Federal Lawmakers Consider Drop in De Novo Applications
What are the reasons behind the decline in new bank and credit union charter applications?
What happened
Members of the House Financial Services Financial Institutions and Consumer Credit Subcommittee considered this question at a recent hearing, "Ending the De Novo Drought: Examining the Application Process for De Novo Financial Institutions." In a memorandum released prior to the hearing, lawmakers noted that the number of new bank and credit union charters has declined to historic laws.
Between 2000 and 2008, 1,341 new banks and 75 new credit unions were chartered. But from 2010 to 2016—after the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act—only five new banks and 16 new credit union charters were approved.
Speaking on behalf of the American Bankers Association, Ken L. Burgess, Chairman of FirstCapital Bank of Texas, placed the blame squarely at the feet of the statute. "Lack of de novos has its roots in excessive regulation," he said. "If I were in the position of starting a bank under today's conditions, I would not do so."
Excessive and complex regulations that are not tailored to the risks of specific institutions are driving banks to merge and creating barriers to entry for new banks, Burgess said, noting that 1,917 banks (or 24 percent of the industry) have "disappeared" since Dodd-Frank was enacted.
While Burgess acknowledged that the Federal Deposit Insurance Corporation (FDIC) launched a concerted effort to encourage de novos, this movement cannot "address the underlying issues that create the barriers to entry: capital hurdles, unreasonable regulatory expectations on directors, funding constraints, an inflexible regulatory infrastructure, technology investments, and tax-favored competition from credit unions and the Farm Credit System."
Capital thresholds are too high, funding constraints limit asset growth, and earning assets are under stress, Burgess told lawmakers. "If it does not make economic sense, no one will start a new bank," he said. "Look no further than the lack of new charters for proof of this. Fix the underlying problems and new charters will result."
He offered several suggestions to spur the creation of de novos, including a fast track for new banks, reducing the minimum initial capital and required capital ratio for the first three years, and further reduction of the "penalty box."
Keith Stone, President and Chief Executive Officer of The Finest Federal Credit Union, testified on behalf of the National Association of Federally-Insured Credit Unions and similarly pointed the finger at Dodd-Frank.
The number of credit unions has decreased by 20 percent since the law's enactment, "largely due to the drastic increase in regulation—mostly stemming from the new [Consumer Financial Protection Bureau]—that many smaller credit unions simply can't keep up with," Stone said. "The relentless rising cost of compliance deters many would-be de novo credit unions."
For Stone, the solution involves finding ways to cut down on "burdensome and unnecessary regulatory compliance costs," particularly as lawmakers and regulators "readily agree that credit unions did not participate in the reckless activities that led to the financial crisis, so they shouldn't be caught in the crosshairs of regulations aimed at those entities that did."
Testifying on behalf of the Subchapter S Bank Association, attorney Patrick J. Kennedy, Jr. spoke about his decades of experience representing community banks, their shareholders, directors, officers, and related entities, including working on more than 30 de novo charter groups.
"Many banks exited the mortgage loan business because of the complexity and uncertainty resulting from Dodd-Frank, the CFPB, and related rulemaking," he told the legislators. "The costs are significant and it is generally known in the industry that the cost of making a loan of less than $100,000 is not covered by the interest earned, including the cost of capital and loan reserves required to support such a loan, unless the bank has some very unique processes that can be employed to lower costs."
Kennedy disagreed with regulators who have explained the lack of new charters on low interest rates. Noting "widespread skepticism" throughout the industry that increasing de novo charters is a top priority for the FDIC, he said the lack of new banks can be traced to "the seven year business plan and compliance period as well as the significant increase in regulation."
Closing out the testimony, Sarah Edelman, the Director of Housing Policy at the Center for American Progress, presented a difference perspective. The decline in de novo charters "is largely the result of macroeconomic factors, including historically low interest rates reducing the profitability of new banks, as well as investors being able to purchase failing banks at a discount following the financial crisis," she said.
Also playing a role: the "severely damaged" FDIC insurance fund as a result of the financial crisis and the decline in total number of banks dating back to 1985, she added, predating the compliance costs of Dodd-Frank. "[M]ost of the obstacles facing new small bank entrants are not related to the FDIC application process or bank regulations," she testified. "Thus, gutting FDIC oversight is not likely to address the shortage of new bank applications."
Why it matters
Three of the four witnesses at the House Subcommittee's hearing traced the decline in de novo charter applications to the enactment of Dodd-Frank, citing increased regulatory costs and capital hurdles among the barriers to entry in the market. Whether lawmakers act on these concerns remains to be seen.
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Court Tosses CFPB Suit Against Payment Processor
A payment processor scored a victory against the Consumer Financial Protection Bureau (CFPB) when a North Dakota federal court dismissed the Bureau's lawsuit for failing to plead facts sufficient to support the conclusion that the processor engaged in unfair practices resulting in harm to consumers.
