Many community bankers do not realize their own existing capital plans may be more stringent than the community bank leverage ratio (CBLR). We all know bankers like math. So read on to find out how I can prove that simply ignoring the CBLR—without proactive stress testing to document your decision—may be a big and costly mistake.

Our BankGenome™ intelligence system shows that 96 percent of U.S. community banks would be better off not opting into the new standard. However, the decision needs to be data driven.  Simply deciding not to opt in without an analysis is actually worse than opting in—and here’s why.

It’s 2020. Virtually every community bank has a capital plan. To be blunt, most capital plans I have seen are pretty lame—usually nothing more than a check-the-box exercise thrown together to appease regulators. All those capital plans typically contain internal capital thresholds. With few exceptions, almost all the capital ratios are above the PCA guidelines (the written minimums for a ‘well-capitalized’ bank).  The most common set of internal thresholds are:

• Tier 1 Leverage Ratio = 8 percent
• Tier 1 Risk-Based Ratio = 10 percent
• Total Risk-Based Capital Ratio = 12 percent

For purposes of illustration, let’s assume that the above thresholds are in the capital plan for a fictitious bank, First Bank. You are the CEO of First Bank. The regulators have never really said anything to you about your capital plan. You conclude “no news is good news” and assume that they are comfortable with it.  As a result, you decide that not opting into the CBLR makes sense, and you don’t really need to do anything else because you have this capital plan that clearly says your minimum Tier 1 Leverage Ratio is 8 percent, which is less than the 9 percent CBLR.

Makes sense, right?  Well, guess what? Your bank’s minimum Tier 1 Leverage Ratio is NOT really the 8 percent disclosed in your capital plan.  It is actually higher, much higher.

Let’s make the following assumptions about your bank ($ in millions):

• Leverage Ratio Assets = $1,000
• Risk-Weighted Assets= $850
• Reported Tier 1 Capital = $100
• Reported Total Risk Based Capital = $105
• Reported Leverage Ratio = 10.0% ($100 / $1000)
• Reported Total Capital Ratio = 12.4% ($105 / $850)

Simple math here says that using the Leverage Ratio, the bank would have $20 million of excess capital based upon the 8 percent minimum stated in its capital plan. What’s the catch then?

Here comes the math part! Using the Total Risk-Based Ratio, the bank’s capital requirement is $102 million (equal to $850 in risk-weighted assets times a 12 percent requirement).  Except this time, the bank only has $105 million of Total Risk-Based Capital, meaning the bank only has $3 million of excess capital, not $20 million!

For this bank, the Total Capital ratio is the constraining ratio, not the Leverage Ratio.  Therefore, the Leverage Ratio requirement of 8 percent in the Bank’s capital plan is irrelevant.  The only thing that matters is the Total Capital Ratio requirement.

We asked BankGenome™ to tell us how many U.S. community banks would first be tripped up by the Total Capital Ratio under stress.  The number is startling:  3,542 banks, which is 70 percent of all community banks.  This makes a lot of sense; as banks trend more toward becoming ‘loaned up’, they will have a heavier percentage of their assets in loans that carry a 100 percent risk weight.

So now let’s get back to First Bank. You ask your CFO the following question:  What does our capital requirement on the Total Capital Ratio translate to in terms of the Leverage Ratio?  In other words, what is the equivalent requirement on the Leverage Ratio that would leave you with the same amount of real excess capital as estimated by the Total Capital Ratio?

Your CFO does some quick and easy math.  She says, “Well, the Total Capital Ratio is constraining an extra $17 million of our capital versus the Leverage Ratio.  If I divide that $17 million by our leverage ratio assets of $1 billion, that will add an extra 1.7% to our Leverage Ratio Requirement of 8.0%.  Oh my God…our real Leverage Ratio requirement is 9.7% percent if we keep our Total Capital Ratio requirement at 12 percent.”

You are stunned.  You immediately realize that you would have been better off opting into the CBLR as a ‘least bad alternative’.  You then ask your CFO: “Why is our Total Capital Ratio requirement 12 percent?  Could it be lower?  And how do we figure out what it should be?”

Boom. There it is. Not opting into the CBLR but doing nothing else would cost your bank $17 million of capital. This is strictly a self-inflicted wound.  And this is why banks need to do the math and take a data-driven approach to determine their capital requirements.

What kind of math is required?  Stress testing is the right tool for the job.  A properly constructed stress test will tell you which ratio is the most constraining for your bank. It will also reveal your unique capital requirements, based upon the characteristics of your loans, composition of your balance sheet, and structure of your business model.

Back to First Bank. Your bank takes the correct course of action and runs a stress test. The results translate to an ideal Total Risk-Based Capital Ratio of 10.5 percent, which is in full compliance with Basel III (which also includes a capital conservation buffer).  With this new requirement, your bank now only requires $89.3 million ($850M times 10.5%) of capital, leaving you with $15.7 million of excess capital instead of only $3 million.  The equivalent REAL Leverage Ratio requirement?  It’s now only 8.4 percent, compared with 9.7 percent.  Armed with the right information, you have the confidence to opt out of the CBLR. And you also amend your capital plan, based on these new data-driven thresholds backed by a stress test, with full oversight and support from your board.

Choosing not to opt into the CBLR is likely the correct decision for most banks. However, blindly opting out without doing the work could be even more devastating than blindly opting in, as the math for First Bank shows above. The cost and time to do the correct math using a stress test is a rounding error compared to the cost of getting this decision wrong.  As the old saying goes, “An ounce of prevention is worth a pound of cure.”

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