Banking Law Fundamentals - Powers and Limitations

Unlike general corporations, which can engage in any lawful business, banks are limited to activities that constitute or relate to "the business of banking."

Translation: Banks can take deposits, make loans, facilitate payments, and engage in activities "incidental" to these core functions.

The restriction on bank activities reflects several policy concerns:

Depositor Protection:
Bank deposits are federally insured. If banks could engage in risky activities, losses could threaten the deposit insurance fund and taxpayer dollars. Limiting activities limits risk.

Concentration of Economic Power:
If banks could own industrial companies, they could dominate the economy in concerning ways. The separation of banking and commerce prevents banks from becoming general conglomerates.

Stability:
Banking crises are economically devastating. Restricting banks to traditional activities—which are well-understood and manageable—promotes stability.

Historical Experience:
The Great Depression, the S&L crisis, and the 2008 financial crisis all reinforced the view that banks need constraints.

When banks want to engage in new activities, the OCC evaluates whether those activities are "incidental" to the business of banking. This framework is how crypto activities were approved.

12 C.F.R. § 7.1000(d) - OCC's Permissibility Framework:

1. Is functionally equivalent to or a logical outgrowth of a recognized banking activity
2. Is convenient or useful to carrying on the business of banking, such that it:
3. Poses risks similar to those already presented by activities the bank engages in

How This Applied to Crypto Custody:

OCC Interpretive Letter 1170 (July 2020) analyzed crypto custody under this framework:

CRYPTO CUSTODY PERMISSIBILITY ANALYSIS

Question: Is crypto custody permissible for national banks?

Test 1: Functionally Equivalent?
→ Banks have custodied assets for centuries
→ Custody involves safekeeping, recordkeeping, reporting
→ Crypto custody is same function, different asset type
→ PASS

Test 2: Convenient or Useful?
→ Clients want unified custody across asset types
→ Facilitates client relationships
→ Enables banks to compete for client business
→ PASS

Test 3: Similar Risks?
→ Custody risks include loss, theft, operational failure
→ Crypto custody has similar risks (plus technical risks)
→ Manageable with appropriate controls
→ PASS

CONCLUSION: Crypto custody is permissible.

The limitations are real. Banks cannot:

Own Non-Financial Companies:
JPMorgan can't own GM. This is the "banking-commerce separation."

Engage in Commerce:
Banks can't operate retail stores, manufacture goods, or engage in non-financial businesses.

Speculate:
Banks can't take principal positions purely for speculation. Activities must relate to customer service or liquidity management.

What About Crypto?

CRYPTO ACTIVITY PERMISSIBILITY

Activity                    | Permissible? | Rationale
----------------------------|--------------|---------------------------
Custody for clients         | Yes          | Traditional custody function
Holding stablecoin reserves | Yes          | Like holding deposits
Running blockchain nodes    | Yes          | Like running payment networks
Trading on behalf of clients| Yes (limited)| Execution at client direction
Proprietary trading (speculation)| No      | Speculation not permitted
Issuing tokens for profit   | Unclear      | Banking-commerce questions
Owning crypto exchanges     | No           | Commerce, not banking

"Safety and soundness" is the fundamental standard for bank activities. Regulators can take enforcement actions against banks that fail to operate in a safe and sound manner.

What "Safety and Soundness" Means:

It's easier to define by example than abstraction:

• Inadequate capital for risk level

• Poor loan underwriting leading to losses

• Insufficient liquidity to meet obligations

• Weak internal controls enabling fraud

• Management not qualified for activities undertaken

• Excessive concentration in risky assets

• Failure to properly value assets

• Inadequate risk management systems

• Capital appropriate to risk

• Diversified lending with proper underwriting

• Adequate liquidity buffers

• Strong internal controls

• Qualified management and staff

• Proper risk measurement and monitoring

• Accurate financial reporting

When banks consider crypto activities, they must demonstrate to examiners that the activity will be conducted safely and soundly. This means:

Bank examiners visit regularly—annually for most banks, continuously for the largest. They evaluate whether activities are conducted safely and soundly.

This is why the 2025 regulatory shift mattered beyond just rescinding formal restrictions. The shift signaled that regulators would examine crypto like other activities—critically but not hostilely.

