If Your Capital Plan is Missing this Metric, It’s Broken and Needs to be Fixed Now

By Adam Mustafa, Invictus Group CEO

Regulators have made it clear in recent guidance: As the economic fallout from the coronavirus continues, capital plans will be under the microscope at your next exam. And while most community banks have a capital plan, way too many are missing a key metric that makes the plan virtually useless.

A properly developed capital plan will include a select list of early-warning indicators designed to govern when and how management and the board should take action to preserve capital if the bank comes under stress. A bank should not wait until its capital levels fall to the well-capitalized minimum before it takes defensive action. Moving earlier in the cycle gives the bank more options, including the possibility of raising additional capital.

Unfortunately, most capital plans I have seen are missing the single most important early warning indicator: The Classified Asset Ratio, aka the Texas Ratio.  A quick refresher:

Classified Asset Ratio =Classified Loans + OREO Assets
Tier 1 Capital + Loan Loss Reserve

This ratio is the metric of choice used by regulators. They will tell you that it’s one of many metrics they consider when observing the safety and soundness of a bank, but I can tell you from first-hand experience it’s the most important one. Regulators focus on this ratio because it’s proven to be a leading indicator of bank failure. In working with many banks that were in trouble going back to the Great Recession as well as more recently, here is what I have found banks can expect from regulators when this ratio reaches the following thresholds:

  • 25% = You will trip a wire and show up on a watch list at minimum.
  • 30-50% = Expect a tough exam and you are likely in MOU and Camels 3 territory.
  • 75%+ = Public consent order and Camels 4 ratings likely on the way.

The above thresholds are rough estimates and may vary slightly across regulatory bodies and regions. However, community bankers and directors who were not involved with a troubled bank following the 2008 Financial Crisis may not be aware of the importance of this ratio. It reached unimaginable levels for many community banks that failed or were on the brink of failure during the 2008 crisis; I saw some banks with ratios between 150 percent and 200 percent.

Be smart. This ratio must be in your capital plan, with an appropriate trigger and limit. If you don’t manage this on your own, your regulator may do it for you, and you don’t want that.

The importance of this ratio is not limited to regulators. Some banks will also find it as a covenant within the loan agreement between their bank holding company and a correspondent lender. It will also likely be a metric that professional investors will expect, especially for public banks. At minimum, management teams should begin tracking and sharing this ratio with their boards on a recurring basis. Do not make it a ratio buried in a pile of other ratios. It deserves special attention.

The Classified Asset Ratio – A Ticking Timebomb Because of COVID-19?

Regulators have encouraged banks to work with borrowers to provide relief via deferrals on principal and interest payments during the current crisis. Banks can offer borrowers the opportunity to defer payments for up to 180 days without having to treat these loans as troubled debt restructurings, which would immediately put them into classified asset territory.

Based on my observations working with many community banks, the average bank has 20 percent to 25 percent of its entire loan portfolio in deferral these days. Some exceed 30 percent, if they have more exposure to borrowers operating in industries disproportionately affected by lockdowns and social distancing. Many of these deferrals were granted in March and April and allowed borrowers to avoid making payments for 90 days. Now that we are in July, the first wave of borrowers will be reaching that first 90-day checkpoint. Some borrowers will begin to resume payments again, but many more will need an additional 90 days as the economy slowly recovers with an elevated amount of risk and fragility.

Those borrowers who are provided a second deferral will have until late September and October. However, at that point, the full 180 days of TDR-free treatment allowed by the regulators also will have expired.

This could mean that the amount of classified loans could spike in an instant. While it’s possible the regulators could extend the TDR-free treatment window past the 180-day mark, it’s unlikely. Recent guidance by the regulators suggests the opposite; they are going to begin cracking down on banks if they are not appropriately managing risks caused by the pandemic. More specifically, they call out “Classification of Credits” as something they will focus on in upcoming exams.

Let’s assume you are the CEO of a bank with the following characteristics:

  • Assets = $1 billion
  • Loans = $800 million
  • Classified Assets = $10 million
  • Tier 1 Capital = $100 million
  • ALLL = $10 million
  • Loans Currently in Deferral due to COVID-19 = $160 million (20% of loans)
  • Classified Asset Ratio = 9.1% ($10 million divided by $110 million)

Now let’s say that one out of four loans currently in deferral fails to continue payments at contractually obligated levels and becomes a classified loan in the fall. For this bank, classified loans would increase by $40 million.

