Larger banking organizations directly affected by the U.S. federal banking agencies' recent proposed capital rule have been busy analyzing the substantial changes, increased costs, and other requirements and effects that have been proposed. A robust and spirited notice and comment process is no doubt under way.

Even short of a finalized rule, banking organizations that are directly affected will likely start preparing for these proposed changes, causing market rebalancing and ripple effects. Other market participants will likely experience both direct and indirect fallout from these movements, both during the rulemaking and certainly after finalization. This alert explores some considerations for smaller banks and non-banks (other than hedge funds, private equity, and the like).

For purposes of this alert, "smaller banks" or "smaller banking organizations" means community banks and other banking organizations with less than $100 billion in total assets. "Larger banks" and "larger banking organizations" means those with $100 billion or more in total assets.

Key Considerations

1. No new requirements generally introduced for smaller banks. Smaller banks can keep working within familiar frameworks. For instance, under the community bank leverage ratio framework, banking organizations with less than $10 billion in total assets may maintain a leverage ratio of greater than 9 percent. These community banks are considered to have satisfied the risk-based and leverage capital requirements in the federal banking agencies' generally applicable capital rule and are considered to have met the well-capitalized ratio requirements for purposes of Section 38 of the Federal Deposit Insurance Act.

   In addition, certain bank holding companies and savings and loan holding companies with pro forma consolidated assets of less than $3 billion and that meet other requirements can rely on the small BHC Policy Statement.

2. Market risk provisions may still apply. Nevertheless, the market risk provisions would apply to any bank organization, including smaller banking organizations, with total trading assets and liabilities equal to $5 billion (currently, $1 billion) or in excess of 10 percent of total assets. While many smaller banks do not engage in those activities, smaller banks seeking to grow their businesses in that space should understand and carefully monitor this much smaller threshold.
3. New opportunities for lending and other fee-based services. Under the proposed capital rule, some lending activities are expected to become more costly for larger banks, notably certain mortgage lending, among others. In addition, various non-interest fee-based operations are slated to become more costly for larger banks. If larger banks pare back (or completely push out) these lending activities or other non-interest fee-based operations because of the increased costs associated with these activities under the proposed capital requirements, smaller banks and non-banks will likely stand to pick up these opportunities.
4. Growth by merger. Smaller banks may appear more attractive to merger partners as targets, especially to those larger banking organizations that cannot scale down to less than the $100 billion total consolidated assets threshold. These larger banking organizations would be subject to more intensive capital requirements and may look to grow by acquisition (putting too-big-to-fail and anti-merger considerations aside) to compete more profitably under the more costly proposed rules.

   In addition, mergers between two institutions that cause the resulting banking organization to remain under the $100 billion total consolidated assets threshold will similarly appear advantageous, at least with regard to regulatory capital requirements.

5. Growth by partnerships. Smaller banks looking to grow and compete on a national scale could still do so through partnerships with fintechs. In addition, as certain businesses may be pushed to the non-bank sector—generally unburdened by the regulatory capital rules that apply to banks—these partnerships may become more strategically important. Although not constrained by the proposed capital rule, these arrangements must comply with the federal banking agencies' guidance on third-party risk management, among other considerations.
6. Growth by equity investments. Smaller banks with available funds—and within applicable limits and conditions under other authorities—may have an appetite to make equity investments in other companies, including fintechs and related technology companies. Higher capital requirements, as well as the prospect of looming long-term debt requirements (announced this week), may cause larger banking organizations to forgo certain other spending and opportunities.
7. Larger banks may pass on increased costs. Larger banking organizations that provide products and services to smaller banking organizations and other non-bank providers may pass on the increased cost of capital and compliance to smaller banks, non-bank market participants, and customers. As these smaller banks and non-bank counterparties negotiate contracts and fee schedules, they will need to be aware of the constraints that their larger bank counterparties face and may not be successful in avoiding larger costs charged by these institutions. These kinds of constraints may also cause counterparties of larger banks to shop around, including at other larger banks, smaller banks, and, for instance, credit unions (which also would not be subject to the proposed capital rules).