Tiered Regulation for Banks Is a Tax on Growth

Many years ago, we predicted there would eventually be two distinct types of bank regulation: one set for large banks and one set for community banks. It turns out that we were incorrect. Thanks to the Dodd-Frank Act, there are now at least seven different levels of regulation based on banks' asset size. Several conclusions can be drawn from the evolution of this segmented form of regulation.

First, large bank regulation trickles down to other banks, often in the form of best practices. Second, the larger the bank, the greater regulators' expectations of self-imposed governance and compliance programs. Finally, the cumulative impact of size-based regulation equates to a tax on growth. This is by design — and it means that banks will have to analyze the cost of growth against the financial benefits it provides.

A look at the seven levels of regulation, which are cumulative, reveals how they impact a bank's decision to grow.

Level 1 applies to bank holding companies with consolidated assets of $500 million or more, which are now subject to the Federal Reserve's capital requirements. Pending legislation would raise this limit to $1 billion. Banks that cross the $500 million threshold are no longer eligible for an extended 18-month examination cycle available to their smaller peers and instead are subject to a 12-month cycle.

Level 2 is for banks with $1 billion or more in assets, which will become subject to new restrictions and requirements on incentive compensation. Proposed rules would prohibit incentive compensation arrangements that provide management with excessive pay or encourage individuals to take inappropriate risks.

Institutions with at least $10 billion in assets become subject to Level 3 requirements. These include the examination and enforcement jurisdiction of the Consumer Financial Protection Bureau, the Fed's rules implementing Dodd-Frank's Durbin Amendment cap on merchant interchange fees on debit card purchases, the requirement to conduct annual stress tests, and board risk committee requirements.

At Level 4, banking organizations with $15 billion or more in assets must phase out trust preferred securities from Tier 1 capital by 2016. Notably, organizations that cross the $15 billion threshold as a result of organic growth (rather than an acquisition) would not be subject to the phase-out.

Banks above the $50 billion asset threshold — Level 5 organizations — are considered systemically significant. They are subject to enhanced levels of prudential regulation requiring them to submit annual capital plans to the Fed regarding uses and sources of capital over a nine-quarter planning horizon, along with explanations of how sufficient capital will be maintained under various stress scenarios. The Fed's rejection of an institution's plan forecloses future capital distributions, including dividends.

These organizations must also submit annual resolution plans, or living wills, to the Fed and the Federal Deposit Insurance Corp. detailing the company's strategy for “rapid and orderly” resolution in the event of material financial distress or failure. The living wills submitted by the largest banking organizations in 2013 were deemed to have significant shortcomings that must be resolved on or before July 1, 2015, to avoid further supervisory action. Those that fail to file a satisfactory living will are eventually subject to divestiture and other regulatory enforcement orders.

Additional enhanced prudential standards also apply. These banks are subject to a liquidity buffer based on monthly internal stress tests as well as a new liquidity coverage ratio. In addition, they have to employ an independent chief risk officer. Rules currently under consideration would also impose single counter-party credit limits and significant limits on employee incentive compensation arrangements. National banks that cross the $50 billion threshold are also subject to heightened expectations for risk governance under guidelines adopted by the Office of the Comptroller of the Currency.

Banks with assets of $250 billion or more fall under even more regulations at Level 6. They must meet a 3% supplementary leverage ratio and are required under the LCR rules to maintain high-quality liquid assets to cover potential net cash outflows over a prospective 30-day period. They are also subject to a countercyclical capital buffer of up to 2.5% of total risk-weighted assets, which may be activated by regulators based on a range of financial and supervisory factors calibrated to systemic risk.

Last come the too big to fail banks at Level 7. The eight depository organizations with assets in excess of $700 billion, or with more than $10 trillion in assets under custody, are known as global systemically important banks or G-SIBs. They face even higher capital requirements, including a 6% supplementary leverage ratio, in order to be considered well capitalized. Tier 1 leverage buffer rules have also been adopted for these organizations, requiring them to hold capital of at least 2% above the minimum supplementary leverage ratio applicable to banking organizations with $250 billion or more in assets.

The Fed's latest proposal would also subject the biggest banks to a risk-based capital surcharge calibrated to reflect the organization's systemic risk profile. The surcharge would be added to an organization's capital conservation buffer and would be calculated based on various systemic indicators, including the organization's use of short-term wholesale funding. It is estimated that the surcharge for the eight organizations that currently qualify as G-SIBs would range from 1- 4.5% of total risk-weighted assets.

Finally, under new requirements imposed by Dodd-Frank, bank holding company mergers and acquisitions may be prohibited if they increase systemic risk. This suggests that large organizations will face additional regulatory hurdles when applying for approval to grow through acquisitions.

The fact that regulation is increasingly geared to size imposes a progressive growth tax on banks. This will affect almost every operational and strategic decision that banks make going forward.

Whether a tax on size will result in a safer and sounder banking system — and whether it will succeed in restraining growth and overall asset size — remains to be seen. But it seems fair to believe that these limitations may become even more significant and more numerous in the future. Bankers should be sensitive to any further escalation of this trend, and develop a financial matrix that will allow them to calculate the regulatory costs of future growth.

Thomas Vartanian and David Ansell are partners in the financial institutions practice at the international law firm Dechert LLP. Mr. Vartanian served as general counsel of the Federal Home Loan Bank Board under the Reagan Administration and before that was special assistant to the chief counsel of the Office of the Comptroller of the Currency. Mr. Ansell is a former attorney with the OCC.