The Community Bank Leverage Ratio: What if My Bank Does Nothing?

The Community Bank Leverage Ratio: What if My Bank Does Nothing?

Many community banks have decided that the best course of action regarding the new community bank leverage ratio (CBLR) is the easiest: Do nothing. Keep the status quo.  After all, regulators have seen their capital plans and haven’t complained, so why change?

But business as usual is not a good strategic policy. It often means continued failure to generate sufficient earnings or a justifiable ROE for shareholders. And your bank’s capital plan may encumber unnecessary amounts of capital, which is actually cheating your shareholders.

The reality is that most community banks have unintentionally overestimated their capital needs in their capital plans for one or more, if not all, of the following reasons:

  1. They do not want to invite scrutiny from their regulators;
  2. They have not estimated those requirements with any data or analytics, let alone with the correct data and analytics;
  3. They fall victim to the “Peer Group Trap.” That’s when banks with the lowest capital levels in a peer group decide they need to increase their capital, usually after its pointed out to them by the regulators. After they often unnecessarily do so, a new group of banks within the peer group now has the lowest capital levels, and then they raise their ratios. This process repeats itself as if it’s a game of musical chairs, and gradually leads to higher and higher levels of capital for all banks over time.
  4. They don’t understand which capital ratio is the most constraining. This is an important point and will be the subject of my next piece on the CBLR.  For the vast majority of community banks, the Total Risk-Based Capital ratio is the most constraining ratio, not the Leverage Ratio.  A community bank may have an 8.0 percent Leverage Ratio threshold written into its capital plan, but if it has a 12.0 percent Total Risk-Based Capital ratio threshold, that would likely trigger first when the bank is stressed.

The CBLR framework was designed to answer community bank concerns that the regulatory capital system was too complicated. No matter what your bank decides, the CBLR decision is a catalyst to revisit your bank’s views on capital.  Capital is the lifeblood of a bank. The more capital you can leverage without jeopardizing the bank’s safety and soundness, the more value you create for shareholders.

The first step for every bank should be to truly understand how much capital it requires to support its existing balance sheet and business model.  The only proper way to do this in a post-2008 world is with a stress test.  From there, you can determine how much excess capital the bank has available to deploy.

Management and boards should be scratching and clawing to unlock every possible penny of capital that is above and beyond what is required to support the bank’s existing balance sheet.  The more excess capital you can justify, the larger the war chest you can potentially deploy to generate excess returns for shareholders.   However, the reality is that often banks will find that when doing the right math, their internal capital requirements will seem low relative to peer group levels.  This is true even though these thresholds are sufficient, data-driven, and contain a healthy margin of safety.

This course of action will naturally invite a deeper regulatory examination.  As someone who has advised well over a hundred community banks on stress testing and capital adequacy over the last 10 plus years, I can assure you that this is actually a good thing — if you are prepared and have your act together.  The regulators’ job is to challenge you, especially if your bank breaks from the peer group.  The longer I’m in this business, the more I believe that if the regulators are NOT challenging you on your internal capital requirements, it likely means you have set them too high.

When you are prepared and have utilized the right process and methodology to determine and support your internal capital requirements, the end result will be more regulatory respect, as well as their acknowledgment that your bank is operating with appropriate –not excess– capital limits.

Here’s a question to ask your regulators (off the record): Would they rather oversee a bank with lower capital levels, strong management and a good risk management infrastructure or one with plenty of capital, weak management and insufficient risk management practices. The answer will always be the former.

While I am clearly pushing for community banks to optimize their excess capital, this is both a blessing and a curse.  On one hand, excess capital serves as muscle to fuel growth and/or acquisitions.  On the other hand, optimizing your excess capital also means you are increasing the pressure on management and the board to deploy this capital in a manner that increases shareholder value.  Good management teams and boards want, if not crave, this pressure.

Further exacerbating this pressure are today’s banking conditions.  In the current environment, organic growth opportunities are limited, with increasing late-cycle credit risk, weak loan yields and incremental net interest margins.  But excess capital can potentially be used for acquisitions in an industry that will only continue to consolidate.  In fact, the more excess capital that is available, the more and larger targets a bank can buy.  If all else fails and even acquisitions are not a practical option, the bank can always return its excess capital to shareholders via dividends and stock repurchases.

Choosing not to opt into the CBLR framework, but also not properly calculating internal capital requirements may also lead to what I call ‘capital creep’.  What I mean by this is that the 9 percent CBLR framework could end up being applied to your bank in a de facto manner, or perhaps even worse, regulators may eventually expect you to hold even more capital.

Historically and even under Basel III, the prompt-corrective action (“PCA”) minimum for a well-capitalized bank was a 5 percent Tier 1 Leverage Ratio.  Prior to 2008, it was common for banks to actually operate at or near this level.  However, in today’s world, no regulator would allow any bank to operate anywhere near 5 percent without being under a severe regulatory enforcement action.  Regulators expect community banks to operate well above these levels.  Well, what happens if 9 percent becomes “the new 5 percent” and becomes the baseline to which regulators expect banks to be ‘well above’? Then what is acceptable? 10 percent?  11 percent?  What happens if Democrats win the presidency in 2020 and replace Trump appointees with their own at the Fed, FDIC and OCC?

Banks that choose not to opt into the CBLR, but also pair that decision with a proactive review of their own internal capital requirements using the correct data and analytics, will be in a far better position to immunize themselves from capital creep.

The course of action that community banks should take when approaching the CBLR is clear:  Calculate your own requirements using a stress test, then decide whether to opt in after understanding the benefits and costs of each path.  For most banks, that means not opting in, but also taking control of your own destiny by determining or reevaluating your own internal requirements.  In other words, don’t opt in, but do SOMETHING, not NOTHING.

If banks are planning to opt in and do nothing, I could argue that they are better off blindly opting into the CBLR framework instead.  Not opting in and doing nothing is worse than opting in.  The costs of doing the latter may not materialize until down the road. But when they do appear, whether in the form of an underperforming ROE or a higher capital requirement, the average banker won’t tie this problem back to the real cause:  allowing a bank to become overcapitalized and failing to deploy and/or return excess capital to shareholders.  Banks that do nothing now are not giving themselves a fighting chance.

Those community banks that are proactive rather than reactive, aggressive rather than passive, and are not pennywise and pound foolish, will separate themselves from the pack and operate with a significant competitive advantage over their peers.  Moreover, they will be far more likely to remain as independent entities and/or sell for premium valuations over the next three to five years or even beyond.

Adam Mustafa is the CEO and co-founder of the Invictus Group