This paper seeks to estimate the regulatory capital impact on FDIC-Insured depository institutions resulting from current expected credit loss (CECL), once implemented, based on 3Q2017 financial statements. Net charge-offs (NCOs) of loans and leases between 2005 and 2016 are used to extrapolate the burn-down analysis for total risk-based capital (TRBC) ratios.

Ethan M. Heisler, CFA Heisler’s Quality Letter & Analysis (HQLA) ethan.heisler@thebanktreasurynewsletter.com Joshua S. Siegel StoneCastle Partners, LLC jsiegel@stonecastle.com

The CECL reserve for loan and lease losses is expected to be

larger than current reserves under Generally Accepted Accounting Principles (GAAP). Risk-based capital (RBC) rules cap the inclusion of the GAAP reserve in Tier 2 capital at 1.25% of risk-weighted assets (RWA).

Results from this study suggest that the prevalence of institutions operating at or above the cap is inversely correlated with the institution’s total asset size. Accordingly, a significant portion of small banks may be challenged to maintain Well Capitalized1 TRBC ratios upon implementation of CECL because GAAP provisions for losses will reduce Tier 1 capital and only increase Tier 2 capital up to the regulatory cap. Currently, a bank’s TRBC ratio must exceed 10% to be Well Capitalized; however, by 2019 it must exceed 10.5% to include a Capital Conservation Buffer.

Small banks historically underutilize Tier 2-qualifying

subordinated debt as part of capital planning, instead relying almost exclusively on core Tier 1 capital to meet TRBC requirements. Unlike the capped reserve, subordinated debt is not capped for the calculation of TRBC and can offer a less expensive “CECL capital buffer” to offset the hit to capital resulting from the higher CECL reserve.

(1) “Well Capitalized” status: (i) total risk-based capital ratio of 10; and (ii) has a Tier 1 risk-based capital ratio of 6.0 percent or greater; and (iii) has a leverage ratio of 5.0 percent or greater; and (iv) is not subject to any written agreement, order, capital directive, or prompt corrective action directive issued by the FDIC.

Current Expected Credit Loss (CECL) Threatens Bank Total Risk-Based Capital (TRBC) Levels

December 18, 2017

December 18, 2017 1

SUMMARY The deadline for adopting the Financial Accounting Standards Board’s (FASB) CECL methodology for bank loan losses is now barely two years away. With that in mind, we wrote this paper with the goal of refocusing community and regional banks’ compliance efforts on capital, rather than on just technology.

Smaller banks should fully appreciate what CECL essentially means: an indirect increase in capital requirements, particularly relative to larger banks. Here, we explain why the change is happening and our expectation of its impact, as well as suggest that affected banks begin to prepare now by raising Tier 2 capital as a CECL buffer while the costs of doing so remain historically low. The alternative – to wait until full realization sets in – could result in heightened capital costs as demand intensifies while regulatory compliance is jeopardized across the industry.

TABLE OF CONTENTS 1. CECL: Technological Versus Capital Challenges 2

2. Capital Challenge 3-5

3. Estimating CECL Reserves 6-11

4. A Final Note 12

December 18, 2017 2

CECL: Technological Versus Capital Challenges CECL represents a fundamental change to GAAP. Instead of estimable and probable loan losses over a foreseeable time horizon (typically two years), on the day of origination lenders will be required to estimate and provision for losses over the contractual life of the loan, be it a one-year, five-year, or a more extended-term loan.

Thus far, the banking industry has focused on overcoming significant technological hurdles to meet the deadline for adopting CECL beginning 2020, when all public SEC filing entities (and in 2021 for all other public entities) must comply. To that end, banks have started to forge partnerships in the nascent “RegTech” industry – full of cutting-edge firms designed to help deal with these types of challenges. Much of the RegTech in development requires a custom platform to collect credit data, extract and analyze the appropriate metrics; as well as an interface to integrate the analysis into existing systems including credit approval, loan pricing, and capital and risk management.

This technological challenge is vaguely reminiscent of the Y2K concerns. Everyone knew 2000 was coming, and everyone prepared expecting everything to be okay. But until it was okay, the known unknowns remained a risk.

Setting aside this sense of foreboding, our research suggests that while RegTech and process are currently the focus, CECL presents as much, if not greater, an obstacle for bank regulatory capital compliance. Specifically, we find that more than one thousand U.S. commercial banks will struggle to maintain their Well Capitalized status when CECL is adopted, with TRBC ratios particularly vulnerable. A Well Capitalized bank must meet or exceed thresholds for four different capital ratios; Common Equity Tier 1 (CET1), Tier 1 Capital, Tier 1 Leverage, and a TRBC ratio, which are discussed in greater detail below.