Banks must maintain capital (equity) as a buffer against losses. Capital requirements determine how much equity banks need relative to their risk.

The Basic Concept:

SIMPLIFIED CAPITAL REQUIREMENT

Assets               | Risk Weight | Capital Required*
---------------------|-------------|-------------------
Cash                 | 0%          | $0
Treasury securities  | 0%          | $0
AAA corporate bonds  | 20%         | $1.60 per $100
Residential mortgages| 50%         | $4.00 per $100
Commercial loans     | 100%        | $8.00 per $100
Venture capital      | 400%        | $32.00 per $100

*Assuming 8% capital requirement

• Bank holds $100 million in commercial loans
• Risk weight: 100%
• Risk-weighted assets: $100 million
• Capital required: $8 million (8%)
• This $8 million can't be used for other purposes

The Basel Committee (international bank standard-setter) finalized crypto capital rules in December 2022, effective January 2026.

Group 1 vs. Group 2 Classification:

BASEL CRYPTO CLASSIFICATION

GROUP 1: Lower-risk crypto-assets
├── Group 1a: Tokenized traditional assets
│   → Risk weight of underlying asset
│   → Example: Tokenized bond = bond risk weight
│
└── Group 1b: Stablecoins meeting criteria
    → Must pass redemption test
    → Must be fully reserved
    → Still subject to additional requirements

GROUP 2: Higher-risk crypto-assets (everything else)
├── Group 2a: Limited hedging recognition
│   → 1,250% risk weight
│   → Capped at 1% of Tier 1 capital
│
└── Group 2b: No hedging recognition
    → 1,250% risk weight
    → Same cap applies

What 1,250% Risk Weight Means:

XRP EXPOSURE CAPITAL CALCULATION

Bank wants to hold $10 million in XRP (Group 2)

Risk weight: 1,250%
Risk-weighted assets: $10M × 1,250% = $125 million
Capital required: $125M × 8% = $10 million

Result: Bank must hold $10 million in capital for 
$10 million in XRP exposure (100% capital charge)

Implication: Holding crypto as principal is extremely
expensive. Banks will avoid Group 2 exposures.

Capital treatment differs dramatically based on whether the bank holds crypto as principal or merely as custodian:

The Basel rules are controversial and may change:

• 1,250% risk weight treats stablecoins same as Bitcoin

• US and UK have declined to implement current rules

• Fed Governor Bowman: Rules "not very realistic"

• Basel Chair: "We need to start analyzing" differently

• Lower risk weights for regulated stablecoins

• Recognition of permissionless blockchain progress

• More nuanced approach to different crypto types

Investment Implication:
Basel rules could become more favorable, which would enable more bank crypto activity. Watch for Basel Committee consultations and US regulatory implementation.

Staff Accounting Bulletin 121, issued by the SEC in March 2022, addressed how companies should account for crypto assets they custody on behalf of others.

Why This Was Devastating for Banks:

Under traditional custody, banks don't record client assets on their balance sheet. If you hold securities at BNY Mellon, those securities aren't on BNY Mellon's balance sheet—they're yours, and BNY Mellon is just safekeeping them.

SAB 121 changed this for crypto, requiring balance sheet recognition. For banks, balance sheet items trigger capital requirements.

SAB 121 IMPACT ON BANK ECONOMICS

- Client assets not on bank balance sheet
- No capital impact
- Custody fee = profit

- Client crypto recorded as liability
- Asset also recorded
- Both on balance sheet → capital required
- Capital charge destroys economics

- Custody $10B in crypto
- Record $10B liability, $10B asset
- Capital required: ~$800M (8% of liability)
- Custody revenue: ~$30M (0.3% fee)
- Return on capital: 3.75%
- Required return: 15%+
- RESULT: Don't offer crypto custody

The banking and crypto industries fought SAB 121 vigorously:

Congressional Action:
In 2024, Congress passed legislation to overturn SAB 121. President Biden vetoed it. This was one of only a few Biden vetoes.

Bank Workarounds:
Some banks (notably BNY Mellon) obtained SEC non-objection letters allowing different treatment. This was ad hoc, not systematic.

Industry Lobbying:
Banks and industry groups continuously pressured SEC to modify or rescind SAB 121.

