LEGAL AND REGULATORY DEVELOPMENTS AFFECTING COMMUNITY BANK CONSOLIDATION

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1 Vol. 29 No. 6 June 2013 LEGAL AND REGULATORY DEVELOPMENTS AFFECTING COMMUNITY BANK CONSOLIDATION Never make predictions, especially about the future. Casey Stengel Community bank consolidations declined sharply after 2007 and have risen only slightly in recent years. The authors examine 10 factors that may affect the rate of such transactions going forward, beginning with regulatory uncertainty in the wake of the Dodd-Frank Act and Basel III, and ending with the new capital standards for saving and loan holding companies. They conclude that it is yet to be seen whether any given legal or regulatory change will catalyze or inhibit bank consolidations in the near term. By Douglas J. McClintock, Clifford S. Stanford, and Sara C. Lenet * As banking market conditions have begun to stabilize, many bank boards of directors have begun to turn their attention from sustaining the franchise while weathering market and regulatory storms to a focus on the strategic future. However, it remains challenging to see through the haze of regulatory change that is still emerging. To help provide a clearer view, this article posits a series of plausible scenarios whereby banking regulation will catalyze or inhibit bank consolidation in the near term for small and mid-sized banks. The number of U.S. banks has decreased significantly over the past three decades as a result of many factors, including bank consolidations and bank failures. The total number of banks and thrifts (both referred to as banks in this article) whose deposits are insured by the Federal Deposit Insurance Corporation declined from 17,901 to 7,357 between 1984 and 2011, a decline of approximately 59%. 1 1 FDIC Community Banking Study (December 2012). DOUGLAS J..McCLINTOCK is a partner in, CLIFFORD S. STANFORD is counsel to, and SARA C. LENET is a senior associate in the Financial Services and Products practice group of Alston & Bird LLP in the firm s New York City, Atlanta, and New York City offices, respectively. This article is current as of March 15, 2013 and is based, in part, on the discussion panel led by Messrs. McClintock and Stanford at the BankDirector 2013 Acquire or Be Acquired conference on January 27, The authors addresses are douglas.mcclintock@alston.com, cliff.stanford@alston.com, and sara.lenet@alston.com. This article reflects the views of the authors and does not constitute legal advice. IN THIS ISSUE LEGAL AND REGULATORY DEVELOPMENTS AFFECTING COMMUNITY BANK CONSOLIDATION June 2013 Page 69

2 RSCR Publications LLC Published 12 times a year by RSCR Publications LLC. Executive and Editorial Offices, 2628 Broadway, Suite 29A, New York, NY Subscription rates: $650 per year in U.S., Canada, and Mexico; $695 elsewhere (air mail delivered). A 15% discount is available for qualified academic libraries and full-time teachers. For subscription information and customer service call (866) or visit our Web site at General Editor: Michael O. Finkelstein; tel ; mofinkelstein@gmail.com. Associate Editor: Sarah Strauss Himmelfarb; tel ; shimmelfarb@comcast.net. To submit a manuscript for publication contact Ms. Himmelfarb. Copyright 2012 by RSCR Publications LLC. ISSN: Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been obtained by The Review of Banking & Financial Services from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, The Review of Banking & Financial Services does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions, or for the results obtained from the use of such information. One of the reasons for the decrease in the number of U.S. banks is consolidation transactions. However, the number of such transactions for U.S. small and midsized banks decreased significantly after 2007 and has remained low through the end of The Number of Completed Consolidation Transactions graph in the Appendix illustrates this trend over the last ten years for banks with under $15 billion in assets for transactions in which either the acquirer or the target or both were publicly traded. It is fair to assume that the trend would be similar if transactions involving both a private acquirer and private target were included as well. The graph of the aggregate values for the same transactions (transactions for U.S. banks with under $15 billion in assets in which either the acquirer or the target or both were publicly traded), generally follows the same trends as the previous graph showing numbers of transactions. See the Bank Consolidation Aggregate Transaction Value graph in the Appendix. Before the sharp declines in combination transactions illustrated by the graphs, there were many smaller bank consolidations. Between 1990 and 2006, there were more than 4,200 bank mergers in which either the acquirer or the target or both were publicly traded, and more than 90 percent of these mergers involved acquisitions of banks with under $1 billion in assets. 2 Over half of these acquisitions were made by other banks with under $1 billion in assets rather than larger banks. 