Regulatory Reform Should Spur Consolidation

Edward D. Herlihy and Richard K. Kim are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell publication.

[The May 22, 2018] passage by the House of Representatives of a bill raising the “SIFI threshold”—the threshold for banks to be deemed systemically important financial institutions and subject to more burdensome regulation—from $50 billion to $250 billion brings welcome relief that should spur bank M&A activity. Now that the bill has passed both chambers of Congress, all that remains is for the President to sign it in order for the Economic Growth, Regulatory Relief and Consumer Protection to become law. He is expected to do so prior to Memorial Day. No other factor has had more of an impact on bank M&A than regulation and this will be the first piece of legislation passed in nearly twenty years that is aimed at encouraging, rather than deterring, bank consolidation.

In 1998, the aggregate deal value of U.S. bank M&A was in excess of $275 billion. This was of course the year of the mega-mergers—Bank of America merging with NationsBank, Wells Fargo merging with Norwest and Citicorp merging with Travelers. In subsequent years, aggregate deal value for bank M&A occasionally exceeded $100 billion (e.g., $130 billion in 2004 and $111 billion in 2006). All of this changed following the financial crisis and the regulatory onslaught that followed. Over the past three years, aggregate deal value has been less than 10% of 1998’s all-time peak. The sharp decrease in bank M&A is directly attributable to regulation:

  1. The largest banks—JP Morgan, Bank of America and Wells Fargo—are now permanently sidelined from acquiring banks because they exceed the 10% deposit cap. That limit bars any bank with more than 10% of nationwide deposits from acquiring additional banks; however, it does not limit their ability to grow organically. The limit was arbitrarily set by Congress in 1994 as part of a legislative compromise that permitted nationwide banking.
  2. The large acquisitive regional and foreign banks that powered a substantial portion of bank M&A every year have been put in the regulatory penalty box for years at a time. The absence of large acquirers from the market affects deal activity at all levels—a gap in the food chain affects all links.
  3. At the community bank level, the regulators have slowed the pace of frequent acquirers by also putting them in the penalty box and slowing the pace of acquisitions when they are out. Unlike in other industries, attempting more than one bank acquisition per year frequently draws regulatory concerns about management bandwidth. Rather than reduce risk, this policy has had the unintended effect of encouraging acquirers to focus on larger targets—limiting buyers to fewer bites incents them to take bigger ones.
  4. More broadly, the post-crisis crush of new regulations and the unprecedented wave of enforcement actions has put banks on the defensive. There is greater anxiety in entering into a merger that may not be well received by the regulators or the markets. Similarly, there is more focus on the immediate market reaction to a potential merger, especially its tangible book value earnback period, than on the strategic merits of the transaction.

The bill passed today by the House, while not a panacea, is a step in the right direction. It offers regulatory relief for all but the largest banks. Below is a brief overview of its principal provisions.

Banks < $3 Billion in Assets

  • Qualify for the Federal Reserve’s Small Bank Policy Statement which was previously limited to banks with less than $1 billion in assets (exempt from Basel III and greater flexibility to use debt in acquisitions)
  • 18-month examination cycle if well managed and well capitalized

Banks < $10 Billion in Assets

  • Exempt from the Volcker Rule
  • Mortgage loans originated and retained are “qualified mortgages” for purposes of the Truth in Lending Act
  • Can opt into a community bank leverage ratio (to be set by the regulators between 8% and 10%) which would replace all other capital and leverage ratios
  • Leaves intact the Durbin cap on debit card interchange fees crosses the $250 billion threshold

Banks ≤ $20 Billion in Assets

  • Federal savings associations can elect to operate with the same powers as a national bank without converting their charters
  • In that event, the Qualified Thrift Lender test would no longer apply and federal savings associations would be able to engage in commercial lending on the same footing as commercial banks

Banks < $50 Billion in Assets

  • “SIFI threshold” (e.g., the Federal Reserve’s enhanced prudential standards—most notably the CCAR stress test as well as heightened risk management and liquidity standards) would be increased from $50 billion to $250 billion
  • Bank holding companies with total assets between $50 billion and $100 billion would be exempt immediately
  • Bank holding companies with total assets between $100 billion and $250 billion would be exempt 18 months after enactment (unless exempted earlier by the Federal Reserve)
  • The Federal Reserve has the authority to impose SIFI limitations on a case-by-case basis
  • The Federal Reserve is required to conduct a periodic supervisory stress test

While these changes are not as dramatic as the industry may have hoped, they are significant. The $50 billion threshold has been a powerful deterrent to bank M&A. Since the passage of Dodd-Frank in 2010, only one bank holding company has crossed the $50 billion threshold as a result of an acquisition—CIT through its acquisition of OneWest in 2015. As a practical matter, the $50 billion threshold even deterred mergers where the combined company would exceed $40 billion as the company would then have to demonstrate to its regulators its readiness to cross the $50 billion threshold. For banks above the $50 billion threshold, the complexity and uncertainties of the CCAR stress test also other necessary factors for bank M&A appear to be falling into place:

  • The gradual easing of the regulatory environment by the new leadership at the banking agencies will continue to result in regional and foreign banks leaving the penalty box. Going forward, penalty box stays should be less frequent and shorter in duration.
  • There is a growing confidence that bank M&A deals will receive regulatory approval and in a shorter time-frame. The regulators are resolving protests from community groups more quickly and making it clear that there is no need to reach agreement with them in order to win approval.
  • The competition for deposits has intensified with rising interest rates and greater investor focus on deposit betas. Heightened competition from money market mutual funds as well as the retail banking arms of the “Big Three” banks (JP Morgan, Bank of America and Wells Fargo) and online banks pose an increasing competitive threat to regional and community banks.
  • There is a demonstrated preference by millennials for large banks with sophisticated digital platforms.
  • Increasing investments in marketing, technology and cybersecurity also favor consolidation.

Taken together, these factors should drive a material increase in deal activity, particularly in larger transactions which have been scarce in recent years.

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