FDIC Proposal Offers Welcome Clarity On Brokered Deposits
On Dec. 12, the Federal Deposit Insurance Corp. issued a notice of proposed rulemaking to revise the regulatory framework used to determine whether deposits qualify as brokered deposits.1 The proposed rule follows an advance notice of proposed rulemaking issued by the FDIC in December of 2018.2
Although the proposed rule does not call for dramatic changes to the core components of the brokered deposit regulatory framework, it does attempt to clarify the status of certain funding arrangements that may not be addressed clearly by current FDIC interpretative guidance. The proposed rule also seeks to establish new administrative processes, including an application process for entities seeking an exception from brokered deposit status.
The proposed rule contains several specific requests for public comment on various aspects of the proposal. Comments will be due 60 days after the proposed rule is published in the Federal Register.
Overview of the Current Regulatory Treatment of Brokered Deposits
Section 29 of the Federal Deposit Insurance Act, or Title 12 of US Code Section 1831f, as implemented by Section 337.6 of the FDIC's regulations, prohibits any insured depository institution, or IDI, that is not well capitalized – within the meaning given to that term under applicable regulatory capital regulations – from accepting any deposit obtained, directly or indirectly, by or through any deposit broker, though adequately capitalized institutions may request a waiver from this prohibition.
A deposit broker is defined under the FDI Act as:
1. "[Any] person engaged in the business of placing deposits, or facilitating the placement of deposits, of third parties with [IDIs] or the business of placing deposits with [IDIs] for the purpose of selling interests in those deposits to third parties"; and
2. "An agent or trustee who establishes a deposit account to facilitate a business arrangement with an [IDI] to use the proceeds of the account to fund a prearranged loan."3
The term "brokered deposit" is not used in the statute, but it is used in the FDIC's regulations to define the categories of deposits subject to statutory and regulatory restrictions. The FDIC's regulations establish that a brokered deposit is "any deposit that is obtained, directly or indirectly, from or through the mediation or assistance of a deposit broker."4
There are several enumerated exceptions to the definition of "deposit broker," including, among others, exceptions for IDIs and their employees – within the meaning given to that term under Title 12 USC Section 1831f(g)(4) – with respect to funds placed at that IDI and for any agent or entity whose primary purpose is not the placement of funds at an IDI. The "primary purpose" exception is relied upon in a variety of contexts and is a focal point of the FDIC's existing brokered deposit regulatory framework and the proposed rule.
By the terms of Section 29 of the FDI Act and Title 12 CFR Section 337.6, the brokered deposit restrictions are only directly relevant to IDIs that are not well capitalized. But from a supervisory standpoint, the FDIC and the other federal banking agencies expect that an IDI's acceptance of brokered deposits will be a component of a diverse, well-balanced funding strategy, and not a tactic to generate funding for rapid expansion or to engage in risky banking activities.
IDIs with more significant volumes of brokered deposits are expected to maintain sufficient controls to identify, measure, and monitor applicable funding and liquidity management risks. The FDIC may increase an IDI's deposit insurance assessment rate depending upon the extent of its brokered deposits, its regulatory capital levels, and the existence of other risk factors.
Additionally, the definition of "brokered deposit" in the FDIC's regulations is incorporated by reference into IDIs' call report instructions, newly-insured institution business plan requirements, and liquidity requirements for very large institutions in the liquidity coverage ratio rule and proposed net stable funding ratio rule.
Accordingly, even though the restrictions of the brokered deposit rule do not themselves impose limits on well-capitalized IDIs, the rule's definitions feed into other supervisory and reporting requirements, FDIC assessment scorecards, and liquidity rules that do affect the operations, balance sheets, and expenses of all insured institutions, including those that are well capitalized.
The current regulatory framework used to classify brokered deposits has been developed over the course of several decades in large part through FDIC advisory opinions and other interpretative guidance, some of which predate the current statute and arose from the savings and loan crisis of the early 1980s.
In 2016, the FDIC published its most recent guidance in Financial Institution Letter 42-2016: "Frequently Asked Questions on Identifying, Accepting and Reporting Brokered Deposits."5 The FAQs are essentially a compilation of prior notable FDIC advisory opinions, but they also address certain emerging banking practices relating to the placement of brokered deposits.
In May of 2018, Congress enacted the Economic Growth, Regulatory Relief and Consumer Protection Act, which amended Section 29 of the FDI Act to exempt a capped amount of reciprocal deposits from being classified as brokered deposits for certain institutions. In December of 2018, in connection with its publication of the advance notice of proposed rulemaking, the FDIC issued a final rule implementing these statutory provisions.6
Notwithstanding recent efforts to bring greater clarity to the brokered deposit regulatory framework, industry participants have generally viewed the existing framework as not well suited to address technological and practical changes in the banking industry since the enactment of Section 29. In addition, the administrative processes currently used to classify brokered deposits and to grant exceptions have been characterized as fragmented and opaque.