What happened
Last June, the CFPB filed suit against the payment processor and its two co-owners, alleging that in violation of the Consumer Financial Protection Act (CFPA) the defendants engaged in unfair acts and practices by turning a "blind eye to blatant warning signs of potential fraud or law breaking" by its clients, including illegal withdrawals from consumer bank accounts. The CFPB also alleged that owners provided substantial assistance to the company's alleged violations. The company is a third party payment processor that processes electronic fund transfers through the Automated Clearing House (ACH).
Not only did the company ignore concerns from the originating depository financial institutions questioning the lawfulness of the transactions the company was processing, the company allegedly disregarded complaints from customers, high return rates, and law enforcement actions against its clients, the CFPB said.
The complaint stated two counts: first, that the defendants engaged in unfair acts and practices in violation of the Act, and second, that the two individuals provided substantial assistance to the company's alleged violations of the CFPA.
The company moved to dismiss, arguing that the complaint failed to state a plausible claim.
U.S. District Court Judge Ralph R. Erickson granted the motion, hinging his analysis on whether the complaint adequately stated causes for "unfair, deceptive, or abusive acts or practices."
"A close review of the complaint yields a conclusion that the complaint does not contain sufficient factual allegations to back up its conclusory statements regarding [the company's] allegedly unlawful acts or omissions," the court wrote. "While the complaint indicates that [defendant] was required to follow certain industry standards, it fails to sufficiently allege facts tending to show that those standards were violated. Although the complaint contains several allegations that [the Company] engaged in or assisted in unfair acts or practices, it never pleads facts sufficient to support the legal conclusion that consumers were injured or likely to be injured. Nothing in the complaint allows the defendants or the court to ascertain whether any potential injury was or was not counterbalanced by benefits to the consumers at issue."
An act or practice cannot be considered "abusive" under the CFPA unless it "materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service; or … takes unreasonable advantage" of consumers, the court explained. But the CFPB failed to provide factual allegations to support a finding that the company interfered with consumers' ability to understand the terms of their dealings with the company's clients or that would support a finding that defendant took unlawful advantage of consumers, Judge Erickson said.
"The complaint simply does not sufficiently identify particular clients whose actions provided 'red flags' to [the Company] or how [the Company's] failure to act upon those 'red flags' caused harm or was likely to cause harm to any identified consumer or group of consumers," the court wrote. "Although the CFPB strongly urges this court to find that the complaint's factual detail is sufficient to allow defendants to recognize the specific clients, the complaint does not provide the court with sufficient information or factual detail to analyze whether it is sufficient to state a claim for relief."
The court dismissed the suit without prejudice, enabling the CFPB to amend its complaint to remedy the defects noted by the court.
To access the order, click here.
Why it matters
The decision is a victory for the defendants and a rebuke to the CFPB in its efforts to reign in alleged unfair acts and practices of various third party processors, particularly when their clients operate in problematic industries such as payday lending or debt collection. The victory may be short-lived, however, as the CFPB may in fact have sufficient facts to refile a complaint that can withstand a motion to dismiss.
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Supreme Court Refuses to Hear Interchange Settlement Appeal
The U.S. Supreme Court denied a request to review the U.S. Court of Appeals for the Second Circuit's ruling overturning a $7.25 billion settlement agreement in a case brought by retailers against the card networks and banks, ending any question as to whether that agreement would survive court challenge in its current form.
What happened
In 2013, a New York federal court judge signed off on the deal in consolidated actions filed by merchants against the payment processors and various banks. The estimated 12 million plaintiffs alleged the network rules established by the defendants (such as the default interchange fee and honor-all-cards rule) allowed issuing banks to impose artificially inflated interchange fees that merchants had no choice but to accept.
Originally filed in 2006, the action spanned years of litigation, including 400 depositions, 17 expert reports, 32 days of expert deposition testimony, and the production of over 80 million pages of documents. After repeated mediation sessions and settlement negotiations, the parties reached a deal in 2012, which was finally approved by the district court in December 2013.
The settlement agreement divided the plaintiffs into two classes: one under Federal Rule of Civil Procedure 23(b)(3) covering merchants that accepted either payment processor from January 1, 2004 to November 28, 2012, and a second class under Rule 23(b)(2) for merchants that accepted or will accept payments from either payment processor from November 28, 2012 and onward.
Members of the (b)(3) class would be eligible for a portion of the $7.25 billion in monetary relief provided by the defendants, while the (b)(2) class would receive injunctive relief in the form of changes to the network rules. Under the federal rules, members of the first class (those that received money damages) could opt out of the settlement and bring their own actions for damages, but those in the second class could not. That essentially meant that all U.S. merchants were forced to accept the injunctive relief—whether it was meaningful or not—in exchange for a broad (and highly objectionable) general release of all past and future claims.
Despite substantial objections to the deal by merchants, the district court approved the settlement as fair and reasonable. Numerous objectors and opt-out plaintiffs appealed and the Second Circuit vacated the district court's certification of the class action and reversed the approval of the settlement.
The Second Circuit unanimously held in its decision that class members of the injunctive relief, or Rule 23(b)(2) class, were inadequately represented in violation of Rule 23(a)(4) and the Due Process Clause, because the same attorneys provided representation to both classes of plaintiffs despite the conflict of interest between the two.