In January 2025, the SEC rescinded SAB 121 and issued SAB 122.

Key Changes:

SAB 121 vs SAB 122

Issue                   | SAB 121        | SAB 122
------------------------|----------------|------------------
Balance sheet treatment | Required       | Traditional GAAP
Capital impact         | Major          | Minimal
Custody economics      | Broken         | Workable
Bank participation     | Limited        | Enabled

But Capital Still Matters:
SAB 122 fixed the custody problem but didn't fix the trading problem. Banks holding crypto as principal still face Basel capital charges. This shapes which activities banks pursue.

When a bank evaluates a crypto activity, it considers:

BANK CRYPTO ACTIVITY DECISION FRAMEWORK

1. IS IT PERMISSIBLE?

1. WILL IT BE SAFE AND SOUND?

1. WHAT'S THE CAPITAL IMPACT?

1. WHAT'S THE BUSINESS CASE?

1. DOES LEADERSHIP SUPPORT IT?

This framework explains current bank behavior:

• Permissible ✓

• Safe and sound achievable ✓

• Capital impact manageable (SAB 122) ✓

• Business case exists (client demand) ✓

• Leadership increasingly supportive ✓

• Permissible (limited) ~

• Safe and sound achievable (harder) ~

• Capital impact prohibitive (Basel) ✗

• Business case weak (after capital) ✗

• Leadership cautious ✗

XRP Custody:
Banks can custody XRP for clients. The legal framework supports it (IL 1170, 1183, 1184). The capital framework supports it (SAB 122). The question is client demand and bank priorities.

Stablecoin Positioning:
RLUSD, as a stablecoin, might qualify for Basel Group 1b treatment (lower capital charge) if it meets criteria. This could make bank RLUSD involvement more economical than XRP involvement.

Banking law creates a framework where some crypto activities are viable and others aren't. Custody works—it's legally permissible, examiners will accept it, and capital impact is manageable. Principal positions don't work—capital charges make the economics impossible. Understanding this distinction is essential for realistic expectations about bank XRP adoption. Banks will custody XRP if clients want it. Banks won't hold XRP as treasury assets until capital rules change.

Assignment: Analyze whether a specific hypothetical crypto activity would be permissible for a national bank under the OCC's incidental powers framework.

(This is essentially the ODL model offered by a bank rather than through Ripple partners.)

Requirements:

Part 1: Incidental Powers Analysis (400-500 words)

• Functional equivalence: Is this functionally equivalent to or a logical outgrowth of recognized bank activities?
• Convenient or useful: Does it facilitate products, enhance sales, improve efficiency, or avoid economic waste?
• Risk similarity: Are the risks similar to risks the bank already manages?

Provide reasoning for each element and reach a conclusion on permissibility.

Part 2: Safety and Soundness Considerations (200-300 words)

• Key risks the bank would need to manage
• Controls that would be required
• Expertise needed
• What examiners would likely focus on

Part 3: Capital and Economic Analysis (200-250 words)

• Would the bank need to hold XRP as principal? For how long?
• What Basel capital treatment would apply?
• Would the economics work given capital costs?

Part 4: Conclusion (100-150 words)

• Is this activity likely permissible?

• Is it economically viable?

• Would you expect banks to offer this service?

• Accuracy of legal framework application (35%)

• Thoroughness of risk analysis (25%)

• Quality of economic reasoning (25%)

• Clarity of conclusion and reasoning (15%)

Time investment: 2-3 hours
Value: Develops skill in evaluating bank activity permissibility—applicable to any future crypto-banking development

1. Incidental Powers (Tests Framework Knowledge):

Under the OCC's permissibility framework, which of the following would be a valid basis for approving a new bank activity?

A) The activity is highly profitable and shareholders want it
B) Competitors are offering the activity and the bank is losing market share
C) The activity is functionally equivalent to a recognized banking activity and poses similar risks
D) The SEC has determined the underlying asset is not a security

Correct Answer: C

Explanation: The OCC evaluates new activities under 12 C.F.R. § 7.1000(d), which asks whether the activity is functionally equivalent to recognized banking, convenient/useful for banking, and poses similar risks. Profitability (A) and competitive pressure (B) are business considerations but not legal bases for permissibility. SEC determinations (D) address securities law, not banking law—different regulatory frameworks. The OCC's framework focuses on functional analysis: Is this activity like what banks already do? This is why crypto custody was approved—it's functionally like traditional custody.

