On March 14, 2018, the Senate passed, 67-31, the Economic Growth, Regulatory Relief and Consumer Protection Act, or S. 2155.  While it may lack a catchy name, its substance is of potentially great importance to community banks.

The following summary focuses on the impact of the bill for depository institutions with less than $10 billion in consolidated assets.  The bill would also have some significant impacts on larger institutions, which could, in turn, affect smaller banks… either as a result of competition or, perhaps more likely, through a re-ignition of larger bank merger and acquisition activity.  However, we thought it was useful to focus on the over 5,000 banks in the United States that have less than $10 billion in assets.

Community Bank Leverage Ratio

Section 201 of the bill requires the federal banking regulators to promulgate new regulations which would provide a “community bank leverage ratio” for depository institutions with consolidated assets of less than $10 billion.

The bill calls for the regulators to adopt a threshold for the community bank leverage ratio of between 8% and 10%.  Institutions under $10 billion in assets that meet such community bank leverage ratio will automatically be deemed to be well-capitalized.  However, the bill does provide that the regulators will retain the flexibility to determine that a depository institution (or class of depository institutions) may not qualify for the “community bank leverage ratio” test based on the institution’s risk profile.

The bill provides that the community bank leverage ratio will be calculated based on the ratio of the institution’s tangible equity capital divided by the average total consolidated assets.  For institutions meeting this community bank leverage ratio, risk-weighting analysis and compliance would become irrelevant from a capital compliance perspective.

Volcker Rule Relief

Section 203 of the bill provides an exemption from the Volcker Rule for institutions that are less than $10 billion and whose total trading assets and liabilities are not more than 5% of total consolidated assets.  The exemption provides complete relief from the Volcker Rule by exempting such depository institutions from the definition of “banking entity” for purposes of the Volcker Rule.

Accordingly, depository institutions with less than $10 billion in assets (unless they have significant trading assets and liabilities) will not be subject to either the proprietary trading or covered fund prohibitions of the Volcker Rule.

While few such institutions historically undertook proprietary trading, the relief from the compliance burdens is still a welcome one.  It will also re-open the ability depository institutions (and their holding companies) to invest in private equity funds, including fintech funds.  While such investments would still need to be confirmed to be permissible investments under the chartering authority of the institution (or done at a holding company level), these types of investments can be financially and strategically attractive.

Expansion of Small Bank Holding Company Policy Statement

Section 207 of the bill calls upon the federal banking regulators to, within 180 days of passage, raise the asset threshold under the Small Bank Holding Company Policy Statement from $1 billion to $3 billion.

Institutions qualifying for treatment under the Policy Statement are not subject to consolidated capital requirements at the holding company level; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans or subordinated debt, to finance growth.

Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.

Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth.  This expansion of the small bank holding company policy statement would significantly increase the ability of community banks to obtain significant efficiencies of scale while still providing enhanced returns to its equity holders.

Institutions engaged in significant nonbanking activities, that conduct significant off-balance sheet activities, or have a material amount of debt or equity securities outstanding that are registered with the SEC would remain ineligible for treatment under the Policy Statement, and the regulators would be able to exclude any institution for supervisory purposes.

HVCRE Modifications

Section 214 of the bill would specify that federal banking regulators may not impose higher capital standards on High Volatility Commercial Real Estate (HVCRE) exposures unless they are for acquisition, development or construction (ADC), and it clarifies what constitutes ADC status. The HVCRE ADC treatment would not apply to one-to-four-family residences, agricultural land, community development investments or existing income-producing real estate secured by a mortgage, or to any loans made prior to Jan. 1, 2015.

It also specifies when banks may reclassify ADC loans as non-HVCRE.  A bank may reclassify an ADC loan as non-HVCRE upon the substantial completion of the construction and when cash flow generated by the property is sufficient to support the debt service costs so long as the bank would be in position to underwrite the loan as a permanent financing.

Qualified Mortgages

Section 101 of the bill would amend the Truth in Lending Act to provide that all residential mortgage loans meeting certain standards and originated and retained in portfolio by depository institutions with less than $10 billion will automatically be deemed qualified mortgages.

In order to qualify as a qualified mortgage, the residential mortgage would be subject to a reduced set of qualifications:

• limitations with respect to prepayment penalties;
• total points and fees do not exceed 3 points;
• no negative amortization or interest-only features; and
• for which the institution has “considered and documented” the debt, income and financial resources of the consumer.

