When it comes to de novos, the Fed's rhetoric doesn't match its actions

Stefani Reynolds/Bloomberg

The member of the Federal Reserve Board representing community banks, Gov. Michelle W. Bowman, recently gave a speech urging the Fed to encourage the formation of de novo banks by "right-sizing regulatory requirements, improving transparency, and supporting regulatory approaches that support new banks." 

We agree with Gov. Bowman's sentiment — but, respectfully, where was she when the Fed recently treated a de novo community bank applicant in the opposite manner? 

The Fed recently denied and then publicly disparaged the de novo applicant, Custodia Bank, in a precedent-setting, 86-page order that unjustifiably denied its proposal to become a state member bank. Regarding the order, which is 14 times longer than any other denial in Fed history (and which Bowman voted for), the Fed not only refused to correct inaccuracies, but it also disclosed an unprecedented amount of confidential supervisory information about Custodia. Because the Fed itself disclosed the information, we can refer to it and shed light on a topic that usually stays in the dark: how the Fed treats de novo community bank applicants. 

The Fed's order contained language implying Custodia would be assigned a Camels rating of 4 or 5 (equivalent to a D or F on an A-F grading scale), but that was not accurate — and every Fed governor, including Bowman, knew the truth. How? Because all Fed governors had access to Custodia's exam results letter, which proved otherwise (and the Oct. 21, 2022, exam letter is referenced here).

One author of this op-ed, Katie Cox, interpreted Custodia's exam results based on her 32 years of Fed experience as implying Custodia achieved a rating of "low 2" on its first attempt (or equivalent to a B-minus), which was just short of the required threshold.

Custodia did not contest the exam results via the Fed's ombuds process last October, or the numerous procedural irregularities and goal-post movements during the exam, because all parties were working toward a follow-up exam (as is customary for all de novo Fed applicants). But then, four months later and after the ombuds window had expired, the Fed abruptly changed its mind and all seven Fed governors — including Bowman – voted to put pens down, deny Custodia's application and release the disparaging 86-page order. This happened despite Custodia's primary regulator and an independent consultant both concluding Custodia was ready to operate on its first try.

How should prospective de novo applicants view Bowman's words against the harsh reality that she and other Fed governors might suddenly deny and publicly disparage them, too?

In her speech, Bowman said, "there should be no net difference in the compliance expectations for banking-as-a-service and de novo banks that engage in the same underlying activity." We agree. 

But those words ring hollow. There was no longer anything unique about Custodia that prevented the Fed from admitting it as a Fed-regulated bank. Custodia publicly disclosed that it submitted a revised business plan to the Fed after learning from the order that the Fed did not grant it permission for the novel activities for which it requested Fed permission. The Fed (including Bowman) nonetheless still denied Custodia's revised membership proposal, even though Custodia had proposed to engage only in Fed-approved activities that incumbent banks are already doing. 

Here's the irony, which we are publicly discussing for the first time: Custodia believed the likely path forward for Wyoming special purpose depository institution ("SPDI") banks was for all SPDIs to become Fed member banks (and therefore federally regulated); Custodia welcomed Fed regulation and reasonable restrictions. Custodia's decision to seek a federal regulator in 2021 actually divided the Wyoming SPDI community, because some Wyoming SPDIs had hoped they would not need to become federally regulated.

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But, in the end, the Fed went overboard — it not only denied Custodia, but it rejected an entire class of de novo community banks: uninsured state banks. The repercussions are not limited to Wyoming. Uninsured state bank charters exist in five states: Connecticut, Maine, Nebraska, Vermont and Wyoming.

The Fed's rejection of Wyoming's uninsured bank charter drew the State of Wyoming into the dispute. Wyoming's attorney general, Bridget Hill, recently moved to join Custodia's existing lawsuit against the Board of Governors and the Federal Reserve Bank of Kansas City as a co-plaintiff. In its court filing, Wyoming's AG noted the Fed created a "Kafkaesque situation" where a Wyoming-chartered bank is denied access to the U.S. dollar payment system "because it is not federally regulated, even while it is also denied federal regulation."

This is doubly ironic because the State of Wyoming worked closely with the Fed to create its new bank charter, rules and examination manual in the first place, holding more than 100 meetings with Fed officials before the charter went live in 2019.

The Fed seems not to trust state bank chartering authorities. But federal law gives those state authorities, not the Fed, the right to choose which banks earn charters and gain access to the payment system. The Fed made clear it does not want uninsured state banks to obtain master accounts, but federal law requires the Fed to provide master accounts to all eligible depository institutions.

Had the Fed played it differently, it could have had its cake and eaten it, too. The Fed could have used uninsured bank charters to bring fintech activities inside the federal regulatory perimeter by admitting applicants to Fed membership — thereby subjecting fintechs to federal regulation, which many Fed governors (including Bowman) continually profess to want. Instead, the Fed chose to reject uninsured state bank charters entirely, thereby rejecting the dual banking system, leaving fintechs "as is" and kicking its treatment of the Wyoming bank charter into federal court.

Gov. Bowman rightly supports de novos that make "community banks more competitive with larger peers and better able to develop new technology and products in-house." We agree that the Fed should welcome de novos, and especially ones that develop innovative products. The Fed should embrace such de novos instead of delaying, disparately treating and then disparaging us.