Comments to OCC. Fed. and FDIC RE: Community Bank Leverage Ratio

Ladies and Gentlemen:

The American Bankers Association (ABA) appreciates the opportunity to comment on thefederal banking agencies’ (Agencies) proposed rule establishing a Community Bank Leverage Ratio (CBLR Proposal). This CBLR Proposal seeks to implement Section 201 of the EconomicGrowth, Regulatory Relief, and Consumer Protection Act (Economic Growth Act). Subject to the comments below, ABA is supportive of the CBLR Proposal.

The CBLR Proposal recognizes what several years of bank supervision have shown, that a largenumber of U.S. banking organizations and depository institutions are so highly capitalized thatthey clearly meet or significantly exceed the risk-based capital requirements and “wellcapitalized” designation of the Agencies’ Prompt Corrective Action (PCA) regulations. Yettoday these institutions must spend the time, effort, manpower, and expense to maintain systemsand make the necessary calculations to demonstrate their compliance with these unnecessarilycomplex capital requirements, which are a poor fit for many of our nation’s bankingorganizations. Implementation of the CBLR would reduce the wasteful allocation of resources to comply with these processes for the banking organizations that would meet or exceed suchrequirements. These highly capitalized banks could deploy the resources expended todaycalculating their minimum risk-based capital ratios more productively elsewhere. Moreimportantly, the CBLR’s development now will create an optional framework that should enablewell capitalized community banks to avoid the costs of implementing future changes to the riskbased capital rules.

ABA supports efforts to simplify and improve the current regulatory capital framework forbanks. Over the last two decades, the regulatory capital framework has grown more complexthan it needs to be for the financial stability or supervisory value it provides. The CBLR is animportant component to achieving a simpler and better regulatory capital framework forcommunity banks. We not only encourage the Agencies to continue this effort, but we encouragefurther efforts to simplify the generally applicable risk-based capital standards to addressunnecessary complexity, particularly for provisions that needlessly inhibit economic growth orconstrain banks in fulfilling their core functions.

In this letter, ABA offers its recommendations for how the CBLR Proposal and the generallyapplicable risk-based capital standards can be improved. ABA’s letter is organized as follows:

• Section 1 provides background on the CBLR proposal.
• Section 2 emphasizes why the CBLR must remain optional at all times and discusses theimplications of the proposed PCA framework.
• Section 3 discusses why a CBLR ratio of 8% is adequate for a bank to be deemed “wellcapitalized.”
• Section 4 discusses the appropriate definition of capital as well as the limiting factors.
• Section 5 includes additional improvements to the generally applicable capital standards that the Agencies should seek to implement.

1. Background on the CBLR Proposal.

Section 201 of the Economic Growth Act requires the Agencies to issue a rule creating a“Community Bank Leverage Ratio,” which they can set anywhere between 8% and 10%. If a“qualifying community bank” is above the ratio, it will be deemed well capitalized and incompliance with risk-based capital requirements such as Basel III. Section 201 is a welcomerecognition that many community banks maintain capital levels far in excess of any amounts thatwould be required by the complex evaluations, measurements, and calculations mandated underthe Basel III regulations. For these highly capitalized banks, the considerable and costly work ofapplying Basel III and related reporting framework yield no additional supervisory, safety andsoundness, or customer benefit.

Section 201(a) sets out criteria governing eligibility for compliance with the CBLR by defining a“qualifying community bank” as a bank with total consolidated assets of less than $10 billion,while also authorizing the Agencies to establish other qualifying criteria governing eligibility forthe CBLR, based on a consideration of the risk profile of qualifying community banks.

The Agencies’ CBLR Proposal defines a qualifying community banking organization as adepository institution or depository institution holding company with less than $10 billion intotal consolidated assets that has limited amounts of off-balance sheet exposures, trading assetsand liabilities, mortgage servicing assets (MSAs), and deferred tax assets (DTAs) arising fromtemporary differences that a banking organization could not realize through net operating losscarrybacks (temporary difference DTAs).

The CBLR would be measured as the ratio of tangible equity capital (CBLR tangible equity)divided by average total consolidated assets. Under the proposal, CBLR tangible equity would bedefined as total bank equity capital or total holding company equity capital, as applicable, priorto including minority interests, and excluding accumulated other comprehensive income (AOCI),DTAs arising from net operating loss and tax credit carryforwards, goodwill, and otherintangible assets (other than MSAs), each as of the most recent calendar quarter and calculated inaccordance with a qualifying community banking organization’s regulatory reports.

