We have been preaching for two months that community banks must take seriously the decision whether to opt into the Community Bank Leverage Ratio (“CBLR”).  Our analysis suggests that it would be damaging to the vast majority of community banks to opt into the new capital framework because it would encumber unnecessary amounts of capital that could otherwise be put to work.  We have also written about how community banks need to calculate their own customized capital requirement, and why stress testing is the only tool appropriate for the job.

However, what we have not discussed in enough depth is how to quantify the ROI for doing all of this.  The purpose of this piece is to provide a ‘back of the envelope’ example of what the math looks like. Hopefully, the results will document why this is such an important decision, and why it is essential for management teams and directors of community banks to make it an essential part of their fiduciary responsibilities.

Setting the Stage

Let’s say you are a director of a fictitious bank called First Bank, a community bank with $700 million in assets.  First Bank has a Leverage Ratio of 10%, meaning it has $70 million in capital.  Management of First Bank is evaluating whether to opt into the CBLR.  If the bank chooses to opt in, $63 million ($700M x 9%) of the bank’s capital would essentially become restricted, leaving the bank with only $7 million of excess capital that can be used to pursue organic growth, acquisitions, or fund capital actions such as dividends and stock repurchases.

Let’s also assume that First Bank’s financial performance is good but not great – it is generating roughly an 8 percent ROE annually.  However, the highest performers in its peer group is consistently generating more than a 10 percent ROE, so Management and the Board of Directors are committed to 10 percent ROE as a goal to increase shareholder value.

Management decides to perform an appropriate stress test to evaluate what its ideal customized capital requirement should be, given the unique characteristics of First Bank’s loan portfolio and business model.  There is a small upfront investment the bank will need to make to perform this stress test by engaging a third party (more on this later).  Management advises the board that it plans to start the analysis immediately, reporting the results in the form of a customized Leverage Ratio requirement in a future board meeting. From there, additional discussions will occur with respect to the implications of these results on the looming decision about the CBLR.

Two months later, Management returns to the board and communicates that the results of the stress test are in:  The Bank’s ideal Leverage Ratio requirement is 8.1 percent.  This estimate is supported by the results of the stress test, which is driven by assumptions that err on the conservative side and include a healthy margin of safety.

You ask Management a practical question: “I get that our capital requirement could be lower if we do not opt in, but could we be just better off taking the simplest approach and opting in anyway?  In other words, what is the true ‘cost’ of choosing to opt into the CBLR, and is it even material?”

Quantifying the Incremental Earnings Created by Not Opting Into the CBLR

In response to your question, First Bank’s CFO begins to lay out the following analysis:

1. With an 8.1 percent requirement as calculated in the stress test, we would only need to restrict $56.7 million of our capital. As a result, we would have $13.3 million of excess capital.
   
2. Since the CBLR would only leave us with $7.0 million of excess capital, we would be increasing our excess capital by $6.3 million.
   
3. Now let’s say we deploy this $6.3 million into loan growth. Since not opting into the CBLR also means that we are subject to the risk-based capital rules framework, let’s assume that we leverage our capital by 10x (inverse of 10%) for simplicity.  This means we could use this capital to support $63 million of additional loan growth that is above and beyond what we can achieve if we simply opt into the CBLR.

1. Now assume that there is enough loan demand in our market. Loan officers originate $63.0 million of loans over the next twelve months. The loans that are made in the first 30 days will accrue 12 months of interest income, but loans that are made in month 12 will only accrue one month of interest income, so there will be a timing issue in Year 1.  Assume for simplicity all the loans are made in the mid-point of year 1 and accrue 6 months of interest income.If we then make certain assumptions regarding loan yield, cost of funds, a one-time loan loss provision expense under CECL, incremental non-interest expenses for items such as loan officer commissions, and tax expenses, we can see that First Bank would basically break even in Year 1.However, when we look at Year 2, and assuming no amortization, prepayments, or defaults for simplicity, we have a full year of interest income for all of the loans, and we no longer have a credit expense for these loans, given that credit deterioration is not more than expected.  As a result, we now have an extra $1.2 million of earnings created by this $63 million of loans that we were only able to originate because we chose not to opt into the CBLR. 

