Saturday, July 28, 2018

For Financial Institutions, Is There Such A Thing As Too Much Capital? Yes. Yes There Is.

I was on a panel at a bankers conference with an investment banker and two bank fund investors. One of the investors' opening remarks was about banks that were over-capitalized. I panned the audience to see if regulators were present.

But there were enough open jaw gapes to see that many bankers share the regulatory belief that there is no such thing as too much capital. And that may be true for financial institutions that don't take investor money. But if your bank is shareholder owned, then you may be hoarding their money. And as a bank shareholder myself, I like to make my own hoarding decisions.

I have written on these pages about a method to estimate your "well capitalized", a question your regulators may have asked you. Having done this, and seeing that your strategic plan has you comfortably above your well capitalized and trending higher, what do you do with the excess capital?

Derek McGee of Austin law firm Fenimore, Kay, Harrison, and Ford had four to-the-point ideas in a recent Bank Director Magazine article. I would like to lay out his four ideas with my take on them.

1. Dividends. "Returning excess capital to shareholders through enhanced dividend payouts increases the current income stream provided to shareholders and is often a well-received option. However, in evaluating the appropriate level of dividends, including whether to commence paying or increase dividends, banks should be aware of two potential issues. First, an increase in dividends is often difficult to reverse, as shareholders generally begin to plan for the income stream associated with the enhanced dividend payout. Second, the payment of dividends does not provide liquidity to those shareholders looking for an exit. Accordingly, dividends, while representing an efficient option for deploying excess capital, presents other considerations that should be evaluated in the context of a bank's strategic planning." 

My take: Amen Derek! In a blog post this year, Bank Dividends: Go Ahead and Drink the Kool Aid, I called for the same thing. And to use special dividends and deliberate shareholder communications to help overcome shareholder expectations mentioned above. I have not experienced a bank that made the pivot from being a growth company to a cash cow, where profits are maximized and dividends are plentiful. It is a natural evolution of a company built to endure. 

2. Stock Repurchases. "Stock repurchases, whether through a tender offer, stock repurchase plan or other discretionary stock repurchase, enhance liquidity of investment for selling shareholders, while creating value for non-selling shareholders by increasing their stake in the bank. Following a stock repurchase, bank earnings are spread over a smaller shareholder base, which increases earnings per share and the value of each share. Stock purchases can be a highly effective use of excess capital, particularly where the bank believes its stock is undervalued. Because repurchases can be conducted through a number of vehicles, a bank may balance its desire to effectively deploy a targeted amount of excess capital against its need to maintain operational flexibility."

My take: Institutional shareholders own greater than two thirds of publicly traded financial institutions' shares outstanding. And share buybacks are a favorite of theirs. The challenge is that they would like to liquidate their ownership when the value is at its peak. Meaning the financial institution purchasing its shares would likely enjoy minimal earnings accretion and create book value dilution. But, as Derek pointed out, it is a highly effective use of excess capital when the bank believes it is undervalued. One bank stock analyst thinks every bank should calculate the earnings accretion of a prospective merger versus the earnings accretion of a share buyback. If the buyback is more accretive, why do a riskier merger?

3. De Novo Expansion in Vibrant Markets. "Banks can also reinvest excess capital through organic expansion into new markets through de novo branching and the acquisition of key deposit or loan officers."

My take: When a race car enters the pits, it is losing time. If not to recalibrate, refuel, and re-tire, drivers wouldn't do it. If you compare bank strategy to a 500-mile race, banks would also enter the pits. But if you compare bank strategy to a few times around the track, you would be foolish to do so. Think of the short race as budgets, and the 500-miler as strategy. You have to be willing to accept the short-term setback of entering the pits (i.e. making strategic investments like Derek mentioned) to position you to win the race. 

4. Mergers & Acquisitions. "Banks can deploy excess capital to jumpstart growth through merger and acquisition opportunities. In general, size and scale boost profitability metrics and enhance earnings growth, and mergers and acquisitions can be an efficient mechanism to generate size and scale. Any successful acquisition must be complementary from a strategic standpoint, as well as from a culture perspective."

My take: Derek's "complementary" comment was right on. Listen to my firm's most recent podcast on M&A cultural integration featuring an interview with Jim Vaccaro, Chairman and CEO of Manasquan Bank, that is in the process of merger integration as I type. In addition to a cultural fit, the geography and balance sheets should be complementary, and the earnings accretion should exceed what the buying institution could achieve on its own. Tangible book value dilution, which tends to get a lot of play in the investment media, should not be to the level to cause long-term downward pressure on the buyer's stock price. 

Out of the four, M&A is the least within the control of the financial institution, as this takes a willing partner.

What other uses of excess capital do you propose? 

~ Jeff


  1. Great post! I wish all the banks that hoard too much capital read this article. I like it when banks repurchase or return capital when the growth opportunities are not that good.

  2. Thank you!

    Not many banks think they hoard capital. But feel they need it for a rainy day fund. And regulators are happy when a bank's coffers are full of capital. So some banks may need gentle nudging to return some of the capital when growth won't put it to work.

    Thank's again for reading and the comment!

  3. The other major one I can think of off the top of my head is to pay down excess debt (be it holdco debt to finance trust preferred, expansion debt, etc). Though it would seem like it would be smart for a lot of banks to pursue stock repurchase stock (especially when publicly traded and their stock is at something less than common industry multiples of BV; though it may be a bit more difficult if they are non-public, but then, issuing or buying stock in a non-public entity is a whole legal can of worms as well, especially if you are management).

    While writing this, I did consider if it should be spent on branding or advertising. Though, I'm not sure if that is the best use, given that a lot of banking services are a commodity base, as well as branding is very hard to measure.

    1. Dave, you are on to something here. Which strategy is more accretive to eps, or bv, depending on how the stock is valued (on earnings or book). And I would do the math on long-term accretion, because strategic investments rarely compares to a buyback, debt buy down, or enhanced dividend in a short time period.

      Thank you for the comment!

      ~ Jeff