As currently proposed, a qualifying community banking organization may opt in to use theCBLR framework when it has a CBLR of at least 9 percent. The CBLR Proposal also providesan alternative PCA framework for banks that have opted in to the CBLR and have had theirCBLR subsequently fall below 9 percent. Specifically, for insured depository institutions, theproposal incorporates CBLR levels as proxies for the following PCA categories: adequatelycapitalized, undercapitalized, and significantly undercapitalized. If a CBLR bankingorganization’s CBLR meets the corresponding CBLR PCA levels, it would be considered to havemet the capital ratio requirements within the applicable PCA category and be subject to the samerestrictions that currently apply to any other insured depository institution in the same PCAcategory.

As currently proposed, the alternative PCA framework is more punitive than the existing PCAframework, recognizing that banks have the right to opt out of the CBLR at any time.

The CBLR Proposal is not designed to reduce the amount of regulatory capital banks need.Rather, it is designed to relieve the unnecessary regulatory reporting of risk-based standards foreligible community banks. If properly designed, the CBLR Proposal should reduce wastefulallocation of resources—such as reducing staff time, outside audit costs, and even examinationtime, for eligible institutions.

2. The CBLR must remain optional at all times.

The Agencies have proposed a flexible framework that allows qualifying institutions to opt in atany time. In addition, banks that have opted in to the CBLR framework are permitted to opt outof CBLR framework at any time by using the generally applicable capital requirements andcompleting the associated reporting requirements. ABA supports a flexible and optional CBLRregime.

However, in its comment letter responding to the CBLR Proposal, the Conference of State BankSupervisors raised questions about how optional the CBLR framework would be in practice.

Some ABA members share these concerns, particularly for the following potentialcircumstances:

• There are concerns that banks could be forced to opt in to the CBLR framework if theirpeers in their community opt in to the framework. These bankers believe that localexaminers will view banks that do not opt in to the framework as outliers and pressurethem to raise capital and opt in to the framework.
• There are concerns that banks could be trapped within the CBLR framework by localexaminers, even as their capital levels decline below the CBLR, by process issues thatwould make it too difficult in practice for banks to opt out.

Both of these concerns stem from past experiences during the financial crisis where examinersused every possible tool to get banks to raise additional capital. If either of these twocircumstances were to occur, banks are concerned that they would be bound to the extremelyconservative PCA proxies envisioned in this CBLR Proposal with no way to opt out. In effect,the apprehension is that the regulatory language to implement Congress’ effort to provide andoptional avenue for community bank relief could be transformed into a supervisory tool used tomandate more capital.

Through examiner training, more transparency on bank ratings, and other appropriate steps, theAgencies must reinforce the optionality envisioned in the CBLR Proposal. The Agencies need toclarify that a bank can opt out at any time. We would note, moreover, that concerns about theproposed PCA proxies become significantly diminished were the CBLR set at 8 percent, asdescribed and recommended in Section 3 of this letter.

3. The CBLR should be calibrated to 8 percent.

The Agencies emphasize that the CBLR Proposal is not intended to reduce the amount ofregulatory capital that banks need. Rather, it is designed to be a regulatory relief measure forbanks that can already demonstrate they meet the Basel III standards. We agree with thispurpose and believe the purpose is served with an 8 percent CBLR.

By ABA’s calculations, every single qualifying community bank that has an 8 percent CBLR isalready meeting the well capitalized risk-based capital ratios. ABA’s calculations show that an 8percent CBLR serves as an effective proxy to determine whether an institution is otherwise “wellcapitalized.” Setting the CBLR at 9 percent is unnecessary, but it will significantly limit thenumber of institutions eligible for the relief that Congress intended.

We would also note that banks effectively maintain capital buffers above minimum regulatorycapital requirements. If the CBLR were calibrated at 8 percent, we anticipate that only bankswith a comfortable buffer above 8 percent would be interested in opting in to the CBLRframework. In practice, 8 percent could become 9 percent, or 10 percent, or higher. Similarly,setting the CBLR at 9 percent, banks would operationally consider the need to hold 10 percent,or 11 percent, or more in capital.

