New Rules of Regulatory Engagement

However one describes the Dodd-Frank Act, it and similar global regulatory initiatives are redefining the terms of financial services safety and soundness, capitalization and profitability. Just as the new Financial Stability Oversight Council and its constituent federal financial agencies are beginning to implement Dodd-Frank, so too the Basel Committee on Banking Supervision, the Financial Stability Board and foreign banking regulatory authorities are considering a range of new capital requirements, stress tests and remedies to address “too big to fail” and other systemic issues.

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Simply put, the traditional rules of engagement for financial institutions and their regulators are changing, and those changes will impact operations, capital, investor expectations and the pace of industry consolidation. Here’s a short list of predictions of how things will play out.

Capital is the miracle elixir that is viewed as the cure-all for financial institutions. It is proposed by the Basel Committee that Tier 1 and risk-based capital levels be raised significantly, particularly with regard to common equity, at the same time that various types of instruments that might otherwise have qualified as capital under prior regimes will be prohibited by Dodd-Frank. New requirements in Dodd-Frank that loan originators and securitizers of asset-backed securities hold at least 5% of the credit risk without transfer or hedging will also impact the capital requirements for companies engaged in securitizations.

Systemically important financial institutions, the largest and most interconnected bank holding companies and significant nonbanking financial companies will be subject to even greater capital requirements, particularly with regard to any high-risk activities and investments in which they engage. The general criteria for designating nonbanking financial companies as SIFIs are set forth in Dodd-Frank, but the specifics of the process and the range and number of such companies to be designated is yet to be determined.

Dividends: The mirror image of capital requirements is the effect that those requirements have on a company’s ability to pay dividends, restructure its balance sheet through stock repurchases and entertain various corporate distributions that impact capital. The Federal Reserve Board is already signaling a new level of concern with regard to the payment of dividends by announcing that it will issue guidance on dividend payments by large BHCs. Reportedly, the Fed will require BHCs requesting permission to resume paying more than token dividends to file pro formas for two years that show how they would handle losses under various scenarios. The pro formas could include various disaster scenarios, such as mortgage and mortgage-backed security put-backs and changes in their business model necessitated by Dodd-Frank.

This guidance could impact a company’s dividend-paying ability as well as its stock repurchase plans and cash-funded mergers and acquisitions.

Once the universe of SIFIs is identified, it does not take much imagination to project similar capital requirements and dividend limitations being applied to the designated nonbanking financial companies. Many of these companies are likely to be subject to such controls for the first time in their corporate lives. This will also be likely to have an impact on their investors’ expectations and their ability to engage in mergers and acquisitions.

“Too big to fail”: Regulators around the world seem just as firm in their resolve to tackle the “too big to fail” issue as are their critics who continue to assert that companies that are “too big to fail will” always be part of the financial landscape. The Financial Stability Board is reportedly developing capital rules for the largest or most dominant SIFIs, including recommendations that these SIFIs maintain a higher risk absorbency capacity consistent with the greater risks to financial stability that they are deemed to pose. These recommendations could include capital surcharges, contingent capital and other hybrid debt instruments that would be constructed to be capable of bearing losses in time of stress, in addition to the more broadly applicable recommendations in Basel III, which are to be implemented in 2013. The Basel Committee is scheduled to issue proposed methodologies to identify and deal with SIFIs by the end of this year.

The orderly-liquidation concept: Dodd-Frank provides for the orderly resolution and liquidation of SIFIs outside the Bankruptcy Code.

Two distinctive components of the orderly liquidation process in Dodd-Frank are the requirement that SIFIs draft plans for their own resolution (“living wills”) and that the Federal Deposit Insurance Corp. act as the receiver for certain SIFIs. These requirements will create a new world for investors.

Living wills create complex issues for companies to the extent that they go beyond requiring a simple inventory of company subsidiaries and assets and call for a road map to be prepared that the FDIC could follow to liquidate the company in pursuit of the government’s interest in financial and economic stability rather than to maximize shareholders’ interests. The fact that Dodd-Frank provides no statutory confidentiality for living wills is a particularly unnerving issue.

Whatever comfort is provided to creditors and other claimants in a bankruptcy proceeding by the presence of an impartial judge presiding over the case in open court will be absent in the case of a SIFI placed into an FDIC-administered receivership. In that regard, the FDIC has begun the process of developing rules that will guide these processes, including its own special perspective on which creditors may be favored in certain situations.

All such realignments of investor expectations will not necessarily be negative. Indeed, given the opportunity in Dodd-Frank for orderly resolutions to be conducted through bridge companies with financing provided by the Treasury Department, and for certain financial interests to be preferred over others, it is possible that SIFIs will be the next class of privileged companies that the market perceives can never fail. If that happens, these companies will actually inherit various market and funding advantages.

Consolidation challenges: Dodd-Frank and its implementing regulations lay the foundation, intentionally or not, for significant consolidation in the financial services industry in the medium and long term, while creating significant obstacles to consolidation in the short term.

The combination of increased compliance costs and new capital and liquidity requirements will make it difficult for a broad range of companies to be successful, and various other factors embedded in Dodd-Frank will impact the value of the retail banking franchise. For example, there are significant changes in the scope of federal preemption, which will impact the delivery of consumer and mortgage credit in the country. The calculation of deposit insurance premiums will also be changed so that the amount of premiums paid will be based on a bank’s total assets rather than its total insured deposits, a disproportionate part of the increase in premiums will be borne by larger banks, which typically are less reliant on deposits to fund assets.

Banks also have new authority to pay interest on commercial demand deposits, which may be a competitive advantage in some cases but may have an overall negative impact on net interest margins. In addition the mortgage finance system in the U.S. is already in need of some form of private market revitalization. At the same time, the factors discussed herein will generally present obstacles to developing a consolidation strategy in the short term.

Companies must determine the impact of Dodd-Frank not only on themselves but also on a potential target at a time when valuing its balance sheet is already a significant challenge. Add to that the new scrutiny and regulatory requirements applied to SIFIs, and it seems clear that the uncertainty built into the marketplace for the immediate future will create a hindrance to mergers.

Thomas P. Vartanian is a partner resident in the Washington office of Dechert LLP, where he heads the firm’s financial institutions transactions group.