Two Distinct Duties: Holding Company vs. Bank Boards

It wasn’t too long ago that banks were restricted from conducting business outside their home state.  But some institutions found a workaround: Bank holding companies offered a way to operate in multiple states, leading Congress to pass the Bank Holding Company Act of 1956. Regulators also wanted to limit banks’ ability to own nonbank firms like a manufacturing company or retailer, which could have allowed them to influence borrowers to patronize those subsidiaries or use deposits to make loans to those businesses, according to Joe Mahon of the Federal Reserve Bank of Minneapolis. 

Interstate banking has been the norm since the 1980s, and the Bank Holding Company Act has been modified several times since its 1956 passage. But generally, the law clarifies the purpose of a bank holding company and gives the Federal Reserve broad powers to supervise these companies. 

Recently, with the failure of Silicon Valley Bank, questions have been raised about a holding company’s role as a source of financial strength. The Santa Clara, California-based bank’s holding company, SVB Financial Group, remained in operation as of Sept. 7, 2023. 

But even in normal circumstances, a holding company presents distinct governance considerations for boards. 

Why Have a Bank Holding Company?
A bank holding company’s primary purpose is to hold stock, or ownership, in a bank. 

Banks don’t have to be held by a holding company — notable examples of banks without holding companies include Little Rock, Arkansas-based Bank OZK, with $31 billion in assets, and $87 billion Zions Bancorp., in Salt Lake City, which merged its holding company into its bank in 2018. Zions said at the time that the consolidation would improve efficiency and cut down on duplicative regulatory examinations. 

A holding company structure eases an organization’s ability to borrow or raise money, and “inject it down into the bank,” says Andrew Gibbs, a senior vice president at Mercer Capital who leads the advisory firm’s deposit institutions group. Equity plans, including employee stock ownership programs, could be easier to manage via a holding company. For smaller banks below $15 billion in assets, it also changes what counts as regulatory capital.

“One of the benefits of bank holding company status is the ability to count securities like trust preferred securities as regulatory capital,” says Gibbs. Zions and Bank OZK didn’t receive those capital advantages due to their size.

A holding company structure also allows a bank to engage in a broader array of activities. “A bank holding company can invest in any kind of company, so long as it holds less than 5% of voting stock of that company,” says Samantha Kirby, partner and co-chair of the banking and consumer financial services practice at Goodwin Procter. Those investments can include fintechs. In Bank Director’s 2023 Bank M&A Survey, conducted last fall, 9% of bank executives and board members reported that their organization had directly invested in fintech companies in 2021-22. 

If a bank holding company wants to offer a broader selection of financial services, such as investment banking or insurance, the board can elect to become a financial holding company, a separate designation created in 1999 via the Gramm–Leach–Bliley Act. 

A bank holding company can also serve as a financial source of strength for the bank, referencing a doctrine that was reinforced in Section 616 of the Dodd-Frank Act, which amended the Bank Holding Company Act. Put simply, the holding company should provide financial support to its insured bank subsidiary “in the event of the financial distress” of that institution. 

James Stevens, a Georgia-based partner at Troutman Pepper, witnessed a number of bank failures in that state during the 2008 financial crisis. Bank holding companies were expected to ensure their subsidiary bank had enough capital to survive. “If a subsidiary bank needs capital, and the bank holding company has additional capital that could be injected into the bank, it is supposed to push that capital into the bank under the source of strength doctrine,” he says. “If a bank holding company doesn’t do that, its board could be subject to criticism from regulators.”

Investors often prefer that capital be held at the holding company rather than at the bank. Gibbs explains that pulling capital out of the bank generally requires regulatory approval, so large capital activities — like dividends — are best handled at the holding company level. “It’s generally easier to keep [capital] at the holding company, and then you don’t need to deal with [the] regulatory process to extract it from the bank, if the bank has too much capital.”

Know Your Role
Both holding company and bank boards have the same fiduciary duties to shareholders, says Kirby, meaning the directors of both boards have a legal and ethical responsibility to act in the best interests of the company’s owners. That said, bank and holding company boards have distinct responsibilities, and directors should have a “clear understanding of whether they are serving on the bank board or on the holding company board, or both,” she says. It sounds basic, but sometimes that line isn’t clear.

Often, the boards mirror one another, but it’s not uncommon for a member or two to serve on just one of the boards. For example, it’s fairly routine for a private equity investor to only serve on the holding company board where they can focus on the overall direction of the company. And sometimes, the holding company and bank boards could be two entirely different groups. 

