But what does all this mean, if anything, for community banks?  Here are five takeaways:

1. Fix your capital plan immediately, especially if you are a dividend payer. Your approach to dividends needs to be airtight, especially for dividends from the bank charter to the holding company. You should calculate how much is required for holding company debt service, and how much for shareholders. The former is far more important right now and should be prioritized over shareholder dividends. To determine shareholder dividends that are appropriate, first estimate how much capital you need to preserve to protect the safety and soundness of the bank in the event the pandemic creates a deep recession that leads to loan losses piling up. The only way to do this with any proper direction is with a stress test designed specifically for the pandemic.  That stress test won’t be perfect, but it can help quantify your margin of safety with respect to regulatory capital. This provides critical information to help adjust your philosophy toward dividends in the near-term.Your capital plan must have the right limits and triggers. Those might need to be revisited as well, which a stress test can help you do. Limits and triggers will govern when you should and need to act, including when and how you change your dividend policy.  It will also demonstrate to regulators that you have the appropriate risk management safeguards in place.I know some of you are concerned that if you are a ‘leader’ in cutting your dividend, you may send the wrong signal to the market and watch your stock price crater. Many banks have individual shareholders who depend on dividend payments as an important source of income. It’s not an easy decision to cut or suspend your dividends. But if your margin of safety is too thin, the last thing you want is to miss an opportunity to preserve capital.

2. Expect your earnings for the June quarter and beyond to be questioned by regulators. Regulators will be looking at your dividend payout ratio because they will start to pressure community banks to also preserve capital, especially those that don’t appear to be doing so sufficiently. This was hinted at in last week’s supervisory guidance, which we outlined in a news alert. Dividends as a percentage of earnings were far too high across the industry for regulatory comfort following the March quarter, when everyone was trying to figure out what was going on. Since dividends are a function of earnings, the regulators will be more concerned about the quality of your earnings than the quantity. The most obvious aspect of your earnings that will come under a microscope will be your loan loss provisions.Mark my words: You will face extra scrutiny if your earnings appear inflated because regulators will perceive your loan loss reserve to be inadequate. You must be prepared to support and defend your reserve, especially if it’s below your peer group.  Unfortunately, most community banks have struggled to do this because of the overreliance on q-factors that has been prevalent for many years now.  There are solutions to getting a handle on your ALLL, but you must start immediately.The Fed is speaking for all regulators when it published the results of the COVID-19 stress tests (aka “sensitivity analysis”) for the large banks in a document called Assessment of Bank Capital during the Recent Coronavirus Event:  “Supervisors remain focused on certain firms that are particularly sensitive to the current economic outlook, whose outlooks are more optimistic than appropriate given current conditions, whose credit cost forecasts have not considered a range of possible outcomes, or whose planning has not been thoughtful.”

3. If you were starting to relax because of the ‘rebound’ in the stock market and state re-openings over the last 4 to 6 weeks, think again. This is the calm before the storm. That must be your mindset. The Fed ran three pandemic stress scenarios on the large banks: A “V-shaped”, “U-shaped”, and “W-shaped” recovery. The V-shaped recovery, the least severe of the three, still generated more losses than the Fed’s Severely Adverse Case scenario in CCAR/DFAST, which basically mirrors the 2008 Financial Crisis. The Fed does say that its stress test results do not include the impact of “unprecedented government support” that may mitigate losses. But it couldn’t be clearer that it remains deeply concerned about a significant downturn. Do not let your guard up.
4. Get a real stress test. Your NOI shock model, focused strictly on your CRE portfolio, is trash. Your ALM model masquerading as a stress test by using historical loss rates from the 75^th percentile bank (or any other form of loss estimates not tied to the loan-level risk characteristics) is even worse. The Fed has basically admitted that the CCAR/DFAST stress tests are of limited use.  However, they at least provided the Fed with a starting point to make adjustments and perform ‘sensitivity analyses’ that created their pandemic stress test results. The Fed also called out the need to stress test loans to borrowers in industries disproportionally affected by the pandemic, such as hotels, restaurants, and retail. No stress test is going to give you a crystal ball. And while I understand the hesitation to rely on models, understand that you don’t need precision, you need direction. Halfway through the following article I wrote back in March, I give CEOs five questions they need to ask the person at their bank in charge of stress testing. If any answer is no, you don’t have what you need.
5. Your stress testing and capital planning needs to be a living and breathing process. The Fed noted that many of the large banks are already doing this: “Firms’ approaches to and timelines for updating their capital forecasts are similarly varied. Most firms have already generated updated multi-quarter capital forecasts, some under a range of scenarios. These scenarios vary in severity. Many firms have noted that they will continue to refresh their full forecasts on a quarterly or semi-annual basis.” As we have preached, pandemic stress tests in this uncertain environment must be repeated with regularity.The Fed also recognized the significant challenges of facing this uncertainty and noted the frustration the large banks have faced with their existing models: “The severe macroeconomic conditions, such as the high unemployment rate arising from the crisis, have resulted in many capital-related models being used outside of their statistical underpinnings, and some firms have struggled to incorporate the effects of the economic stimulus and customer forbearance programs into their capital forecasts. These challenges have prompted many firms to rely upon qualitative approaches, including management judgment, assumptions, and overlays.”

Wrap Up

I’m not saying in this piece that what happens to the big banks will trickle down to the community banks. The regulatory regime for large banks differs from community banks.  However, the spirit is very much the same. And those community banks that read between the lines and act now, rather than wait for a regulatory mandate, will be a step ahead of everyone else.