In this post I’ll review the US bank holding company rules and explain how to avoid them as an international bank licensed in the US territory of Puerto Rico. The last thing a startup international bank needs in the early years is to become regulated by the Federal Reserve. 

Note: In the United States, bank holding companies are primarily regulated by the Board of Governors of the Federal Reserve System, commonly referred to simply as the Federal Reserve or the Fed. The regulation of bank holding companies falls under the jurisdiction of the Federal Reserve as mandated by the Bank Holding Company Act of 1956 and subsequent amendments to that act.

This article considers only international banks licensed in the US territory of Puerto Rico. The information here is not applicable to banks in the United States nor does it apply to the general banks licensed in Puerto Rico (Banco Popular, Oriental and First Bank). Finally, it does not apply to Credit Unions in the United States or Puerto Rico. I’m focused on international banks licensed as International Banking Entities (1989 – 2012) and International Financial Entities (2012 – present). 

I also exclude entities that own both an international bank in Puerto Rico and an FDIC insured bank in the United States. Such a structure would likely mean that the  IFE/IBE would fall under the bank holding company rules, but this is a much more complex analysis than contemplated here. 

For basic information on bank holding companies in the United States, but not Puerto Rico, see: Introduction to US Bank Holding Companies.

In the United States, the framework for regulating banks through bank holding companies is primarily established by the Bank Holding Company Act of 1956 and its subsequent amendments. Under this act, a corporation is classified as a bank holding company if it owns, controls, or has the power to vote 25% or more of the voting shares of a bank. 

Additionally, entities that can elect the majority of a bank’s board of directors or exert significant influence over its management and policies are also considered bank holding companies. Once a corporation meets these criteria, it must register with the Board of Governors of the Federal Reserve System and subject itself to their oversight.

So, in most cases, any company that owns 25% or more of a bank in the United States is a bank holding company and must follow all kinds of rules as a result. 

Limitations on Bank Holding Companies

Below are some of the key limitations that apply to BHCs:

Business Activities:

• Non-Banking Activities: Traditionally, BHCs were restricted to banking-related activities. Over time, these limitations have eased somewhat, but a BHC is generally still not permitted to engage in commercial or industrial activities that are unrelated to banking or financial services.
• Insurance and Real Estate: While BHCs can engage in some insurance-related activities, there are limitations. Similarly, real estate investment and development are generally off-limits except for specific circumstances related to the banking business.
• Merchant Banking: BHCs are often restricted in their ability to engage in merchant banking activities or to own equity interests in non-financial companies.

Regulatory Oversight:

• Capital Requirements: BHCs are required to maintain certain levels of capital as dictated by the Federal Reserve. These capital ratios must be kept at prescribed levels to ensure the financial stability of the BHC and its banking subsidiaries.
• Approval for Mergers and Acquisitions: Any acquisitions, mergers, or other structural changes must generally be approved by the Federal Reserve.
• Dividend Payments: BHCs are restricted in their ability to pay dividends if they do not meet certain financial health metrics, as set by regulators.
• Reporting and Examinations: BHCs are required to submit periodic reports to the Federal Reserve and are subject to regular inspections and audits.
• Consumer Protection: BHCs are also subject to various federal and state consumer protection laws and must ensure that their subsidiaries comply with these regulations.

Financial Transactions:

• Intercompany Transactions: Transactions between the bank holding company and its subsidiaries are subject to “arm’s length” requirements to avoid conflicts of interest and to ensure market terms.
• Investment Limitations: There are restrictions on the types of investments a BHC can make. High-risk investment activities may be restricted to protect the financial health of the entity.

While the Gramm-Leach-Bliley Act of 1999 did expand the types of financial services activities in which BHCs can engage (subject to approval), becoming a BHC still imposes a series of limitations designed to separate banking from commercial activities and to safeguard the financial system.

When is a Bank Holding Company Required?