According to Bank Director’s 2023 Compensation Survey, holding companies and banks tend to have the same number of members, at a median of 10. Bank boards meet a little more frequently, at a median 12 times a year versus 10 meetings for the holding company board.

The bank board should focus on the bank’s activities — put simply, strategies, policies and risks related to the bank’s business of making loans and taking deposits. “Bank regulators will not find it acceptable if the bank holding company is the one that’s managing the risk,” says Stevens. “Same thing with audit and compliance management, and the scope of internal audit. … They want the bank board to be focused on those things.”  

Stevens describes the structure as one that’s “bottom up,” as the bank board makes important decisions about the business, and the holding company makes higher level decisions about strategy — capital allocation and deployment, or prospective M&A activity. “What’s the risk management framework? What’s our internal audit going to look like? Who has lending authority?” says Stevens. “That stuff has got to be at the bank.” 

The holding company typically can add or remove directors from the bank board. “The process and authority depend on the articles and bylaws of the bank,” says Stevens, “but generally the bank holding company, as the sole shareholder of the bank, has the power to change the composition of the bank board.”

Separate Agendas, Minutes
No matter the makeup of the holding company and bank boards, both Kirby and Stevens say it’s important that deliberations — which board is taking action on what — are clearly documented. 

Ideally, the bank board and the holding company board would have two distinct agendas, and two sets of minutes. 

Stevens sometimes sees mirrored boards make joint resolutions. But he says it can get complicated when the two boards aren’t composed of the same directors. “You have to be thoughtful, if you have separate groups, that you’ve got the right people in the room to make the decisions that impact those fundamental banking decisions.”

That isn’t to say that members of the holding company board won’t sit in on the bank board meeting, or vice versa, says Kirby. But, when it comes time for formal action, that should be taken by the appropriate board.

Revisit Your Structure
Choosing to adopt a bank or financial holding company structure — or not — should be a decision informed by the bank’s strategy. Kirby recommends that this be part of the board’s annual strategic discussions. Consider whether the bank has the right structure to pursue its strategic goals and facilitate its growth. 

While the difference between the two boards, holding company and bank, may appear trivial, getting governance right makes a difference on regulatory examinations. The board’s effectiveness factors into a bank’s CAMELS rating, short for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. The board falls under the management pillar. 

“You want to have this buttoned up, and [you] don’t want to get criticized for it,” says Stevens. “If you’re being examined, and you’re on the cusp of being a three or a four, you don’t want the corporate governance issue to move you from a three to a four CAMELS rating. … It’s not a place for boards to be creative and make mistakes.”  

Additional Resources
Bank Director’s 2023 Compensation Survey, sponsored by Chartwell Partners, surveyed 289 independent directors, CEOs, human resources officers and other executives of U.S. banks below $100 billion in assets to understand how they’re addressing talent challenges, succession planning and CEO performance. Compensation data for directors, non-executive chairs and CEOs for fiscal year 2022 was also collected from the proxy statements of 102 public banks. Members of the Bank Services Program have exclusive access to the complete results of the survey, which was conducted in March and April 2023.

Bank Director’s 2023 Bank M&A Survey, sponsored by Crowe LLP, surveyed 250 independent directors, CEOs, chief financial officers and other senior executives of U.S. banks below $100 billion in assets to examine current growth strategies, particularly M&A. Members of the Bank Services Program can access the complete results of the survey, which was conducted in September 2022.

Weighing the Value of a Bank Holding Company

governance-6-24-19.pngIn May, Northeast Bank became the fourth banking organization in two years to eliminate its holding company. Northeast joins Zions Bancorporation, N.A., BancorpSouth Bank and Bank OZK in forgoing their holding companies.

All of the restructurings were motivated in part by improved efficiencies that eliminated redundant corporate infrastructure and activities. The moves also removed a second level of supervision by the Federal Reserve Board. Bank specific reasons may also drive the decision to eliminate a holding company.

Zions successfully petitioned to be de-designated as a systemically important financial institution in connection with its holding company elimination. In its announcement, Northeast replaced commitments it made to the Fed with policies and procedures relating to its capital levels and loan composition that should allow for more loan growth in the long run.

