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. This investment choice could range anything from real estate properties to developing a line of pro drones (see https://letsflywisely.com/professional-drones/). 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.

Much of the discussion we’re having with our clients and other professionals relates to the prospects for financial regulatory reform.  To that end, and looking at it from the political rather than industry perspective, Bryan Cave’s Public Policy and Government Affairs Team has put together a brief client alert examining the political, legislative and regulatory issues currently under consideration.

In his first weeks in office, President Trump has taken steps to undo or alter major components of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). These include delaying implementation of the “Fiduciary Rule,” which regulates the relationship between investors and their financial advisors, directing the Treasury Secretary to review the Dodd-Frank Act in its entirety, and signing a resolution passed by Congress that repeals a Dodd-Frank regulation on disclosures of overseas activity by energy companies.

Read the rest of this alert on Bryan Cave’s homepage.

We’ve also posted about the impact of the proposed regulatory off-ramp on community banks, recorded a podcast episode on the Financial Choice Act, and discussed some of the causes, including hopes for regulatory relief, of the rise in bank stock prices in our podcast episode on the issues associated with elevated stock prices in bank mergers and acquisitions.

A key component of the proposed roadmap for Republican efforts to provide regulatory relief is based on reduced regulatory burdens in exchange for holding higher capital levels.  Specifically, Title I of the proposed Financial Choice Act, as modified by Representative Hensarling’s “Choice Act 2.0 Changes” memo of February 7, 2017, proposes to provide significant regulatory relief for institutions that maintain an average leverage ratio of at least 10 percent.

The principal concepts of this “regulatory off-ramp” have, so far, remained relatively constant since first published by the House Financial Services Committee in June of 2016; any institution that elects to maintain elevated capital ratios (set at a 10% leverage ratio) would enjoy exemptions from the need to comply with certain other bank regulatory requirements.

Choice 2.0

In February 2017, Jeb Hensarling, Chairman of the Financial Services Committee, indicated that the “regulatory off-ramp” included in the proposed 2017 legislation would differ in two critical aspects from the 2016 proposed legislation.

First, the regulatory off-ramp would be based solely on the banking organization’s leverage ratio and would not consider the organization’s composite CAMELS rating.  Originally, the legislation limited eligible institutions to those that possessed a composite two CAMELS rating.  This change eliminates a subjective element to the regulatory off-ramp, but may also highlight that banking regulators would retain a wide array of tools to address institutions with substandard CAMELS ratings, regardless of their capital levels.

On February 3, 2017, President Trump issued an executive order setting forth his administration’s core principles for the regulation of the U.S. financial system.  While generally touted as the administration’s first affirmative steps to dismantle the Dodd-Frank Act, the executive order actually does little to implement any immediate change but says a lot about the overall framework by which the Trump Administration intends to approach financial regulation.

In addition to standard executive order boilerplate, the executive order sets forth two specific actions.  First, it establishes the “principles of regulation” that the administration will look at in evaluating regulations.

Section 1. Policy. It shall be the policy of my Administration to regulate the United States financial system in a manner consistent with the following principles of regulation, which shall be known as the Core Principles:

(a) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;

(b) prevent taxpayer-funded bailouts;

(c) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;

(d) enable American companies to be competitive with foreign firms in domestic and foreign markets;

(e) advance American interests in international financial regulatory negotiations and meetings;

(g) restore public accountability within Federal financial regulatory agencies and rationalize the Federal financial regulatory framework.

Notwithstanding partisanship biases, I think most of these principles express ideas that most Americans could support, even if some would say there are additional principles (such as protecting consumers) that might also be relevant.  Even with some “norms” going out the window, I think everyone should be able to get behind the concept that our financial regulations should seek to “prevent taxpayer-funded bailouts.”  If nothing else, the Core Principles reflect generally mainstream Republican views of the goals (and implied limitations) of federal regulations.

On September 10, 2015, a divided Second Circuit appeals court held in Berman v. Neo@Ogilvy LLC, that an employee who reports wrongdoing internally to management is considered a “whistleblower” under the Dodd-Frank Act, thereby strengthening retaliation protections for employee whistleblowers.

There has been a history of tension between the Dodd-Frank statutory definition of “whistleblower” and the applicability of the Dodd-Frank anti-retaliation provisions to employees who report suspected misconduct internally.    The Act defines a “whistleblower” as “any individual who provides…information relating to a violation of the securities laws to the Commission…”  However, section 78u-6(h)(1)(A)(iii) of the Act prohibits retaliation against “a whistleblower” who makes disclosures “required or protected” by the Sarbanes-Oxley Act.  The U.S. Securities and Exchange Commission’s regulations interpret the term “whistleblower” to include for retaliation purposes employees who report or disclose potential wrongdoing either internally or to the SEC (SEC Rule 21F-2(b)(1)).  This has led to a Circuit split among federal courts as to whether or not Dodd-Frank protects against retaliation only if the whistleblower reports the wrongdoing to the SEC, or if its protections also extend to whistleblowers who report misconduct internally to  management.

