Make Capital Easy Again
My dad, who began his career in banking in the mid-70s, has claimed credit numerous times for ruining community banking. According to him, before he started as a banker, banking was easy. He always liked to say that banking during his first couple of years was “as easy as one, two, three:”(1) pay 1% on your deposits, (2) earn 2% on your loans, and (3) make your tee time by 3:00 in the afternoon. When you think about it, he may have a point. The Truth in Lending and the Fair Housing acts (i.e., fair lending), both of which were passed in 1968, were the beginning salvo in a series of consumer protection and monetary regulations over the next decade that dramatically increased compliance burdens on community banks. They were followed by the Bank Secrecy Act (BSA) in 1970, the Real Estate Settlement Procedures Act (RESPA) in 1974, and the Community Reinvestment Act in 1977. While all of these were well intentioned and harmless enough in their infancy, their ensuing amendments and implementing regulations ballooned into a bureaucracy that has dramatically impacted community banking and access to credit in the communities they serve. All of that immediately preceded the stagflation of the late 1970s as well as the banking crisis and interest rate deregulation in the early 1980s. After he survived another banking crisis in the early 1990s, the Y2K hysteria, the dot-com bust of the early 2000s, the Patriot Act, and finally the Great Recession before retiring nearly three years ago, you can see why he felt his banking career was much different from the one his dad experienced before him. When we worked together a decade ago, I often heard him complain that “banking had just become too darn complicated,” with a possible substitution of another four-letter word on particularly challenging days. Looking back on how much it changed during his tenure, you can understand his frustration.
Well, it may be viewed as “too little, too late,” but Congress did try to help simplify banking just a little when it passed Section 201 of the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA). This section contained a framework for capital rule simplification applicable to qualifying community banking organizations known as the Community Bank Leverage Ratio, or CBLR. Historically, or at least since 1991, when the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, was passed (another highlight of my father’s banking career), the adequacy of bank capital has been judged based upon a complicated series of ratios and formulas known as “Prompt Corrective Action,” or PCA. Under PCA, it was not enough to simply measure how much capital a bank had relative to its assets, but a bank also had to consider the elements comprising that capital as well as the riskiness of the assets it supported by calculating Tier 1 Leverage Ratios, Total Risk Based Capital Ratios, and Tier 1 Risk Based Capital Ratios before proving that it had enough capital under all three to be considered well or adequately capitalized for its operations. Layered on top of this in 2013 was the implementation of Basel III in the United States, with its concepts of common equity tier 1 capital and the new capital buffer, which made tracking a community bank’s capital adequacy a ludicrously complicated task for a community bank that simply accepted deposits and made loans in small-town USA.
In September, the federal banking agencies finalized the CBLR rule, hoping to make this all a little easier for community banks. As announced in the proposed rule that was published in February, the CBLR promises simplicity through the use of a single capital leverage ratio to measure capital adequacy, with the proposed rule establishing the desired capital target above 9%, half way between the range suggested by EGRRCPA of 8 to 10%. While disappointed that the level was not set lower, most community banks are likely to find the finalized CBLR a much better system for tracking capital than PCA, and even a little friendlier than the system proposed in February. Below are three important takeaways from the final rule, which will be effective January 1, 2020.
Sorry guys and gals, the ratio is staying at 9%. When the EGRRCPA was passed in May 2018, many bankers hoped that the federal banking agencies would implement the CBLR by instituting a minimum rate of 8%, which was the bottom of the range suggested in the EGRRCPA. Therefore, there is some disappointment that the proposed rule contained a 9% CBLR instead, a level in the exact middle of the suggested range. During a meeting I attended on September 10, a couple of weeks before the final rule came out, Jelena McWilliams, Chairman of the FDIC, intimated that the CBLR in the final rule would stay put at 9%, saying that a lower rate might have been possible, but only with numerous caveats and qualifications that would have defeated the original purpose of the rule, i.e., to simplify the process for determining capital adequacy of community banks. As promised, the final rule maintained that same basic qualifier for banks with less than $10 billion to use the CBLR, which is a capital ratio of greater than 9%.
Prompt corrective grace? One of the biggest concerns bankers had with the proposed rule was the concept of an alternative PCA framework for those banks that opted into the CBLR. Under the proposed rule, a bank opting into the CBLR would remain “well capitalized” until its capital fell to 9% or lower, after which it would be considered only “adequately capitalized” under the proposed system that treated CBLR capital levels as “proxies” for the existing PCA capital ratios. The PCA proxy concept along with the banker concerns related thereto were better explained by my partner Craig Landrum in an April article titled “Expedited Community Bank Leverage Ratio Resolution Needed.” This system was replaced in the final rule, though, by a two-quarter grace period during which a qualifying community banking organization that temporarily fails to meet the CBLR criteria, including falling to 9% capital or lower, will still be considered well-capitalized as long as the bank maintains a leverage ratio of more than 8%. If the bank has not met all qualifying criteria at the end of the grace period, or it falls to a capital level of 8% or below, it must comply with the standard PCA requirements, including the calculation of risk-based capital ratios, instead of being considered under an alternative standard for the adequacy of capital.
No need to recreate the definition of capital. The proposed rule calculated the CBLR using a ratio of “tangible equity” to average total consolidated assets. Tangible equity would have been defined as total bank equity capital or total holding company equity capital, as applicable, prior to including minority interests and excluding accumulated other comprehensive income, deferred tax assets arising from net operating losses and tax credit carryforwards, goodwill, and other intangible assets. In the final rule, the federal banking agencies decided to use tier 1 capital instead of tangible equity, since many commenters on the proposed rule lamented the complexity created with the proposed introduction of a new way to measure capital. The final rule also noted that using tier 1 capital has the additional benefit of including the existing threshold deduction approaches for mortgage servicing assets and deferred tax assets arising from temporary differences, which allowed the final rule to remove those elements from the qualifying criteria for CBLR used in the proposed rule. Therefore, in order to qualify for use of the CBLR under the final rule, a banking organization must meet the following criteria: (i) a leverage ratio of greater than 9%; (ii) total consolidated assets of less than $10 billion; (iii) total off-balance sheet exposures (excluding derivatives other than sold credit derivatives and unconditionally cancelable commitments) of 25 percent or less of total consolidated assets; and (iv) the sum of trading assets and trading liabilities of 5 percent or less of total consolidated assets. Banking organizations that qualify may opt into and out of the framework by completing the associated reporting requirements in its Call Report or FR-Y9C, beginning with the March 31, 2020, Call Report.
While I think the CBLR is unlikely to convince my dad to come out of retirement, it at least makes banking a little less complicated for those of us who do not yet have that option. Unfortunately, another takeaway I received from my recent Washington trip is that we shouldn’t look for a corresponding BSA simplification any time soon. I guess we will take what we can get.