Why Pressure Is Building to Raise $50B 'Systemic' Threshold

WASHINGTON — Growing up can be hard to do under the Dodd-Frank Act.

First Republic Bank saw its stock plummet more than 15% after it posted second-quarter earnings last week, in part because it is due to reach a key Dodd-Frank threshold of $50 billion of assets by next year. The milestone means that the bank will officially be considered "systemically important," triggering a number of enhanced regulations with which it must comply, including Federal Reserve Board-graded stress tests and greater risk management requirements.

"It's a case study in what happens to a bank when it hits that level," said Edward Mills, an analyst at FBR Capital Markets.

The San Francisco bank's disclosure — and its market impact — illustrate the growing debate in Washington, four years after the enactment of the financial reform law, over whether $50 billion is the right cut-off for determining that a bank is a threat to the economy. There's virtually no chance that Congress will address the issue this year, but it's a discussion that lawmakers, industry officials and regulators are likely to keep having as Dodd-Frank moves closer to being fully implemented.

Daniel Tarullo, a Federal Reserve Board governor, kicked off the latest discussion this spring when he raised questions about the cut-off, bringing the issue more widespread attention.

"The key question is whether $50 billion is the right line to have drawn," he said in a May 8 speech. "Experience to date suggests to me, at least, that the line might better be drawn at a higher asset level — $100 billion, perhaps. Requirements such as resolution planning and the quite elaborate requirements of our supervisory stress testing process do not seem to me to be necessary for banks between $50 billion and $100 billion in assets."

The Fed official wasn't the first to raise concerns about the Dodd-Frank threshold, but he's given supporters of a change a significant boost in their efforts.

A bill by Rep. Blaine Luetkemeyer, R-Mo., to do away with the current threshold and instead give regulators more discretion to determine which institutions threaten the financial system now has 57 bipartisan co-sponsors. Members of the Senate Banking Committee began to explore the issue at a subcommittee hearing last week.

The Bipartisan Policy Center has also renewed its call to raise the threshold to $250 billion and give regulators more flexibility in making SIFI determinations, first laid out in a policy paper in April.

"Nobody believes a $52 billion community or regional bank that's just over the SIFI threshold poses more of a systemic threat, and all the extra regulatory costs, than a similar bank that's just below the $50 billion threshold," said Aaron Klein, director of BPC's Financial Regulatory Reform Initiative.

The biggest problem with the $50 billion bar, critics say, is that it's arbitrary and creates perverse incentives for institutions approaching the cutoff. It's also un-indexed, which could raise new problems going forward as the economy and banks continue to grow in size.

"Having a hard and fast line is a bit problematic. It's hard to imagine a $48 billion bank acquiring a $2 billion bank across the river and suddenly finding themselves designated as systemic," said Klein. "It creates a big kink in the curve — by having such large costs at a sharp threshold, you create a strong disincentive for what otherwise could be sensible growth and acquisitions."

Jim Herbert, chairman and chief executive of First Republic, discussed some of the new burdens the bank faces on a July 16 earnings call, noting that the additional expenses would translate to an increase in the bank's efficiency ratio, a key performance metric of costs relative to revenue.

"As you all know, institutions with over $50 billion in assets are required to operate under significantly heightened regulatory and compliance standards," Herbert said on the call. "This includes initiatives to enhance systems and procedures in many areas such as enterprise risk management, [Bank Secrecy Act/Anti-Money Laundering], capital and liquidity stress testing, compliance, resolution planning, and the still-pending liquidity coverage ratio."

He stressed to analysts that the bank's pace in meeting the new requirements played a big role in the additional cost projections relative to earlier earnings reports.

"I think that the real question here is not so much what changed in the overall needs, but our speed with which we decided to get at it," he said. "The other thing that happens is that the regulators do not wait until you are $50 billion to impose some of this guidance on you."

A spokesman for First Republic declined to comment further.

Still, analysts' reactions to the news were mixed, with many highlighting the likely rise in expenses in their write-ups to clients.

"There's no getting around it: a higher regulatory cost burden as [First Republic] approaches the $50 [billion] asset threshold would materially dampen near-term [earnings per share] power," said Erika Najarian, a Bank of America analyst, in a note.

Another key question for those concerned about the SIFI threshold is how it sets up large community banks, such as First Republic, against the real industry behemoths, like JPMorgan Chase and Bank of America, both of which have more than $2 trillion in assets.

Complying with the enhanced prudential standards under Dodd-Frank is costly — and the costs are proportionally bigger for banks just hitting the $50 billion mark. That raises the question for some of whether the benefits are similarly proportional.

"Some of the fixed costs of Dodd-Frank, like living wills, were higher than expected and not commensurate with the benefits of covering small institutions," said Klein. "The smaller the bank, the less systemically significant the bank is, and the less benefit you'd get for regulating it as a SIFI."

Moreover, some argue that the threshold could disincentivize growth for banks nearing the $50 billion mark, potentially undercutting the financial reform law's efforts at distributing some of the market power away from a handful of the largest players.

"We're getting closer to the final implementation of Dodd-Frank rules, and we now know that for banks with $250 billion in assets and above there is a desire to focus on their core businesses and probably give up market share and exit certain businesses," said Mills. "But you need someone else to pick up that market share or enter into those business lines, and to the extent you're not facilitating — and even inhibiting — the building of that bench behind the biggest banks, you're unable to accomplish your goals."