Read Bryan Cave’s client alert on the Second Court’s Decision in Berman v. Neo@Ogilvy LLC.

In the bankers’ version of March Madness drama, on March 21, 2011, a three judge panel of the U.S. Court of Appeals for the D.C. Circuit handed down a decision that is broadly perceived as a significant victory for banks at the expense of merchants.  (The decision is captioned NACS f/k/a National Association of Convenience Stores, et al. v. Board of Governors of the Federal Reserve System.)

The issue was the legality of the Federal Reserve’s rules implementing the “Durbin Amendment” portion of Dodd-Frank.  That portion of the legislation is generally viewed as having required regulatory caps on the interchange fees that can be charged to merchants.  Merchants criticized the Federal Reserve’s rules for allowing interchange fees at a level much higher than allowed by Dodd-Frank and for allowing interchange competition rules less strict (and thus more favorable to banks) than permitted under Dodd-Frank.  The merchants essentially won this argument at the lower court, the U.S. District Court for the District of Columbia.  The Court of Appeals reversed the district court on all key issues.  The merchants can still appeal the decision to the entire D.C. Circuit appeals court, or to the U.S. Supreme Court.  However, based on our review of this decision, such an appeal appears to have a limited chance of success.  And it seems highly unlikely that either party in Congress is willing to legislate any further on interchange fee issues.

To understand the scope and effect of the decision, a brief review is in order.  The Dodd-Frank Financial Reform Act passed in 2010 included a provision now widely known as the Durbin Amendment, due to its authorship by Illinois Sen. Richard Durbin.  It is widely believed that Senator Durbin authored the provision at the request of the merchant Walgreens, one of his important constituents.  One portion of the Durbin Amendment applies to banks and credit unions with over $10 billion in assets.  For those institutions, the Federal Reserve was required to promulgate regulations to cap interchange or “swipe” fees on debit-card transactions at a level “reasonable and proportional” to the cost the financial institution actually incurs.  Another part of the Durbin Amendment required the Federal Reserve to promulgate regulations to ensure that merchants had at least two unaffiliated networks through which bank account transactions could be completed by using the correct routing numbers.

In response to the Durbin Amendment, the Federal Reserve initially proposed capping interchange fees at about $0.12 per transaction.  Then, after considerable study, analysis and uproar from the banking industry that argued with some force that a $0.12 rate would force them to operate at a loss, the Fed’s final regulation capped interchange fees at approximately $0.24 per debit transaction.  The Fed also provided in its final regulations that debit cards may use one PIN debit network and one signature debit network, as long as the two networks were not affiliated.

While the issue of vendor oversight and management is not new to the financial services industry, recent enforcement actions by the Office of the Comptroller of the Currency (OCC) and the Consumer Financial Protection Bureau (CFPB) manifest heightened attention by federal regulators.  A bank’s board of directors is required to remain vigilant to the hazards posed by outsourcing functions to third parties, or else risk significant financial and reputational harm to its institution.

Federal regulators traditionally have looked with an understanding, yet skeptical, eye towards the issue of outsourcing. Current guidance is clear, however, as to where the responsibility lies. As summarized by the Federal Deposit Insurance Corp. (FDIC) in FIL-44-2008, “An institution’s board of directors and senior management are ultimately responsible managing activities conducted through third-party relationships, and identifying and controlling the risks arising from such relationships, to the same extent as if the activity were handled within the institution.”

Meet the New Boss

Armed with its mandate by Title X of the Dodd-Frank Act to protect consumers, the CFPB entered the vendor management fray by issuing Bulletin 2012-03. Although the message contained in the bulletin was nearly identical to previously issued guidance by the OCC and FDIC, it did provide additional insight. First, the bulletin noted that Title X of Dodd-Frank provides a definition of a “service provider,” which includes “any person that provides a material service to a covered person in connection with the offering or provision by such covered person of a consumer financial product or service.” (Although the legislation did not specifically define the word material, bankers should assume such subjectivity will be interpreted broadly by federal regulators.)  Secondly, and more importantly, the bulletin provided banks a non-exhaustive list of “steps to ensure that their business arrangements with service providers do not present unwarranted risks to consumers,” which include:

• Conducting thorough due diligence to verify that the service provider understands and is capable of complying with federal consumer financial law;
• Requesting and reviewing the service provider’s policies, procedures, internal controls, and training materials to ensure that the service provider conducts appropriate training and oversight of employees or agents that have consumer contact or compliance responsibilities;
• Including in the contract with the service provider clear expectations about compliance, as well as appropriate and enforceable consequences for violating any compliance-related responsibilities, including engaging in unfair, deceptive, or abusive act or practices;
• Establishing internal controls and on-going monitoring to determine whether the service provider is complying with federal consumer financial law; and
• Taking prompt action to address fully any problems identified through the monitoring process, including terminating the relationship where appropriate.