Banks are weighing the role their holding companies play in daily operations. Some maintain the structure in order to engage in activities that are not permissible at the bank level. Others may not have considered the issue. Now may be a good time to ask: Is the holding company worth it?

Defined Corporate Governance
Holding companies are typically organized as business corporations under state corporate law, which often provides more clarity than banking law for matters such as indemnification, anti-takeover protections and shareholder rights.

Transaction Flexibility
Holding companies provide flexibility in structuring strategic transactions because they can operate acquired banks as separate subsidiaries. This setup might be desirable for potential partners because it keeps the target’s legal and corporate identity, board and management structure. But even without a holding company, banks can still preserve the identity of a strategic partner by operating it as a division of the surviving bank.

Additional Governance Requirements
A holding company’s status as a separate legal entity subjects it to additional corporate governance and recordkeeping requirements. A holding company must hold separate board of directors and committee meetings with separate minutes, enter into expense-sharing and tax-sharing agreements with its bank subsidiary and observe other corporate formalities to maintain separate corporate identities. In addition, the relationship between the holding company and its subsidiary bank is subject to Section 23A and Section 23B of the Federal Reserve Act, an additional regulatory compliance burden.

Additional Regulatory Oversight
Holding companies are also subject to the Fed’s supervision, examination and reporting requirements, which carry additional compliance costs and consume significant management attention. The Fed also expects bank holding companies to serve as a source of financial strength to their subsidiary banks, an expectation that was formalized in the Dodd-Frank Act.

Diminished Capital Advantages
Historically, holding companies could issue Tier 1 capital instruments that were not feasible or permissible for their bank subsidiaries, such as trust preferred securities and cumulative perpetual preferred stock. They also enjoyed additional flexibility to redeem capital, an advantage that has largely been eliminated by the Basel III rulemaking and Fed supervisory requirements. A holding company with existing grandfathered trust preferred securities or with registered DRIPs may find them useful capital management tools. Holding companies with less than $3 billion in consolidated assets that qualify under the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement are not subject to the Fed’s risk-based capital rules. These companies are permitted to have higher levels of debt than other holding companies and banks.

Broader Activities, Investments
Bank holding companies, especially those that elect to be financial holding companies, can engage in non-banking activities and activities that are financial in nature through non-bank subsidiaries that are bank affiliates. In some cases, these activities may not be bank permissible, such as insurance underwriting and merchant banking. The Fed also has authority to approve additional activities that are financial in nature or incidental or complementary to a financial activity on a case-by-case basis.

Bank holding companies can also make passive, non-controlling minority investments that do not exceed 5 percent of any class of voting securities in any company, regardless of that company’s activities. By comparison, banks are limited to making investments in companies that are engaged solely in bank-permissible activities or must rely on authorities such as community development or public welfare authority to make investments. Banks may also have limited leeway authority to invest in specific securities or types of securities designated under the applicable state banking law or by the applicable state banking regulator.

Banks that are not interested in activities or investment opportunities available to holding companies may be less concerned about eliminating the structure. But an organization that engages in activities at the holding company level that are not permissible for banks or that desires to maintain its grandfathered rights as a unitary savings and loan holding company may not wish to eliminate its holding company.

Operating without a holding company would result in more streamlined regulatory oversight, corporate governance and recordkeeping processes. But a holding company provides the flexibility to engage in activities, to make investments and to create structures that a bank may not. Bank boards should weigh these costs and benefits carefully against their strategic and capital management plans.

Exclusive: The Inside Story of Colorado’s Leading Bank

bank-4-25-19.pngGreat leaders are eager to learn from others, even their competitors. That’s why Bank Director is making available—exclusively to members of our Bank Services program—the unabridged transcripts of in-depth conversations our writers have with the executives of top-performing banks.

One such bank is FirstBank Holding Co.

With $18.5 billion in assets, FirstBank is the third-largest privately-held bank in the United States and the biggest bank based in Colorado, where its headquarters sits 10 miles west of downtown Denver. It’s among the most efficient institutions in the industry, with an efficiency ratio often dipping below 50 percent. It has an abundance of risk-based capital. And its return on equity has ranked in the top 10 percent of large bank holding companies in all but one of the past 12 years.

Bank Director’s executive editor, John J. Maxfield, interviewed FirstBank’s CEO Jim Reuter and Chief Operating Officer Emily Robinson for the second quarter 2019 issue of Bank Director magazine. (You can read that story, “How FirstBank Profits from Being Private,” by clicking here.)

