The financial crisis of 2008/2009 has focused community banking on capital. As regulators continue to pound on community banks to have a capital plan, institutions are still grappling with the new expectations and requirements. This is the perfect opportunity to go beyond compliance and create strategic thought and discussion.
Careful Assessment
Certainly, over this time period, many banks have been dealing with the effects of loan and investment losses on capital adequacy. Even “healthy” banks questioned their capital adequacy in meeting the continued stresses of the economy. As recovery comes closer and closer to the economy and your institution, concern continues to grow for what the future will bring to capital requirements.
The answer begins with a careful assessment of where the institution is currently and how the bank performed throughout the past two years. This assessment should be more than capital and earnings based. It should also assess the bank’s risk profile for capital risk, credit risk, earnings at risk, liquidity risk, and overall risk. Based on this risk assessment, did the bank have adequate capital?
Modeling
The next piece of the puzzle is pushing the capital planning into the future. Modeling is an important component of this. By modeling the current budget out five and 10 years, an assessment can be made as to whether the institution has an adequate capital base to meet future needs.
The modeling process cannot be based solely on future bank growth. While growth is important, it is essential to include the mix of assets and liabilities and their inherent risk into the projection. The best practice is to use this modeling to produce many key ratios in addition to Tier 1 and risk-based capital. Based on the projections, the management team should also model the impact of changing interest rates on capital and a credit shock on capital.
Proactive Planning
With this information, the management team can facilitate the board through a discussion of capital adequacy, growth, and risk. The outcome should be on whether capital needs to be increased and the manner in which the institution will accomplish this. This will represent a key component of the contingency plan to raise capital and satisfy the necessary regulatory capital documentation.
The key to capital planning is going beyond short-term compliance. The exercise is successful when a proactive capital plan is developed and based on positive and dynamic communication between the board and the management team. Then, and only then, can the question of sufficient capital adequacy be answered and achieved.