WASHINGTON — A new report by the Roosevelt Institute notes a comprehensive coordinated regulatory approach could currently mitigate some risks posed by
The report, obtained by American Banker and authored by former FDIC attorney Todd Phillips, says Imitation banks — a category of online shadow banks — mimic traditional depository institutions, offering high returns on what appear to be deposit accounts while circumventing banking laws and regulation. Phillips says this can mislead consumers, who may mistake them for secure, regulated institutions due to the similarity of their digital interfaces to banking apps, potentially putting their funds at risk.
"[Imitation banks] make specious promises of high returns to gain ground with consumers who may have been historically locked out of more traditional wealth-building opportunities, [and] they're doing so without the necessary government oversight and accountability mechanisms," he writes. "Regulators and Congress must act to address these harms."
The paper identifies four examples of imitation banks — including
Phillips notes that while current law
"It is unclear how Tellus, Zera, and other imitation banks have thus far avoided registering and providing SEC-required disclosures," he wrote.
And while bank regulators are well-equipped to address the risks of depository business models, he notes banking laws — specifically designed to mitigate run risks — are limited in that they only apply to chartered firms.
"Because imitation banks are none of these three and cannot be compelled to convert to a banking charter, they cannot be covered by federal banking laws — with one exception," the report says.
That exception is Section 21 of the Banking Act of 1933, also known as the Glass-Steagall Act. Section 21 criminalizes the business of receiving deposits by firms not subject to bank examination. The problem with Section 21, according to Phillips, is it is ambiguous — it does not clearly define the term "deposit," leaving unresolved whether bonds and notes can be classified as deposits. Even if they could, Phillips says, enforcing the law would be difficult because criminal statutes have a "mens rea" or "guilty mind" requirement, which requires proof a criminal acted knowingly.
"Section 21's mens rea requirement as a criminal statute is a high bar," Phillips wrote. "The Department of Justice is likely the only agency that may enforce its prohibition, and prior court opinions have implied that fraud or other criminal activity is required for Section 21 to be applicable."
Phillips considers Federal consumer financial regulation — within the authority of the Consumer Financial Protection Bureau — the most viable existing route to reign in imitation banks. That is in part because the CFPB's remit includes enforcing legal prohibitions on unfair, deceptive and abusive acts and practices, known as UDAAP.
"UDAAP's prohibition on abusive practices could also apply to any of the imitation banks that take unreasonable advantage of gaps in depositors' understanding about the risk of potential losses related to any assets that are invested in unreasonably risky ventures," he wrote. "The CFPB could perhaps even deem the use of the terms 'deposit' or 'saving' to describe imitation banks' products a violation, since the public generally understands these terms as banking-specific and their use by nonbanks could be misleading."
Section 43 of the Federal Deposit Insurance Act also empowers the CFPB to regulate disclosures made by depository institutions without federal deposit insurance — something Phillips says could adequately inform consumers of the risks associated with imitation banks.
"If depository institutions do not have FDIC insurance, the CFPB can require that they make this fact clear to potential depositors and require depositors to sign 'a written acknowledgement' that the government does not insure their deposits," he wrote. "The CFPB could, for example, require depositors to provide physical signatures acknowledging that their deposits are not insured, which would decrease the likelihood that consumers would participate."
While existing securities and banking laws provide limited regulatory hooks, Phillips says without further Congressional action, they mostly fall short in effectively protecting customers.
"The variety of business models [imitation banks] exhibit necessitates a broad and coordinated approach to regulating them in all their forms," he writes.
The report calls on Congress to more clearly define a "deposit," but also said Congress should make Section 21 a civil statute and explicitly allow enforcement by banking agencies and the CFPB.
"Given that Section 21 contains criminal penalties, not only is its mens rea requirement a high bar to clear, but enforcement most likely relies on the Department of Justice, which does not have the expertise to understand the dire need by depositors and the financial system to enforce its provisions," Phillips wrote.
Lastly, Phillips proposes Congress make the terms "deposit" or "savings" protected labels, prohibiting imitation banks from using terms to foster misleading associations with traditional banks.
"Although, as above, it is possible that the CFPB could deem nonbanks' use of the terms to be UDAAP violations, and although nonbanks taking deposits is a crime, courts may disagree that the CFPB has this authority," he writes. "Congress should clarify that this misuse of terminology is illegal."
The phenomenon of non-banks issuing demand notes — debt instruments redeemable at any time — that look and behave similarly to deposits is not completely new. Corporations — including General Motors, Dominion Energy and Ford Motor Company — offer similar deposit-like demand notes while avoiding bank regulatory oversight. However, Phillips distinguishes imitation banks from other non-banks because of the particularly deceptive language and advertising which unfairly deceive consumers and border on impersonation of FDIC-insured firms. He notes unlike imitation banks, issuers like Ford don't call their products "savings" or compare their account yields to other FDIC-insured banks.
"Traditional demand note issuers use the language of investing, whereas imitation banks use the language of banking," he writes. "Given the fact that all traditional banks in the United States have been subject to federal deposit insurance for decades, the use of banking terms can make customers believe the imitation banks' offers are safer than they actually are, making imitation banks' offerings more abusive than note issuers."
Regulators have taken limited actions within their existing authority to resign in the most egregious misrepresentations by imitation banks. The FDIC
Regulators have been relatively quiet on the issue so far, pointing out the fact that the problem of uninsured deposits is not widespread. But as Phillips notes, online banking is firmly entrenched, meaning imitators will inevitably continue to try to exploit regulatory gaps. If a large enough imitation bank were to fail, he wrote, depositors could demand redemptions that the imitation bank could not pay without haircuts, or losses to depositors.
"If those depositors were other financial institutions, the knowledge that they were not fully repaid could cause them to run as well … result[ing] in a fire sale, causing asset valuations to drop system-wide," he wrote. "Similarly, if one imitation bank fails, it could result in contagion — sparking fear among depositors about the health of and causing runs at other imitation banks, traditional banks, insurers, and other financial institutions."
