The Federal Reserve building

How Not to Enter Banking

On August 17, 2023, the Federal Reserve Board and Washington State Department of Financial Institutions (WSDFI) announced an enforcement action against Farmington State Bank and its holding company, FBH Corporation. The Fed and WSDFI found that the bank improperly changed its business plan without notifying the bank’s supervisors and obtaining prior approval for those changes as was explicitly required by the regulators in connection with the bank’s recent change in ownership and strategy. 

Michele Alt of Klaros Group
Michele Alt of Klaros Group

This enforcement action provides four helpful lessons on how not to enter banking. The first two should be obvious, and the failure of FBH and the bank to heed them is puzzling. The third and fourth lessons, in my experience, often come as a surprise to many would-be acquirers.

  1. Don’t Ignore the Conditions of Approval

Farmington State Bank is located in Farmington, Washington (population 133). When FBH acquired it in 2020, Farmington was the 26th smallest bank in the U.S., with $22 million in assets and a net worth of $5.7 million. It did not offer online banking, credit cards, or reportedly even an ATM. So why did FBH want to acquire Farmington State Bank and rebrand it to Moonstone Bank? And why did Alameda Research, the trading arm of the now-bankrupt crypto exchange FTX, later invest $11.5 million in the bank?

According to Moonstone’s March 7, 2022 press release announcing the Alameda raise, the bank intended to become “a top provider of innovative financial services to fast-growing industries such as blockchain, cryptocurrencies and cannabis.” Later that year, another press release announced an agreement between the bank and Fluent Finance, a blockchain-based fintech company, to facilitate the issuance of stablecoins to the public. These are announcements no bank should make without first talking with its supervisors, and are doubly bad for a bank in Moonstone’s situation. 

In their approvals of the various applications involved in the bank’s acquisition, regulators imposed a number of conditions specifically designed to limit these activities. These conditions prohibited the bank or FBH from changing the bank’s business plan “in any manner” without prior consultation with the Fed and specifically prohibited “chang[ing] the bank’s business plan to pursue a strategy focused on digital banking services or digital assets, or to launch a digital banking application to the general public without receiving prior approval from the Board of Governors or the Reserve Bank for a change in the general character of the Bank’s business.” 

In their enforcement order, the regulators found that FBH and the Bank violated the approval conditions “by engaging in activities which changed the Bank’s business plan and general character without receiving prior written approval.…” In case there was any doubt, asking for forgiveness, not permission is a terrible regulatory strategy.

  1. Don’t Announce Business Model Changes to the Public before Talking with Your Regulators

See above. In an apparent reference to the Fluent Finance partnership, the enforcement order states that “in the most recent examination of the Bank,” the regulators discovered the bank had entered “into a non-binding memorandum of understanding with a third party whereby the Bank committed to ‘work with’ the third party ‘to design the necessary IT infrastructure’ to facilitate the third party’s issuance of stablecoins to the public in exchange for receipt of 50 percent of mint and burn fees on certain stablecoins, and took material steps to implement that memorandum of understanding….” Given the press releases, it probably was not that difficult an examination exercise for the regulators to discover the bank had violated its approval conditions. 

  1. Don’t Grow too Fast

Within months of Alameda’s investment, the bank’s deposits had grown from $10 million to $84 million. Reportedly, FTX deposited $50 million in two accounts at the bank. Even if the bank had not engaged in activities expressly limited by the regulators, this rate of growth could raise regulatory concerns. 

Potential de novo bank organizers and acquirers often seek to impress the regulators with plans for robust growth in the first several years after approval. But regulators must be convinced that a bank has adequate controls in place to manage the risks of such growth. Most new or small banks, like Farmington, do not.

  1. Don’t Forget the Community

As part of its approval of the Farmington acquisition, the WSDFI required that “for a period of three years, FBH remain committed to serving the needs of the Bank’s historical customers and the Farmington community.” This requirement is intended to prevent a post-acquisition “charter strip” (acquiring a community bank and replacing its business model).  Why are regulators concerned about charter stripping?

Community banks play a vital role in the U.S. financial system, helping to strengthen communities by lending in the neighborhoods where their depositors live and work. Regulators are rightly skeptical of community bank acquisition plans that would minimize that role. Fed Governor Michelle Bowman has raised alarms about the risk to community banks of charter stripping, and Acting Comptroller of the Currency, Michael Hsu, has spoken often about the importance of trust between a bank and its community, which such charter stripping undermines. 

A potential bank acquirer must demonstrate to the bank’s regulators a firm commitment to the bank’s existing community. How to do so will depend on the bank being acquired, but regulators will need to be convinced of the positive impact on a bank’s community of any plans for new boards of directors, management teams, offices, technologies, products, and services.

  • Michele Alt

    Michele helps banks and fintechs navigate the complicated regulatory issues that are critical to their growth and sustainability, with a particular focus on helping fintechs develop their U.S. bank licensing strategies and drafting their U.S. business plans. Michele joined Klaros from the Promontory Financial Group, where she led a number of major bank licensing efforts and assisted numerous major banking organizations on a range of Dodd-Frank and Volcker Rule interpretive and implementation matters. Before joining Promontory, Michele spent 22 years in the Law Department of the Office of the Comptroller of the Currency.