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Part 2 of 4: Capital Assessment and Stress: Preparing for an Unprecedented Future

In Part 1 of 4 of our miniseries, we covered specific challenges relating to liquidity during the Coronavirus pandemic.  We discussed the importance of monitoring changes in the loan and deposit portfolios, a comprehensive contingency funding plan, and the importance of a robust stress test. 

We now turn our attention to capital, which serves as the cornerstone for all balance sheets: supporting growth, absorbing losses, and providing a resource for seizing opportunities, or as a last line of defense.  We find ourselves in a time of unprecedented uncertainty, as the impacts from mass business closures and record unemployment ripple through the economy.   The following considerations are key to assessing the current and future adequacy of your capital base:

  • Credit Quality Deterioration – The depth and severity of cash flow interruption could lead to an expansion in non-performing assets, ultimately increasing provision expense.
  • Margin Compression – With the yield curve down 200bps, asset sensitive banks could likely see a reduction in net interest income when it is needed most to offset increased loss reserves.
  • Asset Growth – Increased loan fundings, customer draws on credit lines, and slower loan amortization may lead to larger balance sheets if the stay-at-home orders persist, or are reinstated later in ‘20-‘21.
  • SBA PPP Loans – Many financial institutions are looking to get involved with the SBA’s PPP Loan program, which is a rapidly evolving process.  Taking advantage of the Federal Reserve’s PPP Loan Facility can help you manage the funding and leverage implications of these loans.

Taylor Advisors’ Take:   Institutions that have a sound capital policy, contingency capital plan, and perform periodic stress testing should be confident in their ability to weather a prolonged period of stress.  Knowing the ‘breaking points’ for your capital base in terms of growth, credit deterioration and a combination of these factors will serve your institution well.  If your stress testing results project risk to your ‘well capitalized’ status, it is important to understand the ramifications this can have on your liquidity and access to various funding sources.

There is good news! Regulatory agencies have updated guidance providing regulatory relief in several areas, such as treatment of loans impacted by the coronavirus, lowering Community Bank Leverage Ratio requirements, favorable treatment for PPP loans, among other measures.  These should eventually phase out, which is why it is critical that we stress test and prepare for the possibility of a prolonged credit cycle. For example, consider the impact of just several changes below to your customer base:

  • Business may realize new efficiencies if they can accomplish more with less during this time
  • The success of telework may impact office space demand going forward
  • Appetite for business and leisure travel may lessen for a prolonged period of time

What if next time the industry experiences credit challenges, we see stress that is worse than the sub-prime debt crisis?  Does your institution have the policies, stress testing and contingency plans in place to navigate this environment?

Taylor Advisors helps executives by providing strategies and tools to effectively stress test and manage capital.  Here are additional resources if you would like to read a capital success story or ask us a question about your capital process and how we might be of some help.

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