The Mergers & Acquisitions Review: Regulation Of Financial Institutions M&A in the United States
M&A involving financial institutions, which for the purposes of this chapter are defined to include banks and insurance companies, constitute a major segment of the US M&A market every year. This chapter examines the evolving legal and regulatory features of M&A deals in the financial services market, and seeks to provide guidance as to how the changing face of regulation is likely to impact transactions in this important market segment. This chapter is written at a time of great uncertainty related to the covid-19 pandemic and its impact on the global economy. Moreover, the Biden administration could herald a return to more strict regulation, particularly over larger banks. How those events are ultimately resolved will likely have a substantial impact on financial institutions in the United States, and on their activity in the M&A market.
ii Bank M&A
With approximately 230 mergers per year over the past decade,2 and almost 5,000 banks remaining in the United States,3 M&A has been and will continue to be a constant feature of the US banking landscape. Given that they constitute nearly 91 per cent of US banks by number4 (if not by aggregate banking assets), community banks (defined for these purposes as those with less than US$10 billion of assets) will always dominate the M&A space. Indeed, in the years following the financial crisis, there were very few deals outside of community banking, as larger banks enhanced their capital bases and focused on responding to the enhanced regulatory standards imposed by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and enhanced scrutiny by the federal banking agencies.
However, more recently, these larger banks have started to participate in more bank and non-bank deal activity. For reasons discussed below, these institutions, as well as foreign banks seeking to gain greater access to the US market, can be expected to play an increasingly prominent role in the bank M&A market unless the environment turns more negative to growth as a result of political, economic, pandemic or other factors. Indeed, with concerns over asset quality raised by the pandemic, mergers of equity have become more prominent as banks seek to grow without paying significant premiums.
More generally, while economic factors affect all M&A, the regulatory environment, encompassing not only the laws and regulations themselves but also the manner of their implementation by the bank regulatory agencies, impacts bank M&A more than virtually any other industry. For example, the regulatory environment determines the possible participants (very limiting for private equity and non-financial companies), the preconditions for banks to participate (being healthy from a financial and regulatory perspective) and the regulatory burdens facing the resulting institutions. Understanding this environment, both generally and as to the specific institutions contemplating a transaction, is critical to evaluating any possible M&A transaction.
i US-based bank M&A
Before the financial crisis, regional and global US banks aggressively pursued M&A to increase their geographic and industry coverage and customer base, and to obtain the enhanced operational efficiencies resulting from spreading costs across a large revenue base. The financial crisis and Dodd-Frank interrupted this narrative. Dodd-Frank, as implemented by the federal bank regulators shortly after the crisis, applied enhanced prudential standards (EPS), including capital-related burdens and resolution planning, on banking institutions, which burdens increase as an institution crosses various asset thresholds (e.g., US$10 billion, US$50 billion, US$250 billion). Moreover, deals beyond a limited size would require a US bank with assets above US$50 billion to update its capital plan prior to obtaining regulatory approval for the transaction, and the regulators also would require additional information in larger deals so that they could confirm that a deal would not potentially have an adverse impact on the financial stability of the United States. All these additional burdens combined to inhibit the traditional drivers of non-organic growth for larger institutions.
In this regard, one metric of the efficiency of a bank's operations is its pre-tax, pre-provision income divided by its risk-weighted assets (basically, the bank's assets, risk-weighted depending on perceived credit and market risk) (efficiency metric). Using this approach, the optimal size for a banking institution in 2016 (the end of the Obama administration) was between US$5 billion and US$10 billion of assets.5 In other words, in contrast to the pre-crisis trend favouring growth to achieve economies of scale, the increased burdens imposed on larger banks after the crisis resulted in banking institutions becoming less efficient with capital on average as they grew beyond US$10 billion of assets. This regulatory dynamic chilled the incentives for these regional institutions to pursue transactions.
However, the regional banks have continued to strengthen since 2016, and regulators under the Trump presidency finalised regulations to reduce the burden of the EPS for banks between US$100 and US$250 billion of assets (and to eliminate the EPS burdens for banks US$50 billion to US$100 billion of assets) (US tailoring rules). As a result of these developments, the more traditional relationship between increased size and efficiency has returned, with banks above US$50 billion of assets (rather than US$5 to US$10 billion of assets) having the highest efficiency metric. Recent bank M&A supports this return to economies of scale. For example, in October 2020, US$55 billion asset CIT Group and US$55 billion asset First Citizens BancShares announced they would combine in a merger of equals. In July 2021, US$186 billion Citizens Financial Group announced a deal to acquire US$27 billion asset Investors Bancorp. These deals are driven by many of the same factors as have historically applied, as well as a desire to invest funds in technology. These banks need to compete with global banks such as JPMorgan, which spends approximately US$11 billion on technology annually, an order of magnitude several times larger than the entire annual profit of many regional banks.6
Nevertheless, there are still constraints to mergers that create ever-larger US banks. The US tailoring rules maintain material additional EPS burdens for banking institutions that cross US$250 billion of assets. Thus, given the apparent adverse relationship between the enhanced regulatory burden and the efficiency metric, a regional bank with US$100 billion to US$200 billion of assets may want to consider acquiring a banking institution small enough to keep it below the US$250 billion asset threshold unless a strong rationale for a larger transaction exists. For example, in the merger of equals between US$215 billion asset SunTrust Banks and US$225 billion asset BB&T Corporation to form Truist, SunTrust and BB&T stated that their close geographic proximity created significant economies of scale that allowed them to invest in fintech, and that each was by itself approaching US$250 billion of assets and thus likely would have encountered the higher EPS at that level in the near future in any event. Given the EPS burdens of a particular asset level apply in full to a bank once it crosses that asset level, banks have significant disincentive to barely cross a given EPS asset threshold. In other words, from an economies-of-scale-relative-to-burden perspective, no bank would want to be just one dollar above the asset threshold, at which point a higher level of EPS burdens applies.
