CAPITAL PLANNING ISSUES

 

Here are several issues that will impact your capital planning as your look over the next five year planning horizon.


Text Example

Updated to add final Notice of Proposed Rulemaking and final due date - April 9, 2019 - for comments.

Community bank leverage ratio proposal:

The federal banking regulators have issued a proposal for comment on implementing the new Community Bank Leverage Ratio as required under Section 201 of the Economic Growth, Regulatory Relief, and Consumer Protection Act (May 2018).

Under the proposal, a community banking organization would be eligible to elect the community bank leverage ratio framework if:

  • Less than $10 billion in total consolidated assets

  • Total off-balance sheet exposures < 25% of total assets

  • Total trading assets and liabilities < 5% of total assets

  • Limited amounts of certain assets such as deferred tax assets, and

  • Community Bank Leverage Ratio (CBLR) greater than 9 percent.

A qualifying community banking organization that has chosen the proposed framework would not be required to calculate the existing risk-based and leverage capital requirements. Such a community banking organization would be considered to have met the capital ratio requirements to be well capitalized for the agencies’ prompt corrective action rules provided it has a CBLR greater than 9 percent.

Press Release (11/21/2018) - FDIC

CBLR Notice of Proposed Rulemaking (Note: NPR finally issued 2/2/2019)

Comment Questions in CBLR Proposal

Due date for comments: April 9, 2019

Calculation of the CBLR:

CBLR = Tangible Equity Capital divided by Average Total Consolidated Assets

Key considerations by federal banking regulators in designing CBLR framework:

  1. CBLR framework is intended to be available to a meaningful number of well capitalized banking organizations with less than $10 billion in total consolidated assets.

  2. CBLR should be calibrated to not reduce the amount of capital currently held by qualifying community banking organizations.

  3. Federal bank regulatory agencies intend for banking organizations with higher risk profiles to remain subject to the generally applicable capital requirements to ensure that such banking organizations hold capital commensurate with the risk of their exposures and activities.

  4. Federal bank regulatory agencies would maintain the supervisory actions applicable under the PCA (Prompt Corrective Action) framework and other statutes and regulations based on the capital ratios and risk profile of a banking organization.

  5. CBLR framework is intended to provide meaningful regulatory compliance burden relief and be relatively simple for banking organizations to implement.

Today many Community Banks hold capital at levels that will meet or exceed the requirements under this proposal while also exceeding the current capital regulations significantly. However, under the CBLR proposal, a Community Bank will be committing to holding this higher level of capital.

If a Community Bank already exceeds this minimum, why not simply designate that you will operate under this new proposal?

Key questions or issues for consideration before you make this election:

  1. What is the cost burden of complying with the current risk-based capital rules?

  2. Will you need any of the excess levels of capital (i.e., above current capital rule requirements) in the future for balance sheet growth, acquisitions or returning capital to shareholders?

  3. How difficult or costly will it be to opt back out of the CBLR framework at a later date?

The proposal commits community banks to carry 2 to 3 percentage points of higher capital levels. While the simplicity of this approach may be beneficial, an important consideration is whether this CBLR proposal becomes a constraint on your capital management flexibility.

 

Analytical Comparison: While simplistic, a quick means to assess whether a Community Bank should take advantage of the CBLR election is to compare the cost burden of risk-based capital compliance to returning capital to shareholders (or another alternative is to leverage the additional CBLR capital with earning assets).

If a Community Bank were to dividend excess capital to shareholders, there would be a loss of interest income from the earning assets that are liquidated. Let’s assume that this yield = 3.50%. And let’s assume that the Community Bank can dividend up capital equal to 2% of total assets rather than committing to hold that extra capital under the CBLR proposal. For a $25 million total asset Community Bank, this results in lost income of approximately $18 thousand ($500 thousand in excess capital times opportunity cost of 3.50%). Does a $25 million Community Bank spend over $18 thousand annually in compliance of risk-based capital reporting? As the size of the Community Bank increases, this opportunity cost rises. For a $500 million total asset Community Bank, the opportunity cost increases to $350 thousand. Does a Community Bank of this size spend that much on risk-based capital compliance and reporting?

 

The federal banking regulatory agencies propose to establish the initial Community Bank Leverage Ratio (CBLR) at 9.00%. In this bar chart, the green shaded bars show the number of Community Banks that would achieve this minimum level. The red shaded bars show those Community Banks that would not meet this proposed threshold.

This table estimates Community Bank Leverage Ratio for various size banks by total assets within 25 bps increments from 8.00% to 10.00%.

This table estimates the extra capital to be held above the 10.5% Total Capital Ratio minimum under the current capital rules and the 5.0% Leverage Ratio minimum under Prompt Corrective Action rules.


Final Phase-in of Capital Rules Occurs January 1, 2019.

