The Impact of CAP “Stress Testing” on Banks Under $100 Billion  

On February 25, 2009, the United States Department of the Treasury (“Treasury”) announced the terms and conditions of the Capital Assistance Program (“CAP”). Under CAP, the federal banking regulators are conducting forward-looking “stress tests” to evaluate the capital needs of banks with assets exceeding $100 billion. These stress tests have led to much discussion about the approach Treasury will take (such as issuing preferred shares that will be converted to common stock at a discount) if the test results are that the institution needs additional capital that is not forthcoming from the private sector.  

What has not been discussed is how the bank regulators will evaluate banks with assets of $100 billion or less on a going-forward basis. Stress testing of loan portfolios and liquidity sources that yield positive results will benefit those facing regulatory pressures. For others, however, such testing likely will exacerbate regulatory presumptions of a financial institution’s problems.  

The CAP stress test considers the following:

  • the impact on earnings and capital from economic conditions, including future economic conditions,
  • concentrations of credit and asset quality issues,
  • declines in asset and collateral values,
  • off-balance-sheet and other contingencies,
  • the quality of capital,
  • other available sources of capital, and  
  • a catch-all for other risks.

Examiners are already asking about stress testing, but appear to be leaning toward an even more aggressive approach to classifications and risk assessment. Banks should, therefore, be prepared to respond to overzealous examiners who may be more likely to classify fully performing loans and to draw other unfavorable conclusions solely on the basis of current economic forecasts (see table of economic indicators at right), such as national declines in real estate values and job losses, without considering other factors that may be particularly relevant to the institution in question.  

Unintended Consequences of Rate Floors  

Most banks have become successful in instituting interest rate floors on floating rate loans. As a result, loan yields are not falling even as deposit costs drop. Consequently, net interest margins are widening. Banks need every dollar of interest income in this environment.  

Notwithstanding the current state of economic affairs, we can pretty much count on inflation continuing over the long run. In a rising-rate environment, interest rate floors yield perverse results. These floors are currently 1 – 3 percent above what the stated rates on the loans would yield. Consequently, as rates rise, borrowers will not pay more on loans. Thus, net interest margins will be squeezed.  

Economic Indicators Used in CAP Stress Tests

Many interest rate shock tests do not reflect this shrinkage in net interest margins. Such tests should be revised to take into account the scenarios in which deposit costs increase while loan yields do not (until rates exceed the loan floors). With the information from these shock tests, bankers may well want to consider some form of adjustable floors that will maintain or minimize the loss of spread. These modified floors should be imposed now when interest rate pressures remain slight. In addition, to maintain these negotiated returns, bankers should consider imposing prepayment penalties. While competition for loans is on the decline, it is a good time for banks to use their leverage in setting credit terms that will ensure a reasonable rate of return for the bank.  

Bank Compensation Programs  

The political hysteria surrounding the AIG and Merrill Lynch bonuses threatens to engulf all financial institutions whether or not they participated in the TARP Capital Purchase Program. At the recent ICBA convention, Federal Reserve Chairman Ben Bernanke called for examiners to pay “close attention” to compensation practices as part of examinations. He said, “poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization.”  

In light of Mr. Bernanke’s statements, White House assertions that the compensation programs of all financial institutions — not just those receiving TARP funds — should be regulated, and Congress’s inclination to grandstand on this issue, it can be expected that the bank regulators will once again include serious compensation reviews in their examinations.  

Since 1991, when Congress adopted the FDIC Improvement Act, bank regulatory agencies were given the authority to regulate bank compensation. In doing so, they measure compensation programs against the following standards:  

A. Excessive Compensation  

Excessive compensation is prohibited as an unsafe and unsound practice. Compensation shall be considered excessive when amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder, considering the following:  

  1. The combined value of all cash and noncash benefits provided to the individual;  
  2. The compensation history of the individual and other individuals with comparable expertise at the institution;  
  3. The financial condition of the institution;  
  4. Comparable compensation practices at comparable institutions, based upon such factors as asset size, geographic location and the complexity of the loan portfolio or other assets;  
  5. For post-employment benefits, the projected total cost and benefit to the institution;  
  6. Any connection between the individual and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the institution; and  
  7. Any other factors the agencies determine to be relevant.  