Moreover, the burden on the largest Wall Street firms, known in regulatory parlance as global systemically important banks, and the post-Dodd-Frank focus on ensuring financial stability as a factor in applications involving large deals could prevent a return to the large national deals of the 1980s between two US firms, like the merger of NationsBank and Bank of America that resulted in the national retail giant of today. As JPMorgan's heavy investment in fintech indicates, these large institutions appear to be focusing more on using mobile and other technology to enhance market share, rather than relying on traditional bank M&A. Given that JPMorgan has grown deposits at twice the industry average since 2014 – US$215 billion in absolute terms (or equivalent to the seventh-largest US commercial bank) – this approach seems to have provided a nice complement to its branch network.7
Bank M&A also may get more difficult under the Biden administration. First, there is a renewed antitrust focus on bank mergers. On 9 July 2021, President Biden issued a sweeping Executive Order on competition, which encouraged the US Department of Justice (DOJ), in consultation with the federal banking agencies, to review current merger practices and adopt a plan for the 'revitalization of merger oversight' to provide more extensive scrutiny of bank mergers.8 A fact sheet accompanying the Order focused on branch closures, which suggests a physical branch-based analysis.9 However, the US banking landscape has changed significantly over the last few decades, and market share is not necessarily based on the size of the physical footprint. Instead, banks now face competition from fintechs and other companies that only offer their services digitally. In 2020, the DOJ recognised this transformation and sought public comment on updating its current guidelines for bank mergers to 'reflect emerging trends in the banking and financial services sector and modernize its approach to bank merger review under the antitrust laws'.10 With the release of the Order, however, it is not clear whether the modernisation of the guidelines initiated by the DOJ in 2020 will continue to be part of the process, or whether the review will result in a principally location-based analysis that does not reflect the fintech or digital transformation of the banking industry. Second, as the adage goes, 'personnel is policy', and it is anticipated that the change in leadership at the bank regulatory agencies in connection with the change in administration may make bank M&A, and bank operations generally, more difficult.
Nonetheless, M&A remains a significant growth mechanism for the vast majority of US banks. Diligence by each party remains critical; anti-money laundering concerns, a poor Community Reinvestment Act rating and other significant regulatory issues can still significantly delay or even prevent regulatory approval of a transaction.
ii Foreign bank M&A
Large bank M&A in the US market is not limited to US-based banking institutions. Foreign banking organisations (FBOs) comprise 16 of the largest 20 global banks, with JPMorgan sixth after five Asian banks.11 FBOs also have a significant presence in the United States, constituting nine of the largest 35 US holding companies and 10 of the 20 US holding companies with US assets between US$100 billion and US$200 billion.12 These numbers do not include the substantial US branch presence of FBOs. For example, the Canadian FBOs Toronto Dominion, Bank of Montreal and Royal Bank of Canada (RBC) have an aggregate US presence of US$483 billion, US$242 billion and US$207 billion, respectively, and the Japanese FBOs MUFG and Mizuho have an aggregate US presence of US$279 billion and US$176 billion, respectively.13 As a point of reference, the smallest of these, Mizuho, has US branch assets equivalent to a top 30 US holding company.
Some FBOs have shown a strong desire to grow in the US market, in many cases as a result the continued relative strength of the US market and the much more concentrated banking sector in their home markets. For example, in 2015, RBC acquired City National Bank (Los Angeles headquarters), and, in 2017, Canadian Imperial Bank of Commerce acquired PrivateBancorp (Chicago headquarters). However, because economies of scale have returned as a key driver of bank M&A, as discussed above, FBOs are re-examining the growth prospects of their US operations and the need for sizeable technology investment in order to compete.14 Indeed, in more recent years, some FBOs have been contracting their banking operations in the United States. For example, Spain's Banco Bilbao Vizcaya Argentaria sold most of its US-based operations to PNC in June 2021, while HSBC announced in May 2021 that it was selling its US mass-market retail branches to Citizens Financial Group and Cathay Bank and MUFG announced in September 2021 that it was selling its US retail bank to U.S. Bancorp.
