• Banking & Financial Institutions Law
  • National Versus State Banks
  • Regulating Banks
    • Regulatory Agencies
    • Periodic Reports
    • Bank Examinations
      • Status of Outstanding Loans
      • Portfolio Balance
      • Uniform Interagency Bank Rating System
    • Limits Placed upon Bank Loans
    • Limits Placed upon the Use of Bank Funds
  • Lender Liability
  • Resources

Banks and financial institutions are financial intermediaries that link those who have money--depositors--with those who need money--borrowers. Banks and financial institutions play an important role in modern, industrial economies by gathering deposits, repackaging them into a staggering variety of financial instruments, and reselling them to borrowers. The important position that banks and financial institutions have in modern economies also is one of the easiest positions to abuse. Recognizing the potential for abuse and mismanagement inherent in the banking and financial institutions systems and the negative effect that weak systems have upon a larger economy, state and federal authorities have created an extensive set of regulations that make the banking industry one of the most heavily regulated sectors of the economy. No other industry, through its day-to-day operations, affects as many other businesses as banking does. Many business managers feel frustrated when dealing with banks and financial institutions because they fail to understand that federal or state regulators sometimes put these institutions in regulatory straightjackets, or they do not understand that many bankers and financial industry professionals may be motivated in their actions by an understandable fear of borrower lawsuits. The relationship that a company has with its bankers and/or financial institutions is important to its success in business. Understanding the laws that affect banks and financial institutions and their relationships with borrowers can better one's chances of getting a business loan on more favorable terms, and having satisfying business relations with banks and financial institutions.

This chapter discusses the strict regulatory environment in which banks and financial institutions operate and potential sources of lender liability. International Letters of Credit are discussed in the International Business Law Chapter. Several different types of bank loans primarily of interest to new companies are discussed in the Securities & Venture Finance Law Chapter. Workouts for troubled loans are discussed in the Bankruptcy & Workout Law Chapter.

Commercial banks can be chartered either as national banks or state banks. The individuals who start a bank are free to choose the type of bank charter that best fits their needs. National bank charters are granted by the Department of the Treasury's Office of the Comptroller of the Currency in Washington, D.C. State bank charters are granted by the individual state's banking commission. In California, the California Superintendent of Banks, located in San Francisco, regulates and supervises state bank charters. Whether applying for a state or federal charter, applicants are required to provide extensive information about their financial history, their proposed management structure, the banking needs of the community, and their intentions for serving the community in which the bank will be located.

National bank charters are more expensive to procure although, for most purposes, state banks and national banks have identical rights and privileges once formed. One important difference between national and state banks is that membership in the Federal Reserve System (the "Central Bank" of the United States) and coverage by the Federal Deposit Insurance Corporation (FDIC) are automatic for national banks. State banks must make separate applications to join the Federal Reserve System and the FDIC. Applications for FDIC coverage and Federal Reserve System membership require much of the same information required in the original charter application.

Once a bank is chartered, state and federal regulators have a number of tools available to control bank operations. The goal of most banking regulation is to prevent widespread bank failures like those that plagued the country during the Great Depression. Much tighter supervision of commercial banks and federal guarantees of most bank deposits have promoted much greater business confidence in the banking system and prevented the widespread bank panics that gripped the United States economy periodically in its early history.

Regulatory Agencies

The Comptroller of the Currency has jurisdiction over the thousands of national banks in the country. The Office of the Comptroller issues national charters and has authority to examine and supervise national banks. The Office of the Comptroller's numerous functions are carried out through six regional administrative offices located throughout the country. The state of California is assigned to the Western District, which has its principal office in San Francisco. This office is a good source of information about federal bank regulations. The Office of the Comptroller also maintains duty stations in Los Angeles and Orange County. Bank examinations can also be carried out by representatives of the FDIC and the Federal Reserve. The California Superintendent of Banks regulates branch banking in California, sets maximum interest rates in certain categories of loans, and otherwise supervises state-chartered banks.

Banks and other financial institutions also can be subject to control by a host of other federal and state regulatory agencies. The Department of Justice has authority to prevent bank mergers that it believes may create a trend toward monopoly in a given area. The Securities and Exchange Commission requires banks and financial institutions that sell stock to the public to file periodic reports with the Commission. Banks and financial institutions that choose to participate in a variety of government loan programs are subject to scrutiny by the Veterans Administration or the Departments of Labor, Interior, Housing and Urban Development, or Health and Human Services. In addition, banks and financial institutions, like other businesses, are affected by state and federal regulations regarding equal employment opportunity, discrimination in lending, fair credit reporting, truth in lending, and collection practices for delinquent loans.

Periodic Reports

Periodically, all banks and financial institutions are required to submit detailed financial condition reports to bank and financial institution regulators. These reports must be submitted quarterly by larger banks and financial institutions and at least semi-annually by some smaller ones. Special reporting requirements are imposed on troubled banks and financial institutions and near continuous reporting is required for those thought likely to fail.

Bank Examinations

In addition to having to file periodic reports, banks are subject to periodic visits by teams of inspectors to ensure the banks are being run in compliance with all applicable laws, that sound banking principles are being observed, and that the banks are not discriminating unfairly against any class of people. Often, these inspections are unannounced. Inspectors check all bank records, physically inspect documents, test computer systems, review loan procedures and policies, and count cash. Two areas of particular interest to bank examiners are the status of outstanding loans and the balance of the bank's loan portfolio.

Status of Outstanding Loans

Bank examiners evaluate the strength of loans that a bank has made and make predictions of the likelihood that the loans will be repaid. Each bank receives a grade on the strength of its overall loan portfolio. To evaluate loans, examiners check the collateral pledged for each loan and the cash flow of the borrower repaying the loan. Accurate loan documentation is essential to this stage of the examination and, as a result, a bank may be quite strict in insisting upon proper documentation from even its best customers.

