Community Bank Leverage Ratio Opportunity and Challenges

Under existing capital rules, community banks are required to report a Common Equity Tier 1 (CET1) ratio, a Tier 1 risk-based capital ratio, a total risk-based capital ratio, and a Tier 1 leverage ratio in order to hold their well-capitalized status. The simplified CBLR calculation of Tier 1 capital over average assets treats all assets the same, whereas a risk-weighted ratio assigns assets in the denominator an increasing risk weight to account for unique risk of that asset class.

Key CBLR Rule Components:

• Community banks can now qualify as “well-capitalized” by simply reporting a Tier 1 leverage ratio that exceeds 9%.
• As part of implementation of CARES (Coronavirus Aid, Relief, and Economic Security) Act, regulatory agencies have issued interim final rule
• CBLR ratio has temporarily been reduced to 8% from 9% as of 2Q2020.
• CBLR requirement will be greater than 8% for the 2Q2020-4Q2020, greater than 8.5% for calendar year 2021, and greater than 9% thereafter.
• The transition interim final rule also maintains a two-quarter grace period for a qualifying community banking organization whose leverage ratio falls no more than 100 basis points below the applicable community bank leverage ratio requirement
• Banks with total assets above $10 Billon, advanced approaches banks, or those having outsized unused commitments or trading assets are disqualified from using the CBLR.

The rule will go into effect from 2Q2020, although banks implement capital simplifications rules from the start of 2020.

• A CBLR bank that ceases to meet criteria will be allowed two consecutive quarters to satisfy such criteria or follow general capital rules.
• Banks using the CBLR will be subject to simplified reporting requirements that the agencies intend to propose later.

Based on 4Q19 call reports, SRA analysis shows that over 84 additional banks will be eligible for CBLR due to recently lowered threshold after passage of CARES act. In aggregate 119 banks (2.5% of all banks) will have leverage ratio below 8% threshold. However, 84 banks (1.8% of all banks) will be able to benefit from 2 quarter grace period while 35 banks (0.7% of all banks) will still stay below the threshold even with grace period.

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Key CBLR Considerations:

• While simplifying the rules, the CBLR still requires community banks to hold as much, if not more, capital than before and will incentivize them to maintain strong capital position.
• An informal "buffer" between the required ratio and a bank's actual ratio may be expected. This may deter banks with a leverage ratio ranging from 9% to 10% from utilizing the simpler ratio.
• CBLR banks will forego—for regulatory capital purposes—the use of their outstanding Tier 2 subordinated debt.
• Additionally-strong growth, or planned merger acquisitions could create a conflict between managing to a leverage ratio above 9% and strategic capital efficiency plans. Risk-weighted calculations are relatively complex and difficult to restart once a bank exceeds the $10 Billon guidelines.
• Current Expected Credit Loss (CECL) adoption could also impact capital as any increase in the loss reserves upon transition will be charged against capital.  For some institutions, this amount is could be significant.

Thus, banks that qualify for the CBLR may still choose not to opt in because of asset requirements, internal guidelines or external capital expectations.

We view the CBLR as a favorable option for community banks, relieving main street institutions from compliance rules that are best borne and appropriately designed for the larger banks.

However, high capital levels do not alleviate the necessary strategic focus on credit risk management, stress testing and vigilant risk governance.

Choosing whether to “opt-in” to the CBLR framework should be done only after a careful assessment and consideration of your institution’s specific circumstances.

Amitabh Bhargava
Senior Managing Director
Strategic Risk Associates
Abhargava@srabank.com

Bert Knotts
Partner and Chief Credit Officer
Strategic Risk Associates
aknotts@srabank.com