Confirming an important regulatory concession Congress previously granted to community banks, the Federal Reserve Board recently amended its regulation and related Policy Statement governing “small bank holding companies” (SBHCs) to include companies up to $1 billion in total assets, up from $500 million. The Policy Statement now applies to about 90 percent of all U.S. bank holding companies.
Significance of the Change
This is good news for community banks because the regulation was designed to cut smaller banks and bank owners some slack when it comes to using internal leverage as a source of capital funding. Effectively, Congress has given community banks an “ownership” advantage to help balance against the marketplace advantages enjoyed by larger banks.
Key Benefit of SBHCs
The regulation basically exempts qualifying SBHCs (but not their bank subsidiaries) from the higher consolidated capital generally required for larger banks. Stated differently, the SBHC is deconsolidated from its bank subsidiary, such that only the subsidiary bank is subject to minimum capital ratios. This enables SBHCs to offset the investment inefficiency of maintaining excess capital at the bank level by incurring debt at the holding company level.
For shareholders, the principal advantage of the SBHC structure is that it allows the shareholder’s investment to be internally leveraged with holding company debt, which simultaneously reduces the amount of common equity required from shareholders to support the bank’s capital while increasing the shareholders’ return on the capital invested. Moreover, the cost to the issuer of debt capital is typically about half that of equity capital, partly because interest on the debt would be tax deductible whereas dividends on preferred stock would not. In addition, leverage provides a non-dilutive source of bank-level capital to support growth, as compared to common stock. Accordingly, taking advantage of the opportunities afforded to SBHCs can have a material and lasting impact on shareholder value.
An even more important attribute is operational flexibility, because management can readily tap holding company debt to meet common strategic challenges and opportunities, such as:
- Providing growth capital for a bank subsidiary,
- Buying another bank or branch, and
- Repurchasing stock to support shareholder liquidity.
These situations often demand more rapid and decisive action than might be possible if funding must wait for a successful equity stock offering, especially one undertaken in a small community. In fact, having ready access to capital funding through holding company debt could be the key resource that enables some community banks to preserve their independence. The 1,500 community banks without a bank holding company should consider this advantage as well.
Benefit for Subchapter S Banks
The SBHC advantage will be especially helpful for growing Subchapter S banks because it enables these banks to raise capital without affecting the constraints on numbers and types of shareholders permitted for S corporations.
Regulatory Leverage Limits and Conditions
Holding companies are not required normally to obtain regulatory approval to incur debt up to 100 percent of the holding company’s net equity (typically 50 percent of bank equity). The Policy Statement sets out various conditions and requirements that become applicable when debt exceeds that level or when the company has previously been instructed not to incur debt.
In practice, most SBHCs needing capital for any reasonable purpose (except perhaps to cover loan losses) will be eligible under the rule to borrow more money than their directors would have imagined possible or considered desirable. The limiting factor is more likely to be the marketplace’s appetite for the holding company’s debt rather than regulation.
Sources of Funding
The best resource for senior debt financing will often be an up-stream correspondent or bankers’ bank. These lenders normally expect borrowers to amortize principal over 5 to 10 years, maintain acceptable ratios throughout the financing period and pledge the bank stock owned by the holding company as collateral for the loan. Because of the latter requirement, these loans are often referred to as “bank stock” loans.
Longer term, less restrictive and unsecured or subordinated debt financing could also be sought from major shareholders or other local investors as well as from institutional investors. These instruments tend to provide more flexibility in terms (fixed vs. floating) and can be structured to include conversion features. Moreover, bank holding companies have the ability to issue subordinated debt without the onerous covenants and events of default typically inherent in senior debt instruments.
Well-managed community banks of tomorrow will wish to use every tool possible to deliver value for shareholders. The SBHC could prove to be the most important tool in the box for many smaller banks.