How Does COVID-19 Affect the Looming Community Bank Leverage Ratio Decision?

By Adam Mustafa, Invictus Group CEO

The decision on whether to opt into the new Community Bank Leverage Ratio (CBLR) feels trivial right now. The immediate focus of every community bank in the country needs to be on the safety and economic well-being of their customers and employees. Everything else is secondary.

Community banks can technically choose to opt in or out of the CBLR framework at any time. More practically speaking, I think it will be far more difficult to initially opt in and then opt out later. Regulators will want to know why, and they have plenty of loopholes to pressure banks to hold more capital.

This is just one reason why most community banks should choose to NOT opt into the CBLR right now. Another reason is that most banks can justify a lower capital requirement than 9.0 percent by executing a properly designed stress test to customize their own requirement. By using a stress test to support and defend a lower but more appropriate capital requirement, precious capital can be freed up and used by community banks to support desperate small businesses in the hospitality, retail, manufacturing, oil and gas, restaurant, and other severely affected industries. In fact, this is the only time in my career that I have seen regulators encouraging banks to use excess capital to support borrowers.

With community banks focused on operational issues, choosing not to opt into the CBLR will buy time to run the appropriate stress tests if they haven’t done so already. It is imperative to run the right stress test rather than simply ignoring the CBLR altogether. Choosing to do nothing may have consequences. A more careful analysis shows that the existing capital plans in place at many community banks are even more restrictive than the CBLR – and most of these banks don’t even know it.

Keep in mind the spirit of how regulators have viewed and calculated capital adequacy in recent years. It’s pretty easy to conclude that banks will now need to demonstrate they have enough capital to survive a potential deep recession triggered by the COVID-19 crisis. Stress scenarios must be adjusted to reflect certain characteristics of the COVID-19 crisis that are different than the 2008 Financial Crisis. Some banks that may have performed well in a 2008-style stress test may not perform as well in a COVID-19 stress test – if, for example, they have a large concentration in hospitality or oil and gas loans. These stress tests are just starting to happen and will undoubtably go through many reiterations as the longer-term economic consequences of the COVID-19 crisis emerge. And that’s just another reason to punt the CBLR decision.

Community banks will need to quickly pivot toward preparing for a worst-case scenario, should it unfold. Stress testing can become the CEO’s best friend right now. It can help keep the board of directors calm by quantifying the strength of the bank’s capital, while simultaneously identifying those loans that have the highest risk of stress. Banks can then be proactive by restructuring those loans with the borrowers. A correctly constructed stress test will also enable banks to properly allocate capital to their bank and within different business lines and asset classes. The CBLR decision, while no longer a high priority, will become obvious as a natural byproduct of this analysis.

So, my strong recommendation is don’t opt in, focus on the COVID-19 crisis, and use stress testing to guide you through the potential hard times ahead. In doing so, you’ll kill the CBLR bird with the same stone.