Prior to Dodd-Frank, Section 701(e) of the Equal Credit Opportunity Act provided that a loan applicant had the right to request copies of any appraisals used in connection with his or her application for mortgage credit.  Section 1474 of Dodd-Frank amended Section 701(e) to require that lenders affirmatively provide copies of appraisals and valuations to loan applicants at no additional cost and without requiring applicants to affirmatively request such copies.

The appraisal documentation must be provided to the loan applicant in a timely manner and no later than three days prior to the loan closing unless the applicant waives the timing requirement.  The lender must provide a copy of each written appraisal or valuation at no additional cost to the applicant, though the creditor may impose a reasonable fee on the applicant to reimburse the creditor for the cost of the appraisal.

In September of 2013 the Consumer Financial Protection Bureau adopted final regulations amending Regulation B to implement the statutory changes. The amendments to Regulation B went into effect on January 18, 2014. Among other things, the revised Regulation requires lenders to provide a notice to a loan applicant not later than the third business day after the creditor receives an application for credit that is to be secured by a first lien on a dwelling, a notice in writing of the applicant’s right to receive a copy of all written appraisals developed in connection with the application.

In facing Congressional and industry backlash related to the effect of the Volcker Rule on TruPS CDOs, federal regulators were expected to choose between two options.  Door 1 was to provide an exemption for TruPS CDOs held by all institutions.  Door 2 was to provide an exemption only for TruPS CDOs held by banks with less than $15 billion in assets, consistent with the Collins Amendment to Dodd-Frank.

The regulators chose neither door, instead opening Door 3: the regulators have exempted TruPS CDOs for all institutions, so long as the TruPS CDO primarily holds TruPS of banks with less than $15 billion in assets.  It will likely take a few days for the full analysis to come in, but I would expect that this has the effect of exempting all TruPS CDOs, as the CDO structure was primarily used in conjunction with private offerings of TruPS by smaller financial institutions.

The Interim Final Rule, issued on January 14, 2014, adds a new Section __.16 to the Volcker Rule, effective on April 1, 2014 (the same effective date for the Volcker Rule generally).  Section __.16 provides that the “covered funds” prohibition of the Volcker Rule do not apply to investments in a CDO if:

1. the CDO was established prior to May 19, 2010 (the grandfather date for Tier 1 treatment for TruPS);
2. the bank reasonably believes the offering proceeds of the CDO were used to invest primarily in TruPS issued by banks with less than $15 billion in assets (the Collins Amendment threshold); and
3. the bank acquired the TruPS CDO on or before December 10, 2013 (the date the final Volcker Rule was approved by the regulators).

On January 9, 2014, the Municipal Securities Rulemaking Board (the “MSRB”) published draft MSRB Rule G-42, which sets forth standards of conduct and duties of municipal advisors when engaging in municipal advisory activities other than the undertaking of solicitations.  As written, section (f) of the draft rule appears likely to force some banks who, directly or through an affiliate, are registered as a municipal advisor to exit the municipal advisor business.  The rule does not allow municipal advisors to both give “advice” to their municipal clients and to conduct other business with those clients.  Forced to choose between being a pure fiduciary /advice municipal advisor and engaging in other business with municipal entities, including more lucrative services as a depository bank, investment advisor, lender or swap provider, some banks will have no practical alternative but to exit the pure fiduciary business entirely.  Forcing banks to unbundle their services appears likely to drive up overall costs, since banks will be artificially removed as competitors from the marketplace and a separate entity acting as municipal advisor (and their counsel) will now be added to municipal bond transactions in addition to the municipal entity’s (and bond issuer’s) standard platoon of legal advisors.  It seems that both banks and their municipal entity customers (such as bond issuers) should lobby against this seemingly counterproductive rule.

The genesis of Rule G-42 the grant of rulemaking authority to the MSRB under the Securities Exchange Act, as amended by Dodd-Frank.  Section 15B(b)(2) of the Exchange Act requires the MSRB to promulgate rules for several types of entities, including municipal advisors.  Under that statute, the MSRB is required to promulgate rules designed to prevent practices inconsistent with a municipal entity’s fiduciary duty to its clients.  Dodd-Frank did not expressly require that municipal advisors be limited to a pure fiduciary role but that is essentially how the MSRB has chosen to draft section (f) of Rule G-42.

The MSRB’s theory in restricting municipal advisors to a purely fiduciary role is that client consent to a dual role, even after receiving complete disclosure, cannot be valid given the “high potential for self-dealing in such situations.”  In its regulatory notice accompanying proposed Rule G-42, the MSRB did not address the market reality that, just like real estate appraisers or bond rating agencies that do not “get along,” any municipal advisor acting in a purely fiduciary role will quickly find itself without clients if it gains a reputation for torpedoing bond deals negotiated by the real parties in interest.  In short, a pure advice / fiduciary municipal advisor will be strongly incentivized to bless the business deal negotiated by the business people and their lawyers.