3 The sharp decline in bank consolidation transactions after 2007 can be largely attributed to the severe recession that began around the same time, as well as the many resulting legal and regulatory changes that U.S. banks have faced. There is certainly a correlation between the economic environment and the effects of cyclical and reactive bank regulation. For the same reasons that explain the decrease in bank consolidations, the number of U.S. bank failures increased dramatically after 2007 through 2010, but the failure rate has begun to decelerate. Although bank 2 Julapa Jagtiani, Understanding the Effects of the Merger Boom on Community Banks, Federal Reserve Bank of Kansas City Economic Review, Second Quarter Id. failures often resulted in FDIC-assisted bank combinations, the decrease in the number of banks resulting from bank failures likely contributed to the decrease in the number of bank consolidations (other than FDIC-assisted transactions). The third graph in the Appendix illustrates the increase in bank failures after 2007 and the current downward trend in the number of bank failures. In addition, the number of de novo banks formed increased in the few years leading up to and including 2007, began decreasing steadily after 2007, and has continued to decrease through the end of 2012, with only one de novo bank being formed in See the Number of U.S. De Novo Banks Formed graph in the Appendix. The same economic and regulatory circumstances that have contributed to the downward trend in bank consolidation transactions and the upward trend in bank failures have likely also contributed to the downward trend in de novo bank formations. Having depicted, at a high level, the trends of the past, this article describes some plausible scenarios whereby the current legal and regulatory landscape for banks might be expected to affect bank consolidation in the near future. In many cases, the same regulatory aspect might either be a catalyst or an inhibitor with respect to bank consolidations. Although there are a wide array of legal and regulatory factors that affect the bank buyer and seller calculus, this article focuses on ten such factors. FACTOR 1: REGULATORY UNCERTAINTY The last few years have been characterized by a great deal of regulatory uncertainty as banks waited to see how various new laws, such as the Emergency Economic Stabilization Act of 2008, the 2010 Dodd- Frank Wall Street Reform and Consumer Protection Act and the Basel Committee on Banking Supervision s Basel III capital and liquidity rules would be implemented, through regulations and otherwise through regulatory guidance and examination practices. 4 The 4 Emergency Economic Stabilization Act of 2008, Public Law , Division A, H.R. 1424, 110 th Cong. (Oct. 3, 2008); Dodd-Frank Wall Street Reform and Consumer Protection Act, June 2013 Page 70

3 American Bankers Association reports over 5,200 pages of proposed Dodd-Frank Act-related rules and over 5,700 pages of Dodd-Frank Act-related final rules published as of March 4, With the notable exception that the full complement of capital and liquidity rules required under the Dodd-Frank Act and Basel III have yet to be issued in final form in the United States, a substantial amount of the uncertainty with respect to bank regulatory policy has been resolved or at least mitigated. Enhanced regulatory certainty should be expected to result in improved price certainty for bank consolidation transactions and a narrowing of bid-ask spreads. Armed with increased certainty, banks may shift to a more strategic focus and evaluate more consolidation opportunities. However, in many respects, the waiting continues, and there is still a fair amount of regulatory uncertainty that hinders strategic judgment. Final rules take time to digest and be implemented, and it also takes time to resolve the unintended consequences of final rules in the market. Although banks are aware of the contents of the Dodd-Frank Act and Basel III, critical capital and liquidity-related implementing regulations are yet to be issued in final form, and many of those are far past the required or expected timeframes. As another example, the Dodd-Frank impetus for limiting reliance on credit rating agencies as a proxy will have impacts on community bank debt securities issuance, investment portfolios, and capital valuations, as many community banks lack the institutional capability to perform independent due diligence on investments that will satisfy new regulatory expectations. 6 These factors and others may limit any felicitous increase in pricing certainty in the near future, and bid-ask spreads may not narrow as much as may otherwise be expected. That said, regulatory uncertainty does not seem to be the dominant concern of community bankers when footnote continued from previous page Public Law , H.R. 4173, 111 th Cong. (July 21, 2010); Bank for International Settlements, Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems (Dec. 2010, revised June 2011). 