Here is the definition of a bank for the BHC regulations (12 USC Ch. 17: Bank Holding Companies – From Title 12—Banks and Banking): 

(c) Bank Defined.—For purposes of this chapter—

(1) In general.—Except as provided in paragraph (2), the term “bank” means any of the following:

(A) An insured bank as defined in section 3(h) of the Federal Deposit Insurance Act [12 U.S.C. 1813(h)].

(B) An institution organized under the laws of the United States, any State of the United States, the District of Columbia, any territory of the United States, Puerto Rico, Guam, American Samoa, or the Virgin Islands which both—

(i) accepts demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others; and

(ii) is engaged in the business of making commercial loans.

Because nearly all banks in the United States, and all general banks in Puerto Rico, are FDIC insured, they require a bank holding company if owned by a corporation. This is so common that most texts simply say that all US banks fall under the Bank Holding Company Act. 

The only notable exception to this general principle are international banks licensed in the US territory of Puerto Rico. International banks in the territory are unique in many regards, such as not being a part of the FDIC, capable of accepting deposits from customers anywhere in the world (within reason), and paying only 4% in tax on their net profits (US Federal Income Tax does not apply to Puerto Rican sourced income 26 U.S. Code § 933 – Income from sources within Puerto Rico).

International banks in Puerto Rico are not FDIC insured, and  thus do not fall into category A above. Therefore, IFEs and IBEs can avoid falling under the BHC regime by structuring around category B above. This is not possible for 99.9% of US banks (because they are required to be insured by the FDIC) and not a distinction of which most US banking lawyers are familiar with.

Let’s consider Section B:  

We can dispense with (B)(i) quickly. All international banks are meant to take deposits from the general public. If you’re not accepting deposits which can be withdrawn by check or wire or  ACH, you’re not a bank. 

Therefore, our attention is focused on (B)(ii) and the statement “is engaged in the business of making commercial loans.”

How can an international bank licensed in the US territory of Puerto Rico that accepts deposits avoid the Bank Holding Company requirements? Don’t make commercial loans … simple enough.  

Thus, the final step is to understand what constitutes a commercial loan. The term “commercial loans” isn’t specifically defined under 12 USC Ch. 17. The regulations on bank holding companies generally cover aspects like ownership, control, activities, and oversight but do not necessarily delve into the specific types of loans, such as commercial loans, that a bank may offer.

“Commercial loans” are generally understood to mean loans extended to businesses rather than to individuals. These loans are often used for specific business purposes, such as purchasing equipment, funding operations, or other types of expansion. Commercial loans can come in a variety of forms, including term loans, lines of credit, or commercial mortgages.

Practical Implications for International Banks in Puerto Rico

There are three ways international banks in Puerto Rico deal with the issue of bank holding companies and their application to IFEs and IBEs on the island. 

Aggressive Approach: 

The international banking statutes have been in place in Puerto Rico since 1989, and were updated in a major revision in 2012. There are currently about 60 international banks operating on the island. 

In all of those years, the US  Federal Reserve has never attempted to enforce the bank holding company regulations on international banks operating from Puerto Rico. It’s commonly understood that the Federal Reserve is not  interested in regulating international banks on the island unless they decide to apply for Fedwire.

As for the local regulator, OCIF, has taken the unofficial position that bank holding company rules are under the purview of the Federal Reserve and not their concern. Thus, OCIF has not required the formation of a bank holding company for any international bank operating on the island. 

For these reasons, the majority of international banks in Puerto Rico ignore the Bank Holding Company Act and claim amnesty based on the unwritten common practice of the Federal Reserve and OCIF. They will issue commercial loans and rely on history and industry practice. 

Moderate Approach: 

But, let’s say you’re a large publicly traded company and require something more substantial than “unwritten common practice.” You need more certainty than “it’s never been an issue before so it won’t be an issue in the future.” 

In that case, you have two options. You can go with the moderate approach, to which I  personally subscribe, and the conservative approach, which is what is likely  to be used if you request an opinion letter from a quality law firm rather than reading the blog of some guy on the internet. 