According to FDIC Chairman Jelena McWilliams, the proposed rule seeks to address these concerns and was designed, in part, to encourage innovation within the banking industry by recognizing various types of partnerships between IDIs, financial technology companies, and other third-party service providers, and by clarifying whether the provision of products and services through such arrangements may result in the placement – or facilitation of the placement – of brokered deposits.7
Summary of the Proposed Rule
Clarifications on the Definition of a Deposit Broker
The statutory definition of a deposit broker hinges on two concepts: what it means to "engage in the business" of placing deposits, and what it means to engage in the business of "facilitating" the placement of deposits.
Perhaps due to the absence of clear statutory or regulatory definitions of these concepts, the FDIC has historically treated many different types of involvement by a third party connecting depositors with IDIs as facilitating the placement of deposits. The FAQs provide only that "the definition of deposit broker is broad," and as a "result of this broad definition, a brokered deposit may be any deposit accepted by an [IDI] from or through a third party ... other than the owner of the deposit."8
In the proposed rule, the FDIC clarifies that it would consider an agent or entity "to be engaged in the business of placing deposits if that person [or entity] has a business relationship with its customers, and as part of that relationship, places deposits on behalf of the customer (e.g., acting as custodian or agent for the underlying depositor)."
The proposed rule further clarifies that an agent or entity would engage in the business of facilitating the placement of deposits if the agent or entity (1) shares depositor information with the IDI; (2) has the legal authority to close a depositor's account or move the account to another IDI; (3) is involved in setting rates, fees, terms or conditions for the deposit account; or (4) acts as an intermediary, directly or indirectly, between a depositor and an IDI for the purpose of placing deposits, other than in a purely administrative capacity (e.g., providing reporting or book-keeping assistance without steering the depositor or possessing any decision-making authority).
The definitions of "placing" and "facilitating" deposits set forth in the proposed rule add detail to the contours of the term "deposit broker." However, while adding detail and clarity, the practical effect of these proposed changes may be somewhat more restrictive and may bring more third parties into the definition of "deposit broker" – thus bringing the deposits of the customers they refer to an IDI into the rule's definition of "brokered deposits."
For instance, the proposed rule indicates that the proposed facilitation prong of the deposit broker definition is intended to capture activities that reflect an active role in the opening of an account and the subsequent maintenance of a level of influence or control over the account after it is opened.
New Tests for the Primary-Purpose Exception
Under the current brokered deposit regulatory framework, the primary-purpose exception is based entirely on the intent of the agent or entity placing or facilitating the placement of deposits.9 There are no general tests to divine an agent or entity's intent, and the only presumptions in effect are derived from years of prior FDIC guidance. For example, under the FAQs, general purpose prepaid cards are presumed to fall outside of the primary-purpose exception and, thus, within the scope of the FDIC's brokered deposit rules.
In the proposed rule, the FDIC proposes three new tests for determining the applicability of the primary-purpose exception: (1) the "less than 25%" test, (2) the "transaction enabling" test, and (3) a catch-all test for other deposit placements.
- The less-than-25% test: This test provides that if an agent or entity places less than 25% of the total assets that it has under a particular business line at depository institutions, the agent or entity does not have the primary purpose of placing funds for that business line at depository institutions.
- The transaction-enabling-test: This test holds that an agent or entity is not a deposit broker if the agent or entity places 100% of its depositors' funds into transactional accounts at an IDI in order to enable payments and no fees, interest or other remuneration is provided to the depositor in connection with such placement. However, if the IDI pays even nominal interest on the deposit accounts subject to the exception, the FDIC will more carefully scrutinize the agent or entity's relationship with the IDI. This amendment could be a boon to deposit products used in a range of payment systems.
- The other-business-relationships test: This test would allow agents and entities that do not meet the above tests to argue that their business practices nevertheless meet the primary-purpose exception. In determining whether the primary-purpose exception applies, the FDIC will consider (1) how the agent or entity receives the majority of its revenue; (2) whether the marketing activities of the agent or entity were geared toward opening a deposit account or providing some other service and, if so, whether opening the deposit account was incidental to providing another service; and (3) the fee arrangement for the agent or entity placing deposits.
Brokered certificates of deposit, or CDs, and deposits placed for the purpose of encouraging savings or securing deposit insurance would never be eligible for the primary-purpose exception under the proposed rule.
Unlike many of the case-by-case determinations set forth in FDIC advisory opinions and the FAQs, the three tests outlined in the proposed rule would establish clear standards for the application of the primary-purpose exception and would apply to multiple technologies and business relationships. Thus, in practice, the proposed tests likely would be of greater utility for IDIs and third-party entities in determining whether the primary-purpose exception applies to particular relationships and funding arrangements.
Primary-Purpose Exception Application Process
The proposed rule provides that an IDI would be required to formally apply to the FDIC to rely on any of the above tests. Applicants could include IDIs or nonbank third parties that are engaged in purported deposit placement or facilitation activities.
The proposed rule states that approvals of particular relationships and funding arrangements could be applicable to other relationships and arrangements outside of those presented to the FDIC to the extent that the facts of each relationship or arrangement are the same. However, the proposed rule does not discuss whether approval orders will be made public in any form.
