In recent months, sovereign wealth funds have made direct investments totaling more than $24 billion in US financial firms, often accounting for a significant portion of the total additional capital raised by these financial companies in this period.
The recent wave of sovereign wealth fund investments in US financial institutions consists of non-controlling investments below 10% of voting equity. Citigroup recently received a capital infusion from the Kuwait Investment Authority (KIA), the Abu Dhabi Investment Authority (ADIA), and the government of Singapore Investment Corporation (GIC), one of Singapore’s two sovereign investment funds. None of these funds acquired more than 10% of Citigroup’s total equity.
Three sovereign wealth funds, the Korea Investment Corporation (KIC), Temasek and KIA each made similar non-controlling investments in convertible preferred stock in Merrill Lynch and Co. These are all passive investments that have not triggered formal review under US banking law.
Generally speaking, the same statutory and regulatory thresholds for review by the federal banking agencies apply to investments by sovereign wealth funds as apply to investments by other domestic and foreign investors in US banks and bank holding companies. These requirements are established in two federal statutes, the Bank Holding Company Act (BHC Act) and the Change in Bank Control Act (CIBC Act). The BHC Act requires any company to obtain approval from the Federal Reserve before making a direct or indirect investment in a US bank or bank holding company if the investment meets certain thresholds.
The BHC Act requires board review when a company acquires ownership or control of 25% or more of any class of voting securities of the bank or bank holding company; control of the election of a majority of the board of directors of the bank or bank holding company; or the ability to exercise a controlling influence over the management or policies of the bank or bank holding company.
In determining whether an investor may exercise a controlling influence over the management or policies of a US bank or bank holding company for purposes of the BHC Act, the board considers the size of the investment, the involvement of the investor in the management of the bank or bank holding company, any business relationships between the investor and the bank or bank holding company, and other relevant factors indicating an intent or ability to significantly influence the management or operations of the bank or bank holding company.
The BHC Act applies only to investments in banks and bank holding companies that are made by “companies”. The Act specifically excludes investments made by the US Government or by any state government. On this basis, the board has long held that the provisions of the BHC Act do not apply to direct investments made by foreign governments.
The BHC Act also specifically excludes from its coverage any corporation controlled by the US or by a state government. The effect of the board’s long-standing interpretation is that a sovereign wealth fund that seeks to make an investment in a US bank or bank holding company that exceeds the thresholds in the BHC Act would be required to obtain board approval prior to making the investment and would become subject to the other provisions of the BHC Act, but its parent foreign government would not.
Investments by sovereign wealth funds that do not trigger the requirements of the BHC Act may nevertheless require approval from a federal banking agency under the Change in Bank Control Act (CIBC Act).
Prior approval from the Federal Reserve under the CIBC Act generally is required for any acquisition of 10% or more of any class of voting securities of a state member bank or bank holding company. Unlike the BHC Act, which imposes ongoing restrictions on the non banking activities of corporate owners of banks as well as ongoing reporting, examination, capital, and other requirements, the CIBC Act does not impose any activity limitations or any ongoing supervisory requirements on owners of banks.
Several sovereign wealth funds, including some that have attracted attention with their recent investments in US financial institutions, also have interests in foreign banks with US operations. US branches of foreign banks are generally not permitted to accept retail deposits. Foreign bank agencies cannot accept deposits from citizens or residents of the United States.
After 1991, the International Banking Act (IBA) decided that any foreign bank seeking to establish a US branch or agency must apply to the Federal Reserve for prior approval. All foreign banks controlled by sovereign wealth funds that have US branches or agencies established those branches or agencies before the IBA was amended in 1991 to require Federal Reserve approval of the establishment by foreign banks of new US branches and agencies.
Since a sovereign wealth fund is a company for purposes of the BHC Act, if a fund were to acquire control of a US bank or bank holding company, it would be treated as a bank holding company and would be subject to the US regulatory regime applicable to such companies. This regime is designed in significant part to help ensure the safety and soundness of US bank subsidiaries of bank holding companies.
Among the most important tools that US bank regulators have to protect the safety and soundness of US banks are the legal restrictions that limit the ability of a bank to lend to affiliates. Section 23A of the Federal Reserve Act provides that a bank may not lend more than 10 percent of its capital to any one affiliate or more than 20% of its capital to all affiliates combined.
Any loan to an affiliate must be either fully collateralised by cash or US Treasury securities or overcollateralised by 10 to 30%, depending on the type of asset or instrument used to secure the loan. Section 23A also prohibits the purchase of low-quality assets by a US bank from its affiliates. Section 23B of the Federal Reserve Act requires that all transactions between a bank and its affiliates be conducted only on an arms-length basis. These restrictions are designed to limit the ability of an owner of a bank to exploit the bank for the benefit of the rest of the organisation.
A US bank controlled by a sovereign wealth fund would not be permitted to fund the operations of other companies controlled by the same sovereign wealth fund or its government owner, could not provide any uncollateralised loans to such companies and could not purchase low-quality assets from those companies. It would therefore be important for any US bank that might come to be controlled by a sovereign wealth fund to have information on which companies are controlled by the fund and by the government that owns the fund. This type of transparency would be necessary to allow the bank to comply with the affiliate transaction restrictions of sections 23A and 23B.
Recent sovereign wealth fund investments in US banking and financial services organisations have attracted much attention and there is no doubt that sovereign wealth funds are growing in size and number and are making increasingly significant investments in financial services organisations worldwide. But foreign government-owned entities, including sovereign wealth funds, have owned foreign banks with US operations for many years.
Sovereign wealth funds, like private investment funds, US state investment vehicles, hedge funds, and many other investors, have generally made investments at levels that are not large enough to trigger the thresholds for review and approval by the federal banking agencies under the federal banking laws.
If a sovereign wealth fund were to make an investment in a US banking organisation that triggers one of these thresholds, the application would be evaluated by the Federal Reserve or other appropriate federal banking agency under the relevant statutes with no preference or handicap relative to other investors. Any sovereign wealth fund controlling a US bank or bank holding company would be required to operate subject to the limitations on affiliate transactions in sections 23A and 23B of the Federal Reserve Act.