For many years, bankers have asked the question, “What size is the right size at which to sell a small community bank?” Some offer concrete asset size thresholds, while others offer more qualitative standards. We have always believed the best answer is “whatever size allows an acquirer’s profits and capital costs to deliver a better return than yours can.” While that answer is typically greeted with a scratch of the head, a recent change in law impacts the answer to that question for smaller companies. Given a proposed regulatory change by the Federal Reserve, a growing number of small bank holding companies will soon have lower cost of capital funding options that are not available to larger organizations.
President Obama recently signed into law an act meant to enhance “the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, and increase individual savings.” The new law directs the Board of Governors of the Federal Reserve System to amend its Small Bank Holding Company Policy Statement by increasing the policy’s consolidated assets threshold from $500 million to $1 billion and to include savings and loan holding companies of the same size. By design, more community banks will qualify for the advantages of being deemed a small bank holding company.
The Federal Reserve created the “small bank holding company” designation in 1980 when it published its Policy Statement for Assessing Financial Factors in the Formation of Small One-Bank Holding Companies Pursuant to the Bank Holding Company Act. The policy statement acknowledged the difficulty of transferring ownership in a small bank, and also acknowledged that the Federal Reserve historically had allowed certain institutions to form “small one-bank holding companies” with debt levels higher than otherwise would be permitted for larger or multibank holding companies. The first version of the policy statement had a number of criteria for what constituted a small bank holding company, most importantly that the holding company’s subsidiary bank have “total assets of approximately $150 million or less.” The asset threshold has been revised on several occasions, most recently in 2006 to the current level of $500 million in consolidated assets.
In light of this new law, the Federal Reserve has proposed these changes to its policy statement and recently announced parallel changes in reporting requirements for these small bank holding companies. The primary benefit of being deemed a “small bank holding company” is the exemption from the requirement to maintain consolidated regulatory capital ratios; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans, to finance growth.
This change should affect strategic and capital planning for all bank holding companies with consolidated assets of between $500 million and $1 billion and for all savings and loan holding companies with assets of less than $1 billion. These companies, which previously were required to comply with the capital requirements applicable to much larger institutions, can now use traditional debt at the holding company level to generate higher returns on equity. With trust preferred securities now a thing of the past, larger institutions cannot use debt or hybrid equity to meet their requirements for Tier 1 capital. Instead, larger institutions are left with traditional equity sources such as common stock and non-cumulative preferred stock, which typically carry a higher cost of capital.
Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.
Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth.
While new threshold has not received much press, we believe it could and should have an impact on merger discussions involving smaller institutions. Those companies that will soon be considered “small bank holding companies” should revisit their financial projections to consider whether introducing debt funding at the holding company can increase returns on equity without taking on unwarranted financial risk. Boards may find that this change makes the option of staying independent more viable in the future. Potential acquirers of small banks should also be aware of this change in order to demonstrate that a potential transaction provides a better risk-adjusted return to shareholders than remaining independent. On both sides of the transaction, this relatively quiet change should generate a new way of analyzing the question, “Is bigger really better?”
The greatest challenge to CEOs, chairmen and their boards will be how to generate acceptable returns to shareholders in the face of ever-growing compliance concerns and a continued sluggish economy with high unemployment and historically low interest rates. Without an administration change, 2013 promises to continue increasing and more stringent banking supervision and additional regulation, including consumer compliance initiatives and aggressive enforcement from the Consumer Financial Protection Bureau and new capital requirements from Basel III. This will not only impact decisions on day-to-day operations and planning but also shape thinking on mergers and acquisitions activity and the raising of capital. Specifically, if new capital rules are adopted, boards will need to explore the availability of capital, and whether capital can be raised at satisfactory pricing levels.
Talent. There is a shifting environment of constant change that is the new normal for how all businesses operate. Pressure is intensifying—from regulators to creative innovators who are bucking the traditional banking models trying to influence change. Bottom line, CEOs need to have the right talent in place to lead effectively—not only to confront the current challenges, but to create an organization with a connected culture to be the bank of the future.
The top challenge is that banks cannot earn their cost of capital in today’s environment. The combination of higher capital requirements, margin pressure due to extraordinarily low rates, slow economic growth and cost pressures associated with regulation translates into inadequate returns for shareholders. A CEO’s job is to outperform peers in this environment while making investors realize that these challenges will not last forever. In the event that a bank can’t operate more effectively than its peers, it is the CEO’s responsibility to his/her board to face that reality and proactively explore exit opportunities.
Notwithstanding the difficult business climate and the continuing economic challenges facing the banking industry today, the regulatory burden is the top strategic challenge facing bank management and boards today. While the reelection of Obama results in some certainty that the barrage of new regulations will continue, there continues to be considerable uncertainty. For example, what will the creation of the CFPB mean for community banks not directly regulated by the CFPB? What will happen with Basell III? Regulatory costs are also a significant factor when considering the optimal asset size to best leverage today’s cost of doing business. 
The entire U.S. banking industry breathed a collective sigh of relief recently when the three federal bank regulatory agencies postponed indefinitely the effective date of the Basel III capital and liquidity rules, which had been set for Jan. 1, 2013. The proposed rules, which would have applied more or less equally to all institutions—from the country’s largest bank, JPMorgan Chase & Co., to very small community banks in out-of-the-way rural locations—set off a firestorm of protest throughout industry.
Basel III is bearing down upon us. The U.S. bank regulators issued their final proposals to adopt Basel III capital standards on August 30, 2012. Numerous members of Congress, the industry and even senior officials at the Federal Deposit Insurance Corp. (FDIC) and the Comptroller of the Currency have expressed concerns about these proposals.On the other hand, the Basel Committee has expressed concerns about timely, consistent implementation of Basel III around the world. The U.S. bank regulators announced on November 9 that they would further consider the Basel III proposals, and that these would not become effective on January 1, 2013, as originally contemplated. 
Basel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.
If adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes. Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry. For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010. Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term. 
The impact will be positive in the long term. Basel III’s higher capital requirements will be phased in over a number of years. While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources. The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability. 
The real impact will be the change on Main Street. The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.
The implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.
Basel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking. Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting. Yet, the Basel accord now mandates it for the securities portfolio. The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans. Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions. Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.