Banks are creatures of limited powers under both state and federal law and are tightly constrained when it comes to the types of investments they may hold. Those constraints apply to both debt securities a bank may hold for investment, and also equity securities, explains Davenport Evans lawyer Chuck Gullickson. Federal law controls what investments are permissible for a national bank, and in the end, federal law also determines what investments are permissible for state banks.
For state banks in South Dakota, the legislature has delegated the responsibility of determining what investments are permissible to the South Dakota Division of Banking (see SDCL 51A-4-25) The Division of Banking’s primary regulation listing “general investments” permissible for a state bank is found at ARSD 20:07:03:12. A separate regulation concerning investments a state bank may make in mutual funds is found at ARSD 20:07:03:12:01.
In the case of national banks, permissible investments are delineated in regulations issued by the Office of the Comptroller of the Currency, found at 12 CFR Part 1. The OCC’s regulations distinguish among five different types of securities depending upon the issuer, whether or not they are investment grade, and the nature of the investment represented by the security. Type I securities generally consist of debt obligations issued by state and federal governmental entities (and include certain qualified Canadian debt obligations), and a national bank may hold Type I securities without regard to any limitation based upon the bank’s capital and surplus. Generally, the amount of Type II, Type III, Type IV, and Type V investment securities held by a national bank is limited to a specified percentage of the Bank’s capital and surplus.
As a practical matter, federal law also governs a state bank’s permissible investments because federal law provides that state banks may not engage in activities that are not permissible under federal law for national banks (see 12 U.S.C. § 1831a). Thus, federal law acts as a constraint on investments a state bank may hold even if the investment is permissible under state law. On the other hand, federal law acts to enable a South Dakota state bank to make investments that might not otherwise be permissible under South Dakota law, because of South Dakota’s “wildcard” statute that permits state banks to exercise such powers and make such investments as are permitted under federal law for national banks (see SDCL 51A-2-14.1).
Thus far, this article has contemplated investment securities that represent the issuer’s debt obligations. What about equity securities? Are they permissible for banks? In the case of South Dakota state banks, there are statutes that allow a bank to make equity investments in a “community development corporation” and for the purpose of promoting “the public welfare” (see SDCL 51A-4-20 through 51A-4-20.4). National banks may also make equity investments for purposes of fostering community development and promoting the public welfare (see OCC regulations found at 12 CFR Chapter 1, Part 24). Equity investments permissible for national banks under the OCC’s community development and public welfare regulations are generally limited, however, to investments that benefit low- to moderate-income neighborhoods or provide jobs or related benefits for low- to moderate-income individuals.
The only authority under federal law for national banks to make equity investments that are not tied to benefiting these specific groups are investments in operating subsidiaries permitted under 12 CFR § 5.34 and certain non-controlling equity investments authorized by 12 CFR § 5.36. Those equity investments, however, are limited to investments in entities that engage in banking or financial services-related activities.
Bankers may also wonder what activities are permissible for their holding companies. The Federal Reserve Board has a number of regulations that address the investments and activities that are permissible for bank holding companies and a common theme here emerges – those, too, must be closely related to the business of banking. The Board has a list of activities that are permissible for bank holding companies (whether directly or through their investments in subsidiaries) in 12 CFR § 225.28.