Currently, the TRBC vulnerability can be addressed cheaply via the market for subordinated debt at the bank holding company level. Should this situation change in 2020, due to capacity issues driven by heightened capital demand or a change in general capital market conditions, banks may have no alternative remedy but to raise expensive equity to meet regulatory compliance.

December 18, 2017 3

CAPITAL CHALLENGE CECL’s first order effect is to require larger allowances for loan losses2. As a reminder: under TRBC standards, additions to the allowance for loan and lease losses are treated as a deduction from Tier 1 capital and as an addition to Tier 2 capital, subject to a cap of 1.25% of RWA.

Once the reserve exceeds the cap, every dollar deducted from Tier 1 capital is also deducted pre-tax from TRBC, which is the sum of Tier 1 and Tier 2. While a bank could hold as much Tier 2 capital as it wants – all of which would count towards its total regulatory capital requirements – it can only include reserves for loan losses of up to 1.25% of RWA in Tier 2 capital. Economically, the excess, disallowed reserve is still available as a source of actual loss absorption (loan charge-offs), a fact that hopefully will not be lost on rating agencies. However, specifically for regulatory capital purposes, this excess is of no use. Thus, CECL’s requirement of larger allowances is a new capital burden on banks, and, as such, is an accounting and operational weight on them.

Graph A: Reserve for Loan Loss as a Percent of Basel Risk-Weighted Assets

Even without CECL, this excess, dead-weight allowance can be a drag. For example, during the last credit cycle, the reserve for loan losses peaked at over 2% of RWA for banks over $10 billion (Graph A). Even today, a peer average of banks with total assets under $1 billion is just shy of exceeding the 1.25% cap.

(2) The terms “allowance for loan losses,” “allowance,” “reserve for loan losses,” “reserve for loan and lease losses, and “reserve” are all used interchangeably throughout this paper and denote the contra-asset account deducted from the book value of total loans on the balance sheet.

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December 18, 2017 4

Therefore, even a consensus view of the potential impact should raise alarm. A survey conducted by SNL Financial in September 2016 showed bank CFOs forecasting an increase of between 10% and 50% to their credit loss reserve accounts when CECL is adopted, implying that smaller banks will have to deduct most of their CECL reserve from their Tier 2 capital and TRBC ratios, while larger banks – with some room to maneuver under the 1.25% cap – will not.

Capital – Where We Are Now

Banks are required to maintain regulatory capital to meet four different capital ratios: Common Equity Tier 1 (CET1), Tier 1 Capital, Tier 1 Leverage, and a TRBC ratio. The denominator for the Tier 1 Leverage Ratio is quarterly average GAAP assets less goodwill; and the denominator for the other three ratios is Basel RWA. TRBC is equal to Tier 1 and Tier 2. In addition to the reserve for loan losses allowable under the cap, Tier 2 capital consists of subordinated medium-term notes.

Graph B: Tier 1 and Tier 2 Ratios by Peer Average (12/07 vs. 09/17)

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Under Basel 3, banks can include total Tier 2 capital without any caps or restrictions in TRBC, provided that they maintain a minimum 6.5% CET1 ratio, a 8% Tier 1 capital ratio, a TRBC ratio over 10%, and a 5% leverge ratio to meet the threshold for a Well Capitalized bank under the Prompt Corrective Action regulatory supervisory rules. Since the financial crisis the industry has focused on building up CET1 and Tier 1 capital, but has paid little if any attention to building up Tier 2 capital. Graph B demonstrates how smaller community banks have relied much less on Tier 2 capital, relative to their larger peers. CECL will reduce Tier 1 ratios, but without any additional Tier 2 capital to manage the 1.25% cap, the excess CECL reserve will reduce TRBC as well. On average, the industry could not stand more than a 4% to 5% reduction of capital before breaching the 10% minimum threshold.

It is important to keep this in mind as we look forward to capital stress testing in the age of CECL – even before we discuss the magnitude of CECL itself. Such stress testing incorporates all the basic capital requirements, and given the potential impact of CECL on TRBC, it will have to be specifically reckoned in capital planning as banks begin their final preparations to adopt the new GAAP in 2020. Because regulatory accounting follows GAAP, banks will not only have to demonstrate that they have adequate capital resources to absorb future credit losses, but also to contend with maintaining their capital ratios above regulatory thresholds, where such distinctions are critical.

