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  • Writer's pictureJohn Demeritt

The Capital Conundrum

The Capital Conundrum

Capital | Credit

The onset of the pandemic and economic shutdown brought fear to the industry. Credit losses appeared imminent for many financial institutions. However, it became clear through 2020 that extraordinary government intervention would not only prevent the economy from deteriorating further but also result in a faster recovery than many had anticipated. On average, credit conditions improved.

Now the industry is presented with a new set of capital challenges. Fiscal and monetary policy have contributed to tremendous balance sheet growth, earnings pressures, lower capital ratios, increased credit uncertainty, and concentration risk. Capital planning has evolved into one of the most critical risk management practices to help financial institutions understand how various economic environments, and expectations for growth, earnings, and capital distribution, can impact capital buffers and strategic planning. Capital planning and sensitivity testing are helping management teams deal with the greatest risk everyone is talking about: uncertainty.

The following are 5 reasons why capital forecasting is a critical exercise.

1. Capital Initiatives

  • How much capital do we have?

  • How much capital do we need?

The answers to these questions will impact the decisions you make regarding allocating capital. Dividend distribution strategies, whether through stock dividends or paid back to members in the form of lower loan rates or higher deposit rates, will require an understanding of how growth, earnings, and potential losses are expected to impact capital over time.

Discussions on subordinated debt issuance and other potential capital raises have become more and more frequent. The lack of a clear understanding of how capital is expected to trend with model assumptions that are quantifiable and supportable could put you in a vulnerable position. A dynamic and comprehensive pro-forma capital simulation will minimize the potentially costly error of raising unnecessary capital or put you in a position of excessive risk if capital buffers are too tight.

Having the flexibility to quickly assess how different combinations of conditions (e.g. economic, growth, earnings, losses) will impact capital provides comfort in moving forward with strategy.

2. Loan Concentration Risk

Loan concentration risk has been a bubbling regulatory topic. In working with clients to defend concentration levels, DCG starts by understanding how the existing loan concentration limits were formulated. We often find the limits are arbitrary or were established years prior. The lack of support for concentration limits can have a material impact on income generation (i.e. opportunity cost of unnecessarily maintaining low limits) and the ability of the institution to withstand potential losses.

A recent client exam had a formal comment that credit loss modeling results were not incorporated into the capital, earnings, or ALLL processes. These findings are becoming more commonplace, especially considering there has been an increase in banks that have exceeded the regulatory references guidelines for commercial real estate concentrations over the past couple of quarters.

Quantitatively defending concentration levels through pro-forma capital modeling will calm the fears of stakeholders and potentially provide support for higher concentration levels, providing a competitive advantage in your market.

3. Industry Growth Trends

Community banks and credit unions have experienced tremendous growth since 2019, spurred by the low interest rate environment and government stimulus programs. The trends have contributed to approximately a 1% decline in Tier 1 Leverage and Net Worth Ratios across the industry.

The concern today is how much more growth capital can support before buffers tighten enough to put the institution at risk if credit issues begin to mount. It is equally important to measure how a shift from cash/investments to loans will impact risk-based capital ratios. For those of you who are expecting robust loan growth in 2022, the opportunity cost of slowing growth due to perceived capital constraints could be the difference in maintaining/increasing earnings moving forward.

4. Earnings Pressure

As the title of a recent S&P Global article stated, “U.S. bank margins continue to take a beating.” The good news is, earnings at community institutions remained strong in 2020 and thus far in 2021. Earnings trends have helped to minimize the decline in leverage capital ratios in the industry; however, they are also elevated in large part by spread and fee income generated on loans originated under the Paycheck Protection Program (PPP) and through mortgage refinancing activity. Earnings pressure is inevitable with fee income expected to decline, and a low rate environment that is expected to persist. The challenge is to understand what investment and/or loan growth would be required at current yields to maintain the current level of earnings. Do your capital buffers support the level of growth required? What if deposit growth continues to outpace loan growth? What if earnings are less than expected and the balance sheet continues to grow? What if unanticipated credit issues begin to materialize? Forward-looking capital simulations that incorporate a variety of potential outcomes are crucial to understanding if your current strategy is prudent for your institution.

5. Credit Uncertainty

While credit concerns for many have faded over the past year, the potential for credit deterioration is still elevated relative to pre-COVID expectations. The expiration of government programs such as Federal pandemic unemployment benefits, the moratorium on evictions, mortgage forbearance, and stimulus checks, along with the easing of underwriting standards and inflation of real estate values, all present credit risk uncertainty. DCG’s web-based Credit Risk and Capital Simulator solution quantifies potential forward-looking credit losses under various economic environments and the impact to capital over time, which has proven to relieve the fear of the unknown and provide comfort with capital management decisions.

Exhibit 1: DCG web-based Capital Simulator

DCG web-based Capital Simulator

Concluding Comments

Capital planning is no longer just a regulatory exercise. Defend your balance sheet strategies, portfolio initiatives, elevated concentrations, or additional capital required for your growth plan as you prepare for more uncertainty ahead.


Learn more about capital planning.



John Demeritt is a Managing Director at Darling Consulting Group working directly with senior management teams in capital planning and credit risk management initiatives. DCG’s web-based Credit Risk and Capital Simulator provides credit risk assessments through a multitude of macroeconomic scenarios and allows customizable and instantaneous capital ratio forecasting on growth plans.


© 2021 Darling Consulting Group, Inc.

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