5 American Bankers Association Dodd Frank Tracker, available at 6 See Advance Notice of Proposed Rulemaking Regarding Alternatives to the Use of Credit Ratings in the Risk-Based Capital Guidelines of the Federal Banking Agencies, 75 F.R (August 25, 2010). The final rule has not yet been issued. considering consolidation opportunities. In the 2013 Bank M&A Research Summary Report prepared by Crowe Horwath LLP in association with BankDirector in 2012 ( Crowe Horwath Report ), 234 officers and directors of banks of various sizes, most of which were under $10 billion, were surveyed on multiple topics related to combination transactions. One question was what would be considered the top barriers to buying another bank. Each respondent selected three choices, and the most popular response (61.7%) was that pricing expectations of potential targets were unrealistically high. 7 When asked what would be the top barriers to selling their banks (with each respondent asked to select three choices), the most popular response (71.1%) was that current pricing was too low. The third most popular response to the question posed to sellers (27.6%) was that the regulatory outlook was too uncertain and potential acquirers were risk adverse. Although this was the third most popular response out of eight possible responses, it is interesting that 72.4% of respondents did not believe that regulatory uncertainty was one of the top three biggest barriers to selling their banks. While it begs the question as to whether regulatory uncertainty is a contributing factor, the age-old views of acquirers (that targets want unrealistically high prices) and of targets (that acquirers pricing is too low) continue to dominate. FACTOR 2: REGULATORY FOCUS SHIFTS The seemingly gradual rise in regulatory ratings, resolution of problem banks, and the lifting of enforcement actions imposed in the aftermath of the downturn all should begin to counter the regulatory chilling effect on strategic deals and free up the attention of bank boards of directors and management, both on the buyer and seller sides. The current economic and regulatory climate is also more deal-friendly than in recent years, with improving capital markets and a reduction in weak and troubled banks. 8 These factors should support bank consolidations. On the other hand, although economic and regulatory conditions have improved in some respects, the overall regulatory burden on financial institutions has increased exponentially. As banks spend more time focused on 7 Crowe Horwath LLP in association with BankDirector, 2013 Bank M&A Research Summary Report (October 2012). 8 As one indicator, the Unofficial Problem Bank List compiled by the Calculated Risk blog reports that there were 805 institutions with assets of $296.4 billion that had problem bank status as of March 8, A year ago, the list contained 956 institutions with assets of $383.4 billion. See June 2013 Page 71

4 (i) heightened consumer compliance examinations, (ii) stress testing, (iii) new regulatory requirements under the Dodd-Frank Act, Basel III and other rules, (iv) private lawsuits in the mortgage and consumer compliance arena, (v) regulatory enforcement actions in the consumer compliance, fair lending, and Community Reinvestment Act compliance arenas, and (vi) adapting to the rules, supervision, and enforcement activities of the Consumer Financial Protection Bureau, they may be distracted from evaluating strategic combination transactions. FACTOR 3: CAPITAL, CAPITAL, CAPITAL As banks begin to settle into their new required capital minimums, improve their retained earnings, and begin to amass capital to support growth and/or acquisitions (including, perhaps, via new provisions under the Jumpstart Our Business Startups Act, or JOBS Act, provisions), the desire for combinations may increase % of the bank officers and directors surveyed in the Crowe Horwath Report stated that one of the top three reasons for buying another bank would be to use surplus capital. On the seller side, but also as a potential catalyst to combination transactions, struggling banks will likely have difficulty meeting their capital requirements, which would be expected to result in more banks looking for buyers to acquire them. Continued recognition of losses, a lack of sustained earnings, a reluctance of investors to invest in weak banks, the 9 Jumpstart Our Business Startups Act, Public Law , H.R. 3606, 112th Cong. (Apr. 5, 2012). The JOBS Act, among other things, (i) provides for significant deregulation of private securities offerings, (ii) increases the threshold for public securities offerings to be exempt from registration from $5 million to $50 million (so-called Regulation A+ ), and (iii) makes it easier for banks and bank holding companies to deregister under the Securities Exchange Act because they may now deregister when they have fewer than 1,200 stockholders of record, whereas they previously needed fewer than 300 stockholders of record to deregister. As a result of the foregoing, many banks and bank holding companies with fewer than 1,200 stockholders of record have decided to deregister, resulting in compliance cost savings to those banks and bank holding companies. This deregistration provision does not apply to thrifts and savings and loan holding companies, but there is currently a bill pending to make the deregistration provision the same for savings and loan holding companies as it is for bank holding companies. The JOBS Act should also increase the ability of banks to access capital through both private and public offerings, although the SEC has not yet proposed or promulgated the regulations necessary to implement Regulation A+. impact of heightened standards of quantity and quality of capital, stress testing requirements, and tired boards of directors all will begin to feed the desire to sell. However, although these heightened capital requirements and related market factors may be a catalyst for sellers, on the buyer side, these same factors will simultaneously cause many potential buyers to raise or preserve capital just to meet minimum requirements, not simply to build a war chest of acquisition capital. Given continued caution with regard to asset valuations, regulators have set high expectations for bank buyers to infuse capital into weaker banks. 