By Megan L. Desso
As a result of the Dodd-Frank Act (DFA), there is no longer a cut-and-dried definition of a well-capitalized bank. The term may mean one thing to a seasoned banker, while a regulator’s definition may be
quite different. Standard capital ratios no longer mean what they did in pre-DFA days.
FDIC Chairman Sheila Bair has stated that excess leverage and thin capital cushions were primary drivers of the financial crisis. The Dodd-Frank Act now requires regulators to review current capital regulations and make sure the amount of capital increases in times of economic expansion and decreases in times of economic contraction, consistent with the safety and soundness of the company.
However, the act does not provide specific guidance as to what the new capital levels should be. It merely states that minimum leverage and minimum risk-based capital requirements “shall be established … and shall not be less than the generally applicable leverage capital requirements … that were in effect for insured depository institutions as of the date of enactment of the act.”
The act goes on to state, specifically, that the current levels should serve as a floor for new ones. Reading between the lines, banks should expect higher required capital levels; risk-based, of course.
Bankers, fighting to survive the economic crisis, probably have not had time to notice a new challenge: the demand for additional capital. Mandated higher levels of capital would hit community banks hard. In this market, banks are typically left with one of two alternatives to improve ratios – either raise new capital or shed assets (typically good assets).
The effect has already been felt across the country, as examiners from all regulatory bodies are ordering banks of all sizes and complexities to increase their capital ratios well beyond the regulatory established well-capitalized minimums. It’s easy to spot the trends. Specifically, examiners are seeking 9 percent to 10 percent Tier 1 leverage capital ratios and 12 percent to 14 percent risk-based capital ratios.
It is anticipated, as dictated in the Dodd-Frank Act, that trends will be more towards capital requirements based on risk profiles. This is a move from the old industry standards, which were specified by regulation, to a more individual or dynamic approach. For example, banks with significant credit concentrations or deteriorating asset quality will be expected to hold higher capital levels than peers with the same level of assets but lower risks. As a result, the guidelines are not precise and are subject to interpretation.
However, there appears to be some good news. It seems that the regulatory bodies are attempting to manage this change on a bank-by-bank basis, instead of raising the minimums across the board. There is still hope that community banks will be treated in accordance with their characteristically lower risk profiles. If that’s the case, the largest banks will bear the burden of the majority of the increased mandates.
It seems fair to conclude that, yet again, public monetary and fiscal policies and regulatory bodies may be fueling the very fire the Central Bank has been attempting to extinguish. While monetary policy is attempting to provide for an expansionary environment, regulatory actions are deflationary in nature.
The Central Bank wants banks to lend, but the regulators are issuing enforcement actions to raise capital ratios and Congress is passing bills that call for stronger capital requirements. The positions seem contradictory and at odds with each other. Higher capital levels for many healthy community banks are counterproductive because they force otherwise healthy institutions to shrink their balance sheets –
make fewer loans and/or sell good assets.
What action should a community bank take now? First, develop a plan. And, second, don’t put it off. Begin now.
The goal of every financial institution is, of course, to be well capitalized. But how can a community bank plan to meet that objective when bankers can’t be sure what that means for their institutions? The prudent view is to develop several alternative plans and options for raising capital and do it as quickly as possible.
Although the game has not changed, the rules have. When it comes to finding sources of capital in today’s market, financial institutions need to be creative, resourceful, and prepared. Plans should, at a minimum, identify multiple and diverse funding sources and financial instruments. Anything less is playing with fire.
Megan L. Desso is enterprise risk manager for Bankers’ Bank Northeast.