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Additional Clarity on TARP Approval Process & Standards

On August 6, 2009, the Office of the Special Inspector General for TARP (SIGTARP) published its report on whether external parties (i.e. politicians) unduly influenced TARP Capital Purchase Program decisions.  We will write more about that subject shortly, but the Report also provided the most detailed summary that we’ve seen of the factors considered by Treasury and the federal banking regulators in determining whether to approve a TARP application.

First, composite CAMELS ratings clearly played a significant role in determining the likelihood of success for any given institution.

  • 1-rated institutions were generally sent directly to Treasury for approval, and seemingly regularly approved for Capital Purchase Program funds.
  • 2-rated institutions with “acceptable performance ratios” were also sent directly to Treasury for approval, and again appear to have been regularly approved for funds.  2-rated institutions with “unacceptable performance ratios” were subject to further review by the interagency council, where at least three of the four federal banking regulators had to approve the application.  The Report states that the interagency council then analyzed “the viability of the institution based on the quantitative and qualitative  factors of the case” in determining whether to recommend approval to Treasury.
  • 3-rated institutions were originally treated like 2-rated institutions, but “relatively early in the CPP application review process,” Treasury decided that all 3-rated institutions needed to be reviewed by the interagency council.
  • 4- or 5-rated institutions were generally asked to withdraw, without the application being forwarded to the interagency council.

The Treasury would then make an independent evaluation of each application before making recommendations to the three-member Treasury Investment Committee.  The Treasury Investment Committee would then make a recommendation for final approval to the Assistant Secretary.  While only the Assistant Secretary can actually approve a TARP CPP application (all other actions are merely recommendations to approve), according to the Report, the Assistant Secretary had not rejected any recommendation forwarded by the Investment Committee for approval.

Performance Ratios

The Report also includes, as an Appendix, a copy of a “Case Decision Memo Template” that appears to have been the form used by the region/district level office of each federal banking regulator that reviewed TARP CPP applications.  The Memo provides further guidance on the specific performance ratios considered by the agencies.  In addition to CAMELS and CRA ratings, the  Memo called for an evaluation of the following performance ratios, both before and after a TARP infusion and both for the holding company and the largest bank subsidiary:

  • Tier 1 Risk-Based Capital
  • Total Risk-Based Capital
  • Tier 1 Leverage Ratio
  • Classified Assets/(Net Tier 1 Capital + ALLL)
  • (NPLs + OREO)/(Net Tier 1 Capital + ALLL)
  • Construction & Development Loans/Total Risk-Based Capital

While the first three performance ratios are consistent with the three historical measures of bank capitalization, the last three performance factors highlight the focus of the banking regulators on these ratios.

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To TARP or Not to TARP

To TARP or Not to TARP

June 30, 2009

Authored by: Robert Klingler

As noted by the Wall Street Journal (subscription required), a steady stream of small banks are still lining up for government money.

Since May 31, 20 small banks have received a total of $164.1 million in taxpayer-funded capital, according to the Treasury’s latest available figures.  Half of those banks got the money in the same week that 10 big financial institutions gave theirs back.

Analysts see no end in sight to the trend.  The recession and borrowers are squeezing most of the 8,200 federally insured commercial banks and savings institutions in the U.S., so even a dollop of TARP funds could make a difference.  Some banks are turning to the government to fill a void left by investors who are leery about pouring money into the sector, despite the rebound by bank stocks since early March.

Meanwhile, the rules and stigma of TARP that turned some executives such as J.P. Morgan Chairman and CEO James Dimon against the program are irrelevant to small institutions.

Their employees usually don’t fly on corporate jets or collect hefty bonuses that trigger outrage from taxpayers, customers and Congress.  And curbs on dividend payments are a modest price to pay for greater assurance that the banks can plow ahead with their core mission to gather local deposits, lend them nearby and support local charities, some recent TARP recipients said.

It’s certainly a stretch to say the executive compensation restrictions are “irrelevant” to small institutions, but community banks generally don’t have the excesses that have drawn public and congressional scorn.  With the deadline for smaller community banks to apply to participate under the TARP Capital Purchase Program extended until November 9, 2009, many institutions are taking a fresh look as to whether to apply, even as larger institutions are making a decision as to whether to seek to redeem the TARP investment they’ve already received.