Even if rating agencies decide to look through the accounting reserve, a breach of regulatory minimum requirements would represent a per se serious credit safety challenge – possibly even an event of default – with grave economic consequences. Regulators could also restrict a bank’s activities if it fell under minimum regulatory requirements. So, CECL is not just an accounting rule, it may likely cost the industry in an economic sense as well. Consider the fact that banks between $100 million and $50 billion in total assets have about $2 trillion in RWA. If the banks in aggregate fell below 10% TRBC by one percent (well below the levels indicated below), that group of banks would need to raise $20 billion to repair the capital deficiency.

December 18, 2017 6

ESTIMATING CECL RESERVES The Drivers

The size of a CECL reserve is driven by estimating a credit’s risk of default, expected loss given default, the term period of the loan, and the point in the credit cycle’s timeline when the loan is written. Therefore, a CECL reserve taken early in the credit cycle should be lower than one taken when the credit cycle is peaking. Also, since most real estate loans are long-term, they will likely require a larger reserve than a short-term loan such as a commercial and industrial loan.

Graph C: Selected Loan Mix as a Percent of Loans at (9/17)

*HQLA: Heisler’s Quality Letter & Analysis

Graph C broadly compares the four peer groups by selected loan mix to support our five-year term assumption. The graph highlights how banks with total assets over $10 billion hold nearly twice as many short-term commercial and industrial loans than banks with total assets between $100 million and $500 million. Real estate loans were 74% to 78% of the loan mix at the smaller banks, versus 65% for banks over $10 billion in total assets. Banks with total assets between $500 million to $10 billion had a higher mix of commercial real estate loans – nonfarm and nonresidential CRE, multi-family, and construction – than either smaller-sized banks or banks with over $10 billion in total assets.

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A CECL reserve for a short-term loan could be roughly equal to the reserve under current GAAP because its entire duration is foreseeable at origination. But for real estate loans with terms as long as 30 years, multiples of current GAAP reserves would be required. This is why CECL would be a greater capital burden on regional and community banks than on larger banks.

We think that this is an unfair relative burden and one that is at odds with our most recent industry-wide credit calamity – the financial crisis – which showed smaller banks weathering the storm far better than their larger counterparts.

Exercise: Estimate Effect of the Crisis Assuming CECL Existed Pre-Crisis

For the sake of illustration, let’s assume that, 1) CECL was in effect at the end of 2004; 2) credit officers had perfect foreknowledge of the course of NCOs from the years 2005 through 2016; 3) the loan book’s term was five years; and 4) loans were only booked at year-end.

Consequently, we created seven cohorts based on forward five-year cumulative annual NCOs for the years 2005 through 2011, as will be discussed below. With this perspective in mind, we estimated the CECL reserve for each bank as equal to its actual five-year forward cumulative NCOs for each five-year cohort from 2005 through 2016.

CECL Reserve YE 20XX = Sum of NCOs for the years 20XX-20XX.

Graph D: Estimated CECL Reserve Percent of Risk-Weighted Assets

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December 18, 2017 8

For example, as Graph D shows, the CECL reserve at year-end 2004 would have equaled the sum of NCOs from the years 2005 through 2009 and would have exceeded the 1.25% cap by 1% - 4% of RWA; the reserve at year-end 2005 would have equaled the sum of NCOs from the years 2006 through 2010 and would have raised the disallowed reserve higher each year – until year-end 2011, when the reserve would equal the sum of NCOs from the years 2012 through 2016. After year-end 2007, as the cohort included lower NCOs for the years 2011 and 2012 and onward, banks would estimate a lower CECL reserve; but with the exception of the smallest peer group, the estimate at the end of 2011 would still have exceeded the 1.25% cap.

Graph E: Comparison of the Number of Banks in the Four Peer Groups (9/17)

A word about the different peer groups is necessary at this point. As Graph E demonstrates, the number of banks in each peer group is very different – so peer averages can be misleading. There are only 60 banks in the peer group of banks with the largest asset size, compared to 2,375 banks in the smallest asset size.

Graph F: Number of Banks That Failed to Maintain a 10% CECL-Adjusted TRBC Ratio

With the impact of peer group sizes in mind, Graph F shows the number of banks that failed to maintain a 10% TRBC ratio after a CECL adjustment was applied for each of the peer groups. For example, all but 448 banks out of 3,562 surveyed passed the 2005 CECL scenario, and all but 206 passed by 2011. The peak year was 2007.

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Graph G: Average TRBC Ratio for Banks that fell below 10% TRBC after adjusting for CECL

Graph G shows the average TRBC ratio for banks that failed to maintain a TRBC of at least 10% after adjusting for CECL. We updated the estimates for the CECL reserve that would apply to year-ends 2005 through 2011 as seven different stress scenarios for RBC as of September 2017. For example, the CECL reserve calculated above for year-end 2005 was multiplied by RWA at September 2017 divided by RWA at year-end 2005; the CECL reserve for year-end 2006 was similarly updated by multiplying it by a factor of the ratio of RWA at September 2017 to RWA at year-end 2006, and so on to year-end 2011, when the CECL reserve would be multiplied by a factor of the ratio of RWA at September 2017 to RWA at year-end 2011.