34.4% of the same respondents in the Crowe Horwath Report stated that one of the top three barriers to buying another bank was capital demands on the buyer. Regulatory stress testing expectations have also trickled down to community banks and have altered the mindset of many boards of directors as to the extent that excess capital may be used for acquisitions. Importantly, the ability of smaller banks to raise more community capital also perpetuates their independence, so potential sellers may not be as interested in combination transactions even in the face of continued weak earnings. 65.4% of the bank officers and directors surveyed in the Crowe Horwath Report stated that their banks were not considering selling, and only 5% stated that an inability to attract sufficient capital to meet regulatory requirements would be one of the top three reasons they might consider selling their banks. FACTOR 4: CONCENTRATIONS AND BUSINESS DIVERSIFICATION Many banks have been told by their regulators to reduce concentration risks. In addition, for business purposes, many banks may wish to diversify their lending businesses. Much of this relates back to the regulatory guidance to limit concentration risks in commercial real estate, published in late Continued bank efforts to build a more diversified loan portfolio, including Commercial and Industrial and Small Business Administration loans, for example, should be expected to stimulate demand for specialty banks or selective portfolio or business line acquisitions. However, community banks interested in buying niche businesses often find that these businesses must be built over the long term rather than bought. This is partly because regulators are concerned with infrastructure 10 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, 71 F.R (December 6, 2006). June 2013 Page 72

5 support (related to risk management, audit, credit administration and other areas) and integration risks, and have a renewed focus on business plans. Regulators have shown that they have a jaundiced view of rapid shifts into new lines of business to chase revenues in the absence of a robust risk management infrastructure. FACTOR 5: MORTGAGE AND MORTGAGE SERVICING REGULATION While voluminous and challenging to digest, the thousands of pages of extensive new regulations promulgated by the CFPB addressing various aspects of mortgage servicing 11 and mortgage origination, including the new ability-to-repay and qualified mortgage ( QM ) rules, 12 should remove some pricing uncertainty with respect to mortgage portfolios of target banks. In turn, this should increase potential buyers appetite for consolidation transactions. The QM rules, in particular, were relatively well received by the industry, as they helped ensure a safe harbor from potential litigation (or at least a significant reduction in potential liability) with respect to well-underwritten and less risky 11 See, e.g., CFPB, Mortgage Servicing Rules Under the Truth in Lending Act (Regulation Z); Final Rule, 78 F.R (February 14, 2013); CFPB, Mortgage Servicing Rules Under the Real Estate Settlement Act (Regulation X); Final Rule, 78 F.R (February 14, 2013). 12 Loans that are considered QMs under the final rule significantly decrease potential liability for lenders because, depending on certain factors, QMs either provide the lender a safe harbor from potential liability under the ability-to-repay requirements, or a rebuttable presumption of compliance with such requirements. Lenders may still make loans that are not QMs, but they will not be afforded the same protections as with QMs. The Dodd-Frank Act prohibits certain types of loans from being considered QMs, such as loans with negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. So-called no doc loans, in connection with which the creditor does not verify income or assets, also cannot be considered QMs. A loan also generally cannot be a QM if the points and fees paid by the consumer exceed 3% of the total loan amount. The final rule promulgated by the CFPB, among other things, defines the term qualified mortgage and establishes general underwriting criteria for QMs. Most importantly, the rule requires that monthly payments be calculated based on the highest payment that will apply in the first five years of the loan and that the consumer have a total (or back-end ) debt-to-income ratio that is less than or equal to 43 percent. CFPB Final Rule, Ability-to- Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z), 