Competing government regulations have resulted in a credit crunch in the regional banking sector. The opposing interests of the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) are creating a catch-22 situation, and this dynamic is causing a credit tightening that will likely lead to a shift in credit to the non-bank world.
Regional banks need to raise capital or merge in order to lend, and the majority are not succeeding. The challenge is that the OCC was created to supervise and regulate banks while the FDIC was primarily created to provide insurance on deposits to guarantee the safety of funds kept by depositors.
How this works in the real world is that the OCC is looking at ratios and telling banks to raise capital, which could include merging, and the FDIC has the power to hold up or block a deal if it perceives the deal is too risky for depositors. This is the definition of a banking catch-22.
To remain competitive, banks must merge, but they cannot do so until there is clarity around the regulations. Then they must wait a long time for approval. The banking merger apparatus will remain frozen until banks know the rules of the road. Moreover, the majority of large regional banks are simply not incentivised or frankly, capitalised, to lend right now.
Uncertainty over capital rules, rising interest rates and a looming downturn have quashed bank mergers and halted aggressive bank lending policies. As a result, banks are working to shore up their balance sheets. The need for additional or new credit is in direct conflict with a bank’s need to conserve capital and improve ratios.
Exceptions to the rule
Emergency situations such as JPMorgan acquiring First Republic Bank will most likely be exceptions to the rule given the timing, size and urgency of that situation. Putting First Republic Bank aside, the catch-22 here is simple. The OCC is going to increase regulations on many banks that are specifically focused on capital ratios and criticised assets, which are underperforming and downgraded risk-rated assets that banks need to reserve for. By contrast, the FDIC is focused on managing merger activity, which will at best cause a delay or at worst block something that should happen.
For the first time, these factors are causing the credit crunch to be felt, as evidenced by the rising new business activity in the non-banking sector. There is a real pullback going on among banks, although for the most part this excludes the nation’s largest banks and smallest banks, which are typically deemed too small to focus on.
Most banks with assets greater than $10 billion are intensely focused on capital ratios and very few new loans are getting approved that are credit-only loans. Whatever impending legislation is derived from this latest banking regulation review process will be squarely aimed at the regional banking market, which has morphed into a vital part of the banking system.
The prudent solution to regulatory uncertainty and need to survive is for banks to curtail credit. Regional banks have a strong incentive to merge and reach or increase scale since they will clearly be subject to more regulatory scrutiny and capital requirements. The long-term bank consolidation trend is inevitable but the short term is going to create real constraints. That should play into the hands of the non-bank world, which went through its own consolidation to be in a position to on-board many of the clients that banks want to off-board.
No one is saying that certain banks cannot in fact merge but regulatory powers such as the FDIC and OCC have ironically competing interests. This creates the perception that there is a catch-22 for banks to now do the right thing and merge and build their capital bases. Regional banks are not lending, raising capital or at this point merging and should at least doing two out of the three.
To add to that, the country has too many banks that should merge to ease the concerns of one regulatory body, but by doing so this creates concern for another regulatory body that worries too much about banking power being concentrated. This is the definition of a banking catch-22. So, it’s a good time to be in private credit.
Charlie Perer is co-founder and head of originations at SG Credit Partners, a California-based credit manager focused on the lower mid-market