The formula would be:

Updated CECL Reserve = CECL Reserve 20XX*(RWA / RWA 20XX).

We then deducted the updated CECL reserve from TRBC at September 2017 adding back 1.25% of RWA at September 2017, and then divided by September 2017 RWA to produce a CECL-Adjusted TRBC Ratio at September 2017.

The formula would be:

CECL-Adjusted TRBC = (TRBC – Updated CECL Reserve + 1.25% of RWA) / RWA

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Graph G segments out just the banks that fell below 10% TRBC after our CECL adjustment. The deficient banks with total assets between $10 billion and $50 billion would have reported an average TRBC ratio equal to 5.42% of RWA, more than 4% below Well Capitalized in 2005 (with fully reserved 2005-2009 NCOs). Initially, that was actually the strongest performance. However, as we moved through the peak of the credit cycle, this peer group’s average TRBC ratio fell to under 3% in 2006 through 2008, which incorporates NCOs from 2008-2012 and 2010-2014, respectively – by far the worst performances over the entire period examined for any group. The smallest community banks, between $100 million to $500 million, still fared the best of the different peer groups through the eight scenarios. This speaks volumes to their relatively lower risk assets, including residential mortgage loans. The impact of the hit to the “fail” group’s TRBC ratios after applying a CECL adjustment is shown in Graph H.

Graph H: “Burn Down” of TRBC Ratio for Banks in the “Fail” Group

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Graph I: TRBC Capital Needed to Repair Capital Deficiency for “Fail” Group

Of course, as the cycle progressed, fewer banks in the four peer groups had CECL-adjusted TRBC ratios under 10%. To estimate the cost to repair their TRBC ratios back to Well Capitalized, Graph I was drawn by multiplying RWA for the subset of deficient banks by the difference between the estimated ratio and 10%.

The formula would be:

RBC Capital to Boost TRBC Ratio to 10% = (10% – CECL TRBC Ratio)*RWA

Thus, for example, under a “2007” CECL scenario, banks in aggregate would have a CECL RBC ratio ranging from 3% to 7%, and would need TRBC equal to $45 billion to bring their TRBC ratio back into compliance. If in 2020 the credit environment dictates a “2011-esque” CECL reserve, banks with deficient TRBC would still need to raise $7 billion of additional Tier 2 capital to bring their ratios back to 10%.

What should smaller banks take from this? We draw two key lessons. First, during the crisis their ultimate capital shortfalls were less severe than those of their larger counterparts. Second, less severe is still severe.

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A FINAL NOTE

The analysis presented here is admittedly broad-brush. Further refinements, including recalibrating the cumulative period of forward NCOs more tailored to each bank’s loan mix, would likely reduce the estimates presented above. However, it is clear that smaller banks tend to hold a greater proption of real estate loans than do larger banks, so the burden of CECL will likely fall more heavily on the former group than on the latter. Our analysis assumes that banks target exactly a 10% ratio – without any cushion, and without including the 2.5% Capital Conservation Buffer that would raise the minimum TRBC to 10.5% when it is fully phased-in beginning in 2019. This, of course, only understates the magnitude of the challenge for banks.

Also, while the credit cycle remains relatively strong by historical measures, despite reported storm clouds in the consumer lending and auto lending segments, the current credit cycle is already the longest in modern history. Cycles do not have expiration dates, but neither do they go on forever. Regulators will expect banks to be conservative in estimating CECL, and that will mean that banks will need to build into their models the probability for higher NCOs over the term of their forecasted CECL losses, and will not be permitted to assume the best-case credit cycle.

To prepare, it seems prudent for regional and community banks to raise additional Tier 2 capital as a CECL buffer while issuance costs remain historically low – rather than later, when regulatory capital compliance might be jeopardized and the urgency heightened to rush to market. Under Basel 3, banks can include total Tier 2 capital in total regulatory capital without any cap. Until now, there has not been a strong argument to raise Tier 2 capital, since almost all banks meet minimum requirements with Tier 1 capital. Only 20% of bank holding companies use any holding company debt today, underutilizing the low-cost form of Tier 2 capital. When CECL goes into effect, banks will need to prepare for the double-whammy of a deduction of the reserve from both Tier 1 capital and TRBC.

Ethan Heisler ethan.heisler@thebanktreasurynewsletter.com

Joshua Siegel jsiegel@stonecastle.com