In the interview, Reuter and Robinson shed light on:

  • The benefits of being a privately-held bank
  • How FirstBank became a leader in the digital evolution of banking
  • Strategies to stay disciplined at the top of the cycle
  • The advantage of having three former FirstBank CEOs serving on the board
  • Their philosophy on capital management and allocation

The interview has been edited for brevity, clarity and flow.

download.png Download transcript for the full exclusive interview

Twelve Steps for Successful Acquisitions

acquisition-11-21-18.pngOftentimes bankers and research analysts espouse the track records of acquisitive banks by focusing on the outcomes of transactions, not the work that went into getting them announced. As you and your board consider growing your bank franchise via purchases of, or mergers with, other banks, consider these steps as a guideline to better outcomes:

  1. Prepare your management team
    Does your team have any track record in courting, negotiating, closing and integrating a merger? If not, perhaps adding to your team is warranted.
  2. Prepare your board
    Understand what your financial goals and stress-points are, create a subcommittee to work with management on strategy, get educated about merger contracts and fiduciary obligations.
  3. Prepare your largest shareholders
    In many privately held banks there are large shareholders, families or individuals, who would have their ownership diluted if stock were used as currency to pay for another bank. It is important to get their support on your strategy as the value of their holdings will be impacted (hopefully positively) by your actions.
  4. Prepare your employees 
    While you cannot be specific about your targets until you need to broaden the “circle of trust,” let key employees know that their organization wants to grow via purchases. They will deal with the day-to-day reality of integration, get them excited that your organization is one they want to be with long-term.
  5. Prepare your counsel
    Just as some bankers focus on commercial or consumer loans, some law firms focus on regulatory matters, loan documents or corporate finance. Does your current counsel have demonstrated experience in merger processes? In addition, your counsel should help to educate your Board about the steps required to complete a transaction.
  6. Prepare the Street
    We have seen in recent months several large bank acquisitions announced where the market was unpleasantly surprised; a bank they viewed as a seller suddenly became a buyer. Some of these companies have since underperformed the broader bank market by 5 to 10 percent. If it has been several years between acquisitions, prep the market beforehand that you might resume the strategy. BB&T recently laid parameters for going back on the acquisition trail. And while their stock was down some on the news, it has since more than recovered.
  7. Prepare your IT providers 
    Most customers are lost when you close your transaction by the small annoyances that come with a systems conversion. Understand if your current core systems have additional capacity or begin to get systems in place that can grow as you grow.
  8. Prepare your regulator(s)
    Whether it is the state, the FDIC, OCC or the Fed, they generally do not like surprises. Get some soft guidance from them on their expectations for capital levels and growth rates. Before you formally announce any merger, with your counsel, give the regulators a courtesy heads-up.
  9. Prepare your rating agency
    If you are a rated bank, think about your debt holders as well as equity holders, especially if you need access to acquisition financing. Share with them the broad plan of growth and your tolerances for goodwill and other negative capital events.
  10. Prepare your financing sources
    Do you have a line-of-credit in place at the holding company that could be drawn to finance the cash portion of acquisition consideration? Have you demonstrated that you can fund in the senior or subordinated debt markets, perhaps by pre-funding capital? Are there large shareholders willing to commit more equity to your strategy?
  11. Prepare your targets
    If the Street does not know, and your shareholders do not know, and your bankers and lawyers do not know, then the targets you might have in mind also will not know you are a buyer. Courting another CEO is a time-consuming process, but completely necessary and should be started 12-18 months before you are in the position to pull the trigger. Your goal is to be on their “A” list of calls, and have the chance to compete, either exclusively or in a controlled auction process.
  12. Prepare to walk away 
    After you have done all this work, it is easy to get “deal fever” when that first process comes along. Sometimes you need to recognize it is a trial run for the real thing and be prepared to pack your bags and go home. The best deal most companies have ever done is the one they didn’t do.

How The Fed Changed The Game for Private Banks

stock-11-20-18.pngIn late August 2018, the Federal Reserve issued an interim final rule increasing the asset threshold from $1 billion to $3 billion under the Fed’s Small Bank Holding Company Policy Statement. The interim policy now covers almost 95 percent of the financial institutions in the U.S., significantly enhances the flexibility in capital structure, acquisitions, stock repurchases and ownership transfers, among other things, for institutions organized under a holding company structure.