78 F.R. 6408, at 6409 (January 30, 2013). loans that are deemed QMs. This has the potential not only to clear the air for residential mortgage lending, but also to improve the pricing certainty of mortgage portfolios of selling banks. The CFPB s mortgage servicing regulations have been less well-received, and the complicated and adverse capital treatment of mortgage servicing rights may cause many banks to consider selling their mortgage servicing to banks that have servicing specialties, or to nonbanking entities. Banks that have sold their mortgage servicing portfolios should be considered cleaner banks to sell, which should be expected to aid their sale prospects. In addition, buyers with large mortgage servicing platforms that are better-equipped to handle the new mortgage servicing regulations and adverse capital treatment for mortgage servicing rights may be in the market to buy banks with mortgage servicing portfolios at discounts, which could also fuel consolidation. On the other hand, mortgage-related litigation, heightened attention to fair lending enforcement, and government loan restructuring programs also continue to cause concern about the value of mortgage portfolios and mortgage servicing rights, which may negate any benefit that the new mortgage servicing and origination regulations may have in making bank combination transactions easier to value. In addition, final rules regarding qualified residential mortgages 13 have not yet been issued, but are expected to be issued jointly in the next few months by the OCC, the Federal Reserve, the FDIC, HUD, the FHFA, and the SEC. The lingering uncertainty about what mortgages will meet the definition of qualified residential mortgages may also contribute to a slower improvement in pricing certainty of mortgage portfolios of selling banks. FACTOR 6: RISK MANAGEMENT AND COMPLIANCE INFRASTRUCTURE The extent of express and implied compliance, internal audit, and enterprise risk management infrastructure that is necessary to meet regulatory expectations continues to expand. This may drive 13 Section 941 of the Dodd-Frank Act generally requires securitizers of asset-backed securities to retain at least 5% of the credit risk of the assets collateralizing the asset-backed securities. There is an exemption from this requirement for asset-backed securities that are collateralized exclusively by residential mortgages that qualify as qualified residential mortgages. The final rule containing a definition of qualified residential mortgages has not yet been issued. June 2013 Page 73

6 consolidation in order for banks to take advantage of certain associated economies of scale and efficiencies. A combination should create value with respect to this infrastructure if the fixed costs that the two banks separately incurred in connection with such infrastructure could be significantly reduced when the two banks combined (for instance, if fewer employees, platforms or systems than were necessary when the banks were separate would be necessary when the banks combined). Moreover, the fixed costs of risk management and compliance infrastructures can be better spread across earning assets of larger banks. 41.0% of the respondents in the Crowe Horwath Report stated that one of the top three reasons they believe their bank might make an acquisition would be to rationalize the cost of regulation over a wider base. In addition, larger and more diversified banks are also generally better equipped to handle special and increasingly important issues, such as disaster recovery plans, cyber attack defenses, and information technology advances in payment systems, core processing, and consumer interfaces, which are all areas that have recently drawn more regulatory focus. On the other hand, variable components of compliance, audit, and enterprise risk management costs may increase with business scale. After a consolidation, the resulting bank will be larger and potentially more complicated than either of the combining banks individually before the combination. Therefore, bank consolidations may not provide as many economies of scale when it comes to such costs as one might originally believe. FACTOR 7: TRUST PREFERRED SECURITIES PHASE-OUT Community banks have long relied upon trust preferred securities ( TruPS ), which are essentially debt securities that can behave like equity, to supplement their Tier 1 capital requirements. The Collins Amendment of the Dodd-Frank Act reflected a policy sensibility that these hybrid securities did not serve to cushion the impact of stressed conditions, and should be phased out. 14 Pursuant to the Dodd-Frank Act, although banks with more than $500 million in consolidated assets will no 14 United States Government Accountability Office, Report to Congressional Committees, Dodd-Frank Act: Hybrid Capital Instruments and Small Institution Access to Capital, GAO (January, 2012), available at products/gao longer be able to count TruPS as an element of Tier 1 capital, banks with consolidated assets between $500 million and $15 billion as of December 31, 2009 would be able to continue counting their TruPS issued before May 19, 2010 as an element of Tier 1 capital, up to any applicable