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Capital One to Test Fed's 'Too Big To Fail' Cred

NEW YORK(TheStreet) - "Too big to fail" will get better definition as the Federal Reserve rules on Capital One Financial's (COF) proposed $9 billion acquisition of ING's (ING) U.S. online banking unit ING Direct on Monday, following a delay.

If the Fed were to reject the acquisition, which would make Capital One the fifth largest bank by assets in the U.S. to JPMorgan (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C), it would signal that the "systemically important financial institution" designation of the 2010 Dodd Frank Act may extend to a new range of large but not titanic sized U.S. lenders, putting industry consolidation in doubt. For Capital One, the deal breakup would cast a pall on its growth prospects.

Federal Reserve Chairman Ben Bernanke

The June deal is the largest U.S. bank acquisition yet to face regulatory inquiry into mergers that considers systemic risk in consolidation attempts, as post-crisis laws like the Dodd Frank Act seek to make the banking system less of a threat to the wider economy.

During the financial crisis, a string of bank failures precipitated hundreds of billions in bailouts and instability caused a near freeze of credit in the U.S. Still, the definition of what is a "systemically important" bank and what is just a large lender has not been defined by regulators, with serious implications to bank capital costs, earnings growth and M&A activity.

"This deal could be seen as a marker for what the Fed perceives is too big to fail," says KBW bank analyst Sanjay Sakhrani of the Federal Reserve's pending decision on the Capital One acquisition.

Sakhrani says that if the merger were to be blocked, it would signal that large regional lenders like U.S. Bancorp (USB) and PNC Financial (PNC) are also systemically important, making attempts at growth through acquisition unlikely.

A rejection would also be negative for M&A across the bank space, adds Sakhrani, who believes that the deal will be approved because, "it's a combination of two pretty simple banks that use deposits to make loans to consumers."

The Federal Reserve was expected to rule on the merger on Wednesday, but pushed a decision to next Monday. Capital One attributed the delay to a "scheduling conflict" in a statement.

On Wednesday, the National Community Reinvestment Coalition said hundreds of callers to the Federal Reserve expressed concern on the deal. The NCRC opposes the tie-up, calling Capital One a risky lender with large subprime holdings. The group has also asked for the Federal Reserve to be more transparent in its methodology for determining systemically important banks.

If the Federal Reserve were to approve a deal, it could signify that large banks without significant securities and trading operations can still make transformative acquisitions in the wake of post-crisis regulation. About what represents "too big to fail", FBR Capital Markets analyst Scott Valentin says "I think it would come down to the size and scale of the capital markets business." He expects the deal to pass because of Capital One's ability to bolster credit extension and its [business] of taking in deposits to make loans, or "spread based banking."

Capital One's shares have slightly outperformed the Financial Select Sector SPDR (XLF) in 2012, even as disappointing earnings weigh on share gains. In 2011, Capital One shares significantly outperformed the sector, as it unveiled an aggressive acquisitions strategy.

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For more on Capital One shares, see the 10 most profitable bank stocks.

Stock quotes in this article: COF, PNC, USB, BBT, STI, ING, RBC 

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