Dodd-Frank establishes U.S. financial stability as a critical hurdle for regulators to evaluate before approving future mergers and acquisitions. 

The Federal Reserve Board has begun to illustrate how this element of the law will influence bank consolidations in two orders approving acquisition: The PNC Financial Services Group's acquisition of RBC Bank, and Capital One Financial's acquisition of ING Bank.

Laying the orders alongside the FRB's final rule regarding living wills (adopted jointly with the Federal Deposit Insurance Corporation), the Financial Stability Oversight Council's final rule and interpretive guidance regarding the designation of systemically important financial institutions, the FRB's proposed rule to set heightened prudential standards for large bank holding companiess and SIFIs, and public statements by the FRB's governors, they would appear to create a Rosetta Stone to foretell future regulatory determinations.

Perhaps the two most prominent financial stability factors for designation or consolidation purposes may be the complexity of the company (said another way, the transparency of the company) viewed through the prism of its ultimate resolvability, and its interconnectedness to other large companies and the economy (particularly as it affects liquidity).  The prominence of these two factors is in part a byproduct of the recent financial crisis. 

Large bank holding companies and SIFIs will create work-arounds to lessen financial stability concerns as more consolidations are tested against these new standards. For example, since the late 1970s, banks have used branch divestitures to reduce the adverse competitive impact of mergers and gain FRB approval under applicable antitrust standards. With regard to financial stability, structural changes that increase the transparency of the combined company and improve its resolvability are likely to become good starting points to mitigate financial stability concerns. Dodd-Frank requires the FRB to consider the extent to which a proposed acquisition, merger or consolidation would result in greater risks to the stability of the United States banking or financial system.  The orders identify five factors of the combined entity that are relevant to financial stability: (i) size; (ii) availability of substitute providers of its products or services; (iii) interconnectedness with the rest of the financial system; (iv) complexity; and (v) cross-border activities.  A sixth factor, resolvability, has not been separately enumerated, but the FRB has woven it throughout its analysis of the other factors.

The Basel Committee on Banking Supervision has identified the identical five factors as the basis upon which to identify global systemically important banks, and the Comptroller of the Currency has used these factors, together with resolvability, to analyze a proposed acquisition under a similar amendment to the Bank Merger Act. 

Congress has made it clear that an organization's size is an important indicator of the risk it poses to the financial system. Even before Dodd-Frank, Congress imposed a 10 percent nationwide deposit cap on interstate transactions. In Dodd-Frank itself, Congress closed a loophole in that cap for thrift deposits and set a new 10 percent nationwide liabilities cap on acquisitions by large bank holding companiess and SIFIs. 

Based on the orders, it appears that size alone, whether measured by deposits, consolidated assets or total leverage ratio exposures, will not create an insurmountable impediment. PNC became the 19th largest U.S. financial institutions based on assets, and Capital One became the 20th. Each firm also became, at different times, the fifth largest financial institution based on U.S. deposits. Capital One also became the fourth largest credit card lender in the U.S., increasing its national market share from 7.7% to 11.8%.

The combined firms were admittedly large on an absolute basis, but in the FRB's view, still comprised only a "modest" share of the relevant nationwide markets. Three U.S. financial institutions had between six and eight times the amount of assets of PNC after the proposed acquisition, and seven other institutions had at least twice that amount of assets. PNC and Capital One had approximately 2.2% and 2.3%, respectively of U.S. deposits, but three other U.S. financial institutions had between 3.5 and five times that amount. The FRB also relied on the fact that both PNC’s and Capital One's post-merger shares of nationwide deposits and liabilities were well below the 10 percent limits set by Congress. 

Perhaps most important was the fact that the FRB, sounding somewhat like the Supreme Court in its landmark 1963 Philadelphia National Bank opinion, which cited the then locally limited nature of banking as impacting the antitrust consequences of a bank merger, found it to be highly significant that the parties engaged only in relatively traditional commercial and consumer banking activities. Thus, the FRB observed that the increased size of the combined firms would not increase the difficulty of resolving them. The bottom line: regulatory concern about size is more about complexity and resolvability than sheer scale.

Whether a banking organization engages in activities that are critical to the functioning of the U.S. financial system, and whether other organizations could quickly step in to perform those activities if the combined firm were suddenly unable to do so, are additional hurdles that a proposed merger or acquisition must clear.

PNC, Capital One and the firms they proposed to acquire were engaged primarily in providing business and consumer credit, products for which there were numerous other providers. The FRB concluded on this basis that the proposed transactions would not create, solidify or maintain a position of a combined firm that was likely to pose an unacceptable risk to U.S. financial stability.

The FRB used traditional measures of market share and market concentration to determine whether alternative sources of business and consumer credit were readily available and did not discuss what made an activity "critical" under this test. This suggests that size and substitutability overlap substantially as analytical categories. 

In a future column I will discuss how interconnectedness, business complexity and cross-border activities of banks will impact the FRB’s analysis, and how all of these factors must be blended before a merger or acquisition is approved.

Thomas P. Vartanian is a partner resident in the Washington, D.C. office of Dechert LLP. He is the head of the firm's financial institutions transactions practice, which represented parties in one of the transactions mentioned in this piece.