The Federal Reserve’s Evolving Financial Stability
Analysis in Bank and Nonbank Acquisitions
February 17, 2012
On February 14, 2012 the Board of Governors of the Federal Reserve System (the “FederalReserve”) issued an order approving Capital One Financial Corporation’s proposed acquisitionof ING Bank, fsb. The Capital One order, together with the Federal Reserve’s earlier orderapproving the acquisition of RBC Bank (USA) by The PNC Financial Services Group, Inc., 1 are
the first interpretations of the new “financial stability” factor, which the Federal Reserve isrequired by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“DoddFrank”) to consider in connection with approving acquisitions.
The Federal Reserve describes in the Capital One order the quantitative metrics and otherqualitative factors it will use to assess the impact of a proposed acquisition on U.S. financialstability. The metrics give the Federal Reserve substantial flexibility to assess systemic risk, asdiscussed in detail below. Although the transaction significantly increased Capital One’s size
(from eighth to fifth largest depository in the U.S. by deposits), this was not considered anadverse factor by the Federal Reserve, despite critics of the deal who generally oppose largerbanks. The analysis suggests that while large bank acquisitions will not be discouraged, at least
among domestically-focused U.S. institutions engaged principally in traditional banking
activities, acquisitions among the very largest institutions (which have reached, or areapproaching, the nationwide deposit cap) or those engaged in more complex, foreign or otheractivities that would complicate their resolution in the event of distress, may involve challenges
under the new financial stability standard.
BACKGROUNDDodd-Frank added a new, so-called “financial stability” factor to the criteria used by theFederal Reserve in evaluating mergers and acquisitions between banking organizations andacquisitions by banking organizations of nonbanking companies. The Federal Reserve must
now take into consideration the risk to “the stability of the United States banking or financialsystem” posed by such transactions. 21On December 23, 2011, the Federal Reserve issued an order approving the acquisition by The PNC FinancialServices Group, Inc. of RBC Bank (USA).

2Section 604(d) of Dodd-Frank requires the Federal Reserve to take into consideration the extent to which aproposed bank merger “would result in greater or more concentrated risks to the stability of the UnitedStates banking or financial system.” Similarly, for acquisitions by banking organizations of nonbanks,Section 604(e) of Dodd-Frank requires the Federal Reserve to consider whether a proposed transaction
presents “risk to the stability of the United States banking or financial system.” A financial stability factor
was also added to the Bank Merger Act by Dodd-Frank. See 12 U.S.C. § 1828(c)(5); Dodd-Frank, § 604(f).

Memorandum – February 17, 2012

The Capital One and PNC orders provide a framework, compatible with the Basel Committeeon Banking Supervision’s methodology for identifying global systemically important banks, 3for evaluating the impact on U.S. financial systemic risk going forward.
THE FEDERAL RESERVE’S FINANCIAL STABILITY ANALYSIS
General Standard. In general, the Federal Reserve will “find a significant adverse effect [onfinancial stability] if the failure of the resulting organization, or its inability to conduct regularcourse-of-business transactions, would likely impair financial intermediation or financial
market functioning so as to inflict material damage on the broader economy.” The Federal
Reserve notes such damage could occur by “seriously compromising the ability of otherfinancial institutions to conduct regular-course-of-business transactions or seriously disrupting
the provision of credit or other financial services.”
Metrics. The Federal Reserve employs in the Capital One order five quantitative metrics—
which it considered independently and in combination—to assess the likelihood that failure of
the resulting organization may inflict damage on U.S. financial stability:••Size—The Federal Reserve considered Capital One’s size relative to the U.S. financialsystem, measured in terms of its rankings and shares for consolidated assets,consolidated liabilities, total leverage exposure and U.S. deposits. While the FederalReserve acknowledged the resulting organization’s large absolute size and theincrease in its rankings in many of these categories, it found more significant that
Capital One’s shares in all categories remained relatively small (the largest being a
2.3% share in deposits) and “well below the 10 percent limitations set by Congress.” 4
Substitutability—The Federal Reserve examined whether the institutions engage inany activities that are critical to the functioning of the U.S. financial system andwhether there would be adequate substitute providers that could quickly step in to
perform such activities should the combined organization suddenly be unable to do3

See Basel Committee on Banking Supervision, “Global Systemically Important Banks: Assessment
Methodology and the Additional Loss Absorbency Requirement,” November 2011, available at
http://www.bis.org/publ/bcbs207.pdf. While the factors and metrics considered by the Federal Reserve
are similar to the Basel Committee’s approach to assessing the systemic importance of globally active
banking organizations, the Federal Reserve’s approach to measuring financial stability differs in significant
respects. The Federal Reserve’s metrics are broader and focus on the resulting organization’s position
within the United States (rather than global) financial system. Moreover, the Basel Committee determinessignificance on the basis of a weighted average of all criteria, while under the Federal Reserve’s more
flexible qualitative approach, any one factor could cause a transaction to be deemed to pose unacceptablerisk to U.S. financial stability.

4The Federal Reserve noted in the Capital One order that Congress has placed other limits on the nation’slargest financial institutions that are helpful indicators of potential systemic risk, including the 10%
nationwide deposit cap, a 10% nationwide liabilities limit, and Dodd-Frank’s “enhanced prudentialstandards” for bank holding companies with $50 billion in assets and other systemically important financial
firms.