B. Compensation Leading to Material Financial Loss  

Compensation that could lead to material financial loss to an institution is prohibited as an unsafe and unsound practice. In light of this heightened scrutiny of executive compensation, banks should follow many of the “best practices” that have arisen since the adoption of Sarbanes-Oxley and the SEC’s changes to compensation disclosure requirements, even if the institution is not subject to these requirements. In addition, banks should consider adopting the practices imposed on recipients of TARP funds to support their compensation programs. These include:

  • Adoption of or amendments to policies or the employee handbook to make it clear that the bank expects employees to consider long-term, as well as short-term, risks to the bank in connection with all transactions;
  • As part of the policy, preparation of objectives (what behavior is the bank trying to encourage) and how the bank’s compensation plan seeks to achieve these objectives;
  • Review of all compensation plans to verify that they do not provide incentives to take risks that are not condoned by senior management or the board (the compensation committee should engage in this review annually);
  • Certification/documentation by the compensation committee that it has completed such a review;
  • Reasonable performance goals that do not require excessive risk-taking to achieve them; and
  • A mix of short- and long-term compensation with clawback provisions for long-term payments made that, in retrospect, are not deserved.  

Allowance for Loan and Lease Losses

Most financial institutions do not need prompting to review, and perhaps revise, their general reserve methodologies in recognition of the differences in their recent loss experience as compared with that during previous periods. At a minimum, banks should shorten their typical five-year time frame for reviewing their loss history to not more than a three-year horizon. Even three years may be too long of a period to include in the analysis due to the precipitous changes in the economy in the current period. Clearly, more weight should be placed on the results of the last year or other period from which loan losses started to spike.  

The Interagency Policy Statement on the Allowance for Loan and Lease Losses states that estimates of loan losses should reflect consideration of all significant factors that affect collectability of the portfolio, including the level and trend of nonperforming assets, delinquencies and charge-offs, imprecision of appraisal accuracy, prospective trends in the economy and the possible effect of such trends on commercial real estate and commercial and industrial loans that have not become classified. Banks should assess each factor to determine whether risk is increasing, remains flat or is declining. Even though the bank’s CPA firm has signed off on the bank’s reserves and its methodology, this should not make the loan committee complacent. In the current climate, examiners may require higher allowances, notwithstanding a clean audit.

Enhanced Bank Holding Company Oversight and the “Source of Strength” Doctrine  

On February 24, 2009, the Federal Reserve promulgated a supervisory letter (SR 09-04) that requires Federal Reserve staff to “evaluate the comprehensiveness and effectiveness of management’s capital planning.” Principally, the Federal Reserve intends for holding companies to consider how they will serve as a “source of strength” to their financial institution subsidiaries. Although the statutory underpinnings of the Source of Strength Policy Statement are of questionable validity, the Federal Reserve expects holding companies to husband their resources for their banking subsidiaries over the claims of the holding companies’ creditors and shareholders.  

Holding companies that are developing financial weaknesses or that are at risk of doing so are expected to consult with the Federal Reserve about their condition and plans for addressing any resultant capital needs. Moreover, the Federal Reserve expects a bank holding company to inform the agency reasonably in advance of declaring or paying a dividend that exceeds earnings for the period for which the dividend is being paid or that could result in a material adverse change to the company’s capital structure.  

Specifically, the Federal Reserve believes that dividends, as well as trust preferred debt service distributions and stock repurchases and redemptions, should be limited or eliminated if:  

  • The company’s net income for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends;
  • the company’s prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or
  • the company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios.  

Failure to maintain a capital position that matches the holding company’s overall risk could result in a supervisory finding that the organization is operating in an unsafe and unsound manner. The result, at a minimum, will be a suspension of dividends (including dividends on TARP securities) as well as payments on trust preferred securities.  

In line with the foregoing, the Federal Reserve is also requiring that it be furnished with copies of the governance documents of any entity (including a trust) that acquires 10 percent or more of the stock of a bank or bank holding companies. The purpose of this requirement is to provide the Federal Reserve with information to enable it to enforce the Source of Strength Policy Statement with respect to any entity that might be deemed to be a bank holding company.  

Temporary Liquidity Guarantee Program (TGLP) Cautionary Note  

The FDIC has prohibited banks from issuing notes guaranteed under the TLGP if the bank has a less than “satisfactory” rating. For those banks that do issue guaranteed debt, they must record the debt on FDICconnect within five calendar days of issuance. The FDIC takes this obligation very seriously and will consider enforcement action for failure to abide by this requirement.