limitations. However, inconsistent with the Dodd-Frank Act, the proposed Basel III regulations drafted by the U.S. bank regulatory agencies do not grandfather TruPS issued before May 19, 2010 for institutions with between $500 million and $15 billion in consolidated assets as of December 31, 2009, and instead require these TruPS to be phased out. It is yet to be seen how these inconsistencies will be resolved and how TruPS will be treated for institutions with consolidated assets between $500 million and $15 billion. This upcoming TruPS phase-out for many banks is expected to influence potential sellers as the window to count TruPS as Tier 1 capital shrinks, potentially fueling consolidations in the near term. The TruPS phase-out will also require additional capital raising, resulting in undesirable shareholder dilution, for many banks, which may also cause banks to seek potential acquirers instead. On the other hand, the TruPS phase-out will occur over an extended period. Because of the differences between the Dodd-Frank Act and Basel III with respect to the TruPS phase-out, the full spectrum of banks that will be required to phase out TruPS as an element of Tier 1 capital is not yet clear. As a result of the long phase-out period and lingering uncertainties, it may still be too early for potential sellers to be concerned with the impact of the TruPS phase out on their capital position and this issue may not fuel bank consolidation in the near term in a material way. FACTOR 8: DEPOSIT FUNDING Low-cost deposit funding can be the lifeblood of successful community banks. However, there have been significant regulatory shifts that have altered the FDICinsured deposit market dramatically. The Dodd-Frank Act altered the base calculation for deposit insurance premiums from total deposits to total liabilities. This has meant that the larger institutions, which have been less dependent upon deposit funding, have seen their premium costs rise and have begun to shift their funding models towards increased deposit dependency to lower their funding costs, increasing competition for customer deposits. June 2013 Page 74

7 Further, the December 31, 2012 expiration of the FDIC transaction account guarantee program 15 and the Dodd-Frank Act s lifting of the ban on paying interest on business demand deposit accounts, 16 together with predictable rising interest rates at some point in the future, may alter competition dynamics for deposit funding. For example, these events could be expected to result in a shift of deposits to insured accounts, and likewise create demand for a larger base of depositors to shore up low-cost deposit funding, which could drive potential buyers to seek acquisition targets. On the other hand, many community banks have developed sticky relationships with their customers over the last few years, and implicit and explicit switching costs can be high. Thus, these customers may not seek a larger bank in which to deposit their funds so easily. Accordingly, regulatory changes with respect to deposits may not be as big a factor to consider for healthy community banks that have strong customer relationships. FACTOR 9: SOURCE OF STRENGTH The Federal Reserve first set out its expectations regarding bank holding companies serving as a source of financial and managerial strength in a policy statement 15 On November 9, 2010, the FDIC issued a final rule implementing Section 343 of the Dodd-Frank Act, which provided for unlimited insurance coverage of noninterestbearing transaction accounts for the period beginning December 31, 2010 through December 31, During this period, all noninterest-bearing transaction accounts were fully insured, regardless of the balance of the account, at all FDICinsured institutions. This unlimited insurance coverage was available to all depositors and was separate from, and in addition to, the insurance coverage provided to a depositor s other deposit accounts held at an FDIC-insured institution. The transaction account guarantee program expired on December 31, 2012, and since January 1, 2013, all of a depositor s accounts at an FDIC-insured depository institution, including all noninterest-bearing transaction accounts, are generally insured by the FDIC up to $250,000 for each deposit insurance ownership category. 16 See Section 627 of the Dodd-Frank Act; see also Federal Reserve System Final Rule, Prohibition Against Payment of Interest on Demand Deposits, 76 F.R (July 18, 2011) and FDIC Final Rule, Interest on Deposits; Deposit Insurance Coverage, 76 F.R (July 14, 2011), which final rules implement Section 627 of the Dodd-Frank Act. in 1987, 17 and these views have since been codified by the Dodd Frank Act and now apply to savings and loan holding companies ( SLHCs ) as well. 18 No proposed rules have yet been issued by the federal banking agencies as required by the statute. The codification of the Federal Reserve s source of strength requirements, and the rules to implement those requirements, may force or entice weaker institutions to sell if their holding companies cannot meet the required standards. This may be particularly true for SLHCs, which have not previously been subject to any source of strength requirements. 