This Qualified Mortgage safe harbor is lost upon sale or assignment of the mortgage, unless the mortgage is sold to, and subsequently retained by, another depository institution with less than $10 billion in assets.

Appraisal Exemption for Real Estate Located in Rural Areas

Section 103 of the bill would provide an exemption for all depository institutions from the requirement to obtain an appraisal in connection with extensions of credit involving real property if:

• the real property is in a “rural area;”
• the transaction value is less than $400,000; and
• the depository institution has contacted at least three certified appraisers and documented that no appraiser was “available within 5 business days beyond customary and reasonable fee and timeliness standards.”

HMDA Relief

Section 104 of the bill would provide relief from some of the more detailed HMDA reporting obligations for insured depository institutions that make fewer than 500 closed-end mortgage loans or less than 500 open-end lines of credit in each of the two preceding calendar years.  The relief created by Section 104 are separately applied for closed-end mortgage loans and open-end lines of credit, so institutions could avail themselves to relief of either, or both, types of credit.

Institutions availing themselves of this relief would not be required to disclose the information required by 12 USC 2803(b)(5) or (6).  Institutions would remain subject to the requirements of 12 USC 2803(b)(1) through (4), and thus would still be obligated to report on the number and dollar amount of insured or guaranteed mortgage loans, mortgage loans made to investors, home improvement loans, and mortgage loans and completed applications involving mortgagors grouped according to census tract, income level, racial characteristics, age and gender.

Short Form Call Reports

Section 205 of the bill calls upon the federal banking regulators to issue regulations that allow for reduced reporting requirements for the first and third quarter reports filed by depository institutions with total consolidated assets of less than $5 billion.

Expansion of 18-Month Exam Cycle

Section 210 of the bill would increase the consolidated asset threshold cap for well-managed and well-capitalized banks to qualify for an 18-month examination cycle from $1 billion to $3 billion.

Reciprocal Deposits

Section 202 of the bill includes a limited exemption for the treatment of certain reciprocal deposits (think CDARS) from the brokered deposit limitations for inadequately capitalized institutions.  Less than well-capitalized institutions will be able to renew and/or replace (but not increase) the aggregate amount of reciprocal deposits on their balance sheets without needing a (difficult to obtain) brokered deposit waiver.

Impact on Holding Company Analysis

The advantages and disadvantages of eliminating a holding company structure remains a frequent topic of many bankers and commentators.  In our opinion, the reforms offered by the Economic Growth, Regulatory Relief and Consumer Protection Act would weigh in favor of keeping a holding company structure for institutions under $10 billion in consolidated capital.

A holding company’s flexibility when it comes to non-banking investments is increased by the Volcker Rule exemption, which would allow otherwise prohibited investments in private equity or hedge funds.  We have seen these investments historically viewed as strategic investments to develop future business customers or to expand a bank’s presence in their markets.  We have also seen the potential for investments in fintech focused funds that could give bank holding companies an interesting strategic opportunity to partner with a number of interesting new innovations.

Moreover, for institutions under $3 billion, the expansion of the Small Bank Holding Company Policy Statement greatly increases the potential value of the holding company structure for affected institutions.  Institutional investors are available to make subordinated debt investments in the holding company which can be used to finance stock redemptions and/or growth of subsidiary banks.  Without a holding company, such subordinated debt only qualifies as Tier 2 capital, but a bank holding company under the Policy Statement can downstream the proceeds of a subordinated debt issuance as additional Tier 1 capital for their subsidiary institution.

House Prospects

While the House has historically passed several attempts at regulatory reform, it is unknown how the House will respond to the Senate-passed bill.  The sponsors of the Senate bill kept a fairly tight lid on modifications during the Senate deliberations, fearful of losing their carefully constructed bipartisan support.  Conversely, Republicans in the House have a significant number of additional reforms that they would like to see adopted.  At the time of writing this post, it seems equally plausible that the House will begrudgingly simply adopt the Senate-passed bill, that the House will seek to add up to 30 additional provisions, or the House will revert and approve a radically different set of regulatory reforms, presumably based on the Financial Choice Act.  Either of the two latter approaches would then require a conference committee to resolve differences with the Senate and House each having an up or down vote on the committee’s agreed upon language.

My hope is that (perceived) perfection will not be the enemy of getting positive regulatory relief for the industry.  Given the difficulties of getting any legislation through the Senate, I believe that the Senate-passed bill will ultimately form the basis of regulatory reform.  In light of the upcoming elections, I suspect we’ll know relatively soon the feasibility of getting relief this year.

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