The rise of 'imitation banks' may lead to regulatory scrutiny

WASHINGTON — Compound, previously Compound Banc, offers high-yield digital accounts that earn 7% annual interest on deposits, which customers can withdraw without fees at any time.

But Compound — despite its former name — is not a bank, or even a brokerage. According to its SEC filings, its consumers are actually buying high-risk savings bonds, which it pools and invests in real estate loans and mortgages. Funds customers place in Compound accounts are not insured by the Federal Deposit Insurance Corp., and are not even technically deposits.

"Imitation banks" like these use online bank-like platforms and language to entice retail investors with yields nearly 20 times the national average — all while exempt from regulatory oversight.

And Compound isn't the only one. The FDIC recently issued a cease-and-desist letter to Zera Financial for improperly implying that its customer deposits are insured, and another imitation bank — Tellus — similarly compares its returns to that of FDIC-insured banks.

Tellus' website touts customers' ability to "earn up to 17x more interest on your savings today while keeping your cash out of the markets," and boasts that they pay "4.50-5.90% APY."

Compound said it provides full transparency to its customers.

"We are not a bank," the company said in a statement. "Our product does not look like a savings account and clearly expresses what users are purchasing: bonds."

On March 3, a day after this story was originally published, Compound removed any mention of the term banc from its site, now calling itself "Compound Real Estate Bonds." They also redirect visitors from the old website to a new domain: compoundrealestatebonds.com.

Tellus did not respond to a request for comment.

Though these firms are flying under the radar for now, banking experts think demand-bond agreements like those offered by Compound may be violating the law, and are increasingly drawing the attention of banking regulators. Section 21 of the 1933 Glass-Steagall Act prohibits and imposes criminal penalties on any non-chartered institutions receiving deposits.

Former FDIC lawyer Todd Phillips said that representations like those made by Compound and Tellus could lead to regulatory action.

"It looks like what you're doing is giving them money to make mortgages. That's an investment, not savings," Phillips wrote in an email. "And yes, it's 'keeping your cash out of the markets,' but it's putting them into things that are riskier because you're not diversified."

Art Wilmarth, professor emeritus at the George Washington University Law School, says the Department of Justice has not truly enforced the Section 21 prohibition since 1979, when a department letter indicated money-market funds could legally engage in de-facto deposit taking services. He says recent case law shows the correct interpretation: that drafters of Section 21 did not want unsupervised entities issuing deposits, because of the inherent risks to consumer protection, and financial stability. By that standard, Wilmarth said, Compound is effectively issuing de-facto deposits, and therefore in violation of Section 21.

"Courts have repeatedly held that nonbanks are deemed to receive 'deposits' if they accept funds from other persons while agreeing to hold those funds and repay them on demand or at a specified time," Wilmarth said.

"These are functional equivalents to a deposit, which provide better terms than what you can get at a bank, which is not surprising when they're not paying any deposit insurance premiums, they don't have to meet capital requirements, they don't have to meet liquidity requirements and they don't get examined," Wilmarth continued. "They're freeriding off the safety which we've carefully created for bank deposits since 1933. And we're essentially allowing that all to be arbitraged away."

Phillips says that while DOJ action is unlikely, regulators could use limited tools to prevent non-banks from impersonating depository institutions.

"The CFPB or FDIC could issue a cease and desist order, and require these institutions to make very clear to customers that their accounts aren't FDIC-insured." Phillips said."At the end of the day, though, Congress really needs to clarify that prohibition and make it so someone other than DOJ — like a bank regulator or the CFPB — can bring lawsuits to stop non-banks from taking deposits. If Congress acts to clarify this statute, it should also make clear that taking any kind of deposits — cash, crypto, or something else — is prohibited."

Bank holding companies routinely use terms like "banc" and "bancshares" to differentiate themselves from their banking arms. But Compound is registered with the SEC as a debt bond issuer, similar to money-market funds, and until Congress gets more specific about its definition of a deposit under Section 21, that distinction may escape scrutiny.  But some of these imitation banks are pushing the boundaries into the realm of impersonating a financial institution.

Many states prohibit non-banks using the name, but Compound is registered in Florida, where the commissioner of Florida's Office of Financial Regulation, Russell Weigel III, granted the company the ability to use the name because, as he says, its corporate name — "Compound Banc Real Estate Holdings" — definitively differentiates it from a financial institution. He even specified that the company should not "engage in business purporting to be a financial institution."

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Such a narrow justification may not be enough for federal regulators, like the FDIC, who have recently taken action against non-banks who act too much like a bank.

Compound also expresses its bond yields in annual percentage yield, or "APY" — a regulated legal term under the federal Truth in Savings Act — which could be further evidence regulators use to demonstrate Compound is imitating a depository institution.

Bank industry advocates agree that imitation banks pose risks, and that regulators should capture such behavior.

"Regulators should ensure that any entity that acts like a bank is regulated like a bank and that bank-like products and services are subject to bank-like oversight and protections," said Jeff Sigmund, spokesperson for the American Bankers' Association. "Anything less poses unnecessary risks to consumers and our financial system."

Ian Katz, managing director and Washington analyst with Capital Alpha Partners, isn't so sure about the legal ramifications, but believes Compound's behavior will draw attention.

"I suspect that this issue will get more attention in Washington, and that means regulators and lawmakers will likely start talking about it. I don't know if firms like that are breaking the law, but I think regulators and lawmakers will try to define that before long, and some regulator, perhaps the CFPB, will make some noise to inform the public."

Regulators have been relatively quiet on the issue so far, but when FDIC Chairman Martin Gruenberg was asked about imitation banks at a recent conference, he said the problem of uninsured deposits is not a widespread one throughout the financial system. 

"Uninsured deposits have been declining, insured deposits have continued to increase," Gruenberg said. "It looks like the depositors that represent the large majority of retail deposits are continuing to rely on their insured institutions for their savings."