19 However, it is also possible that the new source of strength requirements will not represent a significant enough shift to have a material impact on bank consolidation. Although the formal requirements are relatively new, the source of strength standard has long existed as a policy matter. The Federal Reserve has not clearly identified how quickly it will address the source of strength rules issue, which may in fact be a lesser regulatory concern given the Federal Reserve s existing policy tools. FACTOR 10: SLHC REGULATION As a result of the Dodd-Frank Act and Basel III, SLHCs will become subject to consolidated capital standards for the first time, among other regulatory changes. This may cause some SLHCs to reconsider their business models, particularly those that are engaged 17 Federal Reserve, Policy Statement on the Responsibility of Bank Holding Companies to Act as Sources of Strength to their Subsidiary Bank, 52 F.R (April 30, 1987). 18 The Dodd-Frank Act added the following language to the Federal Deposit Insurance Act, as amended: The appropriate Federal banking agency for a bank holding company or savings and loan holding company shall require the bank holding company or savings and loan holding company to serve as a source of financial strength for any subsidiary of the bank holding company or savings and loan holding company that is a depository institution. 12 U.S.C. 1831o-1(a). The term source of financial strength is defined as the ability of a company that directly or indirectly owns or controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution. 12 U.S.C. 1831o-1(e). 19 Note that Federal Reserve Regulation LL includes a broad source of strength expectation for SLHCs. 12 C.F.R June 2013 Page 75

8 in non-banking businesses (such as insurance), and could promote consolidation as SLHCs de-bank their operations. However, in many respects, it is yet to be seen how these new regulatory requirements, such as consolidated capital and U.S. Generally Accepted Accounting Principles reporting standards, will be applied to SLHCs by the Federal Reserve. The Federal Reserve may be expected to moderate the impact of the consolidated capital standards and other regulatory requirements on SLHCs, particularly in the case of insurance companies, which have risk-based capital models that are inherently long-term, as opposed to the short-term model applicable to banks. The Federal Reserve may also permit a more orderly path to withdraw from the banking business for SLHCs that wish to do so, although this remains to be seen. CONCLUSION Seeing forward is much harder than examining the past. The only thing that is clear about what potential effects the current legal and regulatory banking landscape may have on bank consolidations is that it is unclear. As described in this article, many of the recent legal and regulatory changes could either be expected to be a catalyst or an inhibitor to bank consolidations, and only time will tell what effects they ultimately have. Of course, recent legal and regulatory changes are only some of the many factors that banks consider when evaluating these transactions in a market context. It is yet to be seen whether any given legal or regulatory change would ultimately catalyze or inhibit bank consolidations in the near term. June 2013 Page 76

9 APPENDIX 150 Number of Completed Consolidation Transactions The data used to create this graph were obtained from a search conducted on FactSet for all completed merger and acquisition transactions for U.S. banks with under $15 billion in assets, in which either the acquirer or the target or both were publicly traded, for the period from January 1, 2003 through December 31, Bank Consolidation Aggregate Transaction Value (Aggregate Amounts in Billions of Dollars) The data used to create this graph were obtained from a search conducted on FactSet for all completed merger and acquisition transactions for U.S. banks with under $15 billion in assets, in which either the acquirer or the target or both were publicly traded, for the period from January 1, 2003 through December 31, June 2013 Page 77

10 APPENDIX (continued) 200 Number of U.S. Bank Failures The data used to create this graph were obtained from the FDIC s Failed Bank List, available on the FDIC s website at banklist.html Number of U.S. De Novo Banks Formed The data used to create this graph were obtained from the FDIC s BankFind website, available at The numbers in the graph reflect the formation of de novo FDIC-insured institutions only. June 2013 Page 78

11 The Review of Banking & Financial Services General Editor Michael O. Finkelstein Associate Editor Sarah Strauss Himmelfarb Board Members Roland E. Brandel Morrison & Foerster LLP San Francisco, CA H. Rodgin Cohen Sullivan & Cromwell LLP New York, NY Carl Felsenfeld Professor of Law Fordham Law School New York, NY Ralph C. Ferrara Dewey & LeBoeuf LLP Connie M. Friesen Sidley Austin LLP New York, NY Robert M. Kurucza Goodwin Procter LLP C.F. Muckenfuss, III Gibson, Dunn & Crutcher LLP Benjamin P. Saul Buckley Sandler LLP Morris N. Simkin New York, NY Brian W. Smith Latham & Watkins LLP Heath P. Tarbert Weil, Gotshal & Manges LLP Thomas P. Vartanian Dechert, LLP June 2013 Page 79