Tarullo's Big-Bank Cap May Discourage M&A Activity

WASHINGTON — A suggestion by a top Federal Reserve Board official that policymakers should cap the size of the largest banks may have a chilling effect on future mergers and acquisitions.

Fed Gov. Daniel Tarullo laid out a two-fold plan this week that would restrict large institutions from expanding their systemic footprint, including limiting their size by the amount of non-deposit liabilities as a percentage of the country's gross domestic product. He also suggested the Fed may prohibit any merger among the largest U.S. banks that have been designated as globally significant to the financial system.

His remarks immediately sparked concern among industry observers, who said Tarullo was sending a strong message to the largest banks not to pursue any mergers or acquisitions. The comments may also discourage mergers among more regional players, some said.

"It means that any transactions for any bank holding company of size that are seen not only to increase that size, but also to add complexity for interconnectedness face very tough going at the Fed, if the Tarullo approach is executed at the Board," said Karen Shaw Petrou, the managing partner at Federal Financial Analytics Inc.

Others in the industry agreed.

"Does this mean that the four largest or the six largest banks can never do an acquisition?" said an industry source, who requested anonymity. "Does it mean that there is a path for U.S. banks that want to be the biggest and as to how big they can grow?

To be sure, Tarullo did not specify how big firms could become, saying the issue should be left to Congress. But just the idea that a top Fed official endorsed some kind of size limit encouraged other regulators who have said more needs to be done to end the problem of too big to fail.

"I am pleased to see the issue of these largest financial firms is receiving increased attention," said Thomas Hoenig, a board director at the Federal Deposit Insurance Corp. who has called for a big bank breakup, in a statement. "How much influence they will have on the economy is a critical issue that needs to be discussed and addressed now before they become the source of the next financial crisis."

Tarullo's plan would fall well short of Hoenig's proposal. Hoenig has called for traditional banking activities to be effectively walled off to ensure the government does not support riskier activities. Such a plan would inevitably force existing banks to become much smaller.

In contrast, Tarullo focused instead on a moving benchmark designed to effectively prevent a large bank from becoming so large it threatened the country's economy. Tarullo argued that a limit on non-deposit liabilities is relatively simple to implement, and would prohibit firms from growing faster than the U.S. economy, while also ensuring a bank's ability to continue to absorb losses during stressful times.

Since the Capital One acquisition of ING Direct last year, which drew objections from some who argued it created another too big to fail bank, the Fed has worked hard on how it should define financial stability as a factor in M&A approvals. Ultimately, the Fed approved that deal, finding little cause for concern, but it has yet to provide guidelines for other banks considering a major merger or acquisition.

That's because there is little guidance on how to proceed, Tarullo said Wednesday in a speech before the University of Pennsylvania Law School.

"There is no legacy of administrative or judicial analysis of the financial stability effects of mergers," said Tarullo. "We literally had to start from scratch."

But observers were also focused on Tarullo's suggestion that regulators will likely challenge any merger of the largest globally-significant banks, a category that includes JPMorgan Chase & Co., Bank of America, and Citigroup.

During his speech, Tarullo also suggested that regulators should deny any acquisition by a firm that is in the top half of companies deemed systemically important to the global economy. Firms at the lower end might have "slightly less robust, but still significant presumption against acquisitions," he said.

Observers said that suggestion alone may have a chilling effect on any mergers by larger regional banks.

Potential deals with the giant banks was always expected to be more difficult, but a view by Tarullo that a statutory size, or a systemic footprint restriction, is seen as a necessity pushes the thinking in a more regulatory approach to financial stability, according to observers.

"The immediate issue for the industry is not so much what Congress will do, but what the Fed plans with regard to additional M&A criteria," said Petrou.

Such a plan is anti-competitive, some warned and may be challenged in court.

"There's a fundamental legal issue, which is will the financial stability factor become a de facto bar on growth by acquisition," said the industry source. "If Congress had wanted to say that, they would have said it. They would have adopted some variation of the Brown-Kauffman bill, but that's not what Congress said. I think there is a serious question if somebody were to file an application and the Fed tried to enforce this, they would lose in court."

Representatives from Citigroup and Bank of America Corp. declined to comment. A spokeswoman from JPMorgan Chase & Co. could not be reached immediately for comment.

But Rob Nichols, president and CEO of the Financial Services Forum, which represents the largest banks, took issue with the plan.

"Proposals to establish a precise limit on bank size overlook both the significant reforms implemented by banks since 2008, as well as enhancements to the supervision of large banks, which together have dramatically improved the safety and soundness of U.S. banks and made failures far less likely," said Nichols. "A better approach would be focusing on full implementation of orderly liquidation plans and living wills to ensure that no institution, no matter how large or complex, is immune from failure."

Others said Tarullo was focused on the wrong kind of size limitation, saying he shouldn't just worry about non-deposit liabilities.

"It seems to go in the opposite direction of where we should be going," said Cornelius Hurley, director of the Boston University Center for Finance, Law and Policy. "The subsidy is embedded in as much in the deposit as much as it is in the lower borrowing rates for non-deposit liabilities, so to focus on one and not the other is to me nonsensical. It's the whole package, it's the subsidy."