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Redefining capital adequacy: Is your bank ready?

Regulators will slam you if risk attitude is “out to lunch”

By Jeffrey Reynolds, Darling Consulting Group
“So what is the number?” 

Many bankers have wanted to ask this question regarding capital adequacy, but they usually refrain. The reasoning: The only opinion that appears to matter is the regulators’, and most bankers fear the unknown and potentially restrictive response.

There’s some truth to these concerns, but I submit that the discussion is unavoidable. And if bankers find themselves in a position where they cannot articulate their own views of capital adequacy and back up those assessments as to why they feel that way, they are setting themselves up for a potentially painful examination. Accordingly, more robust capital policies and planning exercises are quickly becoming part of the ALCO process for all banks, not just those under stress.

But how prepared are you?
Sweeping changes underway in capital adequacy’s definition
If this article was instead a live speaking event, now is the time that I would ask the crowd: 

“Show of hands, how many of you believe that a bank with a 5% leverage ratio is viewed by the regulatory community as being well-capitalized?” 

I would expect to bear witness to a roomful of people sitting on their hands, as nobody really seemed to feel this to be the case even prior to the financial crisis.

The next question might be a little more open-ended:

“If not 5%, what is the number?” 

And here is where we would see some wide-ranging answers, from 7% to as high as 10% on average. Why?  This is the range people hear when talking to peers about recent regulatory interactions, some of which are coming third hand and are almost of Urban Legend status in proportion.

So why has the regulatory community not taken out the ambiguity and officially updated the old Prompt Corrective Action (PCA) thresholds for capital adequacy? 

Not being affiliated with a regulatory agency, I cannot provide the actual answer. But my guess is that there are two answers.

First, U.S. regulators are working diligently with the international community on the integration of Basel III guidelines. They are attempting to do so in such a way that U.S. banks are not placed at an undue competitive disadvantage. This no doubt is a tedious task given the disparities in accounting models, banking systems, and the backstop the FDIC provides the common depositor should capital prove to be an inadequate buffer against a bank failure. This will take some time.

Second, whether planned or not, the capital markets have only begun to thaw for community banks. Short of a “fire sale” self-liquidation, with heavy dilution to existing shareholders, there are few avenues to immediately fill a requirement for an as-of-yet somewhat arbitrary capital threshold.

So affording a little more time for the capital markets for community banks to improve is a positive for the thousands of community banks that may need it.

These factors are providing some time to shore up capital levels if you think your institution is currently below what will likely be required.

But don’t squander this apparent “time out.” The clock is ticking.
 A working unofficial definition of capital adequacy
So while the PCA requirement thresholds have not been officially changed, how far up has the capital adequacy bar moved?  The answer, as the great philosopher and Yankees catcher Yogi Berra might put it is clear:  “It depends.”

Through various client interactions, we find that the new norm for capital appears to be 8% leverage and 12% total risk based. While these seem to be the baseline from which the regulatory community works (and are the requirements most commonly published in regulatory orders), I have witnessed regulatory acceptance of ratios below those thresholds, as well as demands for a capital buffer over them. The disparity comes down to an honest assessment of risk perception.

This being the case, a bank might have only one shot at influencing what is deemed to be adequate capital. And unless you are honest with your self-assessment of the perception of risk, you can really stack the deck against yourself by being perceived as “out to lunch” relative to the new banking environment.
Get out of the vacuum: How does your bank compare?
Your regulators look at your bank versus its peers, so you should start out the same way: How do you stack up against them? How is your balance sheet similar and how does it differ?

If you find yourself below an 8% leverage target, it may not be the end of the world--if you have the right story to tell.

I recently had a discussion with a client that has a leverage ratio lower on their peer group scale and was concerned their regulator would eventually take strong exception to this fact. “Should we expect a harsh reaction during the next exam?,” they asked.

A conservative reaction here is to say “perhaps,” but the same peer data that tells us we are lower on the leverage capital scale also tells us some other key items. While the bank falls in the lower peer quartile for capital, it is also in the lower quartile for loans-to-assets and is among the highest for liquid assets to total assets.

In short, the lower leverage capital position can be justified by a conservative lending strategy that is prudent given this bank’s geographical location. Also, the bank has a strong deposit base that, due to weak quality loan demand, has seen its short-term investment position grow substantially.

