Future for Thrift Institutions

This is the fifth of a series of user guides that will be published by Morrison & Foerster. The user guides provide an in depth discussion on specific topics raised by the Dodd-Frank Act. For our Dodd-Frank overview and brief alerts, please see our dedicated website at: http://www.mofo.com/resources/regulatory-reform/.

With just under four months to go before the transfer of the authority of the Office of Thrift Supervision ("OTS") to the other federal banking agencies, savings institutions should be prepared for some important changes to the regulatory framework to which they are accustomed. The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank" or the "Act") and the new international capital standards will, over time, result in several new requirements for the institutional operations of savings and loan holding companies and their subsidiary thrifts. For the most part, the changes will bring the thrift and bank charters closer together, and thrift holding companies are likely to be treated nearly the same as bank holding companies. At the same time, however, the existing restrictions on thrift institutions, such as the qualified thrift lender test, remain in effect.

For some savings and loan holding companies, especially those with significant nonbank businesses, the coming changes may have far-reaching effects. In some cases, management of a savings institution may want to consider the relative merits of the thrift charter in light of particular operations and business plans. Certain thrift organizations probably should retain the charter, including mutual savings associations, grandfathered unitary thrift holding companies, any thrift institutions that engage in real estate development or brokerage, and, possibly, those with relatively greater concentrations of commercial real estate loans.

This memorandum identifies and discusses the time-sensitive issues that Dodd-Frank presents for thrift institutions, longer-term capital issues, and the array of other important consequences for these organizations.

We do not address here the consumer protection and mortgage-related provisions of the Act, which are the subject of several User Guides that we have published.1 This bulletin covers pertinent parts of Dodd-Frank that deal with federal preemption, but a comprehensive discussion appears in our Federal Preemption User Guide.2

EXECUTIVE SUMMARY

Because many changes will take effect on July 21, 2011, several items stand out for immediate attention by savings associations and their holding companies:

Does the holding company engage in nonbank financial activities? If so, will it meet bank holding company capital requirements? Does it have a composite CORE rating of 1 or 2 and a component risk management rating of 1 or 2? On July 21, thrift holding companies engaged in activities permissible only for financial holding companies will be required to be well-capitalized and well-managed.3 Savings and loan holding companies are today examined by OTS on a qualitative basis for capital adequacy. Now, however, Dodd-Frank requires that thrift holding companies be treated identically to bank holding companies, which are subject to industry-wide quantitative standards. Is the holding company capable of serving as a source of strength? What is the likelihood that it could be called upon to support the thrift? On the same date, all savings and loan holding companies—regardless of the nature of their activities, if any, beyond control of a thrift—will be subject to the source-of-strength doctrine. Regulations implementing the doctrine are due a year later, on July 21, 2012, but the Federal Reserve arguably has authority to enforce the doctrine after July 21 of this year. Assessing the practical consequences of the doctrine is complex. For a federal thrift, does it have operating subsidiaries or agents that avoid state restrictions through federal preemption? Does the thrift have operations that rely on the OTS preemption regulations, 12 C.F.R. 545.2 and 560.2 or on OTS preemption opinions? Dodd-Frank makes some important changes to federal preemption that also will take effect on July 21, 2011. Most importantly, the Act eliminates preemption for operating subsidiaries and agents on a going-forward basis. The Act also effectively repeals sections 545.2 and 560.2 of the OTS regulations through a provision eliminating "occupation of the field" as a basis for preemption. Is the organization prepared for increased enforcement efforts by the states? State attorneys general have authority to enforce federal regulations against thrift (and other) financial institutions, in addition to the power to bring civil suits against federal savings associations. Is the organization prepared for a new examination and supervision regime? Thrift organizations will take on two new regulators in place of OTS: the Federal Reserve Board (the "Federal Reserve") for holding companies and either the Office of the Comptroller of the Currency ("OCC") or the Federal Deposit Insurance Corporation ("FDIC") at the depository level (depending on whether the charter is federal or state). The basic examination and supervision goals remain unchanged, but the day-today functions will be different. Will the subsidiary thrift continue to meet the QTL Test? The Act imposes new sanctions for the failure by a savings association to comply with the qualified thrift lender test (the "QTL Test"). The principal change may be that the one-year remedial period is eliminated. These sanctions appear already to be in place, having taken effect the day after the enactment of Dodd- Frank. For a grandfathered unitary thrift holding company, is it prepared to establish an intermediate holding company? The Act contains a specific provision for the regulation of these grandfathered companies: under certain circumstances, these companies may be required to form intermediate holding companies that will control all of the financial activities of the institution. There is no specified time period, but the Federal Reserve could require the formation of these companies as early as October 19 of this year. Are policies on insider transactions up to date? Dodd-Frank imposes new limitations both on extensions of credit to insiders and on asset sales and purchases with insiders. The new asset sale and purchase requirements take effect on July 21. Other dramatic changes will be coming after July 21. All thrift holding companies (including but not limited to those that must maintain well-capitalized status) must engage continuously in capital planning. Dodd-Frank sets the stage for the implementation in the U.S. over the next several years of the international capital rules known as Basel II and III. It is difficult to predict which rules will reach down to the vast majority of thrift institutions, but changes appear likely in several areas:

Composition of capital. Dodd-Frank requires that savings and loan holding companies adhere to the same capital requirements that now exist for their subsidiary savings associations—a provision that governs capital composition by excluding trust-preferred and other hybrid securities from Tier 1 capital. Basel III introduces a range of other requirements on the composition of Tier 1 capital. New capital ratios. The Act does not provide for new capital ratios other than to require that capital rules incorporate a countercyclical element. However, Basel III provides a more robust set of ratios that U.S. regulators could apply in whole or in part on an industry-wide basis. Liquidity. Dodd-Frank requires that the Federal Reserve adopt liquidity standards for the largest banks and systemically important nonbank financial institutions. Basel III offers two liquidity ratios that U.S. regulators easily could implement throughout the U.S. banking system. The regulators already have statutory authority to do so. Finally, important provisions of the Home Owners' Loan Act ("HOLA") warrant review. Some provisions remain unchanged by Dodd-Frank but, in light of the other changes imposed by the Act, may take on increased consequence. Certain provisions of HOLA have been amended, and while the changes have not been sweeping, they may have an impact on particular operations.

Commercial real estate lending. Dodd-Frank does not amend the commercial lending authority of a federal thrift, and this authority is broader than that available to national banks. As of July 21, 2011, however, when the OCC inherits OTS's examination and supervision function, federal thrifts may encounter a new and more skeptical supervisory approach to CRE lending. Service corporations. This form of thrift subsidiary may engage in the broadest range of financial activities—residential real estate development and real estate brokerage among them—of any affiliate of an insured depository institution. Although this type of subsidiary has never qualified for federal preemption, it may be worth re-considering as a vehicle for new and broader business operations. Lending limits. The Act extends the limits on loans to one borrower and to insiders to capture credit exposures arising from various transactions, including derivatives and repurchase agreements. Transactions with affiliates. The Act also expands sections 23A and 23B to cover new arrangements or transactions that create credit risk. For example, any fund for which a bank (or an affiliate) serves as an investment adviser is now deemed to be an affiliate of the bank. The definition of a covered transaction is broadened to include derivatives and the borrowing and lending of securities. Repurchase agreements with affiliates are now subject to collateralization requirements. ANALYSIS

We discuss below these regulatory changes in greater detail, highlighting the practical implications for thrift institutions.

  1. Matters Requiring Immediate Attention

    On July 21, 2011, the Federal Reserve will assume responsibility for the...

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