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An Update on the Application Backlog

Even as five of the eight initial Capital Purchase Program recipients have redeemed their TARP investments with the Treasury, hundreds of applications are still being processed, as reported by the American Banker on June 26, 2009 (subscription required).

The Government Accountability Office said in a June 17 report that the Treasury had received more than 1,300 applications from federal regulators as of June 12, and that fewer than 100 were still awaiting a decision. The GAO also said bank regulators are reviewing another 220 applications that have not yet been forwarded to the Treasury.

Of the banking agencies, only the Office of Thrift Supervision details the Tarp application process. Of the roughly 800 companies it oversees, the OTS said 302 have applied for capital injections. Forty-nine have gotten the money and 140 have withdrawn their applications. Another 71 are in some state of review while 42 have yet to be considered.

The Treasury may emphasize that “fewer than 100 are still awaiting a decision,” but that excludes over 200 applications that are haven’t even made it to the Treasury yet.  All told, there are probably 300 applicants that haven’t been told whether they are eligible to receive a TARP investment.

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Commentary: NYTimes Recognizes Community Banks

The front cover of the May 17, 2009 issue of the New York Times Magazine asked “Are Small Banks the Future?”  As noted in the article, lending may have slowed at the largest banks, but at the other end of the financial system, there are 8,500 community banks, and most remain very strong.

In the midst of the worst banking crisis since the Great Depression, community banks have generally fared well. That’s because they typically shunned the lending practices that led to high default rates. They rarely participated in the securitization of loans, credit-default swaps and other overvalued financial products that put the global financial system in crisis. Instead, they stuck to the fundamentals. They considered the character and history of their borrowers. They required collateral. Without community banks, the current financial crisis would be a lot worse.

The focus of the mainstreet press, and the Treasury Department, continues to be on the largest institutions, whether it be the initial nine TARP Capital recipients, or the nineteen that underwent the stress test.  There is some rationality for this focus, the majority of assets, deposits and loans are held by these institutions.  But just like small businesses generally, community banks play a critical role in the American economy.

Community banks may have weathered the current crisis better than larger banks, but they remain an American oddity. Most other countries have 5 or 10 na­tional banks, and when they get in trouble, as they did in Iceland, it can be devastating. The balance in this country is tipped toward big institutions (the four largest control half the assets held by American banks and 40 percent of all deposits), but community banks still make 43 percent of all small business loans under $1 million. Since January 2008, fewer than 1 percent of all community banks have failed.

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Commentary: Demonstrating a Bank is Using TARP Capital to Lend

One issue that seems to be gaining traction is the need for banks to show how they are using TARP Capital, with a strong preference for the banks to be using TARP Capital to make loans.  While the fungibility of bank capital makes it virtually impossible to directly tie any particular dollar of capital with any particular dollar lent, that fungibility also gives great leeway to community banks to demonstrate the lending impact of TARP Capital.  Despite the political hot potato, we expect very few, if any, community banks to be criticized for their use of TARP Capital funds.

We do not believe that TARP Capital should fundamentally change the way in which bankers run their banks.  Solely because they have TARP Capital, banks should not approve loans that they otherwise would turn down.  However, any bank with additional capital, which TARP Capital provides, is in a better position to make or renew loans than that same bank would have been without TARP Capital.

A bank should be able to show that TARP Capital is “working” so long as its total loans are higher than they would have been without the TARP Capital infusion.  In recognition of the current economic environment and capital restraints, we believe many banks would be actively attempting to shrink the size of the bank were they not to receive TARP Capital infusions.  As a result, merely maintaining the current levels of loans could, in reality, be the result of TARP Capital increasing bank lending activity.  Even Barney Frank’s proposed reform legislation acknowledges that TARP Capital may simply minimize the decline in lending that normally accompanies economic recessions.  While this metric may be difficult for the Congressional Oversight Committee to accept, anytime the question is asked whether a new program is working, you have to make assumptions about what the situation would look like without the program.

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Commentary: Big Picture Thoughts on Applying for TARP Capital

Whether to apply for or accept TARP Capital is a decision that each bank needs to make individually depending on its own markets and circumstances.  However, as explained below, we believe each bank needs to prepare a realistic, worst-case scenario for the next three years.  Unless your bank’s capital will remain strong, we think you should apply for TARP Capital.

