If the Federal Deposit Insurance Corporation (FDIC) approves Rakuten Bank America’s application for an industrial loan company (ILC) charter, it would trigger a cascading series of problems that would add risk to our banking system at a time when all federal agencies should focus on reorienting the country toward an equitable recovery and a just economy.
Rakuten Bank America (Rakuten Bank) applied to Utah’s Department of Financial Institutions (DFI) for an ILC charter and to the FDIC for deposit insurance. Rakuten Bank has now applied for a charter on three occasions. In each of the two prior attempts, the applications were withdrawn in the face of overwhelming opposition from consumer groups and trade associations.
Opponents contend that ILCs add risk to the banking system, that corporate firms could use their banking subsidiaries to support their commercial activities, and that without the kind of consolidated supervision applied to bank holding companies, regulators may not have the tools they need to prevent problems. They question how well ILCs can be supervised when the FDIC only has limited authority to examine the commercial parent.
The Bank Holding Company Act of 1956 (BHCA) gives the Federal Reserve the power to supervise corporate parents of banks, but as an ILC, Rakuten Bank would be exempt from Fed supervision.
Rakuten Group is a vast conglomerate with five primary business lines: commerce, communications and energy, advertising and marketing, fintech, and investment and incubation services. In Japan, its communications and energy division supplies solar power, streaming content and mobile telecommunications. Its investment and incubation division includes Rakuten Agriculture and a venture capital division with positions in 25 startups. Rakuten Capital invested in Lyft and Pinterest. Its fintech group provides traditional credit products and insurance, crypto exchange, payments and securities trading. Its Commerce division, where it sells and brokers a wide variety of retail goods and services, most closely resembles Amazon. Its Advertising and Marketing category owns the Infoseek search engine, several market research firms and analytics services. In its home country of Japan, it owns professional baseball and soccer teams.
In February, NCRC and a coalition of 36 other community groups, civil rights organizations and consumer advocates filed a comment opposing Rakuten’s application.
The approval of the application would come at a considerable cost, and the risks it would create illustrate the fundamental shortcomings of the ILC charter, which are:
- ILCs are exempt from consolidated supervision and as a result, their presence creates risks to the safety and soundness of the financial system. The decision to apply for an ILC charter sets a course that has historically led to heightened risk-taking. ILCs are not subject to consolidated supervision by the Federal Reserve.
- The ILC charter allows companies to receive banking charters without obligating them to a strong CRA commitment. Although ILCs may provide credit across the entire country, each has only a single assessment area and most are in the same metropolitan statistical area (MSA).
- Rakuten’s corporate parent has subsidiaries with digital retail businesses, and as a result, an approval would create unique challenges for the protection of consumer privacy.
The FDIC has moved forward with the approval of two recent applications for ILC charters and may approve more. Rakuten’s application is one of five pending applications. Now is the time to close the ILC loophole.
Here are more details on why ILC are problematic.
1. ILCs are exempt from consolidated supervision and create serious risks to the financial system and depositors.
The ILC loophole permits commercial firms to own banks, a status that contradicts the rules for all other depositories. Many ILCs are very large and some have created business models that extend well beyond the intended scope of the structure. The continued presence of ILCs creates risks.
Congress does not permit commercial companies to own industrial banks without becoming a bank holding company (BHC). The ILC chartering system is the exception to the rule.
ILCs differ from other chartered financial institutions in two ways: a commercial business can own them, and because they are not subject to the BHCA, they do not undergo consolidated supervision by the Federal Reserve. While laws have historically drawn a bright line between banking and commerce, the ILC has been an exception.
In their original manifestations, ILCs were small institutions that existed primarily as a means for businesses to make loans to their low-and moderate-income workers, many of whom could not otherwise qualify for credit from a traditional bank. Today, some still fulfill narrow niches such as transportation fleet cards or third-party partnerships. However, four ILCs now have assets of more than $10 billion.
The boundaries that divide banking from commerce exist to reduce risk. Traditionally, regulators sought to keep banking separate from commerce because of the fear that a chartered institution would bear risks associated with the commercial division. That would have two adverse effects: first, it would create unfair competitive advantages, and second, a business with banking and commerce might be tempted to make risky loans.
