Cullen/Frost's Fair-Lending Deal with Fed Is an M&A Wake-Up Call

There is no such thing as an easy bank acquisition, just companies that know how to maneuver the obstacles in their push to the finish line.

Cullen/Frost Bankers (CFR) in San Antonio proved to be one of those deft operators in getting regulatory approval last week for its acquisition of WNB Bancshares in Odessa, Texas.

To be sure, the approval came three and a half months later than expected and with some strings: Cullen/Frost is barred from doing any additional "expansionary activities" until it improves its compliance functions, including those related to fair lending. That might not sound like victory, but the company's ability to sway regulators away from a further delay and into a promise to do better next time is noteworthy, industry observers say.

"The successful buyers are the ones who are able to navigate the issues in this environment where compliance, including fair lending, is a major focus for regulators," says Chip MacDonald, a partner at Jones Day in Atlanta. "The companies have to be prepared to demonstrate why and how they are compliant and show they are ready to pledge resources to improve things."

The approval also speaks to the need for sellers to pick their buyers carefully.

"You want to pick a partner who can achieve the price target but also who has the ability to close," says C.K. Lee, a managing director at Commerce Street Capital, a Dallas investment bank. "The seller should get as tight of an answer as it can and determine if they have the facts and evidence to support it."

Commerce represented WNB in the deal, but Lee declined to comment specifically about the transaction.

Dick Evans, the chief executive of the $24.7 billion-asset Cullen/Frost, says the Federal Reserve's demand for it to have a clearly developed compliance policy to support future expansion and to hire additional experienced fair lending staff is a "reasonable request."

"We respect the regulators because they give us a license to operate, and in this time in history compliance is an important factor and Dodd-Frank expanded that subject," Evans said in an interview. "We never can anticipate what the regulators are going to focus on, but we certainly accept it and are moving forward."

Evans declined to say whether the agreement would halt any deals the company was currently pursuing.

Analysts who follow Cullen/Frost downplayed its concession to regulators.

"It is not going to meaningfully change anything — they don't do that many deals and this was probably the only one they were going to do this year," says Brett Rabatin, an analyst at Sterne Agee. "It theoretically could cost them an opportunity if something came up."

The agreement was disclosed in a footnote in the Fed's approval order, and the company also mentioned it in a press release. Cullen/Frost's assets have grown 83% since 2008, primarily through organic growth. The WNB deal is its first since 2006, and Evans says he wants to keep expanding the company.

The Fed declined to comment for this story, but the footnote says it wants Cullen/Frost to have a clearly developed plan and more experienced staff in place to monitor "fair lending risk, which might be heightened by expansion."

Fair lending and community reinvestment experts say the Fed's approval and request for improvement could set a bad precedent. The regulator should have made the improvements a condition of the existing deal, not a further one, says Ken Thomas, an independent bank consultant and economist.

"Why they would have approved it in the first place? Didn't [Fed Chair] Janet Yellen say she was going to look tough at banks?" Thomas says. "This tells other buyers, 'You can have a substandard compliance department and still get a deal approved, so you long as fix it in the future.' "

Matthew R. Lee, founder of Inner City Press, an activist organization that has sought judicial review of several Fed actions including merger approvals, says the company's Frost Bank unit has an "outrageous record" when it comes to fair lending. For instance, the company made 84 home purchase loans in the Houston area to whites in 2012, but only one to an African-American, according to Home Mortgage Disclosure Act data.

There are several counterarguments in the company's favor.

Mortgages are a small part of its business, and so it is unfair to judge the company's fair lending practices based on mortgages, analysts say. Only 0.3% of its total loans are mortgages, and mortgage banking revenue is not broken out in its income statement. Cullen/Frost is primarily a commercial bank that doesn't seek mortgages and likely only does them at the request of their existing business clients, Rabatin says.

Additionally, the Fed noted that Frost Bank's 2008 Community Reinvestment Act evaluation, its most recent, showed good responsiveness to its area's credit needs, particularly with loans to small business and noted that its community development loans were high.

Yet the case highlights many of the shortcomings in the regulatory system, critics say.

The six years that have elapsed since Cullen/Frost's last CRA examination is troubling given its rapid growth, Thomas says.

Ultimately, the Fed's requirement that the company make improvements is a step in the right direction, Lee says. Still, he worries that commitments to improve will gain in popularity, and they don't go far enough to fix the issues.

"While the Fed imposing the condition it did is better than nothing, at some point the Fed will need to deny a merger, to enforce CRA and fair lending," Lee said in an email.