Capital and commercial real estate exposure are top of mind for federal bank regulators as they scrutinize banks more harshly during exams.

Still reeling from the sudden regional bank failures in March 2023, federal banking regulators are ensuring they dot their i's and cross their t's to avoid any more failures, bank advisers said on a panel about the regulatory environment at S&P Global Market Intelligence's Community Bankers Conference. As such, regulators are upping the ante in exams and acting much faster to downgrade banks' regulatory ratings and hand out both confidential and public orders, the advisers said.

There is "a lot less patience from regulators in general," said Jonathan Hightower, partner at Fenimore Kay Harrison LLP.

The lawyer gave an example of a client underperforming in earnings. In the bank's last exam, regulators expressed their unhappiness with earnings, downgraded the bank's CAMELS rating and put it under a memorandum of understanding (MOU), an informal agreement used by regulators to ask banks to correct problems.

"I really think there would have been a lot more patience 18 months ago," Hightower said.

The example is indicative of a broader trend in which regulators react much more quickly to any concerns they may have, handing out traffic tickets like MOUs, matters requiring attention (MRAs), matters requiring immediate attention (MRIAs) and downgrading CAMELS ratings instead of giving out warnings, said Kevin Stein, managing director of Klaros Capital at Klaros Group. A bank's CAMELS rating measures its capital adequacy, asset quality, management, earnings, liquidity and sensitivity on a scale of 1 to 5, with 5 being the worst.

Obtaining a 1 rating on any component or overall is much harder to achieve since the failures, Hightower said. "If you are a 1-rated bank, maybe don't make that your identity … because that can change," he said.

Regulators are also handing out more MRAs and MRIAs and giving banks much less time to clean up the issues addressed in those than they did before the failures, Stein said. That dynamic has led to the recent uptick in enforcement actions, a trend that will continue this year and into 2025, he said.

Capital and liquidity

Regulators are very focused on bank's capital levels and liquidity, the advisers said, zeroing in on metrics like the common equity Tier 1 (CET1) and tangible common equity (TCE).

"It's really important for you to be able to articulate to a regulator, 'Yes, we're a small community bank ... but we understand the implications of where we are from a TCE standpoint, what that would mean for our capital plan if we had to go out and raise capital,'" Hightower said. "Now, again, some of you probably never have any intention of taking on new investors as long as the bank exists, but you still have to be able to talk about it."

Regulators are particularly focused on capital when it comes to mergers and acquisitions, which is why we have seen an uptick in capital raises in conjunction with deal announcements in recent deals such as FirstSun Capital Bancorp and HomeStreet Inc.'s tie-up, and UMB Financial Corp. and Heartland Financial USA Inc.'s merger.

Regulators do not want to see day one hits to capital metrics after a deal closes, even if the buyer will earn that dilution back in short order.

"Now what regulators are saying is essentially, 'What your CET1 was before the transaction, you need to have that same level of capital on day one,' which means that many transactions today are going to need additional capital," Stein said.

Liquidity and interest rate risk management are also top of mind for regulators after the collapses of Silicon Valley Bank and Signature Bank last spring. During exams, regulators want banks to show they have diverse contingent liquidity options and provide lots of detail on their deposit base, such as geography, customer type and duration, said Josh Siegel, managing partner, chairman and CEO of Stonecastle Partners.

"Have the dialogue, 'Here's what we're doing to diversify funding sources. Are you seeing any best practices elsewhere you think we should institute?' Make that a dialogue and that will alleviate some of their concern," Siegel said.

CRE

Initiating dialogue about your bank's CRE portfolio is also crucial for community banks in upcoming exams, the advisers said. Regulators are trying to get ahead of potential capital and commercial real estate (CRE) stress after feeling like they dropped the ball on being proactive about the factors that led to Silicon Valley and Signature Bank's demise, Stein said.

But in doing so, they are scrutinizing CRE harshly and painting all banks' portfolios with the same brush, rather than digging into them and identifying the different aspects that could make a bank's CRE exposure less worrisome, both Stein and Hightower said.

"Regulators just see anything over 300% risk based capital generally as bad," Stein said.

Community banks should come armed with detailed data and presentations on their CRE books, pointing to aspects such as owner versus non-owner occupied, geographic makeup and property type, Siegel said. Banks should also conduct stress tests on the portfolios, according to Stein, and bring data going back 20 years to show how the bank's credit quality has held up through various cycles, since examiners usually focus on just the last few quarters, Seigel said.

Those aspects "really sell your story to them as to why they should worry less ... about you versus the bank industry," Siegel said.

"You need to be prepared to change the direction of what's likely to start as a difficult conversation," Hightower added.

The advisers said regulators are asking banks to hold more capital and increase their reserves against their CRE books. The agencies are also asking some banks to diversify away from CRE, but that could pose a risk for community banks whose bread and butter is CRE.

Diversifying into another lending segment such as commercial and industrial without proper sophistication and talent could prove detrimental for a bank, Hightower said. The lawyer suggested that community banks pluck experienced teams from other banks if they are told to diversify.

Another focus that is top of mind for regulators is governance, particularly for community banks that may have their protocol informally in place but not formally documented.

"The beauty of a community bank is the key decision-makers are right down the hall or a phone call away, that's just not going to cut it for examiners at this point. They want to see it in writing," Hightower said.