Congress took a different course from most countries when it passed laws to constrain banking and commerce combinations. On the other hand, Japan’s government allowed banks to integrate into large conglomerates under the keiretsu system. Even now, Japanese banks frequently act as the hub at the center of a conglomerate of intertwined companies, and individual investors routinely hold stakes in more than one of its firms.
Europe’s Wirecard scandal illustrates how problems can occur when commercial firms own banks. Wirecard, a publicly-traded German firm with a nonbank payment processing and a fully-regulated credit card and bank account bank, filed for insolvency in 2020. Afterward, government investigators found that $1.9 billion in assets held on its corporate balance sheet were in fact non-existent and that neither its auditors nor its banking regulators were aware of the falsifications.
European regulators allowed banks operated by Wirecard to make transactions that brought benefits back to their corporate parents and also to firms in which Wirecard’s management had interests. As in the US, European banking regulators faced constraints to their supervisory powers. Parts of Wirecard fell outside of their domain; this was a notable contrast to the scope of supervision those regulators had over banks without commercial partners.
As is the case with Rakuten, Wirecard had digital platforms for commerce, and as would be the case in the event that Rakuten received an ILC charter, it also had a banking subsidiary (Wirecard Bank).
With its rise, Wirecard became intertwined with many other companies, including other financial institutions. In 2018, it obtained a $2 billion line of credit from a group of other European banks. In 2019, Japan’s SoftBank took a 5% ownership position in the company.
However, Wirecard’s auditor, investors and German banking regulators missed signs of trouble. It turned out that the company was often not profitable, but because it inflated its assets and revenues, its financial statements gave a false impression that the company was well-capitalized. To shore up its finances, the company solicited new deposits from the public. By June 2020, Wirecard was insolvent. The company’s leadership admitted that it could not account for $2.1 billion in missing cash.
In the US, the turmoil after the 2008 financial crisis revealed the inherent risks in the ILC model. Security Savings Bank (2009) and Advanta Bank (2010) failed. Several parents of ILCs, including Flying J Inc., and Residential Capital, LLC, filed for bankruptcy.
While the FDIC can examine the affiliate of an ILC, its supervisory authority over ILC affiliates is far more limited than the powers granted to supervisory agencies of bank holding companies and their affiliates.
The ILC permits evasive high-cost lending. Some ILCs provide credit at rates that would otherwise be illegal, but because the permissive interest rate caps in Utah can be exported, they can overcome state usury caps. For example, Utah-based First Electronic Bank partners with online high-cost non-bank installment lenders. The ILC structure enables these practices – it is entirely appropriate to ask why Utah can have such an outsize influence on the governance of financial services.
2) The ILC charter allows companies to receive banking charters without obligating them to equivalent regulatory responsibilities at the expense of privacy protections and a strong CRA commitment.
With an ILC charter, Rakuten Bank would be required to meet a minimal and fundamentally unsatisfactory CRA requirement and in only one metropolitan area, even though it would operate throughout the United States.
Unlike with standard state-chartered commercial banks, an ILC parent cannot be prohibited from commencing new activities if a subsidiary depository institution has a “needs-to-improve” or “substantial non-compliance” Community Reinvestment Act (CRA) rating.
Although ILCs do business across the entire country, they only have a CRA obligation in a few places. Seven states issue ILC charters, and as of June 2020, only 5 states supervise active ILCs. The majority of ILCs maintain a headquarters in the Salt Lake City area. The willingness to offer the ILC charter by only a handful of states has created “CRA hotspots.” At the end of March 2021, 95.7% of ILC deposits were held in Utah.
CRA exams for ILCs consist only of the community development test. Moreover, since most ILCs have only a single branch, the geographic scope of an ILC’s CRA exam is often limited to a single metropolitan statistical area (MSA).
3) The Rakuten application presents unique challenges for the protection of consumer privacy.
In an era of artificial intelligence, alternative data, and digital commerce, combinations of commerce and banking undermine consumer privacy.
Under Regulation P (the regulation implementing the Gramm-Leach-Bliley Act), financial institutions do not have to allow their customers to “opt-in” before sharing information with an affiliate inside the FIs corporate sphere. Instead, the impetus is on the customer to opt-out.