2. Safety and Soundness (Tests Conceptual Understanding):

A bank is legally permitted to offer a new service. Under what circumstances might the bank still face regulatory problems?

A) Only if the activity loses money
B) If examiners determine the bank lacks adequate risk management, controls, or expertise for the activity
C) Only if Congress passes a law specifically prohibiting the activity
D) If competitors offer the same service at lower prices

Correct Answer: B

Explanation: "Safety and soundness" is an ongoing operational standard, not just a one-time permission. Even for legally permissible activities, banks must conduct them safely and soundly. Examiners evaluate risk management, internal controls, and personnel expertise. A bank that launches a permissible activity without adequate infrastructure can face enforcement actions, cease-and-desist orders, or other penalties. Profitability (A) is not directly regulated. Congressional action (C) is not required for examiner enforcement. Competitive pricing (D) is a business issue, not regulatory.

3. Capital Requirements (Tests Quantitative Understanding):

Under Basel rules, a bank wants to hold $50 million in XRP as principal. XRP is classified as Group 2 (1,250% risk weight). Assuming an 8% capital requirement, approximately how much capital must the bank hold against this position?

A) $4 million
B) $50 million
C) $400 million
D) $500 million

Correct Answer: B

Explanation: Calculation: $50M × 1,250% risk weight = $625M risk-weighted assets. $625M × 8% capital requirement = $50M capital required. The 1,250% risk weight effectively means the bank must hold 100% capital against the position ($50M position requires $50M capital). This is why banks avoid holding Group 2 crypto as principal—the capital charge equals or exceeds the exposure. Option A would be a normal 100% risk weight asset. Options C and D are computational errors.

4. SAB 121/122 (Tests Historical Knowledge):

Why did SAB 121 prevent most banks from offering crypto custody services before its rescission?

A) SAB 121 explicitly prohibited banks from holding crypto
B) SAB 121 required banks to record custodied crypto as balance sheet liabilities, triggering capital requirements that made custody economically unviable
C) SAB 121 required SEC approval for each bank's custody program
D) SAB 121 imposed fees on crypto custody that exceeded revenue

Correct Answer: B

Explanation: SAB 121 didn't prohibit custody—it required accounting treatment (balance sheet liability recognition) that indirectly made custody uneconomic. Traditional custody doesn't require balance sheet recognition; client assets remain off the custodian's books. SAB 121 changed this for crypto, requiring banks to record both a liability and asset. This triggered bank capital requirements against the liability. For a bank custodying $10 billion in crypto, this meant ~$800 million in capital for a service generating perhaps $30 million in fees—destroying the economics. Option A is factually wrong. Option C is fabricated. Option D mischaracterizes the mechanism.

5. Strategic Implications (Tests Applied Analysis):

Based on current banking law and capital frameworks, which of the following bank crypto activities is most economically viable?

A) Proprietary trading in Bitcoin for profit
B) Custody of client crypto assets
C) Making loans collateralized by crypto
D) Using XRP as treasury working capital

Correct Answer: B

Explanation: Custody is the most viable because: (1) it's clearly permissible under OCC letters, (2) post-SAB 122, it doesn't require balance sheet recognition (minimal capital impact), and (3) client demand exists. Proprietary trading (A) would require holding crypto as principal, facing 1,250% Basel risk weights—economically prohibitive. Crypto-collateralized loans (C) require the bank to value volatile collateral and face potential losses if collateral value drops below loan value—significant risk management challenges. XRP as treasury capital (D) faces the same Basel Group 2 capital charges as trading. Custody is the path of least regulatory and economic resistance.

For Next Lesson:
Lesson 4 will examine the 2021-2024 "crypto crackdown" era in detail—how each regulatory action built on the previous, how the "pause letters" worked in practice, and how the environment evolved from theoretically permissive to effectively prohibitive. This historical understanding is essential for evaluating the durability of the 2025 reversal.

End of Lesson 3

Total words: ~5,500
Estimated completion time: 50 minutes reading + 2-3 hours for deliverable