   
   The extra $1.2 million of earnings also increased the bank’s ROE by 1.8 percent, virtually closing the gap between its 8 percent run rate and its 10 percent target.

What if We Can’t Make Enough Loans?  (And Other Considerations)

While the above math makes theoretical sense, there are some important practical considerations. First and foremost, we are in a low growth/ late-cycle environment in which loan demand is tepid and bankers are on high alert for rising credit risks.  Having the capacity to make more loans does not do any good if there are not enough high-quality loans that can be made inside the bank’s footprint.

However, simply sacrificing the underlying capital that creates this incremental capacity (in this example, it’s $6.3 million) to the CBLR framework is certainly not the right answer, either.  In this example, First Bank can explore alternative uses of this freed up capital, such as using it as a source of funding for acquisitions.  First Bank may find that using this $6.3 million as a component to funding an acquisition can be the difference in having the economics of the transaction make sense from a shareholder return perspective.  After all, the cost of that capital is already being borne by existing shareholders, irrespective of whether First Bank uses this capital in an acquisition, or it doesn’t.  As a result, First Bank will have to give away $6.3 million less of equity to a target’s shareholders or will be able to forgo the cost of capital associated with having to raise an additional $6.3 million of debt or equity to fund such an acquisition.  Bottom line – this extra $6.3 million of ‘dry powder’ may prove to be critical down the road, especially as consolidation continues in the community banking industry.

Ultimately, if First Bank cannot deploy this capital in a manner that creates shareholder value over the longer term, its last resort should be to return this capital to shareholders via dividends or stock repurchases.  Shareholders can then redeploy this capital elsewhere on their own.  While we are not the biggest fans of having to use excess capital in this manner, it is certainly superior to having it trapped by the CBLR where it’s essentially locked up, earning a rate of return equal to zero for shareholders.

Conclusion:  First Bank should not opt into the CBLR

By not opting into the CBLR and instead quantifying and supporting its own internal requirement by using a stress test, First Bank has the potential to significantly increase its earnings by nearly $1.2 million in a full year by deploying the $6.3 million of freed up capital.  Meanwhile, the cost of not opting in is ultimately minimal. The bank needs to fill out the risk-based capital schedules on the Call Report – something it has been doing for many years already, and we need to pay for the cost of a stress test.  For a bank its size, an annual CCAR-style stress test would only cost around $30,000, which is a fraction of the $1.2 million of earnings per annum we unlock from it, and only $12,000 more than $18,000 the regulators estimate it would cost to opt into the CBLR.*

To be frank, this is a ‘no brainer’ for First Bank.  This freed up capital can be used in other ways, such as M&A, or as a last resort, returned to shareholders.  This is especially true for First Bank, which is searching for opportunities to increase its ROE to levels that will help it continue as an independent bank.  Banks that opt into the CBLR blindly without undertaking the proper analysis AND have a ROE deficiency are making a decision that is especially egregious.  For larger community banks that are publicly traded with assets between $1 billion and $10 billion, the numbers and stakes get even larger.

Even if a community bank chooses to opt into the CBLR, it should at least do so knowing the cost.  Management and the board of directors for First Bank may ultimately decide that they value being extra conservative over the opportunity cost of deploying this capital.

While I would not personally agree with such a decision because trapping this $6.3 million of capital would have diminishing value serving as a buffer against stress, at least I can respect the decision because they made it with the proper information at hand.  In most situations, each penny of additional capital should be treated as a precious commodity to maximize shareholder value.

— Adam Mustafa is the CEO of the Invictus Group.

*This is a hypothetical example, and any estimate of cost would depend on the bank's size and its unique makeup.