The moderate approach is where your IFE or IBE does not make any commercial loans into the United States. Under this theory, you assume that the US code is focused on US transactions, so the Federal Reserve should only be concerned with commercial loans made into the United States. Thus, your international bank avoids making commercial loans to US persons and US entities.  You will allow the bank to make commercial loans outside of the United States. 

Conservative Approach: 

The issue with the moderate approach is that the USC, Federal Reserve, and OCC do not specifically say loans “into the United States.” These laws are written for US banks doing US business, so mine is a reasonable interpretation. But, the bottom line is that there is no guidance on the issue and thus the most conservative interpretation is the literal reading whereby the IFE/IBE should not make any commercial loans, full stop.

So, the conservative approach is for your international bank to avoid making any commercial loans. If you require absolute certainty that you will not fall under the Bank Holding Company Statute, simply avoid making any type of commercial loan.

More on Commercial Loans

The Office of the Comptroller of the Currency (OCC) and the US Code (USC) define commercial loans in different ways. The OCC defines a commercial loan as “any loan made to a business entity, including a small business, for business purposes.” The USC does not have a specific definition of a commercial loan, but it does define a “commercial bank” as a bank that “accepts deposits from the public and makes commercial loans.”

OCC and USC laws and rules governing commercial loans include:

• The OCC’s Commercial Lending Manual, which provides guidance to banks on how to manage commercial lending risk
• The Fair Credit Reporting Act (FCRA), which regulates the use of consumer credit reports in commercial lending
• The Equal Credit Opportunity Act (ECOA), which prohibits discrimination in lending on the basis of race, color, religion, national origin, sex, marital status, age, or because an applicant receives income from a public assistance program
• The Truth in Lending Act (TILA), which requires lenders to disclose certain information about loans to borrowers

In addition to these OCC and USC laws and rules, commercial loans are also subject to state law. State laws may vary in terms of the specific requirements for commercial loans, such as the types of collateral that can be used and the interest rates that can be charged.

Here are some examples of commercial loans:

• Term loans
• Lines of credit
• Equipment loans
• Commercial real estate loans
• Inventory loans
• Working capital loans

Again, the term “commercial loans” is not defined in the USC, so we’re left to use these general definitions.

Legal Determination

Another course of action for an international bank requiring clarification on these matters is to request a letter ruling from the Federal Reserve. If the Fed determines it’s in their best interest to issue a private or public ruling on your specific facts and circumstances, they might just answer you.  

Requesting a letter ruling or interpretive determination from the Federal Reserve on a bank holding company issue is a formal process that typically involves a legal inquiry into the specific application of existing statutes or regulations to a particular set of circumstances. Banks or bank holding companies often consult with legal experts or compliance officers to ensure that their requests are aligned with regulatory requirements.

Of course, the vast majority of the international banking industry in Puerto Rico does not want any change in the process. They are happy with the status quo and do not want to risk a negative determination by the Feds.  The vast majority are content operating under the “aggressive approach” as described above.

Filing a request for a determination would likely make you a number of enemies in the industry. Keep in mind that the aggressive approach has served the industry well since 1989 without issue. The last thing any IFE or IBE wants is more scrutiny from the Federal Reserve. 

Conclusion

Under Title 12 of the United States Code, Chapter 17, which governs Bank Holding Companies, certain conditions might exempt a financial institution from being classified as a bank holding company. For an international bank licensed in Puerto Rico that is not FDIC insured, avoiding the bank holding company designation is as simple as refraining from making commercial loans, even if it does accept demand deposits. By not engaging in both activities concurrently, the institution may successfully sidestep the regulations and oversight associated with becoming a bank holding company under U.S. federal law, as outlined in 12 USC Chapter 17.

Just keep in mind that, when researching this issue, or working with lawyers outside of Puerto Rico, the possibility to avoid the bank holding company regulations is unique to international banks licensed in Puerto Rico. The assumption in the United States is that “bank equals bank holding company.”

I hope you’ve found this article helpful. For more information on setting up a new bank in Puerto Rico, or acquiring an existing bank on the island, you can reach me at info@banklicense.pro.