the financial services industry.
- The OCC, through its rulemaking procedures, is also seeking to make it easier for FinTech companies who partner with banks—so-called “rent-a-charter” arrangements—to circumvent state laws that impose lower usury rates by allowing exportation of the rates from states with higher usury rates. The OCC is seeking to overturn court decisions that treat a FinTech company that purchases a loan from a “rent-a-charter” bank as the “true lender” for purposes of state usury laws.
- Until recently, holders of digital assets, such as bitcoin, have looked to state-chartered trust companies and other state regulated entities to provide custody and other support services for such assets. Many states have encouraged such activities by specifically authorizing their state chartered banks to hold digital assets in custody. Wyoming has created a bank that can engage in deposit taking from institutional depositors without FDIC insurance.
- Beginning in July 2020, the OCC staff began issuing interpretive letters affirming the authority of national banks (1) to provide certain “cryptocurrency custody services” to their customers and (2) to accept deposits of funds that constitute “reserves” backing “stablecoins,” a type of cryptocurrency. This guidance signals that the OCC wants the digital asset industry to view national banks as a viable alternative to using state-chartered banks or trust companies for these purposes.
I. The U.S. Regulatory Scheme: The Role of the States
Under the so-called “dual banking system” in the United States, state law determines a financial company’s legal status: Is it a bank? A money transmitter? A non-bank lender? If a company is determined to be a bank under the law of any state, the company can choose to satisfy state law by either obtaining a bank charter from that state or a national bank charter from the OCC. A national bank charter permits the bank to preempt a number of state laws, including laws that would prevent the bank from “exporting” the usury rate from a high usury rate state to a state with a lower usury rate. State-chartered banks insured by the FDIC can also export higher usury limits from their home state, but enjoy more limited ability to preempt other state laws.
In virtually every state, state law requires an entity that accepts deposits from the public to obtain a bank charter. Prior to the savings and loan crisis of the 1980s, states were free to empower their state-chartered banks and savings associations to engage in activities not permitted to federally chartered banks and savings associations, while still having their deposit insured by a federal deposit insurance fund. Use of these powers to make risky investments caused the Federal Savings and Loan Insurance Corporation to go bankrupt and the FDIC to become nearly insolvent.
As a result of this crisis, Congress required state-chartered banks to be limited to the same powers that can be exercised by a national bank as a condition of obtaining FDIC insurance and subjected state-chartered banks to oversight by a federal bank regulatory body.1 State-chartered banks are also subject to many federal regulatory requirements, including rigorous capital standards. Under this current regulatory regime, virtually all banks are subject to regular examination by their primary federal banking regulator and to a panoply of federal consumer protection laws.2
In contrast to almost all banks, money transmitters—companies that facilitate the movement of money or other “value” from one person to another—are licensed and regulated solely by the states. They are subject to minimal capital standards and less rigorous examination. At the federal level, registration with FinCEN is required for purposes of complying with federal anti-money laundering standards, but examination for compliance is delegated to the Internal Revenue Service.
Money transmitters are subject to a number of federal consumer protection laws enforced by the Consumer Financial Protection Bureau and the Federal Trade Commission. However, neither agency has the authority to examine money transmitters for compliance.
Similar to money transmitters, non-bank companies that make, or facilitate the making of, loans, particularly to consumers, must obtain a license in many states if they meet state requirements for lender licensing and no exemption applies. There is no federal lender licensing requirement, though lenders are subject to federal consumer protection laws. There is no federal agency that examines state-chartered lenders.
In short, a state-chartered non-bank company, whether it is a lender or a money transmitter, is subject to less regulation than it would be if it were a bank.
II. The Growth and Significance of FinTech
Technology has changed the way financial services are delivered. Consumers now conduct their banking from their smart phones, making deposits and transferring funds to friends and merchants. Online platform lenders make credit available either directly or through partnerships with banks.
The bricks-and-mortar delivery model is increasingly under assault, and banks are responding by closing branches, a trend that will likely accelerate in the post-COVID 19 world. To illustrate the cost-savings to banks of encouraging consumers to use mobile banking features, the cost to a bank when a consumer deposits a check in a branch is $0.65, but a mobile bank deposit costs the bank only $0.03.3
This assault on traditional delivery mechanisms for financial products and services is clear from the data on FinTech industry growth. KPMG reported that 2019 set an annual record for investment in the U.S. FinTech industry, with $59.8 billion invested, up from 2014 investment of $31.3 billion.4 The portions of the FinTech industry that are the subject of this Alert—FinTech lenders and FinTech payments providers—have each seen rapid growth in recent years as well.
