For the largest U.S. banks, the incentives and objectives of the current regulatory landscape are clear—you must shrink to reduce your regulatory burden and concurrently become less systemically important. However, for the vast majority of U.S. banks, those with less than $50 billion of assets (including the large majority of much smaller banks), the framework resulting from the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and other regulatory initiatives provides a much more muddled context for growth decisions.
Dodd-Frank imposes greater regulatory burdens on all banks, including the smallest U.S. institutions. Prudent organic or acquisitive growth is a typical way to increase economies of scale, and thus reduce the relative costs of such burdens. However, at the $1 billion, $10 billion and $50 billion asset thresholds, Dodd-Frank and the rest of the U.S. framework impose increasing regulatory burdens, offsetting the benefits of growth to at least a degree. The banking agencies have indicated little desire or ability to materially reduce these burdens.
This article is intended to assist community and regional bank leadership in the above asset level ranges to make informed judgments as to whether the benefits of a particular growth opportunity outweigh its regulatory burdens.
$1 Billion of Assets
In a 2014 survey published by the Mercatus Center at George Mason University, covering banks with a median asset size of $220 million, almost 60 percent of these banks stated that they were altering mortgage offerings in response to Dodd-Frank regulatory requirements, with a specific focus on the regulations of the Consumer Financial Protection Bureau (CFPB). The stated reason for these retrenchments is the increased compliance costs (including doubling of compliance staffing) after Dodd-Frank.
In the interest of completeness, it also should be noted that at $500 million of assets, a non-Dodd-Frank requirement applies—the Federal Deposit Insurance Corp.’s annual independence and reporting requirements for audit committees. However, the FDIC began implementing those rules in the 1990s, and the 2014 survey did not cite them as a disincentive to growth.
Thus, to reduce the Dodd-Frank burdens, there appears to be a significant scale advantage in a small community bank prudently growing to close to $1 billion of assets. Moreover, as discussed in the next section, if a less than $1 billion bank or thrift does not have a holding company, the Federal Reserve Board recently provided a substantial funding benefit to such a bank establishing one.
$1 Billion to $10 Billion of Assets
Until recently, there was no regulatory disincentive to a bank holding company or savings and loan holding company crossing $1 billion of assets. However, on May 15, 2015, the Federal Reserve Board’s revised Small Bank Holding Company Policy Statement (the Policy Statement) becomes effective. The revised Policy Statement increases the asset threshold of institutions to which its benefits apply from $500 million to $1 billion.
Subject to certain limitations, the revised policy statement excludes holding companies (but not their underlying banks/thrifts) with less than $1 billion of consolidated assets from the risk-weighted and leverage capital requirements (further heightened by Dodd-Frank) that apply to larger holding companies. This capital requirement elimination makes it much cheaper for these holding companies to raise funds for acquisitions and other activities (including replacing more costly capital instruments), principally by enabling them to issue more senior debt. In this regard, an analysis by a prominent investment bank states that the Policy Statement will allow up to 3:1 senior debt to equity funding, which could lower an eligible holding company’s weighted average cost of capital to 6.15 percent compared to 12 percent for exclusively common equity funding.
Given this funding advantage, a holding company with assets approaching $1 billion must carefully evaluate any growth strategy. On the one hand, growth above $1 billion should provide important economies of scale to reduce the impact of Dodd-Frank’s enhanced compliance burdens. On the other hand, growth above $1 billion of assets will remove an important funding advantage (i.e., greater use of senior debt) that less-than-$1 billion asset institutions have over larger competitors.
There also is a new Dodd-Frank Act-required compensation rule to consider if a bank goes above $1 billion in assets. All banks and thrifts at that level will have to disclose more about their compensation practices, including their incentive pay practices, in a rule proposed in 2011 by joint banking regulatory bodies, but not yet implemented.
$10 Billion to $50 Billion of Assets
Crossing $10 billion
Dodd-Frank’s asset size-triggered burdens first truly apply to a banking institution crossing $10 billion of assets. Rather than simply being subject to CFPB regulations as administered by their primary bank regulator (as occurs with less than $10 billion asset banks), the CFPB itself examines institutions above $10 billion. Many of our clients have commented that the CFPB moves much more rapidly to burdensome and costly enforcement actions than their primary bank regulators, and even have taken the added precaution of asking us to perform pre-exam reviews to reduce the likelihood of such actions.
Moreover, these institutions for the first time become subject to mandatory regulatory stress testing. These stress tests impose systems and operational burdens, and also can impair the institution’s reputation because it must publish the results. If the institution is publicly traded, and most banks above this level are, it is required to establish a stand-alone risk committee with a “risk” expert as defined in the statute. Finally, the Dodd-Frank Durbin Amendment applies to these banks. By capping the interchange fees that banks issuing debit cards can charge on merchant transactions at about half of their previous level, the Durbin Amendment costs the banking industry about $8 billion per year. Crossing the $10 billion asset threshold thus can be particularly costly for banks that are significant debit card sponsors.
Approaching $50 billion
Although efforts to raise this threshold are under way, Dodd-Frank currently imposes its most substantial asset-based enhanced burdens at the $50 billion asset level. However, banks with assets even $10 billion or more below that level, and experiencing or contemplating material growth, may consider preparing for, and even implementing, elements of this enhanced framework. These banks thereby can seek both to protect themselves from adverse regulatory action by demonstrating a commitment to “best practices,” and to position themselves for prompt regulatory approval of growth opportunities if they cross $50 billion, by showing an ability to satisfy the enhanced requirements.
Because the enhanced burdens at $50 billion are material, publicly traded banks further face difficult disclosure decisions. Publicly traded banks approaching $50 billion, and even those banks well below $50 billion, need to consider and review their disclosure as a whole—from regulation and supervision disclosure to Risk Factors and Management’s Discussion and Analysis (MD&A) disclosure in offering documents and ongoing reports —to reflect the full scope of the impact of approaching and eventually crossing $50 billion. The Securities and Exchange Commission (SEC) regularly issues comments to banks requesting additional discussion of the impact of heightened prudential standards and increased compliance expense that result upon crossing $50 billion. Disclosure procedures for these banks also need to be reviewed to integrate Basel III’s Pillar 3 reporting standards into existing disclosure review procedures. For example, while final Basel III Pillar 3 rules provide banks flexibility on how to make Pillar 3 disclosure, this flexibility raises questions about whether to include Basel III Pillar 3 disclosures in SEC reports, whether to furnish or file these Pillar 3 disclosures with the SEC, and whether and how to incorporate these Pillar 3 disclosures into securities offering documentation.
As the above indicates, while Dodd-Frank largely focuses on the biggest U.S. banks, the current regulatory framework also requires complex analyses by community and regional banks as to whether particular opportunities are worth the enhanced compliance burdens they may raise.
Gregory Lyons of Debevoise discusses the nuances of different asset thresholds and what banks must consider. Video length: 6 minutes