Fed Policy Change Could Spur More Banks to Stay Below $1B in Assets

Community banks consider it a key milestone to hit $1 billion in assets, but a recent policy change could prompt more bankers to carefully manage how they cross that threshold.

The Federal Reserve Board recently finalized a rule to allow bank holding companies with up to $1 billion in assets to finance acquisitions with up to 75% in debt. The exception, originally implemented in 1980 to encourage small community-based bank deals, had a previous cutoff of $500 million in assets.

While closely tied to M&A, the change could also encourage more banks to form holding companies or raise senior debt to replace bank-level subordinated debt. Banks could also use funds from a debt issue to buy back stock and boost performance, industry experts said. Bank holding companies with less than $1 billion in assets, for the most part, will also be exempt from Basel III capital rules.

As a result, more banks could consider lingering below $1 billion in assets while they line up financing and consider their options in terms of capital structure and acquisitions.

Banks that "are right at the cusp" of the new cutoff might be open to "managing below" the threshold, said Lowell Harrison, a lawyer at Fenimore, Kay, Harrison & Ford. He noted that there were instances of banks managing how they approached the previous cutoff.

The policy creates a "fundamental change" to earnings for banks that cross the expanded threshold, said Tim Coffey, an analyst at FIG Partners. That potential change could be more noteworthy than crossing over other key asset thresholds, he added.

The rule change was mandated by a recently enacted law that directed the Fed to expand its Small Bank Holding Company Policy Statement to cover banks with up to $1 billion in assets. The policy exempts banks and thrifts from certain capital and leverage rules, allowing them to carry higher levels of debt compared to bigger competitors.

Fed Gov. Daniel Tarullo, who pushed for the change, said last November that a higher cutoff could help spur small-bank consolidation and reduce regulatory burden for the industry's smallest players.

Executives contacted by American Banker declined to comment or said they are still trying to assess the benefits that could come from the change, leaving most discussion on the topic to analysts and other industry observers.

The change could create a financial incentive for bank holding companies to stay below $1 billion in assets — at least in the near term — because debt financing is typically cheaper than using equity, said Thomas Killian, a principal at Sandler O'Neill who recently wrote a report on the issue.

"Responsible banks that take advantage of the policy statement want to try to help lower their average cost of capital," Killian said. "By lowering their cost of capital, they can enhance returns to common shareholders."

The change was an acknowledgement by policymakers that "smaller, non-complex institutions don't present the same risk to the system" as bigger banks, said Jeffery Smith, a lawyer at Vorys, Sater, Seymour & Pease.

For instance, qualifying banks must meet certain criteria, including a requirement that they do not engage in "significant nonbanking activities."

The updated policy reflects "that the average size of community banks is increasing, and is changing what is truly considered a small bank in today's market," Harrison said.

The policy change made 460 bank holding companies eligible for the new exemption, Killian wrote in his report. Nearly 90% of the nation's bank holding companies are now eligible for the new exemption, representing about $436 billion — or 2% — of the banking industry's total assets, he added.

Given the potential capital flexibility, more small bank holding companies could elect to stay under — or shrink below — $1 billion in assets, Coffey said. Marginally profitable banks with more than $1 billion in assets could shed low-yielding assets to dip below the cutoff, Coffey's firm wrote in a recent report.

Such scenarios could make small banks more appealing to investors. "From a [return on equity] perspective, they're going to screen better," Coffey said.

Harrison disagreed that banks would look to slim down.

"Banks are generally growing in size through consolidation or organically," Harrison said. "I don't see banks managing it the other way."

While bankers were reluctant to discuss the issue, representatives for key trade groups downplayed the potential of members purposely restraining growth to reap benefits from the policy change.

Hovering below $1 billion in assets could be a "temporary" possibility for banks that "don't see a real need to grow extensively," said Chris Cole, senior regulatory counsel at the Independent Community Bankers of America.

The more important takeaway is that the policy gives banks new tools to raise capital. "We've always looked at it as an access to capital issue," Cole said.

It is possible that banks could manage when they cross the expanded threshold, Wayne Abernathy, executive vice president of financial institutions policy at the American Bankers Association, said. Still, he said the Fed policy will be more important for "specific mergers" that require more debt financing.