In addition, we believe that the adoption of the planned current expected credit loss standard(CECL) could impact the number of institutions eligible for CBLR relief, especially during aneconomic downturn. We believe that CECL will not only increase credit loss reserves but alsothe volatility of those reserves at community banks. Such increases will be at the expense of, andserve the same purpose as, regulatory capital, with the potential volatility requiring furtherbuffers on top of those just discussed. The ability of these increases of reserves to absorb lossesfurther justifies setting the CBLR calibration at the lower 8 percent bound.

The Agencies should finalize the CBLR Proposal with the “well capitalized” PCA category set ata CBLR of 8 percent. Should the Agencies maintain the alternative PCA framework, adequatelycapitalized, undercapitalized, and significantly undercapitalized PCA categories should similarlybe adjusted as follows:

• Adequately capitalized—CBLR of 6 percent or greater;
• Undercapitalized—CBLR of less than 6 percent; and
• Significantly undercapitalized—CBLR of less than 4.5 percent.

4. Subject to the finalization of the regulatory deduction proposal, the CBLR shouldbe defined as the Tier 1 Leverage Ratio and the qualifying criteria should besimplified.

The Agencies have proposed a simple and reasonable definition of “tangible equity.” However,it is clear the Agencies are concerned about certain asset classes, because they have also includedvarious qualifying criteria. For example, banks with mortgage servicing asset (MSA)concentrations that exceed 25 percent of tangible equity would not be considered qualifyingbanking organizations. These qualifying criteria are an unnecessary complexity.

Instead of adopting a simple numerator with complex qualifying criteria, the Agencies should—

• Finalize the regulatory deduction proposal issued in 2017;
• Use the revised Tier 1 leverage ratio that reflects the new deduction methodology as theCBLR; and,
• Eliminate the qualifying criteria that relate to assets deducted from Tier 1 capital.

Community banks are already familiar with the calculation of Tier 1 capital, and the Tier 1leverage ratio would not require any changes to internal processes. Moreover, use of a Tier 1leverage ratio will facilitate the ability of investors and bank supervisors to compare capitaladequacy across community banks within the CBLR Framework and those outside theFramework. The use of Tier 1 capital will also ensure that certain instruments that have beenissued by community banks, such as Trust Preferred Securities (TruPS) and common stock issuesby bank subsidiaries, will be counted as capital, up to the limits imposed by Basel III rules.

Future adjustments need to be made to accommodate accounting changes

ABA continues to monitor the impact on community banks of the upcoming implementation ofthe current expected credit losses standard (CECL). A recent survey performed by ABAsuggests that CECL reserves would spike in a stressed economic environment. If applied tocommunity banks, the surveyed reserve levels might disqualify many from qualifying for theCBLR. More work is required, however, since most community banks are still in the beginningstages of model development. Therefore, due to the still uncertain impact, ABA firstrecommends that the Agencies provide for an ongoing adjustment to the numerator used in theCBLR that approximates the incremental regulatory capital impact of CECL credit lossallowance levels over levels currently recorded. Until a long-term recalibration of the regulatorycapital framework can be completed, incremental allowances required under CECL after theeffective date can be estimated through use of streamlined proxy incurred loss methods tomitigate the operational challenges of estimating the differences on an ongoing basis. Such anadjustment will allow time for the Agencies to determine how to integrate the higher lossabsorbency aspect of CECL into the capital framework.

The Agencies can avoid embracing arbitrary thresholds.

ABA understands that Section 201 requires the Agencies to develop a CBLR for institutions with$10 billion or less in consolidated assets. However, Section 201 places no limit on the ability ofthe Agencies to apply a CBLR to institutions with above $10 billion in assets. ABA encouragesthe Agencies to tailor application of the CBLR to institutions based on their suitability for relieffrom the generally applicable risk-based capital standards and not base this relief on arbitraryasset thresholds.

Arbitrarily set thresholds are inapt, fixed dividing lines for banks that fail to capture marketdynamics when established and become worse over time as they perpetuate market distortions.Inevitably, the proposed static threshold in the CBLR Proposal will come to exclude bankswhich were originally eligible for this relief but have grown, even if only marginally. ABAbelieves that in addition to tailoring application of the CBLR threshold to institutions based ontheir suitability for relief, not their asset size, the Agencies should index applicability to take intoaccount inflation or other relevant market measures.

