The current momentum behind cannabis legalization, coupled with an ever-increasing need for financial services to support these new and booming businesses, has created an environment where financial institutions are simultaneously faced with an immense opportunity and a complicated challenge.  With varying state laws, shifting regulatory guidance and stalled legislation in Washington, it can be difficult to navigate the legal environment around cannabis banking.  Accordingly, we invited Nelson Mullins LLP Partners Brad Rustin and Craig Nazzaro, two leading experts on the subject, to share their thoughts on what financial institutions should focus on in 2021 and beyond. 

Mike Kennedy, Green Check Co-founder and Head of Product:  

Craig, being a former in-house chief compliance officer, you understand the burden and the opportunity that these financial institutions are facing when it comes to servicing the cannabis businesses in their community.  Putting your former compliance officer hat on, what would you say are the leading drivers for clients in choosing to work with the industry, and what are perhaps some risks that would preclude an institution from deciding to move forward?

Brad Rustin:

Perhaps most striking to me sitting on the outside is the number of banks and credit unions who are really interested in this space.  You’re seeing institutions that we work with who I would not have expected to show a lot of interest in cannabis-related businesses coming to us and saying, “hey, we have meaningful client relationships and we’re looking to accommodate this.  We see this as a growth area.  We see this as becoming an area of focus for the bank.”  

And I think that’s being driven by both societal acceptance, by regulatory and state legal acceptance , as well as the number of FinTechs and the sophistication of the industry increasing to a point that is making banks and credit unions much more comfortable in this space.   

Mike Kennedy:

What are you advising your clients to be mindful of and to take stock of as they build their program?

Craig Nazzaro:

When we see regulators come in and start to ask our clients about this space, or any high-risk area for banking, [it’s important] not only that the controls are there or that they contemplated what the risks were, but also how they did it? How did you document that properly?  It’s easy to say we discussed it in our risk committee meeting or that the compliance department changed their monitoring and testing protocols around certain aspects, but can you document how you presented it to the board and who the subject matter expert was?  Did you have that [subject matter expert] internally or did you go out and hire a consultant to come in and provide a risk analysis of their current regulatory framework? 

Those opportunities to document I always view as you collecting your armor and your weaponry for the supervision that’s going to come in the next year or two. 

Mike Kennedy:

Let’s talk about 2020.  It was a landmark year in a number of ways.  Prior to 2020, deposit growth was a large factor to why a financial institution would get into this business.  Well, with deposits at an all-time high and loan demand and net interest margins declining, what are you seeing as the impact to your clients in terms of the sheer number of institutions that are evaluating this space or those that have chosen to wade in during 2020?

Brad Rustin:

I think it’s really a retention issue as much as it is an acquisition issue.  To your point, a lot of the banks that historically were seeking out deposits, whether that be through partnerships or new business lines, now have too many deposits and can’t make revenue off of loans.  Okay, so what are you going to do?  Well, now you’re looking at fee-based products or other ways to generate revenue, so you’re looking at things like payment processing, third-party relationships, things that can generate fee revenue because your lending and your deposits are not going to be there for you right now.  A lot of these institutions are saying, “okay, if we are working in this space we may be able to get a loan and the competitiveness for that loan may not be the same as if we were doing CRE.  

If you think about what’s driving loan pricing right now, there’s extreme demand and you have collapsed prices.  Well, if suddenly 80% of your competitors are not willing to go into that space, then suddenly your loan pricing changes and you’re not having to be as cost competitive, and it’s the same thing on the payment side.  We have some of our banks that are large fintech payment players and the revenue related to MRBs when you’re in the payment space can be two to three times what you would get from a normal payment processing relationship. I think a lot of banks and credit unions are looking at that and saying, “wait a minute, this is a competitive advantage that may make traditional financial products more attractive to us as a bank.”

Mike Kennedy:

Let’s talk about lending for a minute.  There’s a small but growing number of institutions that are lending either to indirect cannabis businesses or to a lesser extent, direct plant-touching businesses.  Are you seeing that as well?

Brad Rustin:

Yeah.  We’ve had a lot more of that occurring.  I still think direct lending is by far lower than indirect lending, but we’re seeing more and more people playing in the direct lending space as well. 

Mike Kennedy:

And what do you attribute that to?  Is it the conditions you were just describing where it’s becoming more attractive because other options are less available, or is there an additional sense of comfort to how these loans can be structured to insulate the institution from undue risk? Or maybe both?

