WASHINGTON — A landmark Treasury Department program designed to invest billions in poor communities around the U.S. through specialized financial institutions is being hamstrung by little-known Federal Reserve guidance, significantly reducing the capital available for certain small banks.
Policymakers in recent years have increasingly turned to specialized, community-focused financial institutions to deliver targeted investments in the nation’s poorest neighborhoods. Since 2020, the federal government has allocated a
But one of the largest and most anticipated federal efforts in community finance — the $8.75 billion Emergency Capital Investment Program, introduced by Congress’s 2021 budget — has become ensnared by conflicting supervisory rules between the Federal Reserve and Treasury Department, in some cases sharply reducing the potential investments some banks will be able to receive and put towards their communities.
“Because of this arbitrary rule that’s out there — unless there's an exception made to it, or we're not subject to it — we're not going to be able to serve the community” with all of banks’ ECIP-allocated funds, said Robert Barnes, president and CEO of PriorityOne Bank in Magee, Mississippi.
Advocates say that this regulatory impasse applies to about a third of the banks approved for ECIP funds by Treasury, and their inability to access that capital could leave billions of dollars on the table at a precarious time for the U.S. economy. The Community Development Bankers Association estimates that roughly $2 billion allocated by the Treasury Department through ECIP — out of the total of nearly $9 billion — could be impacted to some degree by the supervisory conflict between the Treasury and Fed.
ECIP fail
To qualify for ECIP funds, financial institutions submitted applications for specific amounts of investment capital to be approved by the Treasury Department. In December 2021, Treasury approved just under 200 financial institutions for ECIP funding, 101 of which were banks. Most recipients will take the investment in the form of preferred stock by default.
But of those 101 ECIP-approved banks, 34 are organized as S corporations, a type of corporate charter not uncommon among the country’s smallest banks that are owned by a small number of local shareholders or families. That subset includes 28 community development financial institutions, or CDFIs, and six minority depository institutions.
The chief benefit of S corporation, or S corp, status is tax flexibility; corporate tax is not paid by the bank directly but instead by the bank’s shareholders. But unlike C corporations — a more common form of corporate organization for banks — S corps are prohibited from issuing preferred stock.
That presents a crucial difficulty for S corp banks trying to receive ECIP funds they’ve been approved for by the Treasury Department. The ECIP alternative to preferred stock is subordinated debt, which could adversely affect a key debt-to-equity leverage ratio supervised by the Federal Reserve’s bank examiners under the agency’s “
“Where we've got a problem here is that the statute that Congress passed allowed financial institutions to be able to qualify for significantly larger amounts of ECIP money than some of them — probably most of them — can take once you apply these ratios to them,” said Jeannine Jacokes, CEO of the Community Development Bankers Association.
“There's this obvious conflict between what these two agencies are doing," Jacokes added. “And while this is totally in the weeds, it actually makes a really big difference.”
The impact of the conflicting regulations between Federal Reserve and Treasury Department policy will be significant. Any S corp bank that takes the funds and runs foul of their supervisory ratios could attract significant regulatory scrutiny and require Federal Reserve permission to make many business decisions, including the issuance of dividends.
“You are literally treated like a troubled bank,” said Ken Hale, president and CEO of the Bank of Montgomery. “You could be a 1-rated CAMELS institution, and you might take this capital from the Fed, push it down to the bank, and your bank could be 30% tier 1 capital, but you’re still considered a troubled institution because of the debt-to-equity and double leverage ratios.”
While bankers and lawyers in the community development ecosystem say the matter could be resolved quickly if the Federal Reserve announced that ECIP funds would be exempted from such ratios, the central bank has made no indication to date that it will do so.
“The Fed has the authority to exclude this capital from the debt-to-equity calculation, to create relief so that these banks can take full advantage of this program," said Ben Sones, a member at Sones & White in Ridgeland, Mississippi. "Without this exclusion, it's going to be difficult for the ECIP capital to be fully deployed into the communities that need it most."
And although bankers and advocates say Treasury officials have moved fairly quickly to implement the program on their end, Fed officials have signaled little urgency to the public on the matter.
“When you talk to the people in Treasury, they're like, yeah, [the Fed] won't tell us where they are, either,” Jacokes said. “Despite all the pushing everybody is doing, we're not getting anything concrete that there's movement inside the agency.”
The Federal Reserve codified its stance on federal funding through the ECIP program in March 2021, when it issued an interim rule outlining how preferred stock and subordinated debt would be treated for the purposes of banks' leverage ratios.
And while that interim rule went into effect immediately after being published in the Federal Register, it also asked for public feedback. That means that in a future, final rulemaking, the Fed could introduce the types of exemptions that S corp banks are seeking.
But time is running out: Last week, the Treasury Department notified ECIP-approved banks they would have until March 18 to determine how much funding they would accept from the government, if any.
Precedented action
The Fed's inaction so far has come as a surprise, advocates say, in part because there is clear and recent precedent for such a move. In the years following the 2008 financial crisis, federal funds delivered by two emergency programs — the Troubled Asset Relief Program and Small Business Lending Fund —
The Troubled Asset Relief Program "was intended to be a bailout for troubled institutions, whereas [ECIP] is intended to be a boon to the good guys," Sones said. “They're very different in their tone, purpose and policy objectives. So for TARP to get friendly capital treatment from the regulators whereas this program doesn’t — it really is not fathomable. I don't know the policy reason for that."