No Consolidated Capital Treatment
The most significant benefit of small bank holding company status is that qualifying banks are not subject to consolidated capital rules. Instead, regulatory capital is evaluated only at the subsidiary bank level. As a result, small bank holding companies have the unique ability to issue debt at the holding company level and contribute the proceeds to its subsidiary bank as Tier 1 common equity without adversely impacting the regulatory capital condition of the holding company or the bank. Due to the expanded coverage of the new rule, banking organizations with up to $3 billion in assets can now take advantage of this benefit to support organic and acquisitive growth, stock repurchases and other corporate transactions.
Acquisition Leverage

Perhaps the most significant application of this benefit is in acquisitions by private institutions, whose equity may be less attractive or undesirable acquisition currency. For these institutions, an acquisition of any scale often requires additional capital, and, without access to public capital markets, utilizing leverage may represent the only viable option to fund the transaction.

Under the Small Bank Holding Company Policy Statement, an acquiring bank holding company may fund up to 75 percent of the purchase price of a target with debt, which equates to a maximum debt to equity ratio of 3-to-1, so long as the acquirer can reduce its debt to equity ratio to less than 0.3-to-1 within 12 years and fully repay the debt within 25 years. The enhanced ability to utilize debt in this context is designed to enable private holding companies to be more competitive with other institutions who have access to the public capital markets or who have a public currency to exchange.

Stock Repurchases
Ownership succession also remains a critical issue for many private holding companies, and the new rule extends the ability to use debt to enhance shareholder liquidity to an expanded group of organizations. In many cases, and especially for larger blocks of stock, a holding company represents the only prospective acquirer for privately-held shares. By using debt to fund stock repurchases, a small bank holding company can create liquidity to a selling shareholder, while providing a benefit to the remaining shareholders through the increase in their percentage ownership.

Moreover, stock repurchases often present themselves at times and in amounts that make equity offerings a less suitable alternative for funding. Finally, as discussed below, stock repurchases can be utilized to enhance shareholder value.

Attractiveness to Investors
While the new rule increases the operating flexibility of banking organizations by providing additional tools for corporate transactions, the use of leverage as part of an organization’s capital structure also results in a number of meaningful benefits to shareholders. First, holding company leverage, whether structured as senior or subordinated debt, generally carries a significantly lower cost of capital, as compared to equity instruments. The issuance of debt is non-dilutive to common shareholders, which means existing shareholders can realize the full benefit associated with corporate growth or stock repurchases funded through leverage without having to spread those benefits over a larger group of equity holders. In addition, unlike dividends, interest payments associated with holding company debt are tax deductible, which lowers the effective cost of the debt. Accordingly, funding growth or attractively priced stock repurchases through leverage can be immediately accretive to shareholders.

Final Thoughts
Funding growth, stock repurchases and other corporate transactions can be a challenge for banking organizations that do not have access to public capital markets or have a public currency. However, the revised Small Bank Holding Company Policy Statement provides management teams and boards of directors with additional tools to fund corporate activities and growth, manage regulatory capital, and enhance shareholder liquidity and value.

Do You Really Need a Bank Holding Company?

holding-company-2-23-18.pngThe boards of directors at three, multibillion-dollar, publicly traded banks recently chose to get rid of their holding companies. Bank of the Ozarks, BancorpSouth and Zions Bank, N.A. are now or soon will be stand-alone, publicly traded banks. For years, Republic Bank and Signature Bank have also operated as publicly traded banks without a holding company.

According to the public filings of Ozarks and BancorpSouth, the boards of those two organizations decided that having a holding company on top of their bank was way more trouble than it was worth in terms of dollars and time. The Zions board concluded that subject to regulatory approval, the bank would no longer be “systemically important” if it did not have a financial holding company structure. In the process, all three banks eliminated at least two regulators—the Federal Reserve, which oversees bank holding companies, and the Securities and Exchange Commission (SEC). None of the former holding companies were engaged in any significant nonbanking activities that couldn’t be conducted by the bank, either directly or through a subsidiary. For banks, the federal securities laws are administered by the bank’s primary federal banking regulator, rather than the SEC.

Life is a series of trade-offs, and none us can predict the future, but the increase in efficiencies for these organizations seems to have been worth giving up the flexibility afforded by operating in a bank holding company structure. For most banks that aren’t actively using their holding companies to engage in those non-bank activities that may only be performed under a holding company structure, the cost of eliminating the holding company is quickly recovered. If it turns out that eliminating the holding company was a bad idea, the Federal Reserve seems receptive to accepting and approving applications to form bank holding companies from many organizations, including those that had previously eliminated them.