Brad Rustin:

I think it’s both, but I think what we’ve seen over the last few years is the second piece of that, which is the comfort that an institution has.  I hate to say it, but FinCEN was the greatest benefit to financial institutions looking to participate in any sort of financial relationship with cannabis-related businesses.  

According to FinCEN, six hundred of your peers are banking, depending on what month you’re looking at, various cannabis-related business enterprisesSimilarly, there’s guidance now.  We can have direct deposits into the Federal Reserve from dispensaries and other marijuana-related businesses.  

Even beyond that, we have state financial regulators who are encouraging banks to participate in this space. 

And candidly, the position that a lot of the banking and credit union regulators take then is that they would much rather have it in probably the most regulated, controlled space in America.  We can either have cash-intensive businesses that present systemic risk for the state programs, or we can put this in the regulated financial system where there are SARs and monitoring transactions and software platforms, etc.  Isn’t that better for the state in terms of the long-term health of their cannabis programs?  And so we’re actually seeing encouragement by regulators in this space.

Mike Kennedy:

What are some of the new or expanded controls that you are recommending clients to adopt or embrace as part of their BSA/AML functions?  What are the risks they’re controlling that are unique to the cannabis line of business that maybe they wouldn’t otherwise have if they were just looking at MSBs or other high-risk businesses?

Craig Nazzaro:

From a know-your-business perspective, it’s a lot further drill down on the inventory of the business or what exactly they are doing, even down to how the agreements are structured.  It’s one of the few businesses where there’s a very razor-thin line in certain states as to what is legal and what is not legal depending on the chemical compound of the product you’re selling, or the THC threshold.  It’s to that level which you need a solution to solve for the BSA/AML controls or the KYB controls, whereas in some other high-risk business silos you don’t necessarily need that granular level.  

A lot of these smaller banks or smaller clients that we have might have a small BSA/AML department, have a small compliance department, and they’re looking for tools to leverage for the enhanced due diligence that they need.  You see them looking for automation and looking for outsourcing where they can to bolster the subject matter expertise.  

Mike Kennedy:

Certainly. In fact, that’s the entire mission behind Green Check! We built a team of cannabis banking experts, centralized that expertise, and then productized the collection analyses of data for initial and ongoing due diligence, integrated with various cannabis industry systems, and built a set of tools for bankers to better manage their oversight activities.

Mike Kennedy:

Speaking of subject matter, one of the shifts that we’ve identified is that there’s been an increase in “subject matter experts” within the federal agencies, but I can’t say there’s been an increase in subject matter expertise.  They’re given the name. They’re given the directive, but I don’t necessarily think that they’re given the tools to really build up that expertise and serve as that point person for the region or for the agency.  So, the result is you’re left with a lot of mixed senses of priorities from different EICs.  Are you seeing that as well from your clients.

Brad Rustin:

Yeah.  The years in the 70s,  80s and 90s of calling up your examiners and saying “help us think about this business and how you’re going to look at it,” doesn’t apply here.   There’s too much complexity.  You need to build the elementary school textbook for your examiners.  Don’t call them up and ask them what their regulatory expectations are if you move into CRBs.  Instead, have the board presentations already done and at a level that the board could understand it.  Candidly, I don’t mean to knock on board members, but if you can explain it to a board member you can explain it to even the most new, freshly minted examiner.  And it’s the same thing with how you think about and document your BSA policies and how you think about your advertising in your statements to customers. Treat it as though [the examiners] don’t know about it.  Now to your point, I think now with more examiners being exposed to banks in this space, they’re getting more expertise.  

Craig Nazzaro:

I think also when we talked earlier about how you document your decision-making processes and when you’re looking to get into these spaces, we always view that as your first opportunity to start to shape the narrative of the exam that’s coming in 12 to 18 months.  So it may sound redundant to walk through the regulatory history and how you arrived at your decision, but keep in mind that the regulator, the EIC, is reading that.  Their team is reading that, and that’s forming their opinion of this space.  It could be their first time seeing this space, so you want them to walk through those materials and come away with an understanding of your thinking.  It’s much easier if they read that on their own. 

Mike Kennedy:

The SAFE Banking Act is  on everyone’s mind.  It passed again in the House for now the fourth time, but the first time in which we have a Democratic administration.  Do you individually or the firm collectively have an opinion or perspective on the SAFE Banking Act and what might be in store for 2021 or 2022?