DISCUSSION: What is the impact on your balance sheet growth? What is impact on dividends and dividend payout rates for your shareholders? There is a trade-off for these increased minimum capital ratio requirements. Growth in capital (i.e., retained earnings) will impact the dividend payout ratio and slow the growth in future dividends. Will this also impact the valuation of your bank - does holding more capital reduce the premium to book value?

Link to PDF.    Discussion:  On January 1, 2019, bank capital ratios will increase by another and final 62.5 basis points, or 6.3 percent. As you start to think about your 2019 annual planning, you should confirm that you achieve this new minimum of 10.5% for Total Capital Ratio, 8.0% for Tier 1 Capital Ratio and 7.0% for Tier 1 Common Equity Ratio (too many capital ratio targets?).

Link to PDF.

Discussion: On January 1, 2019, bank capital ratios will increase by another and final 62.5 basis points, or 6.3 percent. As you start to think about your 2019 annual planning, you should confirm that you achieve this new minimum of 10.5% for Total Capital Ratio, 8.0% for Tier 1 Capital Ratio and 7.0% for Tier 1 Common Equity Ratio (too many capital ratio targets?).


How does your 2019 or Long Term Planning Scenarios stack up against the Fed's Capital Stress Testing Scenarios?

 

GDP: Base Case has GDP growing on average 2.0%. Adverse Case assumes mild recession with GDP down 2.7% followed by a solid recovery. Severely Adverse Case has harsher recession with GDP dropping 7.8%. followed by a strong recovery.

Unemployment Rate; Base Case has Unemployment Rate remaining low in 3.8% to 4.1% range. Adverse Case assumes mild recession with Unemployment Rate peaking at 7.0%. Severely Adverse Case has harsher recession with Unemployment Rate rising to 10.0%.

3-month U.S. Treasury Yield: Base Case has 3-month US Treasury rising 50 bps to 2.8%. Adverse Case assumes mild recession with 3-month US Treasury dropping to 0.1%. Severely Adverse Case has harsher recession with 3-month US Treasury dropping to 0.1%.

5-year U.S. Treasury Yield: Base Case has 5-year US Treasury rising 60 bps to 3.4%. Adverse Case assumes mild recession with 5-year US Treasury immediately plummeting to 0.5% before recovering to 1.3%. Severely Adverse Case has harsher recession with 5-year US Treasury dropping to 0.3% and recovering to 1.2%.

10-year U.S. Treasury Yield: Base Case has 10-year US Treasury rising 60 bps to 3.6%. Adverse Case assumes mild recession with 10-year US Treasury immediately plummeting to 0.8% before recovering to 1.9%. Severely Adverse Case has harsher recession with 10-year US Treasury rate also falling to 0.8% before rising to 1.8%.

U.S. Treasury Yield Curve Slope (10-year minus 3-month): Base Case has slope narrowing to 40 before recovering to 80 bps. Adverse Case assumes mild recession with slope rising to 180 bps. Severely Adverse Case has harsher recession but with slope only rising to 170 bps.

Mortgage Rate: Base Case has Mortgage Rate rising 50 bps to 5.1%. Adverse Case assumes mild recession with Mortgage Rate immediately plummeting to 3.5% and holding near this level. Severely Adverse Case has harsher recession with Mortgage Rate volatile until declining 3.5%.

Mortgage Rate Spread to 10-year U.S. Treasury: Base Case has spread flat at 150 bps. Adverse Case assumes mild recession with widening to 260 bps before recovering to 170 bps. Severely Adverse Case has harsher recession with widening to 340 bps before declining back to 170 bps.

BBB Corporate Bond Yield: Base Case has BBB bond yield rising only 20 bps to 5.2%. Adverse Case assumes mild recession with BBB bond yield falling to 3.7%. Severely Adverse Case has harsher recession with BBB bond yield rising to 6.5% before declining back to 3.7%.

BBB Bond Yield Spread to 10-year U.S. Treasury Yield: Base Case has spread flat at 160 to 170 bps. Adverse Case assumes mild recession with widening to 370 bps before recovering to 190 bps. Severely Adverse Case has harsher recession with widening to 550 bps before declining back to 190 bps.

DJIA: Base Case has DJIA rising 4.6% annually on average. Adverse Case assumes mild recession with DJIA falling 22% to near 20,000 before recovering to above 25,000. Severely Adverse Case has harsher recession with DJIA falling 50% to under 13,000 before recovering to above 25,000.

VIX Index: Base Case has VIX generally stable. Adverse Case assumes mild recession with VIX jumping to 44 before recovering to above 20. Severely Adverse Case has harsher recession with VIX rocketing 2X to 70 before recovering to 20.

Housing Prices: Base Case has HPI rising 2.7% annually on average. Adverse Case assumes mild recession with HPI falling 14% before recovering. Severely Adverse Case has harsher recession with HPI falling 26% before recovering.

Commercial Real Estate Prices: Base Case has CREI rising 4.5% annually on average. Adverse Case assumes mild recession with CREI falling 18% before recovering. Severely Adverse Case has harsher recession with CREI falling 35% before recovering.