Author : Adam Mustafa, CEO, Invictus Analytics

Community banks now have the clearest path in nearly two decades to reshape their regulatory capital requirements—and they shouldn't miss it. While most recent efforts to ease capital burdens have favored large banks, the deregulatory tailwinds sweeping through Washington carry real, if quieter, momentum for community banks as well.

Although community banks haven’t been the focus of proposals related to burying the Basel III “end game” or easing the Supplemental Leverage Ratio requirements, they’re strongly positioned to benefit from the broader deregulatory wave. Those of us steeped in the sector know the truth: capital requirements in the ‘real world’ for community banks have long been shaped more by unwritten rules than formal ones, especially in the post-2008 era.

Take the Tier 1 Leverage Ratio. Regulators define 5.0% as "well-capitalized" in writing via the prompt-corrective action guidelines. Yet, in the ‘real world’, regulators will not let banks go anywhere near that level. In reality, the informal expectations lie on the following spectrum:

• 8.0% for banks perceived as lower risk (moderate or low growth, limited CRE exposure)
• 9.0%+ for banks perceived as riskier (aggressive growth, CRE concentration)

Regulators often took a rigid approach to setting their expectations with banks, often taking their direction from top-down philosophies that are ultimately traced back to ivory towers in Washington DC.

Banks that do violate these unwritten rules run the risk of regulatory penalties, such as MRAs, MOUs, public consent orders and CAMELS rating downgrades. These regulatory actions could also end up including IMCRs (stands for “Individual Minimum Capital Requirements”), which are always going to be high and can take years to shake off.

Five years ago, regulators introduced the Community Bank Leverage Ratio (“CBLR”) as a simplified alternative. But at 9.0%, it's too high for many institutions based on their actual risk profiles. Unsurprisingly, banks that adopted the CBLR are also gradually becoming victims to the “unwritten rule phenomenon” and have increasingly been pushed to hold even more capital.

Another technique regulators often use is playing the peer group card. Every bank is a member of a peer group and regulators would often use the UBPR report to pressure those banks with the lowest capital levels within a peer group to take action. Soon enough, a new group of banks represented the laggards within the peer group and they were pressured to do something about it too. This game of musical chairs continued, albeit gradually and quietly, for the past 17 years. Whether a community bank remained under the Basel framework or adopted the CBLR, the goal posts kept moving backwards.

Now, with deregulation gaining traction, the unwritten rules are finally being drafted in pencil instead of pen. The top-down initiatives are becoming less rigid and more flexible with respect to the unwritten rules. For the first time in nearly two decades, community banks have the power to define their own capital requirements that fit their business model—if they have the data and analysis to support it.

Those that seize this moment will unlock real value. Imagine a $1.0 billion bank with a CRE concentration. Regulators have indicated it must hold 9.0% capital, despite not adopting the CBLR. If the bank can demonstrate that 8.2% is more appropriate, it frees up $8.0 million of capital that can fuel loan growth, M&A, dividends, or buybacks, rather than sit idly as a zero-yield buffer of unexpected losses for assets already on the balance sheet.   This can easily translate into an additional $1.0 million plus of earnings annually without having to raise a penny more of capital. The ROI of this exercise should be obvious.

While this opportunity isn’t entirely new, it’s now far more attainable. In the past, many banks viewed the process as an uphill climb if not convinced their regulator wouldn't take their analysis seriously.

But that posture is shifting. The new regulatory environment is tilting towards “innocent until proven guilty.” Regulators are far more open—but banks still need to present their case. Arbitrary numbers won’t cut it. A thoughtful, data-driven framework makes it easier for regulators to say yes—and this time, they’re more likely to do so. Every penny of capital counts. Don’t miss the moment.

Invictus Analytics helps banks customize their capital requirements and lending concentration limits using stress testing and other techniques. For a free consultation on how Invictus can help you quantify your own capital requirements, please contact us at pcasaleggio@invictusgrp.com.