The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) was enacted in the wake of the 2008 financial crisis. Although reforms under Dodd-Frank primarily targeted large banks, they have affected banks of all sizes. During the years of implementation of Dodd-Frank, it became clear that the regulatory tightening in response to the crisis was becoming onerous especially for smaller community banks. In response, Congress, led by Senate Banking Committee Chairman Mike Crapo, passed the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018, Pub. L. 115-174 (the Crapo Act). As a result of the relief provided by the Crapo Act, in addition to the current market environment for smaller banks, the industry expects to see increased merger and acquisition activity for both regional and community banks.
This new law provides meaningful relief for many financial institutions while keeping the basic framework of Dodd-Frank intact. However, many commentators have focused on the regulatory relief it grants to larger regional banking organizations. Specifically, it raises the asset threshold from $50 billion up to $250 billion for the systemically important financial institution designation at which enhanced prudential standards apply. These standards include, among other things, comprehensive, company-run stress tests. Prior to the Crapo Act, banking organizations had been reluctant to undertake mergers that would create a combined company exceeding $50 billion in assets because of the additional costs and regulatory scrutiny associated with enhanced prudential standards.
Although the Crapo Act reduces the regulatory burden for about two-dozen regional banks, it has a much more widespread effect on the nation’s community banks. (Federal Reserve Statistical Release, Large Commercial Banks as of March 31, 2018; see also Federal Reserve, National Information Center (there were 4,657 commercial banks, 481 savings banks, and 167 savings and loans chartered in the United States with assets less than $10 billion as of June 30, 2018)). Regulatory relief is granted to community banks through a few different avenues. (See Gregory J. Hudson & Joseph E. Silvia, Crapo Helps Community Banks, 135 Banking L.J. 456 (Sept. 2018 (discussion on how the Crapo Act reduces the regulatory burden for community banks)). This includes capital simplification, extended examination cycles, reduced reporting requirements, and increased simplicity for small bank holding companies to finance the acquisition of banks. More specifically, the Crapo Act lays out a capital simplification scheme through the establishment of the “community bank leverage ratio,” it raised banks’ eligibility for an 18-month exam cycle from $1 billion to $3 billion in assets, and made short-form call reports available for banks under $5 billion. Banking organizations with assets less than $10 billion are also provided relief from the prohibitions on proprietary trading and relationships with hedge funds and private equity funds under section 13 of the Bank Holding Company Act—the so-called Volcker Rule.
Finally, the Crapo Act reforms expanded the number of institutions eligible to use debt to facilitate bank merger and acquisition transactions. This was accomplished by amending the Federal Reserve’s Small Bank Holding Company Policy Statement (the Policy Statement), which we review below.
Small Bank Holding Company Policy Statement
On August 30, 2018, the Federal Reserve published an interim final rule in the Federal Register, which was effective the same day and implements relevant provisions of the Crapo Act by expanding the applicability of the Policy Statement through an increase in the Policy Statement’s asset threshold from $1 billion to $3 billion in total consolidated assets. The Policy Statement also applies to savings and loan holding companies with less than $3 billion in total consolidated assets.
Almost 40 years ago, the Federal Reserve acknowledged that small bank holding companies have less access to equity financing than larger bank holding companies; therefore, the transfer of small-bank ownership often requires acquisition debt, which was previously unavailable to them. Accordingly, the Federal Reserve originally adopted the Policy Statement in 1980 to allow small bank holding companies to assume debt at levels higher than typically permitted for larger bank holding companies. (Regulation Y, 12 C.F.R. § 225, Appendix C to Part 225 (Small Bank Holding Company and Savings and Loan Holding Company Policy Statement)). Under the Policy Statement, holding companies meeting the qualitative requirements described in Regulation Y may use debt to finance up to 75 percent of an acquisition, subject to the following ongoing requirements:
- Small bank holding companies must reduce their parent company debt consistent with the requirement that all debt be retired within 25 years of being incurred. The Federal Reserve also expects that these bank holding companies reach a debt-to-equity ratio of .30:1 or less within 12 years of the incurrence of the debt. The bank holding company must also comply with debt servicing and other requirements imposed by its creditors.
- Each insured depository subsidiary of a small bank holding company is expected to be well capitalized. Any institution that is not well capitalized is expected to become well capitalized within a brief period of time.
- A small bank holding company whose debt-to-equity ratio is greater than 1:1 is not expected to pay corporate dividends until such time as it reduces its debt-to-equity ratio to 1:1 or less and otherwise meets the criteria set forth in Regulation Y. (See 12 C.F.R. § 225.14(c)(1)(ii), 225.14(c)(2), 225.14(c)(7)).
This marks the third time the Policy Statement has been amended. It was previously revised in 2006 to raise the asset threshold from $150 million to $500 million. In 2015, the asset threshold was raised further from $500 million to $1 billion, and the scope of the Policy Statement was expanded to include savings and loan holding companies.
Legislation Encourages Bank M&A Activity
When the Policy Statement was first adopted in 1980, there were more than 14,000 commercial banks, according to the FDIC’s Historical Statistics on Banking. Today, there are less than 4,900 commercial banks. Bank failures play a role in the decline in the number of banks, but so do mergers and acquisitions. Over the last 10 years, there were approximately 2,300 bank mergers in the United States.
There are a number of factors beyond just regulatory relief that could drive further consolidation across the banking industry. Yet, the reforms implemented under the Crapo Act will encourage merger and acquisition activity. Regional banks have been reluctant to complete acquisitions that would push their asset size above the $50 billion threshold due to the enhanced prudential standards that would then apply. However, the Crapo Act’s increase in that threshold allows many regional banks to complete substantial acquisitions while remaining well below the new $250 billion threshold.
In addition, the revised Policy Statement allows an additional 280 small bank holding companies to use debt to facilitate acquisitions of other smaller banks. As a result, there are now 3,670 holding companies that can take advantage of the Policy Statement. The increased asset thresholds for the applicability of the enhanced prudential standards, along with the increased asset threshold for small bank holding companies to take advantage of the Policy Statement, is expected to result in further consolidation of the industry through increased merger and acquisition activity.
Gregory J. Hudson is director of examinations at the Federal Reserve Bank of Dallas where he oversees the regulatory supervision of banks and holding companies. Joseph E. Silvia is senior counsel in the Banking and Financial Services Department and a member of the Bank Corporate Group in the Chicago office of Chapman and Cutler, LLP. Messrs. Silvia and Hudson currently serve as chair and vice chair of the ABA Banking Law Subcommittee on Community Banks and Mutual Savings Associations. The authors thank Mimi Connors for her assistance. The views expressed do not necessarily reflect the official positions of the Federal Reserve System.