Capital One-ING Merger as Test of Dodd Frank

The Dodd-Frank Act requires the Financial Stability Oversight Council and the Federal Reserve to establish a definition of “systemic risk” and keep banks and other financial institutions from growing so large that they become a risk to the system. Thus far, the definition process has been slow going and it isn’t clear exactly how regulators will treat so-called too big to fail banks. The FOMC has come out with guidelines naming firms with $50 billion or more of assets as “systemically important” but the Fed has not nailed down further details on how it will define systemic risk in terms of mergers or expansion.

Enter Capital One and ING Direct. The former has decided to buy the later, and the combined financial institution will create the fifth largest bank in the country—though still tiny relative to Bank of America. The question at hand for regulators is will this merge create more risk in the system than benefits? They shouldn’t have to ask this question—regulations should simply outline the consequences for fraud or failure and force the organizations to ensure they will be stable as a combined company—but they are asking anyway.

There are host of issues involved in this matter and what the Fed decides may lead to a defined rule for similar mergers in the future. Over on DealBook, Steven Davidoff has some interesting thoughts:

Because the Federal Reserve has yet to spell out its own “too big to fail” guidelines, Capital One has proposed its own test to the Fed. Capital One looks at bank size and its interconnectedness and importance to the financial system. Not surprisingly, Capital One fails to meet this criteria. The bank rightly notes that after the two acquisitions, it would still be a pipsqueak next to Bank of America, the largest United States bank with $2.26 trillion in assets. Capital One will have only a measly $300 billion or so. How could this increase systemic risk?

Moreover, Capital One argues that it does not engage in the complex type of banking that a Goldman Sachs or Morgan Stanley does, like writing derivatives. Capital One is going to be a simple, deposit-taking institution that lends money primarily on credit cards.

Some analysts have said that the ING Direct acquisition will make Capital One sounder because it will provide Capital One a more stable source of financing for its lending activities than borrowing in the short-term lending market.

In general, interested parties will agree or disagree with this based on their own interaction with the market. If you don’t want more credit card debt you’ll call BS on Capital One’s claims. If you agree that having a credit card company get access to a steadier stream of deposits would make a financial institution sounder then you’ll agree with Capital One’s logic. It shouldn’t matter what others think, but since it does it is worth being aware of bias in the debate.

One of the biased parties is the National Community Reinvestment Coalition, which opposes the deal because it thinks that consumers might be hurt. But National Community isn’t so much interested in the safety of the system as they are using force to get financial institutions to subsidize the low-income families in their grassroots base. Davidoff continues:

[National Community] argues that Capital One’s application to acquire ING Direct is suspect because Capital One refuses to lower its credit standards to extend Federal Housing Administration-insured loans to people with credit scores of 580. This is the lowest credit score allowed by the F.H.A. National Community contends that this is discriminatory against members of minority groups because they tend to have lower credit scores and have been hit harder by the financial crisis.

Capital One has responded by agreeing to lower its credit score requirements by 2012. For National Community, this is not enough, because Capital One’s F.H.A. loan volume is relatively flat in growth. Capital One is now a bit player with less than 1 percent of the F.H.A. loan market. National Community wants the combined entity to make more of these loans, since they help people who could not otherwise afford a mortgage.

So National Community is arguing that Capital One should take more risk when making home loans, but less risk in getting bigger and offering credit cards. Remember, the financial crisis was caused in significant part by excessive, and sometimes predatory, subprime lending. Capital One may not be predatory, but the borrowing National Community wants is lower down on the subprime scale and will create more risk.

Ultimately, the questions are: should the government have a role in deciding what kind of banking system we want? Some will want to focus on whether regulators should try to keep banks smaller or allow the system to become more concentrated—but they should look at the incentives built into the regulatory system and tax code to see what is driving the consolidation of banking.