The total amount of classified loans at that point would be $50 million, adding in the $10 million of assets that were already classified. Assuming the Tier 1 Capital and ALLL remain flat for simplicity (ignoring a quarter or so of earnings), the Classified Asset Ratio would jump from 9 percent to 45 percent ($50 million divided by $110 million).

This would put this bank into MOU and Camels 3 territory overnight, using the grid I laid out earlier in this article! All it took was one out of every four loans currently in deferral to be unable to continue debt service three months from now. For those of you wondering, the Classified Asset Ratio would reach 57 percent if one out of three loans in deferral fails to continue debt service, rather than one out of four.

This would create an unprecedented situation where hundreds, and possibly thousands of banks, could see their Classified Asset Ratio spike into ranges that typically trigger significant regulatory pressure. This is unfortunately a highly plausible scenario if the economy does not recover quickly enough and/or a second wave leads to states rolling back re-openings.

What Banks Should Be Doing Right Now to Get Ahead of This

The very first thing that community banks must do is make sure that there is a trigger and limit for the Classified Asset Ratio in their capital plans. Why? Regulators are watching this ratio. If regulators are forced to triage hundreds or thousands of banks, they are far more likely to give the benefit of the doubt to those banks that have self-governing mechanisms already in place. At the end of the day, this is all about trust. Can examiners trust you more than other banks? If you have your own limits and triggers, and you act based on them, you will have far more control and flexibility over the process. If you wait for the regulators to tell you what to do, the repercussions will be far more painful.

For example, imagine you are bank that has a bank holding company with debt that needs to be serviced. The servicing of that debt is entirely dependent on a dividend from the bank to the bank holding company. If the bank trips a Classified Asset Ratio trigger in the capital plan, but management proactively takes action by implementing a contingency plan that focuses on deleveraging, it has a far better chance of being able to maintain that dividend versus having the regulators come in and tell the bank what to do, which may include hitting the pause button on the dividend and putting the bank holding company at risk of defaulting on its debt. (Remember, regulators don’t care that much about the holding company, they care about the bank!).

Risk management is critical. Monitoring the Classified Asset Ratio is one thing banks should be doing, but they should also be running appropriate COVID-19 stress tests. If you haven’t done so yet, you need to jump on this immediately. You should be evaluating your capital ratios under stress. Keep in mind that, in the eyes of the regulators, it is not sufficient anymore to just be happy if you remain well-capitalized under stress if your Classified Asset Ratio increases to challenging levels. They will expect you to take defensive action.

Every management team in the country should be developing a contingency plan that could include concepts such as de-leveraging, reducing dividends, and expense reductions. You can also include capital injections, but be careful not to overly rely on actions that depend on external factors like raising capital and asset sales when the capital markets could shut down or result in draconian prices if we have an economic setback. That contingency plan should then be evaluated under stress to measure the impact on capital so you can demonstrate that it is sufficient, even in a downturn. 

Community bankers should also be thinking about a philosophy toward classified assets if stressed conditions further develop in the economy. There is a trade-off. The more aggressive you are with borrowers, the more you reduce classified assets. But the customer pays the price. Remember, community banks are in the relationship business. However, the less aggressive you are, the longer it takes to work your way out of purgatory, and the greater the risk of loss associated with these credits.

This means having to make tough decisions on classified loans. For example, there may be a significant number of borrowers with major cash flow problems, even though they appear to have a loan with a low loan-to-value based on their last, likely pre-pandemic, appraisal. Banks may pressure those borrowers to liquidate the underlying assets to pay off the loan, but at a reduced valuation driven by decline in cash flows and lack of market liquidity. This workout strategy would reduce or eliminate any money the bank has at risk and also reduce the balance of classified assets, but it would likely be very painful to borrowers because it would wipe out a significant amount of their equity.

Wrap Up

It is critical to track the Classified Asset Ratio for a multitude of reasons. It’s highly plausible that banks will be forced to classify a significant number of loans that are currently in deferral within the next 90 days. There is not a lot of time to get out in front of this. My advice: Get this ratio into your capital plan, evaluate it in a properly designed COVID-19 stress test, and have a contingency plan and workout philosophy developed, just in case there is a setback in what is a very fragile economy right now.