The insights gained from the cash flows in a Rakuten Bank checking account or the purchase history of a Rakuten credit card provide important data for marketing and perhaps even for setting prices. The development of artificial intelligence brings added significance to the need for rules that protect consumer privacy. A technologically sophisticated company like Rakuten can combine its knowledge of a consumer’s banking profile with its data on a consumer’s shopping history. In an era of dynamic pricing and just-in-time discounting, that information confers an advantage to Rakuten. For example, with the knowledge it can obtain from a consumer’s bank account, the retail side of Rakuten could estimate how much a consumer is willing to pay for a good.
The ILC loophole should be closed, and now is the time to act, as there are five pending applications before the DFI and the FDIC.
The FDIC, through its power to approve or deny an application for deposit insurance, can stop an application even if the Utah DFI supports it.
FDIC Chair Jelena McWilliams’ leadership heralded a new approach at the FDIC. On March 17, 2020, McWilliams said that deposit applications could be approved if ILC applicants met certain conditions. The next day the FDIC approved applications for deposit insurance from Square Financial Services and Nelnet Bank. On December 15, the FDIC issued a final rule to reduce barriers for companies seeking to get an ILC charter. McWilliams said the new rule would “provide transparency to market participants regarding the FDIC’s minimum expectations for parent companies of industrial banks.”
The change in the willingness of the FDIC to approve charters has prompted new interest among commercial firms to apply.
In just the last 18 months, Rakuten and five other commercial firms have applied to the Utah DFI for an ILC charter. While one has withdrawn, five (including Rakuten) remain pending. The others, listed by recency:
- Thrivent Bank (February 2021) would become a subsidiary of Thrivent Financial, a faith-based fraternal organization. Thrivent manages investments, provides financial advice and offers insurance. Thrivent is also the parent company of Thrivent Credit Union and an FDIC-chartered trust company.
- GM Financial (December 2020). GM Financial would use its charter to finance automobile loans and leases to its customers, and would offer negotiable-order-of-withdrawal (NOW) accounts and other payment accounts, but would refrain from mortgage lending. General Motors sold a majority stake in its GMAC financing division in 2006 after aggressive subprime lending activity led to hundreds of millions of dollars in losses and scores of foreclosures. Subsequently, the federal government had to bail out GMAC’s new ownership group. NCRC’s comment letter opposes application and raised concerns about the insufficient CRA plan, the lack of a consumer protection and fair lending compliance plan, the lack of a commitment to responsible lending practices despite GM’s concerning history of subprime lending, and the choice of a board with extensive experience in payday lending, debt collection and other abusive product sectors.
- Edward Jones Bank (July 2020). The application exemplifies the mismatch between how the CRA creates an assessment area for an ILC and where a company is a part of a community. Edward Jones has 5,000 employees in St. Louis and another 15,000 retail offices throughout the United States. At one point, Edward Jones’ had the naming rights to the St. Louis Rams’ stadium. In spite of that, the ILC’s CRA activities would be limited to the Salt Lake City MSA. As a St. Louis Post-Dispatch columnist remarked, “St. Louis or Salt Lake? Edward Jones’ real hometown should benefit from its bank.” (NCRC and the St. Louis Equal Housing and Community Reinvestment Alliance filed a joint comment.)
- GreatAmerica Bank (March 2020) would use its charter to provide commercial equipment financing. The parent company maintains its headquarters in Cedar Rapids, Iowa, and other offices in Georgia and Minnesota.
On August 9, small business fintech Brex withdrew the application that it had filed in February 2021. However, a Brex spokesperson said it would “modify and strengthen our application and resubmit at a later date.”
By allowing a commercial company to own an industrial bank without becoming a bank holding company, the ILC chartering system breaks from the well-established rule in US banking regulation that separates banking from commerce. The ILC system creates a loophole that should be closed.
Without consolidated supervision, the Federal Reserve cannot monitor the fiscal health of the companies that own ILCs, and as a result, the ILC exception creates unnecessary risks.
By having an ILC charter, a bank will not have the same expectations for providing loans, investments and services that meet the needs and conveniences of the community that would come with a standard charter.
Approval of Rakuten’s application – or any decision to charter a giant multinational corporation with the analytical capabilities to see the financial and shopping activities of consumers – presents unique threats to consumer privacy.
For these reasons, the FDIC should not approve Rakuten’s application.
Adam Rust is a senior policy advisor for NCRC.