Page 2Memorandum – February 17, 2012••so as a result of severe financial distress. The Federal Reserve found that, in the caseof most of Capital One’s activities, the resulting organization would have a small
market share on a nationwide basis and numerous competitors would remain in themarket. With regard to the market for credit cards—historically Capital One’sprincipal product—the Federal Reserve noted that although the resultingorganization would be the fourth largest card issuer, with approximately 12% of themarket, three competing lenders would have substantially larger outstanding credit
card books, leading the Federal Reserve to conclude there would be no significant
disruptions in the supply of credit card loans if the bank were to experience
distress. 5 In many respects, the Federal Reserve’s quantitative analysis as tosubstitutability resembles an antitrust analysis, which focuses on market share,ranking and the availability of new entrants or other likely competitors.
Interconnectedness—This metric examined whether financial distress within thecombined organization could be transmitted to other U.S. institutions or markets.
The Federal Reserve concluded that Capital One does not engage in activities thatpose significant risks to other institutions, after looking at the combinedorganization’s (i) use of wholesale funding as a share of U.S. wholesale funding
overall, and (ii) shares of U.S. intra-financial system assets and liabilities and finding,in each case, that the resulting organization would have less than 1% of the market. 6
The Federal Reserve also noted that the transaction would not increase exposure to
any single counterparty among the top-three counterparties of either institution
prior to the proposed combination.
Complexity—The Federal Reserve considered the extent to which the combinedorganization would contribute to the overall complexity of the U.S. financial system
by looking at its complex assets, 7 trading book and available-for-sale securities—
again, as a share of the U.S. financial system. Central to this analysis was the degree

5This analysis suggests that, in addition to the largest, most complex banking organizations, organizations
providing unique financial services (such as wholesale settlement or clearing) or operating in moreconcentrated markets (like certain payments markets), might have more challenges in meeting this criteria,notwithstanding their size relative to larger institutions.

6

In response to comments, the Federal Reserve also reviewed Capital One’s share of the securitization
market, finding its total share of all such securitizations to be less than 9%, and noting recent accounting andregulatory capital changes that require credit card securitizations to be consolidated on the balance sheets of
the issuing banks that, among other factors, presumably reduce the riskiness of the financing source.

7

The Federal Reserve did not define the term “complex assets” in the Capital One and PNC orders. Under
the Basel Committee’s methodology (discussed above in footnote 3), an organization’s complexity isassessed based on its gross notional value of non-centrally cleared (i.e., OTC) derivatives and its Level 3
assets, as well as the other metrics considered by the Federal Reserve in assessing an organization’scomplexity.

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Memorandum – February 17, 2012

•to which the complexity of the combined organization’s activities would complicate
the resolution process. 8
Cross-Border Activity—Finally, the Federal Reserve reviewed the cross-borderactivities of the acquiring and target institutions to determine whether they would
present difficulties in coordinating any resolution in the event the resulting
institution experienced distress, thereby significantly increasing the risk to U.S.
financial stability. The Federal Reserve noted Capital One’s overseas credit card
operations were “similar to” its U.S. operations and would not add any substantial
complexity.

Safe Harbors. The Federal Reserve identified three types of transactions that could be subject toprior approval or notice under Section 3 or 4 of the Bank Holding Company Act, but that theFederal Reserve recognizes are unlikely to raise financial stability concerns:•••

an acquisition of less than $2 billion in assets;
a transaction that results in an organization with less than $25 billion in total assets; ora corporate reorganization.

Qualitative Factors. In applying its quantitative metrics, the Federal Reserve also considered
qualitative factors that could add to the difficulty of resolving the resulting organization, suchas the “opaqueness and complexity of an institution’s internal organization,” as noted above inthe discussion of the metrics.
Conclusion. Building on a framework initially outlined in the PNC order, the Capital One orderreveals a new regime of heightened regulatory scrutiny with regard to systemic risk mandatedby Dodd-Frank. Acquisition-minded banking organizations should be prepared for thisscrutiny. While the Capital One and PNC orders provide valuable insights for potential
acquirers as to the factors the Federal Reserve will consider, the orders contain few bright line
standards, and each transaction will be evaluated on the basis of its unique risk characteristics,
within the evolving framework discussed in these orders.
*8**

The Federal Reserve mentioned core clearing and settlement services—which Capital One does not engage
in—as the type of “complex activities” that could complicate the resolution process.

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Memorandum – February 17, 2012

For more information, please contact any of the members of our Financial Institutions Group, aslisted below.
Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Stacie McGinn(212) 455-2250
smcginn@stblaw.com

Maripat Alpuche(212) 455-3971
malpuche@stblaw.com

Ellen Patterson(212) 455-2499
epatterson@stblaw.com

Elizabeth Cooper(212) 455-3407
ecooper@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com

This memorandum is for general informational purposes and should not be regarded as legal advice. Furthermore,
the information contained in this memorandum does not represent, and should not be regarded as, the view of any
particular client of Simpson Thacher & Bartlett LLP. Please contact your relationship partner if we can be ofassistance regarding these important developments. The names and office locations of all of our partners, as well asadditional memoranda, can be obtained from our website, www.simpsonthacher.com.
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any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

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Memorandum – February 17, 2012

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