In three years, your bank will likely be in position to redeem the TARP Capital.  If that’s true, then the TARP Capital will have served as an inexpensive insurance policy that went unused, and you won’t be subject to any further government restrictions.

On the other hand, it is possible that, in three years, the financial condition of your bank makes you unable to redeem the TARP Capital.  In that event, it is very clear that you needed the TARP Capital.

With only these two scenarios, we believe almost every bank is better off applying for TARP Capital.

Where is the Economy Headed?

As the residential real estate market declined, all the contractors and subcontractors associated with that market began to suffer.  These contractors and subcontractors include our drywall installers, plumbers, painters, flooring specialists, lighting specialists, landscapers, pavers, pool installers, and numerous others – a vast group of construction and service-industry workers.  With new residential starts drying up, and with in-progress projects shutting down, many of the employees in those contracting and subcontracting fields began to lose their jobs.

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Commentary: Tightening of TARP Capital Standards

Conversations with each of the federal banking regulators over the last several days confirm what we have heard elsewhere: the distribution of TARP Capital that started out with a more liberal bias has now turned more conservative.  Regulators have recently indicated that institutions with a CAMELS rating of 1 and 2 are almost certainly likely to receive an investment, while 3-rated institutions are now described as “perhaps” receiving an investment.  4 and 5-rated banks are unlikely to receive any TARP Capital, absent unique circumstances.  (Just a few weeks ago, these same regulators were telling us that a 3-rated institution would be treated more like a 2-rated institution, and that 4-rated institutions would “perhaps” receive an investment.)  This shift is certainly an outgrowth of Treasury’s position that the main test of which institutions will receive capital investments is assured long term viability.

What does this mean for the thousands of banks that will not receive funding?  They certainly need to be considering a public relations initiative to manage or preempt the questions that will come at them from shareholders and the local media.  Perhaps the conversation could be along the following lines: “(i) the banking industry did not ask for this plan (which has changed dramatically since it was first proposed); (ii) an investment by the Treasury in a bank is not an automatic guarantee that a particular bank will be successful and neither is a decision not to invest some sort of condemnation; (iii) our loan portfolio reflects our community and the real estate lending which helped our community grow is suffering; and (iv) we are here for the long run and look forward to meeting the credit needs of our customers for years to come.  Together we will both survive the current economic challenges.”

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Commentary: Reputation Risk from Participation

The ABA has noted that some banks are concerned with the reputational risk of participating in a bail-out.   While some customers may have this concern, it does not change our belief that all eligible banks should strongly consider participating.   Having said that, we also think banks should be prepared to deal with this issue and should be proactive with their customers.   The emphasis should be on supporting the Government’s program to strengthen the entire banking system in order to enable banks to continue supporting their local community through this economic downturn.  The program is designed to earn a return for the Government (and thus the taxpayer), and is thus not a “bail-out” at all.   The program is for healthy banks, not to save problem banks.  Customers should be comforted by the facts.

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Commentary: Does Accepting TARP Capital Mean Additional Regulation?

We have heard a number of bankers state that they are concerned with accepting the TARP Capital, fearing potential future regulation imposed on those that accept government money.  While each bank’s situation is unique, we generally consider this concern to be overstated for the following reasons:

  1. Once the TARP Capital is in place and the preferred stock and warrants are issued, the terms of those instruments are defined by contract.  The government should not be able to modify the terms to give itself a better deal.  For example, the government cannot require that the institution pay the 9% dividend before the expiration of five years.
  2. We believe that if the government decides to impose additional regulatory restrictions (which in this economic environment seems likely), it is more likely to do so with regard to the whole industry rather than distinguish between banks that accepted the TARP Capital and those that did not.  From a policy perspective, Congress and the regulators may view “the whole industry” as having been helped and therefore that “the whole industry” should bear the burden of any additional regulations.
  3. The government already has broad powers to regulate financial institutions; it seems unlikely that the government would use its relatively weak power as a preferred shareholder to impose change when it has stronger regulatory powers to impose change.
  4. The government may impose one or more of the restrictions that are currently associated with the TARP Capital program on all companies – for example, it is possible that the executive compensation changes may be expanded to all companies, whether or not they have accepted (or were even eligible for) TARP Capital.

That’s our belief.  We’d love to hear yours in the comments.

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