Brad Rustin:

So as a firm no, but I was talking to a lobbying group yesterday and they had some pretty interesting perspectives they were sharing.  With SAFE Banking, it’s a little bit of a Band-Aid to a larger problem, which is that we can’t address this bigger question of what is the legal status of cannabis and cannabis-related products.  The current thinking by some of the lobbying groups that focus on the banking space is that there’s going to be a push in Q1 2022 towards broader legalization as part of a social justice and criminal penalty reform legislation package.  That’s why the Senate is sitting on SAFE Banking right now.  

Mike Kennedy:

Here’s what I like about SAFE, the stipulation that the FFIEC will produce exam procedures within 180 days of passing.  What do you see as the outcome if all of a sudden marijuana is descheduled?  Does the FFIEC still come in and produce those exam guidelines, are they bound to do so?  What do you think the future would hold if that bill were to go through?

Brad Rustin:

I think you’re still going to have FFIEC who’s going to try to issue guidance.  I don’t think there’s ever going to be a scenario where there is no regulatory overlay related to cannabis.  The whole idea that somehow if cannabis is descheduled the world is just free flowing at that point is not the reality of banking.  Instead, you’re going to still need some examination guidance.  It will probably be teed off of the FinCEN guidance, and you’re going to continue to have active monitoring.  There will be limits to what can and can’t occur, and you’re still going to have to, as a financial institution, make sure you’re playing within those rules.  I think in any event, there’s got to be a push for clear regulatory guidance around this beyond just FinCEN and the fight over whether the Cole Memo exists or doesn’t, that whole dance that we do every day in the banking world, to really provide that guidance, to really get more broad-level adoption within institutions.  I don’t think descheduling it changes that.

Craig Nazzaro:

I can make the argument that descheduling it creates an influx of banks into the space, which would be met with a higher level of scrutiny from the regulators themselves because the people that you have going in with eyes open now are engaging the likes of Green Check and are going to law firms to vet their entrance into the industry.  You’ll start to see entities and depositories coming in that are smaller in nature, with maybe one or two people in the compliance department.  They don’t change anything about their risk profile, and they don’t do anything with the controls around banking the entities or lending to the entities.  I think that will set the regulators off into, down a path of more scrutiny.

Mike Kennedy:

So Brad, Craig, do either of you have a clear view in your crystal ball where we are a year from now?

Craig Nazzaro:

A year from now I think you’re going to see the continuation of the trend toward legalization both adopted by more and more states as well as at the federal level getting closer to that.  In my mind, the way I think of that is not a solve-all for banking in this space.  It just takes one level of the risk out.  I do think that requires the same enhanced due diligence of other high-risk business lines, but I do think that that’s where we’re headed.  So I think some of the reputational risks would be diminished, a good portion of the regulatory risks will be diminished, but the compliance risks that are inherent in any high-risk business will remain and banks will have to adopt best practices of their peers or the space in general in order to be successful.

Brad Rustin:

I think you’re going to see more state and federal banking and credit union regulators pushing you to get into the space.

 This industry is growing to the point there’s enough dollars moving that it’s just like cryptocurrency.  The one thing the Fed hates more than anything in this world is untraced funds, and there’s one group of people who are really good at understanding the sources and destinations of funds, and that’s our nation’s financial institutions.  This idea that we’re going to continue to operate this industry on a cash basis as states start to legalize I think is ludicrous, and we’re already seeing state regulators pushing institutions to try to get in this space, bring it into the regulatory framework of mainline banking.   I think you’re going to see a lot more of that in the coming year.

Mike Kennedy:

Magic wand — what would you change,  and how would you do it?

Craig Nazzaro:

What I would change is just clear guidance. I am a fan of bright-line tests.  I am a fan of updated regulations even though it’s evolving and it’s hard to keep up with sometimes.  I like when there’s a significant amount of written guidance that you can follow that provides a framework that you can adopt so you’re not constantly guessing as to what the regulator’s threshold of acceptable risk is.  

Brad Rustin:

I’m going to say I would love for the Conference of State Bank Supervisors or the Uniform Code Commission to come out and say let’s standardize the states and come up with a model code or a CSBS regulatory structure for banking in cannabis.  This fragmentation where my credit union that’s located in Utah has different standards than California and New Mexico, it’s just driving the compliance risks through the roof and that’s not healthy for the industry, it’s not healthy for the banks and it’s not healthy for systemizing that process.