Among notable FinTech lenders, non-bank platform lenders Lending Club and Prosper made only $3.3 billion in loans in 2013, but in 2019 they made a combined $15.0 billion in loans.5 In 2019 it was reported that FinTech lenders in the aggregate made nearly half of all personal loans in the United States, up from less than 1% in 2010.6 In each year since 2017, FinTech-originated personal loan balances have exceeded outstanding loan balances originated by banks, credit unions, or traditional finance companies.7
The jump in payments processed by mobile payment providers has been no less significant. In the second quarter of 2020, PayPal announced that year-over-year total payment volume increased 29% to $221.7 billion, while its subsidiary Venmo processed more than $37 billion in total payment volume during the quarter, a 52% increase year-over-year.8 PayPal expects total payment volume to increase another 30% in the third quarter of 2020.9 According to PayPal, since becoming an independent public company in 2015, the company’s platform has “scaled rapidly,” with 21.3 million net new active accounts in the second quarter of 2020, an increase of 522% since the second quarter of 2015.10
Non-banking entities providing loan products and payment services are required to obtain a license from state banking authorities, including money transmitter licenses for companies engaged in payments (e.g., PayPal, Venmo, Apple Pay, etc.) and lender licenses for companies engaged in extending credit (e.g., Upstart, Lending Tree, SoFI, etc.). This has restored the state regulators to the role of being the primary regulator of a major sector of the financial services industry, a role they lost as a result of the savings and loan crisis in the 1980s.
III. The OCC’s FinTech Charters
A. The FinTech National Bank Charter and Resulting Litigation
In December 2016, the OCC announced in a white paper (“FinTech Charter Paper”) that it would accept applications from FinTech firms for charters as special purpose national banks.11 The FinTech Charter Paper suggested that the OCC could consider applications from FinTech companies that perform any of four services: fiduciary activities, receiving deposits, paying checks, or lending money.12 Each of the four permissible activities is construed broadly by the OCC; for instance, the FinTech Charter Paper analogizes issuing debit cards or facilitating electronic payments to paying checks.13
In implementing a FinTech national bank charter, the OCC relied on a regulation it adopted in 2003 pursuant to the National Bank Act (“NBA”). The NBA permits the OCC to charter associations engaged in the “business of banking.”14 The NBA grants national banks powers necessary to engage in the “business of banking,” in particular, “by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes.”15 (Emphasis added.)
In its 2003 regulation, the OCC authorized “special purpose banks” with activities limited to “fiduciary activities or to any other activities within the business of banking.”16 A special purpose bank that conducts activities other than fiduciary activities must conduct at least one (and need not conduct all) of the following three core banking functions: receiving deposits; paying checks; or lending money.17
Although national banks are required to apply for and receive deposit insurance from the FDIC, and to become members of the Federal Reserve System, neither the FDIC nor the Federal Reserve Board has made any public statement, supportive or otherwise, regarding the OCC’s proposed FinTech national bank charter.18 It is unclear whether the OCC consulted with either the FDIC or the Federal Reserve before proposing to offer the FinTech national bank charter.
The state banking agencies, both individually and through their trade association the Conference of State Bank Supervisors (“CSBS”), have cited concerns both about the OCC’s jurisdiction and the potential federal preemption of state consumer protection laws, including usury limits on loans.
State banking regulators sued the OCC in federal court when the OCC announced its plan to charter FinTech banks, and, after the suit was dropped because it was not ripe for judicial resolution, sued again after the OCC announced, in July 2018, that it was accepting applications for the FinTech national bank charter.19 In the case before the Southern District of New York, the state banking regulators vigorously argued that the “business of banking” clause of the NBA requires all national banks to take deposits, and that therefore the OCC was not permitted to issue a charter to a non-depository FinTech.20
The court granted an injunction against the OCC, ruling that the OCC exceeded its authority in adopting its 2003 regulation.21 The court explained that the OCC was not entitled to judicial deference in its interpretation of the NBA because the statute is unambiguous: the “business of banking” must include, as a necessary component, the taking of deposits. Therefore, without statutory authority, the OCC is not permitted to charter an entity – FinTech or otherwise – that does not take deposits.22 The OCC has appealed the decision to the Second Circuit.23
In addition to its argument that the OCC exceeded its statutory authority, the states argued that allowing the OCC to charter FinTech banks would have negative policy consequences for state consumer protection laws. For example, a national charter would allow a FinTech lender to take advantage of federal preemption of state usury laws.