Portfolio Balance

A bank's loan portfolio also is evaluated for balance. Theoretically, a bank's loan portfolio is stronger if loans are spread out over a wide variety of loan categories such as real estate, manufacturers, service providers, and automobile fleets. A balanced loan portfolio is better able to withstand periodic economic fluctuations in any given industry than a loan portfolio heavily weighted toward one particular industry.

The Uniform Interagency Bank Rating System

More than one regulatory agency may have authority to examine a given bank, but because multiple examinations would be costly for the government and overly burdensome for banks, examiners use the Uniform Interagency Bank Rating System, a uniform set of standards, to grade banks. The Uniform Interagency Bank Rating System grades banks in five different areas--capital adequacy, asset quality, management ability, earnings performance, and liquidity. These five elements commonly are referred to by their acronym, CAMEL. Every bank is rated on a scale of 1 to 5 for each element of CAMEL, with 1 being the highest rating and 5 being the lowest. A rating of 1 is excellent. A rating of 2 is good, with minor problems. A rating of 3 signifies a bank has trouble in that particular area and will usually cause authorities to take action against the bank to remedy the problem. A rating of 4 signifies more trouble and usually triggers more serious corrective action. A rating of 5 is reserved for banks with a very high possibility of imminent failure and usually will trigger a search for candidates with which to merge the troubled bank.

Limits Placed upon Bank Loans

Both federal and state laws control the interest rates that banks can charge to borrowers. Regulations provide a range of permissible interest rates. A bank is free to charge different borrowers different rates within those ranges depending upon the bank's perception of each business' ability to pay back the loan, the cost of funds the bank pays its depositors, and the competitive pressures of the financial marketplace. Federal and state laws also set lending limits on the amount that can be lent to a particular individual or business. These lending limits are determined primarily by the bank's capital assets.

Limits Placed upon the Use of Bank Funds

Both federal and state laws place a variety of restrictions on what a bank can do with its own funds. These rules are extremely complex and only an experienced professional can adequately advise bank management. A few general comments can be made, however. National banks and many state banks are prohibited from investing in real estate except to the extent that the investment is used for the bank's own needs. The total investment in the bank's own real estate may not exceed the amount of its capital stock. Additionally, national banks and many state banks are prohibited from investing in nearly all equity securities. Limited exceptions permit investment in subsidiaries performing bank functions, United States Treasury securities, and general obligations of state and municipal governments. Banks generally are prohibited from investing in nonfinancial sectors of the economy such as manufacturing and health care. Within the financial services sector, banks are prohibited from making some investments in insurance or securities underwriting. These limits are coming under increasing scrutiny, however, and Congress currently is considering whether to do away with some of these restrictions.

A big worry for lenders today is potential liability for the loans they make. There was a time when bank officers felt free to step in and tell a business how it ought to be run whenever that business failed to make timely loan payments. Then, a wave of lawsuits by business owners convinced juries that bank interference with business decisions had been the cause of business failures. Failed businesses sometimes won very substantial verdicts or settlements from their banks. Early successes spawned a rash of copycat lawsuits challenging every conceivable action a bank might have taken before the business failed. Banks have lost lawsuits alleging bad faith for failing to loan enough money, for loaning too much money, for calling in loans too early, and for failing to call in loans early enough.

A bank or financial institution always needs to resist the temptation to take control of a business too quickly because if the bank or financial institution becomes so involved in the debtor's business that it "controls" the business, the creditor can become liable for any liabilities incurred by the business. This possibility is particularly serious because the definition of when a creditor "controls a debtor" is hazy. There is no simple formula to apply, so courts look to all the creditor's actions in the broadest context in answering the question. A lender needs to be extremely careful about using its influence to get the borrower to take actions detrimental to the company but beneficial to the bank. Attorneys experienced in this area of law frequently are called upon to advise their bank and financial institution clients on how to ensure better payment of loans without unnecessarily incurring liability. The advice of experienced counsel is strongly recommended.

If all this were not enough to cause the average banker or financial institution professional to lose sleep, today's bankers also need to worry about lawsuits brought by the government for environmental cleanup costs at the sites of borrowers' operations. Financial management of a debtor's business can have especially high risks in the realm of environmental matters. In one notorious case, Fleet Factors, the court held that a lender could be held liable for Superfund cleanup costs at the debtor's facility if the lender "had the ability to influence the hazardous waste decisions of its borrower" even though the lender had never actually participated in the decision-making process. The court's position that mere ability to influence a borrower's hazardous waste-handling decisions can trigger lender liability for cleanup sent shock waves through the banking and financial institutions community. The Environmental Protection Agency (EPA) has tried to assuage the fears of many bankers by promulgating new rules to determine when banks can become responsible for environmental cleanup costs. However, many people in the banking and financial institutions industries are not comfortable with the new rules and fear the potential for liability is still great. Banks and financial institutions and their clients concerned with how their actions might be interpreted by a court assigning responsibility for environmental cleanup costs should consult counsel experienced in interpreting EPA lender liability rules.

Lender liability lawsuits are having a dramatic effect on the way lenders and borrowers interact with each other. Many longstanding relationships that once were consistently cordial are becoming increasingly adversarial. Even a borrower in excellent financial condition may find it increasingly difficult to secure loans if it has a history of business litigation. Banks and financial institutions now feel threatened by possible lawsuits from regulators and borrowers. Understandably, they may be reluctant to offer business advice or to introduce business managers to new business contacts.