The Capital Challenge


Managing today’s heightened capital-adequacy standards

By Karen Epper Hoffman

Eager to meet more stringent regulatory requirements, community banks are embracing the growing importance of holding on to enough capital, typically through retained earnings, to keep themselves in regulatory good standing.

Capital adequacy evaluations trigger the most regulatory action, according to the Federal Reserve Bank of Kansas City. Indeed, the C in the CAMELS safety and soundness rating system represents “capital adequacy.” Since the 2008 recession, regulators have raised their risk-based capital requirements, most conspicuously and controversially for banks with significant concentrations of commercial real estate lending.

Chris Cole, ICBA’s executive vice president and senior regulatory counsel, says the new Basel III capital standard that banks are transitioning to adopt through 2019 is one of the main issues “creating a challenge here for community banks” by raising the capital requirement for common equity Tier 1 (CET1). As a result, he says, “banks end up withholding dividends, because the new requirements are higher … and they’re tougher on assets like mortgage-servicing assets.”

“Maintaining regulatory capital is not a new challenge for community banks,” says Tim Yeager, the Arkansas Bankers Association chair in banking at the Sam M. Walton College of Business at the University of Arkansas. “Banks have had to adhere to Basel capital requirements since 1992. Capital ratios at most community banks have always been far above the [prompt corrective action] guidelines.”

The Prompt Corrective Action, the result of the Federal Deposit Insurance Corporation Improvement Act of 1991, requires federal banking regulators to take quick action against inadequately capitalized, FDIC-insured depository institutions before the institutions exhaust their capital and can pose a threat to the federal deposit insurance fund should they fail. Although the leverage ratio for a well-capitalized bank remains the same at 5 percent, under the new Basel III rules, a bank must have 6.5 percent CET1 and 8 percent Tier 1 capital over risk-based assets to stay well capitalized.

But Yeager points out that “most banks hold capital well in excess of that level.” The more significant change with Basel III, he says, is that community banks face restrictions on dividend payouts or executive compensation when CET1 dips below 7.0 percent.

“So all community banks feel pressure to maintain [the common equity ratio],” Yeager says.

Other pressures
Basel III might not be all to blame. J. Paul Compton Jr., partner at the law firm Bradley Arant Boult Cummings LLP in Washington, D.C., sees recent capital adequacy pressures as an outgrowth of the stricter regulatory attitude over capital since the Wall Street financial crisis. “Sufficient capital is not a new or even, in the abstract, greater challenge than it has been in the past,” he says. “However, the discretionary levels of capital required by regulators for community banks are certainly higher today than [they were] before the 2008 recession, and the means by which community banks can obtain capital are far more restricted.”

Yeager says interest-rate risk is the most common reason, besides poor loan quality, that regulators require capital above the Prompt Corrective Action guidelines. “In the case of banks with high loan quality, those banks rarely suffer losses large enough to severely impair their capital,” he adds.

However, community banks with high concentrations of commercial real estate loans—a common trait among banks that failed during the financial crisis—also are experiencing significant regulatory pressure over capital adequacy, Cole says. As such, he recommends larger community banks delving significantly in commercial real estate lending to stress-test their loan portfolios for examiners.

“We’re seeing stress-testing becoming more routine,” Cole says. “It’s not driving them out of any businesses, but it’s a headwind.”

Capital solutions
In light of these regulatory challenges, Cole and Yeager recommend that community banks embrace the new regulatory emphasis on capital stress-testing, an informal and flexible process, and not a rigid requirement, for community banks.

Most community banks are struggling with higher demands on capital adequacy and are managing to avoid raising capital by “retaining more earnings and paying few dividends,” Cole says. A few banks, he says, have turned to issuing stock or even looking at “crowd funding” as a possibility for raising capital. Although, Cole acknowledges, “there are ‘gotchas’ with private placements,” and crowd-funding campaigns have yet to prove successful for banks.

Compton agrees that going the public route could appeal to some community banks, but is fraught with its own challenges. “[There are] oppressive burdens imposed upon small public companies under Securities and Exchange Commission regulations and current accounting requirements,” Compton says. In combination, he says, these demands have made it almost impossible for institutions of less than several billion dollars in size to function profitability and without undue risk of shareholder lawsuits as public companies.

Despite the fact that industries outside of the banking industry have had “explosive growth through private equity,” Compton says that under Federal Reserve requirements it is “both difficult and, experience has shown over the last eight years, often unattractive for private equity to participate in banking.”

“This is a significant change from 10 or 15 years ago,” Compton adds. “Thus, public capital markets are effectively closed to most community banks.”

“Maintaining regulatory capital is not a new challenge for community banks.”
—Tim Yeager, banking

Donald D. Hutson Jr., a partner with BKD LLP consulting firm in Louisville, Ky., suggests that “all community banks develop and maintain a comprehensive capital plan.” Their capital plans should be developed as part of their strategic planning document outlining intended lending, growth and expansion plans and dividend goals, he says. This capital plan also should be considered as part of the annual budget process and managed proactively throughout the year.

“We’re seeing stress-testing becoming more routine. It’s not driving them
out of any businesses, but it’s a headwind.”
—Chris Cole, ICBA’s executive vice president and senior regulatory counsel

Hutson says that a comprehensive capital plan is critical to manage capital and avoid the need to raise additional capital from other sources. As part of such a plan, he suggests that a comprehensive dividend plan can assist a community bank in planning for its capital needs. Some tax planning strategies also can be used to enhance capital—especially for Subchapter S corporation banks—such as municipal bond portfolio investment strategies, he says.

Compton also believes that more can be done. First, he says, community banks should continue to be very conservative in their dividend payouts, because “preserving an ample cushion of retained earnings is the best defense.” Second, banks should be cautious in using capital for operational expansions, which may themselves increase operational risk, he says. Expansion relying on “creating goodwill on the books” can become “a land mine waiting to explode” during any economic or business downturn, he says.

In positive economic environments, Compton encourages community banks to consider establishing bank holding company lines of credit to protect them in down markets. Internal modeling of various economic scenarios can help a bank better understand what its potential weak points are. Although in some ways similar to formal stress-testing, which isn’t formally required for community banks by regulators, internal modeling is “more of an effort that focuses on being prepared to neutralize potentially adverse results rather than the regulator’s greater focus on process,” he points out.

Karen Epper Hoffman is a financial writer in Washington state.