At the same time, the regulatory landscape for banks' capital requirements has changed dramatically since the passage of the Dodd-Frank Act, and the Fed's previous exemptions for TARP and the SBLF occurred years before the law's changes went into effect. Any number of those reforms — including the implementation of Basel III capital rules — could complicate the path the Fed takes towards a potential fix.
The problem has received significant attention from federal lawmakers in the meantime; more than a dozen members of Congress, both Republican and Democrat, have written to Federal Reserve Chair Jerome Powell in recent months urging the conflict to be resolved.
Two leading Democrats in financial policy — House Financial Services Chair Maxine Waters of California and Sen. Mark Warner of Virginia, a member on the Senate Banking Committee — wrote to Powell on Jan. 18, urging the Fed to “promptly” act and deliver regulatory relief for S corp banks.
“We have heard concerns from certain Community Development Financial Institutions (CDFIs) and Minority Depository Institutions (MDIs) that there is a lack of clarity on these issues that might unintentionally force these institutions to limit the ECIP capital they accept,” Waters and Warner wrote. “In a manner consistent with promoting the safety and soundness of these institutions, we urge the Federal Reserve to give their request for clarity due consideration.”
A second letter, issued on Jan. 21 and signed by a Republican group of southern U.S. senators and representatives, urged the Fed to take “immediate action to secure funding for the distressed communities that this program was designed to help.”
“Given past precedent regarding an exemption to this policy we respectfully request that the Board amend the debt-to-equity leverage ratio and double leverage ratio for subchapter S and Mutual bank ECIP recipients,” the Republican lawmakers wrote.
A coalition of several major banking advocacy organizations also flagged the issue for the Federal Reserve in December 2020, including the American Bankers Association, Community Development Bankers Association, Independent Community Bankers of America, National Bankers Association and the Subchapter S Bank Association.
“These banks are heavily disfavored (versus C corps) under the terms of the ECIP program and existing Board regulatory requirements, especially due to their limitation to receiving Sub Debt only, rather than preferred equity,” the trade associations wrote.
Without changes to the Federal Reserve’s small bank holding company guidance, they wrote, “tremendous opportunity will be lost and ECIP will fall short of meeting its Congressionally mandated purpose.”
The Treasury Department declined to comment on this story, directing questions to the Federal Reserve. A Federal Reserve spokesman said in a statement to American Banker that the central bank "understands the importance of minority depository institutions and community development financial institutions to the local communities they serve" and is "aware of the concerns being raised around [ECIP] and [is] looking closely at the issue."
'The Fed should be embarrassed'
The impact of the Federal Reserve’s supervisory ratios on different S corp banks approved for ECIP funding appears to vary widely. Sones, whose firm helped a number of CDFIs secure approval for ECIP funding, said that average loss of funding among his S corp clients without a Fed exemption was about 33%.
"There is no corresponding restriction on the amount of ECIP capital that our C corporation clients can accept," Sones said.
Barnes said his bank would need to leave $18.6 million in ECIP funding behind in order to comply with the Federal Reserve’s supervisory ratios — a 21% reduction in their Treasury-approved funds.
“If you look at it from a leverage standpoint, for every dollar we have in capital, we can loan out roughly ten dollars,” Barnes said. “So if you do the math on $18.6 million — that's the true impact to our community.”
Hale, the Bank of Montgomery CEO, said that his firm’s access would be starkly affected by the Fed’s inaction, with an 80% loss of ECIP funding. (Treasury has not made public how much each of its approved banks were cleared to receive under the program.)
“What disappoints me more than anything is that politicians on the left, politicians on the right, people in government go on and on about racial inequality, about helping the disadvantaged, helping the poor, helping rural Americans,” Hale said. “Well, there ain't many folks as poor as they are in Louisiana and Mississippi.”
“I think the Fed should be embarrassed, because they’re not doing anything,” Hale said.
The problems posed by the Fed’s inaction are significant enough that several S corp banks are weighing a change their corporate charters to the more common C corporation structure. Hale said the Bank of Montgomery’s shareholders planned to meet in early March to give up their S corp status and exchange it for a C corporation charter in order to use the full amount of ECIP funding awarded by Treasury.
“We're going to literally take the exact same amount of money whenever this is finished and become a C corp and lose our S, just because the Fed won't make a decision,” Hale said. “Literally, if we check a box with the IRS by March 15 of this year, we can take the exact same amount of money at the holding company level, under the same terms,” without the regulatory issues.
Barnes, of PriorityOne Bank, said his bank had had “some preliminary discussion” about changing charters. “It’s a pretty major decision that would impact our shareholders,” he said.
The decision could be a costly one in the near- and long-term for small community banks that often operate on comparatively thin profit margins.
"This is a battle, and these banks are kind of fighting it on multiple fronts," Sones said. "They’re definitely looking at the option of converting to a C corporation, but this requires an extensive cost-benefit analysis.”
