Regulators are more concerned about capital in the banking industry than at any point since the 2008 Financial Crisis. This includes the 2020 Pandemic which saw regulators go out of their way to help banks handwave away concerns about capital. For the first time in 15 years, there are several issues that are all converging at the same time

Take a “Check the Box” approach at your own risk.

By Adam Mustafa for Invictus

Regulators are more concerned about capital in the banking industry than at any point since the 2008 Financial Crisis. This includes the 2020 Pandemic which saw regulators go out of their way to help banks handwave away concerns about capital. For the first time in 15 years, there are several issues that are all converging at the same time:

• A global recession emerging as the consensus base case scenario
• AOCI issues that are proving more persistent than anticipated
• Rapidly depleting liquidity levels and the breakout of a deposit war
• Structural and cyclical concerns about CRE
• A stiffer cocktail of geopolitical risks than the usual

Over the last six months this reinvigorated focus on capital has manifested itself in an increasing number of MOUs and MRAs related to capital planning shortfalls. I have seen a sharp increase in the number of community banks who have reached out to our firm looking for help with their capital plans because they were slapped on the wrist by their examiner in charge.

In some instances, these banks did not even have a capital plan. In other cases, they did but it was embarrassingly out of date. Still others had capital plans that were missing critical elements and were deemed worthless in the eyes of their examiner in charge (EIC).

The concept of a capital plan isn’t necessarily a new one, but it became something that regulators pushed in the wake of the 2008 Financial Crisis. At the time, many community banks responded to this request via a one-time exercise that prioritized “checking the box.” This rush for ‘capital planning’ culminated in a document with the right title but many of the wrong ingredients - in some cases, leading to artificially binding policies and procedures for community banks. Back then, regulators considered this to be good enough, especially if these banks created capital and concentration limits that were acceptable to them. Today, many of these plans have been stuffed in the drawer and long forgotten. As a result, banks have been breaching the limits they created years ago due to growth without even knowing it.

These same plans are no longer good enough. Regulators want to see more. Now you need to support and defend your limits with data. They want to see how it relates to your strategic plan. If you have an AOCI problem, it is no longer safe to rest on your laurels because you opted out of including AOCI in how you calculate Tier 1 Capital.   If you have a CRE concentration, you now need to segment your portfolio and have a specific trigger and limit for each. Also, stress testing must be more than just adding up the loan balances whose DSCR’s would fall below 1.0 and LTVs would exceed 100 percent under a NOI shock – it has to consider the capital impact. Regulators want to see how your stress tests directly impact your capital levels. And if you have a funding problem, you better have concentration limits on items such as brokered deposits and wholesale funding. Further, you should show how you plan on handling your funding problem if your bond portfolio is on ice because of AOCI.

The limits and triggers are certainly the focus, but there’s more. They want to see that you have procedures for regularly quantifying, monitoring, and reporting on risks to capital. They want procedures for regularly stress testing capital (even if you do not have a CRE concentration). They also want there to be a policy in place for how often the capital plan gets updated. (Hint: the capital plan should be updated during each strategic planning cycle, if not during each annual budgeting cycle).

Many banks who have gone through safety and soundness examinations over last six months have learned the hard way. Community bankers are all overworked. It’s easier now to focus on today’s fires and take your chances with your exam on this issue. Depending on your bank’s size, business model, balance sheet, regulator, and region, this might be a good bet to make. But for most banks it isn’t.

This isn’t 2018 when regulators were just trying to get banks to keep their guard up. Its not 2020 either when regulators practically rolled out the red carpet for banks. MOUs and MRAs can distract and strain Management for months on end. It can also cause frustration in the board room. And it can translate to lower Camels scores.

As Ben Franklin once famously said, “An ounce of prevention is worth a pound of cure”. The obvious motivation to be proactive and take capital planning seriously is to increase the probability of a successful outcome on your next exam. The less obvious but far more impactful outcome is one in which you have a regulatory blessed capital plan that allows you to operate with lower capital limits and higher concentration ratios than the average bank. Perhaps its obvious, but that is much easier to defend from a position of strength.  

Invictus Group assists banks with writing capital plans, stress testing, and both identifying and quantifying limits and triggers for key ratios which are customized to the bank. For more information on these services, please contact Patti Casaleggio at pcasaleggio@invictusgrp.com.