Mr. Smith made a significant return on his investment

Mr. Smith made a significant return on his investment in several technology companies. As someone who worked in technology from the outset of his career, he knew the industry well and knew, in particular, that technology firms were not subject to much regulation. He used this to his advantage to “disrupt” areas of the industry which he felt were ripe for change.

He has decided that he wants to start a financial services company because he feels that the financial services industry is ripe for disruption. He lists some of his initial inclinations as follows:

  • He wants to put as little of his personal money into the company as possible, hoping to attract significant cash by way of deposits by clients. He estimates that he will fund the company with $5 million of his own money.
  • He understands that the best way to make money as a bank is on interest spreads between interest paid on deposits and interest received on loans, and he therefore wants to organize his company as a bank and trust company.
  • He estimates that, within 6 months of opening, he will be able to attract $50 million in deposits by new customers. A friend who is also a successful investor has already committed to depositing $15 million.
  • He targets lending $35 million to clients as commercial loans by month 9. He is confident he can get to this number because his wealthy friend, who currently has a loan of $20 million with another bank, has already agreed to move his loan to his friend’s bank once they open.
  • He wants to establish credit lines for clients to use to buy stock, and he thinks the total amount he would want to lend for stock borrowing by month 12 is $15 million.
  • To incentivize his employees, he wants to charge a fee to the borrower of 1% that would go directly to the employee as a “thank you” for getting them the loan.
  • He is unaware of the fact that state banks are required to keep a minimum of 10% in reserve, and that Federal Reserve member banks are required to  deposit 50% of their capital with the FRB for membership and then keep 7.5% reserve for time deposit liabilities and 10% for demand deposit liabilities in their FRB account.
  • He is also unaware that both state and member banks are subject to two important lending requirements under current rules. First, they must limit unsecured (uncollateralized) loans to no more than 25% of their deposit liabilities. Second, they are prohibited from lending for speculative stock-buying purposes.

Write an essay of between 750 and 1000 words in which you analyze the fact pattern above based on the principles of banking and financial institutions we have discussed so far in order to provide Mr. Smith with additional information and guidance. Be sure to identify the specific facts here that are problematic. In your conclusion, please indicate clearly whether Mr. Smith could meet his objectives as he proposes and, if not, which items in particular would have to be addressed.

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