As long as we are confident that factors other than credit (e.g., interest rate risk) will not impede profitability, the fact that this bank has significantly less credit risk than the peer group should be taken into consideration.

It is up to the bank in this case to be ready to state its case and have factual support for it prior to the regulators asking about it.

The trick is to do the research, formalize this thought process, and define why your bank is “well-capitalized” before someone else does it for you. Doing so can be the difference between a “suggestion” rather than an “order” of improving capital levels, and an entirely different regulatory perception in regards to management’s understanding of the issues.

Be warned: There is a very real trickle-down effect that weak capital has on the other five CAMELS ratings.
What are my true risks?
Outside being below the baseline capital ratio targets, being on the minus side of a few peer performance measures can tell you how hard the capital discussion will be. Asset quality, weak earnings, and concentration of credit risk in particular are the factors that draw the most scrutiny.

If a peer comparison should show your bank is in the 98% percentile for commercial real estate concentrations, you can bet that there will be a higher level of importance placed on your capital reserves to support that risk (real or perceived). Realistically, 8% might not be the number for this bank.

Perhaps there are some mitigating factors behind the concentration (e.g. the underlying credit characteristics of the portfolio are pristine). However, we cannot escape the times we live in and political pressures that must be placed on our field examiner to not allow the potential of this concentration risk to go unchecked.

But what is the “right” number if it is not 8%?  Is it 9%?  Is it 10%?

There is good value in being prepared to tell your story here as well. There should be a plan in place that shows an improvement in the capital position to deal with the concentration. Consider as well a plan to reduce the concentration.

Either way, do not be delusional with regard to the tone of the final report of examination if leverage capital today is at 7%. But having the capital plan ready for review before being asked for it can buy a lot of goodwill and perhaps some time to deal with the matter.
How do you know when you are in trouble?
As the bank goes through its self-assessment for risk, it can identify areas that common sense suggest would be of concern and stratify the level of concerns that would result in contingency risk mitigation actions being more actively discussed and pursued. Most already do this in some form (ratios monitored on a board report of some sort), but do not have it clearly formalized and articulated.

Proper capital policy/plan documentation that demonstrates your preparedness can make a big difference in the perception of your risk management practices and capital adequacy.
Simulation and stress testing
What can go wrong with a bank in 2012? An infinite number of things can go wrong. However, common sense told us the most significant were those events outlined earlier in this article.

Most banks prepare a budget plan. Some identify risks to the plan and the potential impact on earnings. Few go on to simulate the required actions that would need to be executed to repair a potential capital hole and document the responsibilities for executing the plan.

Having some examples that demonstrate that management and the board conducted a “what if” analysis here can go a long way in generating regulatory comfort with a business plan. But take care in developing a good rationale for the stress tests you perform. They need to strike a good balance between highly probable (your base plan) and the improbable, and demonstrate that management and the board understand what the response would be if the latter were to unfold.

Looking ahead: more change brewing
The days of a one-size-fits-all definition of capital adequacy may be behind us forever.

Ambiguity on the subject at present can be somewhat frustrating, but it must be dealt with. Risk assessment, capital planning, policy development, and stress testing are all exercises that are coming soon to your desk, if they haven’t already landed there.

The time and resources invested in preparing for their arrival likely pale in comparison to the cost of not doing so.

About the author

Jeff Reynolds is a managing director at Darling Consulting Group. After serving as an auditor in the insurance and banking industries, Jeff joined DCG in 1996. His analytical and managerial skills led him on a career path within DCG that culminated in his current role as Managing Director. In this capacity, Jeff’s primary responsibility is advising clients on ways to enhance earnings while more effectively managing their risk positions. He regularly assists clients with strategic and capital planning projects and has also served on numerous due diligence teams for client acquisitions. Jeff is a frequent author and speaker on a variety of balance sheet management topics and has served as a guest faculty member for the ABA’s Stonier Graduate School of Banking.

ALCO Beat articles featured exclusively on are written by the asset-liability management experts at Darling Consulting Group. Individual authors' credentials appear with their articles. DCG's consultants have served the banking industry for more than 30 years. You can read more about the firm's history here.

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