Much of the recent discussion about industrial banks — also known as industrial loan companies, or ILCs — focuses on differences in the way their parent companies are regulated versus the oversight for bank holding companies.

The Federal Reserve has called the method for regulating IB parents a "supervisory blind spot," echoing other IB critics who say the specialized structure that leaves the Fed out of the equation is a risk to the banking system. I am familiar with both models and I hope the following will clarify the actual differences.

In the simplest terms, the Fed regulates the organizations that own or are affiliated with a bank, while IB regulators regulate the relationship between the bank and its affiliates.

Federal Reserve
The Federal Reserve has called the method for regulating industrial bank parents a "supervisory blind spot," echoing other IB critics who say the structure that excludes the Fed is a risk to the banking system. Bloomberg News

Both Fed and IB regulators have similar powers to ensure compliance with applicable laws. (IBs are regulated by the states where they are housed and the Federal Deposit Insurance Corp.) Under both the Fed and non-Fed regimes, bank parents are subject to regular examinations, and possible cease-and-desist orders and civil money penalties. Both the Fed and the FDIC can ban institution-affiliated parties from further participation in the affairs of the bank.

The Fed encourages holding companies to be deeply involved in managing the bank. Many banks and parents have common management and interlocking boards. This enables the Fed to effectively regulate the bank through the holding company.

In contrast, the FDIC and state regulators require IBs to maintain a high degree of independence. IB boards must have a majority of outside directors. Each IB must have its own management team. This helps insulate the bank from undue influence in a diversified organization.

The Fed approves every business activity of a holding company and prohibits any that is not "closely related to banking." The Fed also controls the financial and organizational structure of each holding company.

In contrast, IB affiliates can engage in any lawful activity. IB regulators monitor activities of the bank's parent and affiliates that may impact the bank. Typically, an IB parent must sign a contract with the regulators committing to provide capital and liquidity to the bank if needed. The regulators carefully scrutinize all transactions and contractual relationships between the bank and affiliates for compliance with sections 23A and 23B of the Federal Reserve Act. Conflicts of interest of any kind are prohibited.

Because of the extensive restrictions on affiliate activities in the Bank Holding Company Act, most bank holding companies are shells that only hold the bank's stock. Raising capital is a challenge for most Fed-regulated parents and is nearly impossible if the bank is failing and needs new capital because the disclosure requirements in the securities laws are more likely to start a run on the bank than attract new investors. Even parents with other subsidiaries engaged in permitted activities will usually fail if the bank goes down. This was the case with Washington Mutual’s holding company.

The opposite is usually the case with an IB's affiliates. The biggest concern there is insulating the bank in case the parent goes bankrupt and has to liquidate or reorganize. This has happened in many cases and thus far none of the bank subsidiaries failed along with the parent. A good example was Lehman Brothers’ IB, Lehman Brothers Commercial Bank. It made commercial loans to customers of its parent and had grown to about $7 billion before its parent famously collapsed. When its source of business was cut off as a result of the parent’s bankruptcy, the bank decided to self-liquidate. There was no run on the bank because its deposits were all brokered CDs matched to the terms of its loans, so loan payments were sufficient to repay maturing deposits and cover operating expenses. In time, all depositors and other creditors were paid in full and the bank was left with nearly $2 billion that it paid to the parent's bankruptcy trustee.

In cases where the parent filed bankruptcy to reorganize, each IB subsidiary continued to operate normally. The former truck-stop retailer Flying J is a good example; its industrial bank survived the parent’s reorganization and still operates under a new corporate structure.

From a policy and regulatory perspective, the biggest difference between the two models is the ability of the parent to support the bank. The Fed says the basic purpose of its regulatory scheme is to ensure that the parent will serve as a "source of strength" to its bank. But that is meaningless to the point of being a mockery in most cases. I closed a lot of banks when I was a regulator the late '80s. Every one had a Fed-regulated holding company that was incapable of doing anything to save the bank.

This same pattern developed during the Great Recession.

Nationally, more than 550 banks have failed since 2008, most of them owned by a Fed-regulated holding company that clearly had no ability to support its bank. This calls into question the effectiveness of the Fed's source-of-strength doctrine.

During that same period, two IBs failed. Both were owned by financial parents. In one case, both the parent and IB were involved in a similar business and they failed when their small-business loan programs were severely impacted during the downturn. The other was essentially a community bank lending to the local housing markets in Nevada. No IB owned by a commercial parent has ever failed.

Most IB holding companies are diversified and hold substantial assets apart from the bank. Capital is not an issue for those banks. They have ready access to all the capital they need. There was even a case where a bankrupt holding company provided a substantial capital contribution to an IB subsidiary at the height of the recession to cover mark-to-market write-downs in loans it had booked as held for sale. This kind of access to capital is unthinkable for most other banks.

Bottom line: There is no regulatory "blind spot." In fact, over the past 30-plus years, the IB regulatory model has been stronger and safer than the Fed's model.

George Sutton

George Sutton

George Sutton is an attorney at Jones Waldo Holbrook & McDonough. He served as the Utah commissioner of financial institutions from 1987 to 1993.

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