Should Community Banks Consider the CBLR at 8 Percent?

By Adam Mustafa, Invictus Group CEO

Under the CARES Act signed into law by President Trump last month, the Community Bank Leverage Ratio CBLR) threshold temporarily drops from 9 percent to 8 percent until the earlier of December 31, 2020 or the date on which the national emergency declaration related to the coronavirus expires.  The question now is whether this makes opting into the CBLR more attractive.

The answer is that it depends. It’s not one size fits all. And I hate to sound like a broken record, but the only way to make the proper assessment for each bank is by running a properly constructed stress test. But COVID-19 – and the subsequent regulatory adjustments to the CBLR – require that banks use stress tests in a different way to answer this question.

A declining capital ratio can be a good thing if it’s an indication that asset growth is so strong that it is outpacing growth in capital via retained earnings. This is why acquisitions often lead to reduced Day One capital ratios. As a result, a bank with aspirations for aggressive (and hopefully smart) organic growth or acquisitions is certainly better off with a lower capital threshold if it can justify one because it optimizes the amount of excess capital it can put to work toward funding those initiatives.

However, this is not the situation that community banks are dealing with right now. The COVID-19 crisis is still a big fat unknown with respect to its ultimate impact on the economy. It is not out of the realm that this could create a deeper and protracted recession even worse than the 2008 Financial Crisis. And that’s based on the IMF. The threat of loan losses piling up, coupled with reduced earnings from NIM compression, could easily create a situation in which bank capital ratios decline for bad reasons.

When you think about it like this, then the only way a bank could possibly be better off opting into the temporary CBLR at 8 percent is if it believes it would avoid prompt corrective action (“PCA”) guidelines triggered earlier by another capital ratio, such as the Total Risk-Based Capital ratio. The minimum definition of a well-capitalized bank per the PCA guideline using the Total Risk-Based Capital ratio is 10 percent. When including the capital conservation buffer, which if breached, will cause some restrictions on dividends and executive compensation, the minimum is 10.5 percent.

Theoretically, if your bank would breach the 10.5 percent Total Risk-Based Capital ratio prior to breaching an 8 percent Tier 1 Leverage ratio under stress, then it suggests you should opt into the temporary CBLR at 8 percent to avoid that earlier trigger. Stress tests can help tell you whether you are likely to fall into this bucket. Practically speaking though, I don’t think it will matter very much and is not a good reason to opt into the CBLR. Here is why.

Regulators utilize a variety of early warning indicators to put pressure on banks well before capital ratios reach either of these levels. Most notably is the Classified Assets to Capital ratio. The numerator of this ratio is equal to classified loans plus OREO assets. The denominator is equal to your Tier 1 capital + your loan loss reserve balance.
If the Classified Assets to Capital ratio crosses into the 40 to 50 percent range, regulators get very nervous. Banks can expect an MOU and a CAMELS downgrade, and if things get worse, we’re in consent order and CAMELS-4 territory. Restrictions contained in MOUs and consent orders will often handcuff banks and force them to take defensive actions such as constraining growth, reducing capital actions, or more. A breaching of either the Total Risk-Based Capital ratio of 10.5 percent or the Leverage ratio at 8 percent under the framework becomes a moot point because the MOUs and consent orders will come well before then. The regulators even specify this concept as a loophole available to examiners buried deep in footnote 13 in the Federal Register final version of the CBLR rule.

In a nutshell, having a Leverage ratio in the low 8-percent range while in ‘growth mode’ combined with a low Classified Assets to Capital ratio is very different than having a Leverage ratio in the low 8-percent range coupled with a Classified Assets to Capital ratio above 50 percent.  These are two entirely different situations with different implications for the CBLR. The latter is the scenario that banks should be grappling with short-term, but the former is the scenario they should be thinking about in the long-term. Both need to be considered.

In the short term, stress testing can provide you with the necessary visibility you need to understand your Classified Assets to Capital ratio. It should give you an indication of how high that ratio can get under severely adverse economic conditions, as well as what and how contingency actions undertaken by management can alleviate capital pressure. Stress testing can also give you a sense of how the Classified Assets to Capital ratio aligns with the Leverage ratio and Total Risk Based Capital ratio. With this information, you can make an intelligent decision about whether opting into the CBLR would really have any benefit, even during this temporary period.

What would change the calculus of opting into the CBLR framework is if the 8 percent threshold becomes permanent instead of temporary. But regulators have already decided that they want the ratio to go back to 9 percent by January 1, 2022. They announced on April 6 that they would phase in the increase, allowing community banks to keep an 8 percent ratio in 2020, an 8.5 percent ratio in 2021 and then a 9 percent ratio “thereafter.”

Bank lobbyists view the CARES ACT as winning a battle that gives them momentum toward winning a permanent change in the threshold. Until this happens, I see little value in adopting the CBLR if you have not had time to run your stress tests. Opting into the CBLR framework now and then opting out later will be more difficult, from both an optics and operational perspective, than waiting to see what happens in the next few years. If you haven’t had time to run the appropriate stress tests to assist you with this decision, you are better off buying time and not opting in when you file your March Call Reports. If the stress tests do tell you it makes sense to opt in, you can always opt in later.

Notes on the Classified Assets to Capital Ratio

It is important to mention that this ratio is not affected by the CBLR like other concentration ratios such as the CRE concentration ratio. For the CRE concentration ratio, the denominator is Total Capital (Tier 1 + Tier 2 capital). Since the loan loss reserve is the primary component of Tier 2 capital in most cases, there usually is no difference between Total Capital and Tier 1 capital + the loan loss reserve. However, there is a cap on how much of the loan loss reserve counts as Tier 2 capital, which is equal to risk weighted assets multiplied by 1.25 percent. Since the CBLR does away with risk weighted assets, regulators announced last month that the CRE concentration ratio will now be calculated as the same denominator as the Classified Asset ratio, which is Tier 1 capital plus the loan loss reserve.  Net net, banks that opt into the CBLR may realize a benefit via the calculation of their CRE concentration ratios because there is no longer a cap on how much of the loan loss reserve counts in the denominator. But this has no impact on the Classified Assets to Capital ratio, which never used Total Capital as its denominator.