Many strategists dismissed the newly-final community bank leverage ratio (CBLR) as an interesting earnings boost for small banks with no structural impact.  We disagree.  Our analysis of the new standard points to the leverage ratio’s benefit to non-traditional charters, including those many fintechs and nonbanks now seek at the FDIC.  Proving the point, the American Banker on Thursday highlighted a brand-new industrial loan company (ILC) application adroitly leveraging the CBLR for a new insured-depository business model with considerable competitive potential.

Since the great financial crisis, U.S. and global regulators have adamantly defended the need for a double-barreled capital regime consisting of both risk-based and leverage capital standards.  As we noted in an in-depth 2016 assessment of the new regime, this works well unless the leverage ratio (LR) becomes the binding constraint.  When it trumps risk-based capital (RBC), significant incentives for risk arbitrage result because the sum total of capital standards are unduly costly to low-risk assets such as Treasury obligations and too lax for many high-risk assets.  The banking agencies recognize this danger, with the realignment of the enhanced supplementary leverage ratio and their first crack at a “stress capital buffer” aimed at realigning large-bank regulatory capital to ensure RBC’s supremacy.

The agencies were wary of the CBLR for these reasons, but forced into it by a provision in the 2018 banking law.  The final rule largely rejected smaller-bank efforts to ease the CBLR, retaining the nine percent ratio and most other provisions in order to prevent the new ratio from lowering capital totals at affected banks.  As our report makes clear, the same RBC number can result in a very different LR-fueled asset reallocation, but the agencies take comfort in numbers and thus ensured that the numbers worked at the community banks they know and love.

What happens at new-style banking organizations with assets below $10 billion but non-traditional business models?  Most of these wannabe-ILCs are looking at insured depositories as low-cost funding vehicles for parent operations and/or as havens for value-add products such as retail brokerage, small-business lending, or merchant processing. 

Some prospective charters plan to keep any capital-intensive activities in the parent company, but many now are sure to reconsider whether and how much of their parent-company business they can house in an insured depository to avoid limits on upstreaming funds, discounting services, and on other ILC activities. 

Compared to risk-based rules, the nine percent LR or even the ten percent one pledged by the new broker bank are bare minimums for higher-risk lending such as cash-flow underwritten small business loans.  Since fee-based businesses (brokerage) and operational risks (e.g., payment processing) are wholly outside the LR, non-traditional banks could be home free.

There is nothing in the CBLR final rule that warns non-traditional banks off this new capital ratio if they remain within size and minimal activity constraints.  The agencies do retain the right to deny the CBLR to any charter that gives them the willies and to permit the CBLR only on pain of operational-risk capital buffers or other business-model appropriate safeguards.  Given the critical importance of capital to competitiveness, how or if they will do this is among the most important questions redefining the new U.S. financial construct.