With earnings season over, bank CEOs are making the usual rounds of investor conferences. Evident in many of the investor presentations was the degree to which big banks still count on M&A to boost their prospects. A careful read of the CapOne order is, though, a cautionary tale. In our view, the future rests on organic growth – a term that should not be read to mean the liberal use of natural fertilizer to pretty up the greenery. In the wake of CapOne, big banks can’t do a lot of buying and selling, but there’s a lot of prospect for growth in innovative new products that promise profits without crossing the strict new prudential thresholds that redefine all a big bank does these days. And, given the power-up to non-banks in the current regulatory arena, big banks had better find a way to grow before a withering combination of strict regulation and tough new competitors takes the air out of the greenhouse.

First to what CapOne tells us. It’s not, to be sure, that no bank with a few hundred billion dollars in assets can buy anyone else, especially if the acquisition is relatively small. The FRB was at pains to make clear in CapOne that it isn’t against consolidating super-regional bank deals per se, especially if the banks involved are in traditional retail operations and, as CapOne was forced to do, carefully clean up their acts before coming before the Board. But, even if these deals can be done, they will be harder to consummate and take longer to close because each deal will face tough consumer opposition and a more stringent FRB review, especially with regard to whether regional bank markets could become unduly concentrated if the deal is done.

Thus, the prospects are daunting, but not doomed for super regionals. For the biggest of the big, though, traditional deals are toast. Even if a very big bank sits beneath the tougher new ten-percent deposit cap set in Dodd-Frank, acquisition of any bank worth the bother is effectively barred unless it’s an emergency transaction and the acquiring bank has a squeaky clean capital position and a picture-perfect living will. But, if there’s a yellow light up for super-regionals, and a red light for the biggest banks the traffic signals are blinking green again for big non-banks. Dodd-Frank imposed a three-year moratorium on the entry of non-banks into the insured-deposit arena, a moratorium that will end on July 21 of next year without, we expect, any Congressional action to extend it or turn the moratorium into the permanent ban community banks long have sought. The bigger the non-bank purchase of an insured depository, the more likely it will be to trigger FRB systemic regulation even if the transaction is carefully structured to avoid creation of a bank holding company. But, Dodd-Frank permits creation of “intermediate” holding companies to limit the FRB’s reach to a parent and, for many big non-banks, this structure will have a lot of appeal. Thus, roving non-banks will out-bid any big bank brave enough to try to buy a large insured depository. Importantly, the basic business premise of most large non-banks – cross-selling – was untouched by Dodd-Frank, in sharp contrast to the strategic rewrite for diversified banks demanded by the law.

If traditional bank-to-bank deals are at a huge speed bump, what of less traditional transactions? Several CEOs are talking eagerly about expanding into new business lines like insurance or building out small ones — e.g., wealth management – into formidable national players. Here, we think M&A can be done, but only if banks look both ways before crossing and, even then, ask the crossing guard nicely before taking a foot off the curb. Non-traditional acquisition won’t necessarily raise the concentration and resolution challenges that tried to crimp CapOne, but they could still face tough questioning on complexity, interconnectedness and – hardest of all, we think – the degree to which a bank’s internal controls, capital structure and liquidity-risk management are ready for a new venture.

But, build-out of current businesses and/or new-product development on the borders of current businesses doesn’t pose any of these regulatory hurdles. For one thing, most new-product ventures do not require prior regulatory blessing. New products must be vetted by a primary regulator – usually a friendly audience – but without the public disclosure and resulting controversy attendant to M&A. New standards will require prior board review and careful risk judgments in advance but, in our view, that’s as it should be.

The real challenge here for big banks isn’t getting approval for new products, but thinking prudent ones up. In the past, new bank products came from the evil scientists closeted in the derivatives laboratory, who dream up ever more arcane structures. When there has been innovation in retail banking, it’s largely come from the same laboratory, which wired up no-doc mortgages and the like. Can we take these scientists away from trying to build the next nuclear weapon and charge them instead to come up with energy for peaceful purposes? That, in our view, is the real strategic challenge facing the largest banks, not trying to figure out how to squeeze another deal past the Fed.

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