"The conflict is clear between merchants of the (b)(3) class, which are pursuing solely monetary relief, and merchants in the (b)(2) class, defined as those seeking only injunctive relief," the court explained. "The former would want to maximize cash compensation for past harm, and the latter would want to maximize restraints on network rules to prevent harm in the future."
Such divergent interests, the appellate court held, require separate counsel when it impacts the "essential allocation decisions" of plaintiffs' compensation and defendants' liability. Class counsel and class representatives were in the position to trade diminution of (b)(2) relief for an increase of (b)(3) relief, the panel said.
"Unitary representation of separate classes that claim distinct, competing, and conflicting relief creates unacceptable incentives for counsel to trade benefits to one class for benefits to the other in order to reach a settlement," the court wrote. "Divided loyalties are rarely divided down the middle."
Supporters of the deal filed a writ of certiorari asking the Supreme Court to take the case for review, arguing there was no guarantee that the objectors could get a better deal and that the need for different representation of the injunctive relief and damages classes would require a lot of work for little benefit. The payment processors, in pushing for the Supreme Court to take the case, contended that the Second Circuit decision presented a new interpretation of the rules governing class action settlements. But the justices declined to hear the case, with Chief Justice John Roberts and Justice Samuel Alito taking no part in the decision.
To read the Supreme Court's order list, click here.
Why it matters
In denying to review the case, thereby affirming rejection of the deal, the Supreme Court has sent the parties back to the drawing board to create a new agreement or face the possibility of a trial on the merits of the case. The continuation of the case has significant implications for merchants, card networks and banks since it is unclear where the settlement of this highly contentious case is now headed. In a related action, it also has implications for retailer plaintiffs that brought actions in four states challenging the ban on charging a surcharge on credit card transactions at the point of sale. The U.S. Supreme Court recently held that the New York no-surcharge statute may violate the retailers' First Amendment rights.
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$3M Penalty for Credit Reporting Agency in CFPB Action
A major credit bureau and its subsidiaries will pay a civil penalty of $3 million, accurately represent how the credit scores it markets to consumers are used, and put in place an effective compliance management system in a settlement with the Consumer Financial Protection Bureau (CFPB or Bureau).
What happened
One of the nation's largest credit reporting agencies claimed the credit scores it marketed to consumers were used by lenders to make credit decisions, the Bureau alleged, even though lenders did not use the scores for decision making.
The company developed its own proprietary credit scoring model, dubbed "PLUS Score," which it applied to the data in consumer credit files to generate a credit score it offered directly to consumers. According to the CFPB, the PLUS Score is an "educational" credit score intended to inform consumers about the state of their credit and not actually used by lenders when making credit decisions.
The CFPB alleges that these facts didn't stop the credit bureau from falsely stating to consumers from at least 2012 through 2014 that PLUS Scores were used by lenders, even when there were "significant differences" between the PLUS Scores that it provided to consumers and the credit scores used by lenders.
For example, the CFPB claims that one ad represented that "Lenders review your credit information and so should you. Check your credit score to know what to expect—including what factors may be affecting your credit." Another ad stated: "See the same type of information lenders see when assessing your credit …"
The company did include a disclosure in its ads for the PLUS Score: "Calculated on the PLUS Score model, your. . . Credit Score indicates your relative credit risk for educational purposes and is not the same score used by lenders." But the disclosure "was not always conspicuous and, in many instances, far removed from the claims the disclosure was intended to modify," according to the CFPB consent order.
These actions allegedly ran afoul of the Dodd-Frank Wall Street Reform and Consumer Protection Act's prohibition on unfair, deceptive, or abusive acts or practices, the CFPB asserted, and consumers were allegedly left with "an inaccurate picture" of how lenders assessed their creditworthiness. The CFPB notes that lenders use a variety of credit scores, which can vary by score provider, scoring model, and target industry, with no single credit score or scoring model as the prototype for the marketplace.
The CFPB further alleges that the credit reporting agency violated the Fair Credit Reporting Act (FCRA) by requiring consumers to view company ads before they could access a free credit report. The statute mandates that a free credit report be provided to consumers once every 12 months and prohibits the use of advertising as part of the right to obtain consumer reports.
To settle the charges, the company must pay a $3 million civil penalty to the Bureau and change its practices. The agency will accurately represent the usefulness of credit scores sold to consumers and establish an effective compliance management system to ensure that its advertising practices comply with both federal consumer laws and the terms of the CFPB's consent order.
To read the consent order, click here.
Why it matters
The company allegedly "deceived consumers over how the credit scores it marketed and sold were used by lenders," CFPB Director Richard Cordray said in a statement about the action. "Consumers deserve and should expect honest and accurate information about their credit scores, which are central to their financial lives." This action by the Bureau covers the last of the "Big Three" consumer reporting agencies, following consent orders in January, 2017 with the other two agencies that allegedly duped consumers about the usefulness and actual cost of credit scores, requiring a total payment of $23.5 million in restitution and civil penalties.
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