The Mergers & Acquisitions Review: Regulation Of Financial Institutions M&A in the United States

i introduction

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, a likely change in US leadership could herald a return to more strict regulation, particularly over larger banks. How those events are ultimately resolved will likely have a very substantial impact of financial institutions in the US, and on their activity in the M&A market.

ii Bank M&A

With approximately 250 mergers per year over the past decade,2 and almost 5,500 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 85 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) always will 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 due to 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. This environment designates 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, while with larger deals the regulators also would require additional information so that they could confirm that a deal would not potentially have an adverse impact on the financial stability of the US. 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 clearly chilled the incentives for these regional institutions to pursue transactions.

However, the regional banks have continued to strengthen since 2016. Moreover, the Trump presidency resulted in new individuals leading the US federal banking agencies. These individuals generally have been perceived to favour a more tailored approach to regulation than their predecessors, and indeed the regulators 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, in 2018 the more traditional relationship between increased size and efficiency returned, with banks above US$50 billion of assets (rather than US$5 to US$10 billion of assets) having the highest efficiency metric. The banking industry has showed evidence of responding.6 For example, in March 2019, Fifth Third Bancorp acquired US$20 billion asset MB Financial to create a US$170 billion asset bank. Also in 2019, SunTrust Banks (US$215 billion of assets) and BB&T Corporation (US$225 billion of assets) announced they were entering into a merger of equals that resulted in Truist. These deals are driven by many of the same factors as have historically applied, as well as a desire to invest funds in fintech. These banks need to compete with global banks such as JPMorgan, which has announced it will spend US$11 billion on fintech in 2019, several times the entire annual profit of many regional banks.

However, inhibitors remain to mergers creating 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 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, SunTrust and BB&T stated that they believe their close geographic proximity allows significant economies of scale to invest in fintech, and 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. The acquisition announcement of US$100 billion asset BBVA USA by US$450 billion PNC similarly focused on cost synergies. 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 (i.e., in the case of Truist, US$250 billion) 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 JPM 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

Nonetheless, M&A remains a significant growth mechanism for the vast majority of US banks (and foreign banks, as discussed below), and the environment during the Trump presidency (at least until the pandemic) has been as favourable as it has been for many years. Diligence by each party remains critical, anti-money laundering, a poor Community Reinvestment Act rating and other significant regulatory issues still can significantly delay or even prevent regulatory approval of a transaction. However, the time required for Federal Reserve Board (FRB) M&A approvals in 2018 reduced by more than one-third from the 2014 highs,8 and the FRB appears willing to consider deals as large as SunTrust and BB&T, which will result in the seventh-largest bank in the US.

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.9 FBOs also have a significant presence in the US, constituting 10 of the largest 34 US holding companies, and nine of 21 US holding companies with US assets between US$100 billion and US$200 billion.10 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) each have an aggregate US branch presence of US$346 billion, US$200 billion and US$164 billion, respectively, and the Japanese FBOs MUFG and Mizuho each have an aggregate US branch presence of US$274 billion and US$140 billion, respectively.11 As a point of reference, the smallest of these, Mizuho, has US branch assets equivalent to a top 30 US holding company.

FBOs also have shown a strong desire to grow in the US market, in many cases given the continued relative strength of the US market and the much more concentrated banking sector in their home markets. RBC's acquisition of City National Bank (Los Angeles headquarters) and Canadian Imperial Bank of Commerce's acquisition of PrivateBancorp (Chicago headquarters) represent two of the largest US deals by value announced since 2015.12 MUFG also has stated that it wants to be a top 10 US bank holding company,13 which would require it to more than double in size from its current US$168 billion of US bank holding company assets.