As with their US-based counterparts, the US regulatory regime likely will play a large role in whether FBOs will expand in the United States. The federal banking agencies expressed concern after the financial crisis that the large presence of foreign banks in the United States could impair the US economy in times of global financial stress. As a result, US regulators required all FBOs with US non-branch assets of US$50 billion or more to establish US holding companies to aggregate their US entities, and imposed capital and EPS standards on those holding companies at least equally burdensome as those that apply to their US-based counterparts. As with domestic banks, the federal banking agencies finalised FBO regulations intended to tailor the application of the EPS and other burdens to FBOs (FBO tailoring rules) similar to the objectives of the US tailoring rules.
The impact of the FBO tailoring rules and other drivers of FBO M&A in the United States is not yet fully known. However, given that growth prospects are increasingly tied to size and scale, it will be critical for FBOs (like US-based banks) to evaluate how to remain competitive in the United States. Particularly given the size of their global operations, which in many cases for FBOs with a significant US presence is significantly larger than all but the largest US banks, FBOs are positioned to meaningfully expand into the US market if desired.
iii Non-bank M&A15
While bank M&A tends to garner the largest headlines, both US-based banks and FBOs are also engaging in significant non-bank M&A in the United States. While banks are acquiring a spectrum of financial companies, changes in the regulatory requirements after the financial crisis are also having an impact on these transactions. Banks are required to hold capital to support their assets, and the bank regulators increased the required capital ratios (i.e., the amount of capital that the banks have to hold to support a given level of assets) after Dodd-Frank. Many banks thus have focused on acquisitions of asset managers, M&A advisory broker-dealers and similar service-based entities that allow banks to generate revenue without generating significant balance sheet assets that require additional capital.
Banks are increasingly focused on the fintech space, both to increase internal operational efficiency (e.g., blockchain) and to provide enhanced revenue and services to customers (e.g., payments and lending platforms). While banks often acquire all or a majority stake in the former, in the latter case they often take non-controlling interests. If a bank were to take a controlling stake (certainly more than 25 per cent of the voting stock, but often much lower, particularly if combined with ongoing business relationships), then the fintech company would become subject to the bank's regulatory framework. In that case, the bank would have to be concerned about regulatory and reputational risk with the fintech company, and the fintech company's permissible activities would be limited to those permissible for banking institutions.
Finally, insurance company M&A continues to proceed at a rapid pace in the US market, as private equity firms enter and expand their presence in the market, the Bermuda companies continue to consolidate and global companies significantly enhance their market presence through non-organic growth. Unlike bank M&A, insurance transactions are regulated primarily by state insurance regulators. These regulators have become more comfortable with private equity firms as owners of insurance companies, and the rules governing risk-based capital for insurance companies may favour larger groups once the National Association of Insurance Commissioners' group capital calculation (GCC) is fully implemented. The precise impact of the GCC remains to be seen, and it is to be expected that after an initial period of adjustment, the larger insurance groups will be able to benefit from aspects of the GCC not available to smaller or monoline insurance groups. This may well be a catalyst for M&A activity in a market otherwise characterised by low interest rates (especially relevant for life and annuity insurers) and increasingly positive pricing trends for organic business growth (for property and liability insurers and reinsurers).
After a pause caused by the financial crisis and a subsequent harsher regulatory environment, both economic and regulatory factors during the Trump administration favoured bank and non-bank M&A by both US-based banking institutions and FBOs. However, a less business-friendly Biden administration, coupled with the effects of the covid-19 pandemic, could significantly impair inorganic expansion. For this reason, many banking institutions are currently actively searching for targets to take advantage of the current arrangement. The regulation of fintech and insurance M&A is also at a stage where it may favour transactions with buyers who can fit within the rigorous regulatory framework or even take advantage, in the case of insurance groups, of the emerging GCC in the United States.
1 Gregory Lyons and Nicholas Potter are partners and Clare Lascelles is an associate at Debevoise & Plimpton LLP.
2 Federal Deposit Insurance Corporation (FDIC) Statistics at a Glance – Historical Trends as of 30 June 2021.
3 FDIC Quarterly Banking Profile, Q2 2021, p. 4.
4 id. at p. 17.
5 Keefe Bruyette & Woods; SNL Financial Data.
6 Vijay D'Silva and Zane Williams, 'US Midcap Banking: The Shakeout Ahead?' McKinsey & Company (30 June 2021).
8 The White House, Executive Order on Promoting Competition in the American Economy (9 July 2021).
9 The White House, FACT SHEET: Executive Order on Promoting Competition in the American Economy (9 July 2021).
10 DOJ, Antitrust Division Seeks Public Comments on Updating Bank Merger Review Analysis.
11 S&P Global, 'The World's 100 Largest Banks' (23 April 2021).
12 National Information Center, Holding Companies with Assets Greater than US$10 Billion (30 June 2021).
13 FRB, Structure and Share Data for US Banking Offices of Foreign Entities (31 March 2021).
14 See Allissa Kline, 'Foreign Banks Are Retreating from the U.S. MUFG Is Only the Latest', American Banker (22 September 2021).
15 Including asset managers, fintech and insurance companies.