In our recent analysis of legislation aiming to ban nontraditional banks, we mentioned that one of the new bills surprisingly endorses a charter option allowing securities companies to own limited-purpose insured depositories without much of the muss and fuss of also becoming bank holding companies. The bill (S. 2839) does so by referencing current rules allowing securities holding companies, resurrecting an intriguing option for parents of large broker-dealers hoping to circumvent the Fed. Surprised, many of you asked for more on a little-known charter option with considerable strategic importance. In short, there is indeed a regulatory-arbitrage opportunity for new-age powerhouse securities firms, but one that comes with more than a few caveats.
The broker-dealer alternative charter goes back to the Gramm-Leach-Bliley Act of 1999. At the time, giant securities firms sought to establish a “wholesale bank” that could operate without all the rules and activity limitations mandated for financial holding companies (FHCs). The Fed beat this back, but the SEC found a way to make its charges happy, issuing a 2004 rule creating investment bank holding companies and consolidated supervised entities (CSEs). Through these companies, any large U.S. firm with an SEC-regulated broker-dealer could own a nonbank bank without becoming a BHC, with the CSEs also getting protection from EU supervision along with a significant reduction in broker-dealer net capital.
Several giant securities companies began to set up these charters when the great financial crisis, shall we say, redefined their business model. With the entire U.S. cohort of giant broker-dealers decimated after August of 2008, no one ultimately opened one of these charters.
However, the SEC’s powerful rule remained an option of considerable concern to the Fed. It thus pressed for language then added to the Dodd-Frank Act shutting them down, with the law creating in their stead a “securities holding company” (SHC). Under both the Dodd-Frank Act and implementing rules, SHCs generally don’t exempt a broker-dealer parent from the Fed’s clutches, but significant regulatory-arbitrage opportunities remain.
First, it’s not entirely clear if an SHC is needed for a securities company to own a nonbank bank, doing so even if pending legislation bans this for everyone else. Second, the Fed has considerable discretion to vary its rules, with the activity constraints imposed on FHCs largely inapplicable to SHCs. If it weren’t for the “Hotel California” provisions elsewhere in Dodd-Frank, it seems likely that Goldman Sachs and Morgan Stanley would have instantly elected to become SHCs instead of FHCs to ensure unrestrained merchant banking along with other BHC-banned operations.
And, if it weren’t for the Tarullo reign of big-bank terror under the Obama Administration, it’s also possible that other big broker-dealers would have become SHCs. As I noted recently, the charter choice instead was a savings-and-loan holding company (SLHC), an option that protected the parent from much post-crisis Fed regulation until the tailoring rules brought SLHCs into the tent earlier this year.
It’s far from clear if anyone would have remembered the SHC charter if it hadn’t shown up in the new ILC legislation. This may well just be a bit of over-zealous legislative drafting, but it’s nonetheless a timely reminder of an intriguing option. Interestingly, the SEC’s rulebook omits the consolidated-supervised-entity charter from one part of the rulebook, but leaves it intact (see the cite in the Senate bill for a reference) that retains the significant discount in broker-dealer capital rules. Because the SHC is the successor to the CSE under the Dodd-Frank Act, it is likely that the SEC could pass the discount on to broker-dealers regulated by the Fed. It’s also possible that the Trump Administration Fed would be less stringent when it comes to SHCs, with the Fed perhaps now comfortable enough with its post-crisis framework to consider innovative charters clearly embodied in both law and its own rules.
That said, any company contemplating converting into an SHC to own an insured depository will need carefully to consider the full construct of Fed standards for the parent company. None is made clear in the 2012 rule authorizing the charter nor does the tailoring rule necessarily apply to SHCs. Whether the SEC in 2020 is as willing as it was in 2004 to give big broker-dealers a giant capital break also would need to be confirmed. However, as firms such as Goldman Sachs and Charles Schwab redefine the boundaries between banking and brokerage, the charter may have considerable appeal. Given the new bill, it seems someone else thinks so too.