B. The Potential OCC FinTech Payment Charter
Acting Comptroller of the Currency Brian Brooks has supported OCC initiatives to promote the FinTech industry. Recently, he has given interviews, and he and Bryan Hubbard, Deputy Comptroller for Public Affairs, have made statements reported by banking industry press promoting the idea of a new narrow-purpose OCC charter for FinTech firms “engaged in the payments aspects of banking.”24 In promoting the OCC as a potential FinTech regulator, acting Comptroller Brooks is continuing trends at the OCC that have persisted across at least the last four Comptrollers or acting Comptrollers under both the Obama and Trump administrations, beginning with the FinTech Charter Paper.25
Unsurprisingly, however, the CSBS has taken the position that a narrow-purpose charter for a FinTech entity that does not take deposits is no different from the FinTech charter currently being litigated before the Second Circuit.26 If the OCC moves ahead with such a charter, it is very likely that more litigation would result from the CSBS, New York, or other states.
IV. Money Transmitters: Why isn’t PayPal a Bank?
Peer-to-peer (“P2P”) payment products, of which PayPal is a notable example, are intermediary services that facilitate transfers of funds from one person’s bank account or credit card to another person’s bank account or credit card through a computer, smartphone, or other internet-connected device that can provide instructions regarding the transfer. PayPal offers a suite of financial services beyond these mobile payments and payment processing functions. It provides personal, consumer, and business lending, as well as credit and debit cards which can be used at a network of ATMs.27
Additionally, some P2P payment product vendors, PayPal (and its subsidiary Venmo) included, permit a user to establish an account with the vendor and to self-fund the account and to receive funds from payors to be held in the account for specified or undetermined periods of time. PayPal’s user agreement states unequivocally that its customers are general creditors of PayPal with respect to deposited funds. Specifically, PayPal’s User Agreement says, in relevant part:
Except as provided below, any balance in your Cash Account and any funds sent to you which have not yet been transferred to a linked bank account or debit card if you do not have a Cash Account represents an unsecured claim against PayPal and is not insured by the Federal Deposit Insurance Corporation (FDIC).28
Customer funds held in PayPal accounts in which customers are general creditors constitute deposits. The relationship between a depositor and a bank is that of debtor/creditor: a depositor lends money to a bank that the bank is obligated to repay, based on the terms and conditions of the deposit account established by the depositor with the bank.29
As discussed above, the states have argued that deposit-taking is a necessary condition for engaging in the business of banking. Yet no state has required PayPal to apply for a banking license or charter. In 2002 the then-New York State Banking Department, Department of Financial Services’ (“DFS”) predecessor, required PayPal to register as a money transmitter, though not as a bank, in a letter that recited PayPal’s arguments that its business practices at the time meant that it was acting in an agency capacity only, and that it was not in a debtor-creditor relationship with its customers.30 Now, though, in the accounts where customers keep funds, those customers have an unsecured claim against PayPal for their funds, and therefore PayPal is not acting as an agent with respect to those funds. In fact, PayPal disclaims that it acts as agent or trustee in its User Agreement.
PayPal is a leading example of the increasing importance of FinTechs in the financial services industry, and it is primarily regulated by state banking authorities. Unlike a bank, it has no federal prudential regulator. It is required to be registered with FinCEN for purposes of complying with federal anti-money laundering standards, but examination for AML compliance is delegated to the Internal Revenue Service. It is subject to federal consumer protection laws, but it is not subject to examination by a federal regulator for compliance with those laws.
Large money transmitter FinTechs like PayPal would be unlikely to want the heavy regulation of a national bank if they can continue to provide a full array of banking services that are now part of their business models under “light-touch” money transmitter rules at the state level. Their incentives are aligned with state financial services regulators, which have no desire to lose their authority to regulate FinTechs as money transmitters or lenders – even FinTechs that are increasingly indistinguishable from banks.
The question has been left unaddressed is whether this “regulatory lite” regime is appropriate for FinTech companies soliciting and receiving deposits from consumers. In the event of a failure, there will be no FDIC insurance and consumers will stand in line with all other general creditors to get their money back.
V. Non-Bank Lenders: Rate Exportation and “True Lender” Requirements
The FinTech national bank charter, as proposed in 2016, would have benefitted FinTech lenders because a national bank charter would permit the FinTech lender to preempt a number of state laws, including laws that would prevent the FinTech lender from “exporting” the usury rate from a high usury rate state to a state with a lower usury rate. However, developments since 2016 are likely to render a FinTech national bank charter less attractive, and perhaps unnecessary, for many FinTech lenders.
