How Federal Regulators Can Avoid Penalizing Community Banks for Economic Measures Taken During the COVID-19 Pandemic

Oct. 19, 2022

The consequences of uncoordinated regulatory standards at the federal level are creating an artificial problem at the local level, potentially endangering many community banks’ ability to lend to local customers.

With the Federal Reserve’s aggressive and rapid interest rate hikes shrinking bond prices and affecting many community banks’ capital levels, the Federal Housing Finance Agency’s policy on tangible capital—which is inconsistent with all other federal banking regulators—will limit access to Federal Home Loan Bank advances and threaten to transform a short-term market fluke into a full-fledged problem.

In response, ICBA and state community banking associations have called on the FHFA to align its tangible capital rule with the banking agencies, which would avoid punishing community banks with bond holdings and allow capital levels to be restored alongside the normalization of the bond market. In other words, regulators shouldn’t create an issue by creating an issue.

Historical Background

Some historical context is needed. During the early days of the COVID-19 pandemic, prudential regulators asked banks to refrain from taking certain actions otherwise dictated by rule or governing policies, such as staying foreclosure proceedings, offering loan forbearance, and waiving late fees.

As they always do so well during times of challenge, community banks responded to the pandemic and were there for their customers and communities. Community banks adhered to protectionary measures while leading Paycheck Protection Program lending to small businesses.

During this period, the Federal Reserve maintained low interest rates while most banks were flush with deposits and excess liquidity due to the high levels of emergency stimulus payments to Americans. As consistently prudent lenders, many community banks took the safest and soundest action possible and invested much of the excess liquidity in low-risk U.S. Treasuries, agency mortgage-backed securities, and municipal securities.

Fast forward to the third quarter of 2022, and there is a very different landscape taking shape. While economic indicators such as jobs numbers, consumer confidence, and spending have largely improved, the Fed is rapidly raising interest rates to curb high inflation. In fact, the Fed is hiking rates at a pace not seen in more than 40 years.

As a result, the excess liquidity that banks conservatively invested in is now experiencing the most significant losses and worst year of performance in modern history. Fortunately for investors, these are “paper losses”—bond investors can sit tight and ride out the interest rate storm while the bond market normalizes and values rebound on these tried-and-true investments.

In 2015, the federal banking regulators allowed most banks to opt out of including accumulated and other comprehensive income, or AOCI, as part of their Basel III capital calculations, realizing that these fluctuations would not pose an undue risk to community banks. However, the FHFA never adopted this change in its capital calculations.

Regulatory Mismatch and Supervision Challenges

The FHFA inherited a mark-to-market accounting standard adopted by the Federal Housing Finance Board in 1994 that requires banks to count unrealized losses—that is, losses that have not been realized—in capital calculations to receive Federal Home Loan Bank advances.

The FHFA regulation was originally established to be consistent with the definition established by the FDIC in its final rulemaking on prompt corrective action. But while the FDIC updated its capital regulations in 2015 as part of the adoption of Basel III, the FHFA did not—creating a consequential disparity in capital treatment.

These regulatory disparities now threaten to impose supervisory challenges for community banks preparing third-quarter call reports. While common-sense banking regulations dictate that banks do not need to recognize a loss until bonds are sold, the divergent FHFA regulations bar member banks that cannot meet their tangible capital requirements from accessing FHLB advances unless their primary regulator requests in writing that the advance be made.

With FHLB advances providing a consistent stream of contingent liquidity for banks across the nation, these regulatory restrictions threaten to impose long-term consequences on banks for a short-term problem.

ICBA’s Call to Action

Given the potential consequences of the FHFA’s rules, ICBA is calling on the agency to update its standard to match federal banking regulator capital requirements.

The FHFA could promptly issue an interim final rule, effective immediately, with a 30-day request for public comment. Alternatively, the FHLBs could file a request to change the FHFA’s definition of tangible capital to that of member banks’ primary regulator.

In the interim, the federal banking agencies should ensure that any issues with FHLB advances due to mark-to-market accounting receive an exception. Regulators must exercise restraint when examining otherwise safe, sound, and adequately capitalized institutions.

The financial regulators have the power and obligation to fully mitigate the consequences of the federal response to the pandemic and its economic consequences. Just like the regulators took swift action and worked with community banks to respond to the pandemic, they can now ensure that these same institutions are not penalized as a result.