We see it all the time. Regulatory decisions seem to systematically work in favor of the big guy and work against the little guy, or the upstart. Just recently the “distributed taxi” company Uber has faced incumbent-protection measures from the Washington DC Taxi Commission. Some of the recent proposed Senate legislation to regulate journalism favors traditional news outlets over bloggers. The Affordable Care Act incentivizes doctors to join large hospital organizations rather than remain in small practice. Online education companies are singled out for criticism around borrowing and job placement statistics, criticism that is not leveled at traditional schools.
Why Regulations Often Benefit Large Companies
Why does this happen so much? Sometimes these impacts are a direct result of the process that everyone seems to hate: “Lobbying.” But sometimes these results are simply a side-effect of the fact that complying with any regulation is a burden, and complying with heavy regulation can be a heavy burden. So in finance for example we find that meeting the public company filing requirements under Sarbanes-Oxley has been estimated to cost a company up to $3 million per year. With this being the case, only bigger, stronger companies are in a position to access the advantageous financing that public markets provide.
Dave Jefferds
Other times, however, regulation helping the big guy at the expense of the little guy almost seems like a case of unintended neglect. One area of finance where this may be true, and that may end up having a big impact on the “small bank” economy, is the TruPS (or Trust Preferred Securities) sector.
TruPS: A Critical Financial Instrument
TruPS are hybrid instruments that benefit from equity-like treatment for capital calculations but debt-like treatment for interest purposes. So this kind of security is the best of both worlds for the issuer. Part of the logic for equity-like treatment derives from the fact that issuers can defer payments to investors for up to five years in certain circumstances. This ability to defer payment for such an extended period feels a lot like equity. And many TruPS issuers have been deferring now for just about five years, meaning that they have to fix the situation by making back interest payments or else go into default. This ability of the TruPS bondholders to force default feels a lot like debt.
The issue is coming to the fore. In May, American Bancorporation of St. Paul, Minnesota, suffered the first high-profile involuntary bankruptcy related to TruPS creditors finally acting to enforce their rights.
Crucially for the question of what banks can do now to save themselves from bankruptcy, two of the major bank regulators took different views on TruPs. The Federal Reserve was willing to treat them as equity, allowing the bank to count TruPS towards Tier 1 Capital reserves. The Federal Deposit Insurance Corp. balked, leading to the following anomaly: TruPs at insured depositories are pretty much issued only at the holding company level (regulated by the Fed) rather than at the operating company level (regulated by the FDIC). (For a full discussion see ( HYPERLINK “http://www.dealvector.com/blog/wp-content/uploads/2014/05/TRUPS-Market-From-Start-to-Finish.pdf” The Trust Preferred CDO Market: From Start to (Expected) Finish, published by the Philadelphia Federal Reserve)
Regulatory Decisions Driving Small Bank Failures
The problem is that, in certain cases, regulators are refusing to allow banks to use excess capital reserves to satisfy their TruPS obligations, potentially resulting in regulator-driven default of an otherwise healthy, or at least salvageable, institution. That doesn’t appear to have been the case in the American bankruptcy, but industry sources are telling us that regulators have been reluctant to let a well-capitalized bank use excess funds to shore up the finances of its holding company. So the consequence of the initial regulatory split is that the problem is in one part of the bank, but the solution is in another part of the bank, and the solution cannot be brought to bear on the problem.
The TruPS market is now hitting crunch time because the deferral grace period only lasts for five years. Several hundred regional banks are potentially becoming subject to bankruptcy proceedings if the TruPS creditors decide to enforce their rights, but some find themselves caught in a catch-22. Because it is the bank that generates cash while it is the holding company that owes the back interest, cash needs to be transferred from the bank to the holding company to satisfy the debt, even though they are for practical purposes the same entity. But because the general rule is to disallow the up-streaming of cash to the parent for the payment of dividends (remember the holding company treats TruPs as equity), no cash is available even in cases where the bank has excess capital reserves.
The result may be that some banks with sufficient capital to make good on their loan obligations will be forced into default—in other words, an action ostensibly taken to strengthen the bank (holding excess cash to improve the capital position) may end up bankrupting the bank through the holding company. Yet the Fed and FDIC seem curiously unconcerned about this scenario.
Reasons for Regulatory Indifference
There are several possible reasons for this indifference. It may be the regulators have not observed this type of forced bankruptcy to date, and so inertia wins the day. It may be they believe actually that TruPS creditors will not try to enforce their rights. This is where the American case could be so instructive.
It may also be that they are focused only on preserving capital ratios at the operating bank level, and will not approve any transaction that involves using part of that capital to pay liabilities at the holding company level. If this possibility is really motivating the government, then banks will not get recapitalized at the holding company level. Some of them will be forced into bankruptcy since the five-year deferral period is now ending. The end result of this process will likely be acquisition by larger banks. Consequently, small banks that could possibly have recapitalized will be rolled into superregionals, and smaller banks will go away.
The Wider Impact: Fewer Regional Banks
End result? Fewer, bigger banks. Should we add regional banks (like taxis, doctors, bloggers, and online schools) as another in the long list of small company regulatory losers? Is that what the government wants?
Jefferds is co-founder and chief operating officer at DealVector in Sausalito, Calif. DealVector runs an online platform that connects investors in fixed-income or distressed with other participants in deals.
By Dave Jefferds
In early May, the holders of the trust-referred (TruPs) liabilities of American Bancorporation of St. Paul in Minnesota, forced the company into involuntary bankruptcy. The case is timely because it shows that Collateralized Debt Obligation (CDO) vehicles, one of the major holders of bank TruPs, are finally enforcing their creditor rights. It also raises questions about whether regulators might consider more flexibility in their approaches to preserving bank capital and solvency. Though American’s bankruptcy was complicated by several factors apart from regulation, concern is mounting in the banking community that other bank holding companies could follow a similar path unless banks are given more options for restructuring and avoiding bankruptcy.
By way of background,
Sarbanes oxley compliance costs 3mm
Definitions of journalism for free speech
DC curbs food trucks to help restaurants