The proposed rule sets forth several proposed requirements for the content of applications, which vary depending upon the nature of the applicant (e.g., IDI or nonbank third party) and the test used to determine the applicability of the exception. The FDIC proposes a 120-day processing period for such applications.
Finally, the proposed rule provides that approval orders may be conditioned on periodic reporting by the IDI or nonbank third-party. Such reports may be required to include, for example, the amount of total deposits placed with the IDI as part of the approved arrangement and/or the amount of total assets under the third party's management pursuant to such an arrangement.
The codification of a consistent administrative process for obtaining FDIC approval to rely on the primary-purpose exception would, in certain respects, be welcomed by the industry, as the FDIC has historically taken varying positions, some public and others not, on the extent to which notice to, or the prior approval of, the FDIC is required in order to rely on the exception.
Changes to the IDI Exception
Section 29 of the FDI Act currently excludes IDIs and their employees from being considered deposit brokers for funds placed at their own institutions. The proposed rule would extend that protection to wholly-owned operating subsidiaries of IDIs, provided that such subsidiaries (1) are 100% owned by the parent IDI; (2) place deposits exclusively with the parent IDI; and (3) engage only in activities permissible for the parent IDI.
This is a reversal of the FDIC's current position, which provides that the IDI exception does not apply to subsidiaries of the IDI. The exclusivity requirement – which is not in the statutory IDI exemption – raises some questions as to what is intended and whether that requirement is consistent with meeting the needs of the customers of IDIs.
Status of Existing Guidance
The proposed rule notes that IDIs may be relying on the primary-purpose exception based on existing FDIC advisory opinions or other interpretative guidance. Accordingly, as part of any final rule, the FDIC intends to codify guidance of general applicability that continues to be relevant and applicable and to rescind guidance that is deemed to be superseded, obsolete or no longer relevant.
Some Puzzling Aspects of the Proposed Rule
While the proposed rule represents a long-awaited and much-needed clarification of the current brokered deposit regulatory framework, several aspects of the proposed rule raise more questions than they answer.
For example, the proposed rule often contains no substantive discussion of what the amendments are trying to solve for, other than untangling a web of interpretations that date back 40 years and were meant to address a long-ago thrift crisis.
Additionally, the FDIC's 2011 study on core and brokered deposits, mandated by the Dodd-Frank Act, addressed core-deposit stickiness and other policy and risk issues in some detail, but here, they are left out of the discussion. The reader is left to divine the policy reason, in terms of safety-and-soundness, consumer protection and the public interest, behind broadening the sweep of the facilitating prong of the deposit broker definition, or why deposits of state and local governments and their investment pools are still referenced as being within the scope of the rule. They are after all principal deposits, not agency deposits.
These aspects of the proposed rule clearly impose indirect burdens and costs on consumers, state and local governments, and their citizens, but how do they help stabilize the banking system in a future crisis?
Other aspects of the proposed rule appear to reflect some confusion over how the relevant services function. In discussing the treatment of brokered CDs sold through broker-dealers and traded in secondary markets, for example, the release refers to brokers that "alter the terms of the original CD before selling the new CDs to [their] brokerage customers." Doing so could, of course, raise significant issues with the US Securities and Exchange Commission by converting the master CD into an unregistered investment company and the altered-terms CDs into unregistered securities.
Similarly, the use of the concept of "business line" in the primary-purpose test appears in some places to use deposit types to draw lines that do not align with actual business lines when viewed from the perspective of customers and the institution. When measuring the primary purpose of an agent in providing agency services, using artificial business line distinctions defined by the types of deposits involved to slice and dice a service into multiple different services each measured on a stand-alone basis may not be an accurate way to measure the purposes of the agent or its customer in the service.
Adding to the confusion over what exactly the proposed rule is seeking to solve, when referencing comment letters submitted in response to the advance notice of proposed rulemaking, the adopting release for the proposed rule does not cite to the comment letters that are being referenced. This makes it difficult to check whether the summaries accurately capture the referenced comments.
Hopefully, the adopting release for the final rule will revert to the long-standing practice in rulemakings conducted under the Administrative Procedure Act of referencing specific comment letters submitted in the rulemaking docket and responding to the issues they raise.
The FDIC has demonstrated that reform of its brokered deposit regulatory framework is a near-term agency priority. Moreover, the FDIC recognizes the practical limitations of the existing brokered deposit regulatory framework. The combination of these factors perhaps presents industry participants with an opportunity to influence and shape the rulemaking process to a greater extent than usual. Accordingly, industry participants should review the proposed rule and be mindful of these dynamics when considering the submission of comments.
FDIC Chairman Jelena McWilliams, Keynote Remarks on "Brokered Deposits in the Fintech Age" at the Brookings Institution (Dec. 11, 2019). Implicitly recognizing the limits of regulatory action given the constraints of existing statutory language, Chairman McWilliams in her speech suggests certain legislative changes if Congress were to decide to act.