In a lending arrangement commonly known as the “rent-a-charter” model, a FinTech platform markets a lending product, interacts directly with and collects information from borrowers, and underwrites the resulting loans. The bank enters into the loan agreement with the borrower and funds the loan. After a contractually agreed period, the non-bank will then purchase the loan from the bank and thereafter will collect payments directly from the borrower.
A notable 2015 Second Circuit case held that a non-bank that purchased charged-off loans from a national bank could not charge the same interest rate that the national bank is permitted to charge.31 However, this year, pursuant to new OCC rules, one finalized in May and one proposed in July, as long as the arrangement is structured such that a national bank is either named as the lender in the loan agreement or funds the loan (or both), the FinTech lender would be permitted to assume the loan with the “exported” interest rate that the bank partner would be permitted to charge, even if the borrower resides in a “low usury limit” state.32
Assuming the OCC adopts the second of its two true lender rulemakings substantially as proposed, FinTech lenders will have more certainty that they can export higher interest rates by “renting” a charter, further undermining state jurisdiction over non-bank lenders.
VI. Digital Assets: The Wyoming SPDI Charter and Recent OCC Guidance
Until recently, state regulators have been more active in encouraging the digital asset industry by providing chartering or licensing options for digital asset (e.g., bitcoin, Ethereum and other financial assets evidenced on blockchain or similar distributed ledgers) issuers and exchanges.33
For example, Wyoming enacted a law allowing its Division of Banking to issue a special purpose depository institution (“SPDI”) charter. The first SPDI charter was granted to Kraken in September 2020.34 Among other things, the SPDI charter may allow SPDIs to act as “qualified custodians” for cryptocurrency or other digital assets for purposes of the Investment Advisers Act of 1940. An SPDI may accept deposits from institutions, though not consumers, without being required to obtain FDIC insurance. States are free to create bank charters that do not require banks to have FDIC insurance, but they have generally not done so since the thrift crisis. A “bank” without FDIC insurance would not have a federal prudential regulator and would not be subject to capital standards and other requirements designed to ensure the safety and soundness of FDIC-insured banks. Wyoming may begin a trend of states creating such bank charters for FinTechs or others in order to capture more of the market for FinTech firms that do not want a federal prudential regulator.
The creation of state chartered “banks” that do not have FDIC insurance raises a number of questions about the treatment of such banks under other federal and state laws. Are such banks treated as banks for purposes of the federal securities laws, thereby enjoying exemptions from registration of their securities or registration as investment advisers with the SEC? Will other states treat such banks as banks for purposes of their state securities laws?
Since July 2020, the OCC has been taking steps that may encourage national banks to provide more digital asset services to customers, an industry which has so far been dominated by state-regulated businesses. This year, the OCC has affirmed in guidance that national banks have the authority to (1) provide “cryptocurrency custody services to its customers” by taking possession of the cryptographic access keys to given units of cryptocurrency owned by its customers and (2) take deposits of fiat currency used by issuers of cryptocurrency known as “stablecoins” that are backed by that fiat currency. In each case, the OCC staff clarified that national banks providing such services must take appropriate risk management steps, including adopting and implementing appropriate policies and procedures.35
The war between the federal government and the states for primary regulatory authority over banking institutions is not new, dating to the fight over the creation of the 2nd national bank in the 19th Century. Like many features of our federal system (see, e.g., the electoral college) our dual banking system is the product of a compromise the gave both the federal and state governments the authority to charter banks. However, it is the states that define what activities require a banking license.
The failure of hundreds of depository institutions, both banks and thrifts, during the thrift crisis of the 1980s bankrupted the Federal Savings and Loan Insurance fund and drove the FDIC deposit insurance fund to near-insolvency. As a result, Congress conditioned the availability of FDIC insurance for state-chartered institutions on limiting their powers to the powers of federally chartered institutions and requiring each institution to have a federal prudential regulator that, among other things, conducts regular examinations.
The growth of FinTech companies primarily regulated by the states has restored the state banking regulators to a level of importance they have not enjoyed in 30 years. In order to retain this importance, the states appear to be willing to fight the OCC over jurisdiction and cast a blind eye to their own banking laws.
This debate over state versus federal jurisdiction in the banking industry may simply mirror the ongoing debate in many other areas of our society over a strong central government vs. states’ rights. Unfortunately, this debate has not been conducted in a manner that permits policy-makers and the public to understand the consequences of offering financial services under these various regulatory models.
This new banking model may continue to take root until such time as the failure of a large state-regulated FinTech company results in losses to consumers. At that point, public outcry may cause Congress to extend the federal safety net to these companies and, in exchange, subject them to regulation by a federal prudential regulator.