Catch-22 is a satirical World War II novel by American author Joseph Heller. The meaning behind the phrase “Catch-22” is that you need something to happen, but the exact reason you need it to happen is also the reason it cannot happen. The book follows a protagonist who is a bombardier who must fly a set number of missions in order to return home, but the target number of missions keeps getting increased. Specifically, as it relates to the book: If one is crazy, one does not have to fly missions; and one must be crazy to fly. But one must apply to be excused, and applying demonstrates that one is not crazy. As a result, one must continue flying; either not applying to be excused or applying and being refused. The reader is now probably asking how this dynamic applies to lending.  

The reason is that the OCC and FDIC are creating a modern-day Catch-22 by having competing interests and this dynamic is causing a credit tightening that should lead to a shift in credit to the non-bank world. To compete, banks need to merge, but they cannot merge until there is clarity around the regulations and then they must wait a long time for approval. The banking merger apparatus will remain frozen until banks know what the rules of the road are established. Emergency situations such as JP Morgan acquiring First Republic Bank will most likely be exceptions to the rule given the timing, size and urgency of that particular situation. Putting First Republic Bank aside, the Catch-22 here is simple in that one regulatory body is going to increase regulations on many banks specifically focused on capital ratios and criticized assets. In contrast, another regulatory body is focused on managing merger activity, that will at best cause a delay or at worse block something that should happen.  

The majority of large regional banks are simply not incentivized or frankly capitalized to lend right now.  Uncertainty over capital rules, rising interest rates and a looming downturn have put a lid on bank mergers and have halted aggressive bank lending policies and as a result, banks are now working to shore up their balance sheets. The best way for most banks to become safer and better equipped to handle the increased OCC regulatory constraints is to merge, but to do that is not simple and requires different regulatory approval from the FDIC.  So, banks need to merge to be able to effectively compete and handle new regulations, but on the other hand the government is going to make it harder for banks to merge. This is the definition of Catch-22, and it is creating a credit crunch in the market.  

The need for additional or new credit is in direct conflict with a bank’s need to conserve capital and improve ratios. Lending for the sake of asset growth ties up capital and puts many banks at risk when new capital ratios are imposed. The challenge in today’s market is that regulators are used to evaluating bank mergers based on competition and the needs of a community or region rather than capital ratios from another government body.  There is a lot of uncertainty on both ends of the regulatory spectrum that is putting senior executives at banks in a tough spot. Bank executives must determine if they should merge for safety, but risk being held up for a year by review – putting everything in limbo.

These factors, for the first time, 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 the 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. Furthermore, many banks are looking at the true profitability of their loan book and making a conscious decision to reduce credit, conserve capital and exit marginal and unprofitable relationships. Whatever impending legislation is derived from this latest banking regulation review process is going to be squarely aimed at the regional banking market that has morphed into a vital part of the banking system.  

The prudent solution to regulatory uncertainty and need to survive is 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. Banks know this and henceforth have finally put the brakes on lending. Ironically, the tightening is not being driven by rates, by war or even defaults, but by the perception and uncertainty of impending regulation. The long-term bank consolidation trend is inevitable, but the short-term is going to create real constraints that should lead into the hands of the non-bank world that went through its own consolidation to be in position to on-board many of the clients that banks want to off-board.

At the end of the book the protagonist comes to realize that a Catch-22 does not actually exist, but because the powers that be claim it does, and the world believes it does, it nevertheless has potent impacts. Indeed, because it does not exist, there is no way it can be repealed, undone, overthrown or denounced. The combination of force with specious and spurious legalistic justification is one of the book's primary motifs. This aptly describes the regulatory environment today. No one is saying certain banks cannot in fact merge, but the regulatory powers such as the FDIC and OCC have ironically competing interests that does create the perception that there is a real catch for banks to now do the right thing and merge and build their capital bases.  

The country has too many banks that should merge to ease the concerns of one regulatory body, but by doing so this creates a concern for another regulatory body that worries too much about banking power being concentrated. This is the definition of a “Banking Catch-22”!