Part 2: Consolidation 

If I lend you a fiver I trust you will pay me back, and it stops there. But if I lend you my monthly salary, I would want some additional assurances. Trust, as they say, only goes so far.

I lend my bank my monthly salary on the 28th of each month and where the trust runs out, regulatory capital steps in.

Of course there are other things that give us comfort: many countries for example have a deposit protection scheme and banks are highly scrutinised by their regulators.

But knowing that all banks are required to hold a prescribed amount of capital, and in particular share capital, that is both permanent and loss absorbing is central in maintaining our confidence. Phrases like ‘fortress balance sheet’ emphasise the point.

Regulatory capital rules are long, complicated and at times have more in common with a maths exam than legislation. It is an area in which to dabble is to be dangerous. But in short they deal with three questions: what counts as regulatory capital, how much regulatory capital is required and where that regulatory capital must be held?

Regulators require regulatory capital to be held not only at the level of the bank but also at a group level, or, to put it another way, on a solo and a consolidated basis (although in some cases the solo application can be waived).

When you are thinking about buying a bank, understanding where in your acquisition structure you will have to meet regulatory capital requirements is important and should be part of your early stage structuring discussions. It will impact how you accommodate leverage, how many holding companies you need in your acquisition stack and their location and the structuring of your management incentive plan where relevant.

In the EU I have seen regulators accept slightly different interpretations of the consolidation rules. In some cases they have accepted that only the top EU entity in the acquisition structure needs to satisfy the regulatory capital requirement.

In others, the rules have been applied to require sub-consolidation within each member state, so if the bank is located in Belgium and your bidco is in Belgium but your holdcos are in France and the UK, the top entity in each member state must satisfy the regulatory capital requirements.

However, in recent months I have seen a distinct trend of regulators insisting on imposing sub-consolidation groups within each member state and I suspect this is now also the prevailing view of the ECB. As a result, care should be taken to understand the approach that will be applied to your transaction so that you can structure accordingly with past regulatory approaches no longer acting as a firm guide to future decisions.

Getting your capital consolidation analysis right is an important part of a successful deal. It is also key to the continued viability of the investment because in the eyes of regulators and depositors regulatory capital beats trust every time.