Off balance sheet exposures key to the functioning of mortgage markets should be excluded fromoff-balance sheet qualifying criteria.

ABA is concerned that certain exposures related to safe functioning of the mortgage market maybe captured by the “off balance sheet” qualifying criteria. Many community banks operatemortgage pipelines where loans are originated, seasoned, and eventually sold to GSEs or privatelabel securitizers. Proper risk management of these pipelines of loans proceeding through theorigination process and originated loans Held for Sale often include various hedging techniques that could be captured by the off balance sheet qualifying criteria as currently written. Sincethese transactions lower the credit risk and interest rate risk of a bank, we believe that theAgencies should welcome this activity and not penalize it. ABA recommends that this type ofmortgage origination related hedging activity be excluded from any limiting factor that excludesbanks from being able to use the CBLR Framework.

Similarly, we are concerned that mortgage sales to certain Federal Home Loan Banks (FHLB)through their Mortgage Partnership Finance Program might also be captured by the off balancesheet qualifying criteria. Over 1,000 banks nationwide use the MPF Program to transfer theliquidity risk, interest rate risk, and prepayment risk of their long-term, fixed-rate mortgages,while retaining a portion of the credit risk through a credit enhancement obligation provided totheir FHLB. We note that these activities are already reviewed by the Agencies during theperiodic bank examination process, which is a more appropriate risk management process thanencumbering the CBLR and/or Call Report data for this purpose.

5. The Agencies should make additional changes to the risk-based capital standards.

ABA supports efforts to simplify and improve the current regulatory capital framework forcommunity banks, which is an important and necessary undertaking. The CBLR is a valuablecomponent to achieving a simpler and better regulatory capital framework for qualifying banks.However, equally important is the Agencies’ efforts to simplify the generally applicable risk-based capital standards to address unnecessary complexity, particularly for provisions thatneedlessly inhibit economic growth or without adequate supervisory value constrain communitybanks in fulfilling their core functions.

The Agencies should finalize the proposed regulatory deduction revisions.

In 2017, the Agencies issued a proposal entitled “Simplifications to the Capital Rule Pursuant tothe Economic Growth and Regulatory Paperwork Reduction Act of 1996” (SimplificationProposal). The comment period on the Simplification Proposal closed on December 26, 2017.However, this proposal has still not been finalized. Promptly finalizing the regulatory deductioncomponent of the Simplification Proposal would provide immediate benefits to banks and theircustomers.

The Agencies should revisit the deduction of investments in other financial institutions.

Many community banks have held capital investments in other financial institutions for decades.Until recently, these instruments have been held on a cost basis. The regulatory deductionthreshold was generally not a major concern for these banks until the Financial AccountStandards Board adopted ASU 2016-01, which requires banks to carry these instruments at fairvalue. As a result of the accounting change, and the relatively high fair value relative to costbasis, ABA is increasingly concerned about the regulatory deduction threshold even if it isincreased to 25% of common equity. The Agencies should increase the regulatory deductionthreshold beyond 25% and explore ways to limit volatility associated with the accountingchange.

The Agencies should eliminate the capital conservation buffer.

The Agencies should also eliminate the capital conservation buffer for community banks,because it is redundant with PCA and penalizes Subchapter S banks. Under the Subchapter Srules, shareholders are required to pay federal income taxes on a firm’s profits proportionate tothe shareholders’ ownership interest in the company, regardless of whether profits are actuallydistributed to the shareholders. Generally, shareholders are able to meet their tax obligationsfrom distributions they receive from the S-Corp bank. However, under the capital conservationbuffer requirements, a bank may be limited or prohibited from making such distributions if thebank’s capital levels fall below the required capital buffer, even though the bank is profitableenough to incur a tax liability. In such a case, the tax obligation would remain, forcing the bank’sshareholders to pay taxes on income that they have not received, placing the S-Corp bank at afunding competitive disadvantage relative to its C-Corp counterparts. The capital conservationbuffer is harmful to the growth and viability of S-Corp community banks, especially in times ofeconomic stress. Further, the conservation buffer impedes Congressional intent in creating the S-Corp category to stimulate investment in small businesses.

Thank you very much for considering these issues. If the Agencies would like additionalinformation regarding these comments, please contact Hugh Carney at (202) 663-5324.

Sincerely,

Hugh C. Carney
Vice President of Capital Policy
American Bankers Association