Capital Allocation, Changing Regulations and Banks’ Strategic Plans for 2021

by Wes Scott and Kevin Tran

As 2020 mercifully nears its end, it’s safe to say that we’re living in uncertain times in which volatility seems to be the norm rather than the exception. Currently, we are navigating the aftermath of an extremely contentious election, COVID-19 cases are spiking and there are no guarantees that the federal government will be issuing additional stimulus relief soon. The recent turbulence in the stock market and the choppiness of the VIX Index are prime examples of the daily, meaningful impact these issues are having on the economy.

Allocating and deploying capital

In light of this, every depository institution, even healthy ones, should have a comprehensive plan for raising capital that works in tandem with its strategic plan and its enterprise risk management plan. In more normal times, banks should generally have the capital that allows them to comfortably satisfy regulatory capital ratios, implement their strategic plans and weather an unexpected storm. 

Currently, however, it is wise to have “safety capital,” which means having an appropriate amount of capital and then a good deal more. Some have referred to this as “hoarding capital,” but in these times, having excess capital is prudent not only from a business perspective but also in fulfilling certain legal compliance obligations.

When it comes to deployment, capital can be used generally for defensive and offensive purposes. More defensive uses of capital include those that are designed to shore up capital inadequacies, avoid regulatory issues, offset credit losses, assist with loan modifications and supplement lower or anemic earnings. On the other hand, offensive uses of capital include engaging in M&A activity, organic growth, reinvesting in your business (such as bolstering your cybersecurity), paying dividends, repurchasing debt with higher service costs and conducting share buybacks.

If you’re like the majority of banks that find themselves somewhere between a purely offensive or defensive position, having sufficient capital allows you to play both offense and defense depending upon the issue of the moment. Having that flexibility in the current environment is simply invaluable and, frankly, could ensure your continued viability if your bank encounters difficulties in the near future.

The number of capital raises and the amount of capital raised in 2020 has been significant; however, if you are in a position where you feel you need to raise capital, please contact the authors of this Brief.

What regulatory issues tend to derail strategic plans?

We can generally simplify regulatory impact into two buckets:  infrastructure-changing regulations and ordinary-course regulations.

Infrastructure changing regulations are rules like CECL, the Volcker Rule, the Fed’s Small Bank Holding Company (BHC) Policy Statements, and the 2018 Farm Bill generally legalizing hemp. Essentially, these types of rules either introduce new opportunities or prohibit existing activities which may require banks to reevaluate and amend their strategic plans to incorporate these regulatory-driven changes.  Consider these two examples:

The Small BHC Policy Statement. The threshold to be considered a small BHC has crept up from $500 Million to $3 billion in just 5 years. So what does that mean for a lot of our community banks? It may provide eligible banks with more opportunity to issue subordinated debt, as discussed above, and engage in growth opportunities that previously were less attractive.

The Volcker Rule. Meanwhile, take the Volcker Rule (though this may be more applicable to larger banks). If a bank relied on proprietary trading as a pillar of its strategic plan,  the Volcker Rule likely derailed those plans.  As a result, an affected bank likely would need to revisit its strategic plan and determine alternative business lines it may need to pursue to account for a business strategy that has been heavily restricted by regulation. 

The second bucket involves “ordinary course” regulations. These rules are the staple capital, liquidity and leverage regulations that continue to evolve. Even though there was an enormous overhaul of the regulatory capital framework in 2013, banks are still dealing with the basic premise that maintaining minimum levels of capital reserves is good and overleveraging is bad.

Relatedly, for those on the offensive, whether growing organically or through acquisition, changing funding strategies or diversifying operations, those banks need to keep in mind important asset size thresholds. This concern is probably less of one for community banks given that thresholds have tended to trend upwards. But that being said, you never want to be caught in a position where you’re aggressively pursuing growth and you end up crossing a threshold that makes you subject to a different level of regulatory compliance and scrutiny for which you’re unprepared.

Ultimately, to the extent that changes occur over the years as agencies see more data and better understand trends, what a bank needs isn’t a magic crystal ball trying to anticipate these changes but, instead, an enterprise-wide risk management and compliance structure to deal with these changes and mitigate the costs of evolving regulation.

Establishing enterprise-wide risk management and compliance strategy

Having an enterprise risk management system makes a bank more agile and resilient which will become more and more important as banking becomes increasingly driven by technology. COVID-19 certainly pushed technological innovation on banks, particularly community banks.

Pre-COVID, it wasn’t uncommon for community banks to focus on building relationships with their customers and their communities in person to drive business (whether lending or taking deposits). But now, everything is remote, and in-person meetings are challenging (especially when bank lobbies are closed), making technology key to providing services and building business.

But, once you start going down the path of technological innovation, there are quite a few attendant issues you have to account for, and chief among them are data privacy, cybersecurity and related regulations.  As a result, having a proactive, enterprise-wide risk management function that can react to and address regulatory changes impacting your business lines in a coordinated manner allows for consistent messaging and effective communication internally and externally, and ensures regulatory considerations are always top of mind when pursuing other opportunities and initiatives.

A member of Waller’s corporate practice, Kevin Tran assists clients in matters related to bank regulatory compliance, capital-raising and corporate transactions. Banks, bank holding companies and other financial institutions benefit from the experience he gained with the Federal Reserve Board in Washington, D.C., where he served as a Financial Policy Analyst in the Capital and Regulatory Policy group in the Division of Supervision and Regulation, and as the Policy Staff Adviser/Chief of Staff to the Deputy Director for Policy. Wes Scott is a partner at Waller. Public and private financial institutions, including banks, bank holding companies and investment banks, as well as healthcare companies, including clinical trial and medical device companies, rely upon Wes Scott’s experience, judgment and business acumen to close their capital market transactions.  Wes has quarterbacked numerous initial public offerings, primary and secondary follow-on offerings, mergers, acquisitions, dispositions, joint ventures and other transformative transactions.