Statement of Patrick J. Kennedy, Jr., Partner, Kennedy Sutherland LLP, San Antonio, Texas
February 4, 2015
Background
I have been engaged in the practice of law for 35 years and primarily represent banks, bank holding companies and their shareholders, officers and directors. Our firm has helped banks on a broad range of corporate,securities, bank regulatory and product and service developments. We were actively involved in the successful effort to amend the Internal Revenue Code in 1996 to allow banks and bank holding companies to elect subchapter S tax treatment for example, a change that has significantly benefited the community banking industry by creating a more efficient means of family and local ownership of community banks. Approximately one third of US Banks maintain a Sub S election and 90% of those are in rural communities.
In addition to our community bank practice, we also represent CDFIs, CDEs, SBICs and CDCs and as such have a broad exposure to the particular capital, structural and regulatory needs of those entities. This has given us the opportunity to expose many of our community bank clients to opportunities to engage with these entities which of course are all qualified investments under 12 CFR 24 as “public welfare investments.” I don’t think it would be a surprise to any of the Agencies Community Affairs officers, that a majority of bankers have little or no understanding of what these entities are and whether or how a bank could make an investment or loan or even a referral to them. The banks that do understand and have experience in making investments in these type of entities have benefited themselves and their communities and provided a very nice way to diversify their bank asset base. While the common attitude of bankers is that CRA Compliance is a cost rather than an opportunity to earn a return, we have a number of clients who have made profitable public welfare investments and facilitated significant benefit to low income and special needs communities. As such, we frequently advocate and encourage our bank clients to consider these types of investments. Some of those who have successfully made those investments desire to make more but the current regulations potentially create limits and in certain cases confusion about the amount of “public welfare” investments a bank is permitted to make. National Bank regulations permit a bank to make public welfare investments up to 15% of its Tier 1 capital, surplus and qualifying allowance for loan loss accounts following the investment powers granted under 12 USC 24 Eleventh.
We believe that the agencies should consider ways to increase bank’s ability to make larger public welfare investments. Investment limits are obviously intended to reduce risk and avoid concentrations in asset types; however, the broad definition of investments “that promote the public welfare, including the low and moderate income communities or families” from 12 USC 24 Eleventh isverybroad and theoretically could cover the majority of a community development focused bank. Indeed, the OCC has recognized the ability of a bank to either apply to become a CDFI and to have a special designation in its charter as a community development (CD) bank.The OCC’s public welfare investment authority contains a non-exclusive list of a number of public welfare investment vehicles, including SBICs, CDFIs, CDEs and CDCs. Perhaps a separate investment authority in each type of entity could be considered. Clearly the current regulatory limits on public welfare investments have been guided by a concern to avoid over-exposure to public welfare investments perhaps because they may be viewed as inherently more risky. This does not necessarily have to be the case, though. We have a number of clients who have made investments over the past 10 years in a number of well-run equity partnerships, SBICs and CDEs. They have enjoyed market rate returns in the 10-17% range and have also received their full principal amount as well. In short, we firmly believe that banks can earn a good return, manage risk and benefit themselves and their communities if they could make more “public welfare” investments.
We also think there should be greater clarity as to what constitutes the investment amount since investments get paid back, earn returns and bank capital changes creating some confusion about how to apply current investment limits.
While the OCC rules do permit investment up to 15% of capital and surplus, the current Federal Reserve rule governing member banks does not recognize this same authority and limits public welfare investments to 5% of capital and surplus. See 12 CFR 208.22(b)(4).
There are over 100 CDFI banks who by virtue of their CDFI status make 60% of their loans and investments in areas or to borrowers who would be considered “public welfare” type investments. These entities rightfully enjoy a handful of benefits which non-CDFI banks do not enjoy. We would encourage the Agencies to make the banking industry more generally aware of this opportunity and of the industry’s opportunity to make direct investments in CDFIs in particular.
In addition, we think some clarity should be given to the difference between an equity investment and a loan. While the OCC Interpretive Letter #1076 (December 2006) made clear that a loan was not an “investment” for purposes of 12 CFR 24, we would encourage this to be written into the regulations so there is absolute clarity particularly since the Interpretive Letter focused on the interaction between 12 USC 24 and 12 USC 84.
EQ2 or equity equivalent investments were formally permitted by the Agencies some years ago. We would encourage the expansion of this authority to include other types of investment structures. In particular, we would encourage authorization of banks making “equity” investments in CDFIs since most are organized as not for profit entities and typically cannot issue equity instruments. Having equity is what is most needed in this industry and the current EQ2 instrument counts as debt, even though in most cases it is considered “perpetual” on the books of the CDFI and carried as another investment on the books of the bank.The CDFI industry provides a significant gap need for credit that banks typically cannot fill and as such play a very important role in our economy and in particular, helping underserved communities and persons find credit and the tools to build a profitable business.
We are honored to represent one of the country’s largest micro-lenders and know firsthand of the benefits and the success that this organization and its clients have had. We applaud both the OCC and the FDIC for publishing two excellent papers explaining the CDFI industry to banks and encouraging them to find ways to invest, but more must be done to bring support from the banking industry into the mainstream.
The CDFI industry polices itself to maintain “equity” capital ratios in the 18-20% range and then uses EQ2 investments and other debt to create leverage against this capital. We need to find ways that banks can provide that equity capital other than through grants and not just the debt side of the equation.
I appreciate your time and welcome any questions.
Patrick J. Kennedy, Jr.
Kennedy Sutherland LLP
112 E. Pecan Street, Suite 2810
San Antonio, Texas 78205
T: 210.228.9500
F: 210.228.0781