Author: Adam Mustafa, CEO

Reports are emerging about regulators prescribing Individual Minimum Capital Requirements (IMCRs) to banks with Commercial Real Estate (CRE) and construction loan concentrations. IMCRs are often punitive, forcing banks to hold more capital than planned or available. They also include deadlines for compliance, creating urgency and concern within management and boardrooms.

When a bank's capital levels fall below IMCR thresholds, it exacerbates uncertainty. Many banks with CRE concentrations lack ready access to capital markets, and those that do face unfavorable terms and valuations. This problem is further magnified for banks with leveraged holding companies needing dividends from the bank charter to support debt service. Regulators can prevent the bank from upstreaming dividends if they feel compliance with IMCRs isn't taken seriously, risking default on senior or subordinated debt. Such scenarios were seen after the 2008 Global Financial Crisis, where holding companies declared bankruptcy and pursued section 363 sales, wiping out shareholders despite the underlying bank charter being well-capitalized but restricted by regulators from paying dividends.

In addition, restrictions on dividends from the bank charter could also prevent tax distributions for institutions which are structured as subchapter S corporations, which creates a dreaded “dry income” situation for the members.

Regulators are aware that most community banks below IMCR thresholds lack practical access to capital. IMCRs are primarily used to force banks to shrink their balance sheets, reducing assets and risk-weighted assets to gradually improve capital ratios to meet IMCR levels. Consequently, proceeds from payoffs on existing loans and securities are used to redeem and not renew high-cost liabilities, including Federal Home Loan Bank advances and high-cost CDs. This situation limits or pauses new loans, frustrating the lending team, many of whom may defect to competitors. IMCRs can create a domino effect of challenges if not managed carefully.

Prevention

The adage "an ounce of prevention is worth a pound of cure" applies to IMCRs. The best prevention is a best-in-class capital plan, including internal limits for regulatory capital ratios, early warning triggers, and target operating levels. These limits should be above the Prompt Corrective Action (PCA) guidelines for a well-capitalized bank. Setting internal limits at PCA guidelines invites IMCRs. Success lies in ensuring internal limits are not unnecessarily far above PCA guidelines, as this would encumber too much capital.

For example, the PCA guideline for the Total Risk-Based Capital Ratio is 10.0 percent for a well-capitalized bank, while IMCRs can be as high as 13.0 percent. Setting internal limits closer to the lower end of this range is advisable, provided the quantitative analysis supports it.

This brings me to my next point. Determining capital limits should be quantitative, not arbitrary. In the post-2008 world, stress testing is essential. Regulators use CCAR stress tests for large banks to customize capital requirements using a concept referred to as the “Stress Capital Buffer”, but community banks that volunteer for this exercise often receive regulatory approval for their internal capital limits.

Effective capital plans should include Key Risk Indicators (KRIs) to alert management and directors to potential issues before capital levels fall below internal thresholds. KRIs should cover ratios such as CRE concentration to capital, classified assets to capital, tangible book value to assets (if AOCI is a problem), holding company leverage metrics like the double leverage ratio, and other earnings, liquidity, and interest rate risk measurements. Think of this as an alarm system.

A well-designed capital plan backed by data is the most effective way to avoid IMCRs. While not guaranteed, it offers the best chance.

Post-IMCR Rehabilitation

If your bank has already received IMCRs, it is crucial to take them seriously. Regulators may be more understanding than anticipated if good faith efforts in compliance are shown. Demonstrating progress towards compliance, even if deadlines are not met, can result in regulatory leniency and allowances for dividends for holding company debt service.

Releasing the bank from the IMCR regime is a long-term process. Best-in-class capital planning can accelerate this by showing regulators that the bank can govern itself effectively. Capital planning should be ongoing even while under IMCRs, with quarterly monitoring and board discussions about compliance with capital and KRI thresholds. The capital plan should be updated regularly in tandem with the budget and strategic plan. Recurring stress tests should validate or modify internal limits as needed.

Final Thought

Expect regulators to increasingly rely on IMCRs to manage banks with CRE and construction concentrations. Banks with significant unrealized securities losses and those engaged in banking-as-a-service (BaaS) are also vulnerable to IMCRs.

Effective capital planning gives banks the best chance to prevent IMCRs from being issued and the best chance to expedite their termination if already imposed.

Invictus has substantial experience and expertise in these areas, especially with managing CRE concentrations, stress testing, and capital planning.  Please reach out to Patti Casaleggio at pcasaleggio@invictusgrp.com  to schedule your free consultative session today.