Ozarks and BancorpSouth, like Signature and Republic before them, file their periodic reports under the Securities and Exchange Act of 1934 with the Federal Deposit Insurance Corp. Zions, which operates under a national charter, will make those filings with the Office of the Comptroller of the Currency. The shares of the banks are still listed on Nasdaq or the New York Stock Exchange.

Shareholders and analysts don’t seem to care that the banks’ filings are no longer available on EDGAR, an electronic filing system maintained by the SEC that investors can access. One can argue that bank holding companies that have over $1 billion in consolidated assets and thus are not eligible for the Fed’s Small One Bank Holding Company Policy Statement should consider whether their enterprise is getting its money’s worth from having a holding company—some are, and some aren’t. But remaining in a holding company structure simply because that is the way you’ve always done it is not sufficient analysis to withstand even polite questions from your shareholders.

The process of becoming a stand-alone bank is not intimidating for folks who know their way around the corporate and regulatory world in which banking organizations operate, but there are a number of important questions that bank boards need to consider, including: “Can we execute our business plan without a holding company?” Also, “Are the corporate laws applicable to banks chartered in our state as flexible as the laws applicable to our holding company?”

Three prominent banking organizations making a move like this in a six-month span might not signal a new trend, but it should cause directors at other banks to ask whether they really need a bank holding company.

How Community Banks Can Fund M&A

bank-manda-6-13-16.pngAs bank mergers and acquisitions (M&A) have increased over the past several years, many banks are considering how to participate as buyers and take advantage of growth opportunities. One critical impediment for banks hoping to participate in M&A is funding the purchase. Many community banks lack a publicly traded stock to use as consideration, so they have to offer all cash in a transaction. When common stock is not used in a transaction, no additional capital is created and it becomes difficult to complete the transaction while maintaining adequate capital. Some banks use their holding company as a source of cash through a loan from a correspondent bank or other lender.

The Federal Reserve has a long-standing Small Bank Holding Company Policy Statement indicating that it does not look at capital ratios on a consolidated basis for institutions with consolidated assets under a certain threshold. Initially this threshold was $150 million in consolidated assets, but it increased to $500 million in February 2006. In April 2015, the consolidated assets threshold was increased again to $1 billion. This change is significant because as of March 31, there were more than 3,700 holding companies with less than $1 billion in consolidated assets, according to S&P Global Market Intelligence, formerly SNL Financial. As a result, the overwhelming majority of bank holding companies can take advantage of the Fed’s policy to engage in bank M&A and use leverage to fund acquisitions.

Between Jan. 1, 2015, and May 6, 2016, 183 acquisitions were announced in which the selling bank had less than $250 million in assets. Almost 69 percent of those transactions were not common-stock based. More than two-thirds were deals in which a small bank holding company (by the Federal Reserve’s definition) could have been competitive because consideration did not require common stock for the selling institution to accept the deal.

Funding M&A With Holding Company Debt
As a bank considers its long-term growth plans, acquisitions are a viable option when the size of the seller lends itself well to the type of consideration a bank can use: cash. As banks consider using holding company debt, it would be helpful to be aware of what qualifies a bank holding company to use holding company debt to fund acquisitions under the Fed’s policy statement:

This policy statement applies only to bank holding companies with pro forma consolidated assets of less than $1 billion that (i) are not engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (ii) do not conduct significant off-balance sheet activities (including securitization and asset management or administration) either directly or through a nonbank subsidiary; and (iii) do not have a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the Securities and Exchange Commission.

For most holding companies, these qualifiers won’t have an impact on their ability to rely on the policy statement. When applying the policy for using bank holding company debt in an acquisition, the Fed also includes the following parameters:

  • Acquisition debt should not exceed 75 percent of the purchase price, meaning a minimum 25 percent down payment should be provided by the acquirer.
  • All acquisition debt must be paid off within 25 years.
  • The debt-to-equity ratio at the holding company should be less than 30 percent within 12 years.
  • No dividends are expected to be paid out of the holding company until the debt-to-equity ratio is less than 1:1.

