It has been only one month since the Economic Growth, Regulatory Relief, and Consumer Protection Act was signed into law, which modified and rolled back some provisions of the Dodd-Frank Act that were implemented following the 2008 recession. Undoubtedly, these reforms will impact how banks of various sizes as will conduct business, though the extent of that impact is uncertain.
The headline news has been relief from annual stress-testing for banks holding $50 billion in capital. The bill changed the threshold for capital planning and stress testing requirements from $50 billion to $250 billion (with banks holding over $100 billion in assets subject to an 18 month transitional period and additional testing in certain cases). Banks approaching the $50 billion level can now pursue potential acquisitions and strategic combinations that may push them over that line – these deals were previously avoided because of the increase in costly and time-consuming regulation imposed at the $50 billion level. Indeed, People’s United (a Connecticut based institution with $44 billion in assets) announced in mid‑June its acquisition of First Connecticut Bancorp and Farmington Bank and we expect more announcements to follow in the remainder of 2018.
Benefits for Community Banks
The broader impact of the regulation affects community banks. Those banks ranging in size $1 billion to $10 billion in assets (over 500 banks in 2017) will gain benefits from the new regulation, including:
- For banks under $10 billion, compliance with a simplified community bank leverage ratio of 8% to 10% will replace all risk-based capital and leverage ratio requirements for the institution to be considered well capitalized.
- Federal Deposit Insurance Act (FDIA) call reporting requirements will be reduced for depository institutions with assets of less than $5 billion.
- Banks under $10 billion will be exempt from the Volcker Rule restrictions on investments, so long as total trading assets and trading liabilities are five percent or less of total assets.
- The consolidated asset threshold for qualification for a lengthened 18-month examination cycle by prudential regulators is raised from $1 billion to $3 billion for “well-managed, well-capitalized” banks.
- The “small bank holding company” access to debt financing for acquisitions will now apply to banks with $3 billion in assets (changed from $1 billion in assets).
With these and other changes in the new legislation, management and advisors have taken a rosy view of potential acquisitions and strategic combinations. Community banks will have more cost savings from the decrease in regulation and their management teams will have more time and capacity to focus on growing their core business, evaluating potential merger partners, and pursuing strategic initiatives in fintech.
Risk Management and Compliance Remain Important
Nonetheless, while enthusiasm and a bullish outlook on the sector can be beneficial for both banks and their customers, bank boards and management must balance exuberance with pragmatism and cannot turn their attention away from maintaining a steadfast compliance program. Banks looking at acquisition growth (whether as target or acquirer) are aware of the regulatory approval required after signing an agreement – a process which includes providing extensive information (regarding each party in the transaction) to bank regulators to receive approval under applicable statutes. When this process is delayed or in the worst case denied, the parties incur reputational damage, economic cost, and potential hits to stock value.
Without fully understanding what the new legislation does and more importantly what it does not do banks may be lulled into an over-confidence that could result in missed opportunities. The legislation has done away with many of the onerous regulations that inhibited growth for smaller and mid-size banks. For instance, since the overwhelming number of community banks do not engage in the kind of proprietary trading contemplated in the Volcker Rule, smaller banks either spent significant resources proving a negative, or were required to sell off investments at a loss to remain in compliance.
That however, does not mean that banks are excused from having to undertake the basic blocking and tackling fundamental to any robust compliance program. Risk management is the foundation of that effort. Banks should not view risk management as some disembodied “one-off” that has no correlation to their basic products and services. Like any business, banks need to understand the risks involved with their core businesses in order to thrive and make intelligent strategic decisions. Without thoughtful risk assessment, compliance resources – which are scarce for smaller banks – are wasted pursuing required testing that may have no material correlation to the fundamental risks of the institution. Without an appropriate risk management program and governance structure in place, banks are continually surprised when weaknesses rear their ugly head, usually at the most inconvenient times, such as when they are trying to effect a merger or launch a new business initiative.
Regulators have a role to play, a role that has not been diminished by the passage of this new legislation. While certain regulations have been removed for smaller banks, and regulations are moving toward being more “right-sized” to the institution, the priority remains for banks and financial institutions to invest and believe in robust risk and compliance controls, anti-money laundering controls, and governance structures. Daily decision making at the senior management and board level should be based on reliable data from their risk and compliance teams, as well as operational areas. Supervisors and operational heads need to be risk managers more than ever before if their organizations are to take advantage of exciting new opportunities. The institutions that take seriously their risk and compliance obligations will pass muster with the regulators who must approve mergers and new business initiatives, and will leave behind their counterparts who have misread the landscape. Risk management and thoughtful corporate governance are tools by which banks will reap the benefits of the competitive landscape.
Things to Consider
In sum, community and regional banks who aspire to expand their footprint through mergers or acquisitions should follow the simple guidelines set forth below:
- Ensure that the bank has an enterprise risk management program that determines critical risks for the institution, and how each of the risks is being addressed
- Ensure that there is an experienced team internally and externally that can advise and understands these risks
- Ensure that the compliance management system is based upon a true risk assessment for the institution in order to properly employ resources
- Ensure that business leaders are risk owners and able to identify risks and mitigates in their respective areas
- Ensure there is a repeatable governance structure that informs senior management and the board in daily decision making
- Ensure that appropriate follow up takes place as a result of this effort
Should these very clear rules of the road be followed, this will be an exciting time for smaller banks and financial institutions. The doors are open, banks now need to follow up to push through them.
Don Andrews is a partner in Reed Smith’s Financial Industry Group and chairs the firm’s Risk Management and Compliance Group. Don advises banks, broker-dealers, asset advisers, hedge funds, mutual funds, private equity firms, trust companies, and investment advisors on domestic and international regulatory matters.
Bree Archambault is counsel in Reed Smith’s Global Corporate Group, and represents public and private clients in a variety of corporate and securities matters. Bree’s practice includes transactions such as mergers and acquisitions (including cross-border transactions), joint ventures, registered securities offerings, compliance with SEC rules and national securities exchange requirements, equity and debt financing, and general corporate matters.