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A key component of the proposed roadmap for Republican efforts to provide regulatory relief is based on reduced regulatory burdens in exchange for holding higher capital levels.  Specifically, Title I of the proposed Financial Choice Act, as modified by Representative Hensarling’s “Choice Act 2.0 Changes” memo of February 7, 2017, proposes to provide significant regulatory relief for institutions that maintain an average leverage ratio of at least 10 percent.

The principal concepts of this “regulatory off-ramp” have, so far, remained relatively constant since first published by the House Financial Services Committee in June of 2016; any institution that elects to maintain elevated capital ratios (set at a 10% leverage ratio) would enjoy exemptions from the need to comply with certain other bank regulatory requirements.

Choice 2.0

In February 2017, Jeb Hensarling, Chairman of the Financial Services Committee, indicated that the “regulatory off-ramp” included in the proposed 2017 legislation would differ in two critical aspects from the 2016 proposed legislation.

First, the regulatory off-ramp would be based solely on the banking organization’s leverage ratio and would not consider the organization’s composite CAMELS rating.  Originally, the legislation limited eligible institutions to those that possessed a composite two CAMELS rating.  This change eliminates a subjective element to the regulatory off-ramp, but may also highlight that banking regulators would retain a wide array of tools to address institutions with substandard CAMELS ratings, regardless of their capital levels.

Second, any banking organization complying with the regulatory off-ramp requirements would be fully exempt from the stress tests.  As originally proposed, eligible banking organizations would have remained subject to the stress tests, but regulators would have been prevented from limiting dividends based on the results of those stress tests.  While these original benefits were certainly noteworthy, the complete elimination of stress tests proposed by Choice 2.0 could be a material incentive for institutions near the 10% leverage mark to increase their capital.

Potential Scope

Following the financial crisis and building capital levels to address stress tests and regulatory and investor expectations, the industry as a whole is currently very well capitalized.  To that end, a significant number of financial institutions, at all sizes, would appear to be in position to take advantage of the regulatory off-ramp.

Based on rough back of the envelope calculations, as of December 31, 2016, approximately half of institutions over $50 billion had leverage ratios at or above 10 percent, a third of institutions between $10 billion and $50 billion met the standard, half of institutions between $1 billion and $10 billion met the standard, and almost two-thirds of institutions under $1 billion met the standard.

Recognizing that some of the institutions that currently meet the standard may prefer to return some “excess” capital to their shareholders and enjoy greater returns on equity by shrinking their equity base, I believe the current levels of capitalization demonstrate that there will be significant interest in the regulatory off-ramp if the 10% leverage ratio standard is maintained.

What Burdens does the Off-Ramp Provide?

Many, but certainly not all, of the regulatory burdens lifted by the proposed regulatory off-ramp focus on the larger institutions.  Eligible institutions would be exempt from formal stress test requirements, living wills, liquidity coverage ratios (LCR’s), and total loss absorbing capital (TLAC).  In addition, mergers that result in a banking organization that maintains a 10 percent leverage ratio would be exempt from regulatory review for the impact on the stability of the US banking or financial system and deposit concentration limitations.  These provisions are likely to be beneficial to the industry as a whole, but unlikely to directly affect most community banks.

However, a number of proposed benefits may be of significant interest to community banks.

The proposed legislation provides that qualifying banks shall be exempt from any Federal law, rule, or regulation addressing capital or liquidity requirements or standards.  This should include all risk-based capital requirements, although calculation and publication of such ratios might still be required in Call Reports.  It arguably should also include CRE concentration guidance, as these largely function as constraints based on capital levels.

In addition, the legislation provides that qualifying banks shall be exempt from any Federal law, rule, or regulation that permits an appropriate Federal banking agency to object to a capital distribution.  This could effectively eliminate longstanding laws, regulation and guidance regarding the expectation that dividends only be made out of current earnings and significantly restricted upon the first sign of stress.  This provision could be of significant interest to Sub S banks, where the ability to make tax distributions is a fundamental part of the investment thesis.

Open Questions

Impact on Guidance on Enforcement Actions.  In addition to general questions as to how the banking agencies will interpret the regulatory off-ramp exemptions, the banking agencies will also need to address whether (and to what extent) these longstanding principles and guidance regarding capital and liquidity will continue to impact CAMELS ratings and the extent to which, notwithstanding compliance with the off-ramp’s 10 percent leverage ratio, an eligible bank may find itself in position to consent to regulatory restrictions on capital distributions or otherwise requiring elevated capital levels.

Interplay of Small Bank Holding Company Policy Statement and Off-Ramp.  As proposed, the Choice Act requires institutions to meet the 10% leverage test at the bank and, if present, holding company level.  The Choice Act also proposes to increase the threshold for eligibility under the Small Bank Holding Company Policy Statement from $1 billion to $5 billion.  Presumably, these provisions should be read together to permit institutions under $5 billion to meet the off-ramp’s leverage standard solely at the bank level.  Otherwise, institutions under $5 billion may be in position of needing to decide which form of regulatory relief is preferable for their institution.

Trickle-Down to States.  As federal legislation, the Choice Act would impact all holding companies, but only national banks.  State banks would be relieved from capital requirements imposed by federal laws, but any existing restrictions on capital distributions found in state laws would, on their face, continue to apply.  State regulators and legislators may need to react quickly to ensure parity amongst state and national banks electing the regulatory off-ramp.