As with their US-based counterparts, the US regulatory regime likely will play a large role in the continued expansion of FBOs in the US. The federal banking agencies expressed concern after the financial crisis that the large presence of foreign banks in the US 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 US is not yet fully known. However, 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, continued desire to meaningfully expand into the US market appears likely. Indeed, given their global size, larger US targets would be necessary to make an impact on their balance sheets. Indeed, if MUFG's view about the desired size in the US holding company presence (which would still result in the US holding company presence being less than 15 per cent of its global presence) is representative of other FBOs, the US regional banks would appear logical targets for their growth.

iii Non-bank M&A

14While 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 US. While banks are acquiring a spectrum of financial companies, changes in the regulatory requirements after the financial crisis also are having an impact on these transactions. Banks are required to hold capital to support their assets, and the bank regulators increased their capital ratios (i.e., the amount of capital that they 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. A sampling of approximately a dozen US-based regional banks shows that on average they derive about 38 per cent of their income from non-interest (i.e., non-mortgage or investment security-based) revenue, showing that these types companies are an important part of their overall revenue mix.15 Other regulatory changes resulting from Dodd-Frank, such as the Volcker Rule, have materially limited the ability of banks to acquire private fund complexes or entities engaged in significant proprietary trading, although revisions to the Volcker Rule under the Trump administration may reduce these barriers.

As banking institutions return to fiscal and regulatory health, they have a variety of options to consider as to where to engage in non-bank acquisitions. The proper placement of the target in a consolidated organisation can materially impact the ongoing benefits it can provide. Particularly for financial holding companies, a special designation for well-managed and well-capitalised institutions held by the vast majority of the regional and larger banks acquiring a non-bank entity as a subsidiary of the holding company generally permits the broadest range of permissible activities while requiring no bank regulatory approvals. On the other hand, acquiring a non-bank entity as a subsidiary of a bank permits the bank to fund and support the operations of that entity most efficiently. Particularly if, as is generally the case with larger institutions, the relevant banking institution has a national bank subsidiary, merging the non-bank into the national bank would permit the non-bank to obtain the benefit of the federal preemption over state laws afforded to banks, but this is generally the most burdensome type of acquisition from a regulatory perspective.

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. Moreover, whereas at one point fintech sought to compete with banks, banks have access to low-cost funding (via deposits) and a sticky customer base that fintech firms find desirable.16 As a result, a recent report stated that more than 75 per cent of fintech firms cite collaboration (often via minority investments and business relationships) preferable to competition with incumbents, such as the institutions that dominate the banking industry.17

For acquisitions of all the stock or assets of a fintech company, the bank regulatory considerations are identical to those described above for other non-bank acquisitions. On the other hand, banking institutions typically will acquire a non-controlling interest in a fintech company off the holding company (and not the bank). While banks are also able to acquire non-controlling interests in some circumstances, the holding company often provides greater structuring flexibility from a regulatory perspective. The principal concern with holding company acquisitions of minority interests in fintech companies historically has been the lack of clear guidance as to what levels of voting and non-voting stock ownership and business relationships the FRB will permit without deeming the holding company to control the fintech company from a bank regulatory perspective (which presents the disadvantages described above).

However, the Federal Reserve has recently provided greater certainty as to what constitutes control with acquisitions of less than 25 per cent of the voting stock of a target (at 25 per cent voting stock ownership or above, a company is conclusively determined to be in control of a target under the US banking laws).18 This greater certainty also may increase the desire of both banking institutions and fintech companies to engage in these partnership investments with each other. The recent revisions create a grid, with higher levels of voting stock ownership (in any event below 25 per cent) necessitating the acquirer having fewer other indices of control (e.g., interlocking directors, business relationships) to avoid a banking law control determination. Interestingly, as our firm highlighted shortly after the FRB published the proposal,19 the rule may provide more assistance to fintech companies and activist investors increasing stakes in banking institutions without being deemed in control of a bank than to banks seeking to gain meaningful non-control stakes in fintech companies.

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) comes into effect. The precise impact of the GCC remains to be seen, as for now field testing is just under way, 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).

iv Conclusion

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. As with many other areas of the US, however, the effects of the covid-19 pandemic have been pronounced and the current environment is not stable. A prolonged recession and a likely change in the federal government leadership to a less business-friendly administration could significantly impair inorganic expansion. For this reason, many banking institutions currently are actively searching for targets to take advantage of the current arrangement. The regulation of fintech and insurance M&A also are at a stage where they 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 US.

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