The simplicity of the small bank holding company acquisition debt policy is that it allows holding companies with less than $1 billion in assets to use the cheapest form of capital for corporate level transactions. Subordinated debt, which counts as Tier 2 capital (with limits), is a good source of available capital. However, it should be used to fund an acquisition purchase only if a holding company’s pro forma assets will exceed $1 billion, because the costs and limitations on the debt make it a more expensive and more restrictive type of debt than a simple bank holding company loan.

Additionally, even if acquisitions are not a part of a holding company’s long-term strategic plan, the bank still should consider holding company debt under the small bank holding company policy to:

  • Fund stock repurchases at the holding company to provide liquidity for shareholders.
  • Provide capital for organic bank growth (the repayment can come from future bank earnings).
  • Retire more expensive forms of holding company capital or debt that no longer is needed as a result of the increase in consolidated asset limits.

Industry observers often are critical of regulatory policy. However, this recent change to the small bank holding company policy should be viewed as positive for the industry and the future of community banks.

New Rules Benefit Small Bank Holding Companies

holding-companies-12-25-15.pngConfirming 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.

Investment Advantage
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.

Operational Flexibility
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.

The Takeaway
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.

What will become of thrifts?

maze.jpgThe advantages and disadvantages of converting to a commercial bank

With the Office of Thrift Supervision seeing its last days on earth, what will become of the thrifts themselves?

The Dodd-Frank Act stipulated that the Office of the Comptroller of the Currency would be the new regulator for federally chartered thrifts, and thrift holding companies would be governed by the Federal Reserve, starting July 21.

The savings and loans can keep their thrift charter, or they can convert to commercial banks or bank holding companies. Office of Thrift Supervision examiners will be kept on hand to provide a transition in regulation. The OCC last week said thrifts and banks will be charged the same regulatory assessments based on size; some thrifts will find themselves paying more and some less.

Keith Fisher of Ballard Spahr in Washington, D.C. is one attorney who thinks many federal thrifts will convert to banks.
“Over the next 10 years, I would be surprised to see there were many thrifts left at all,’’ he says.

He thinks there are more reasons for thrifts to convert to commercial banks than drawbacks. For one, they can get rid of limitations on the types of loans they can make (thrifts must keep 65 percent of portfolio assets in qualified loans— mostly residential mortgages).

With periodic residential housing booms and busts causing hardship and failure for so many thrifts, Fisher thinks some thrifts will be attracted to the idea of branching out, say into commercial and industrial loans. The OTS supervised 724 thrifts at the end of March, 114 fewer than it did at the beginning of 2007 (another thrift failed last month, the $129.4 million-asset Coastal Bank of Cocoa Beach, Florida).

Plus, there’s the potential for thrifts to suffer the consequences of being “a stranger in a strange land” at their new regulatory home.

“I’ve spoken to the OTS people and they don’t think (thrifts) will be treated as equals,’’ he said.

The drawback is that federally chartered banks expanding into other states have to submit to each state’s rules on branching, unlike thrifts. Plus, thrifts will have to learn how to handle hugely different lending categories and funding mixes.

For institutions that have savings and loan unitary holding companies, the decision to convert will be more complicated. Bank financial holding companies were created by the Gramm Leach Bliley Act of 1999 to allow banks to engage in activities that formerly were forbidden, such as underwriting and selling insurance, selling securities and merchant banking.  But those institutions and each depository institution must be well capitalized, well managed and maintain a satisfactory Community Reinvestment Act rating.

The consequences of failure to do so can be dire: The Federal Reserve can come up with new rules for the holding company and if the holding company doesn’t agree, it could be forced to sell assets.

“This is not a one-size-fits-all,’’ Fisher says. “There are a lot of thrifts that will say: ‘We like being a community institution and we’ve been profitable and we’d rather not rock the boat.’ Yes, I think they’d be well advised to stick to their knitting and continue what’s been working for them. But some may have been hampered by the fact that (qualified thrift lending) keeps them constrained. They might be persuaded to at least consider conversion.”

(By the way, Fisher actually defends banks in real life and in the movies. He plays the defense attorney in Cleveland vs. Wall Street, a fictionalized account of a real lawsuit where the city of Cleveland sued 21 banks in 2009 to try to hold them accountable for the foreclosure crisis. The movie opened at the Cannes Film Festival last year and Cleveland last month and has been released on DVD in France. It hasn’t opened in other cities or been released on DVD here yet. The real lawsuit by the city of Cleveland was dismissed before it ever got to trial).