Bottom-Up Capital Calculations

Ten years ago I wrote What's Your Well-Capitalized on these pages. It was in response to regulators persistently asking bankers the same question. Today, we have not done much about it because we have relied on that lazy space using the regulatory definition of well capitalized. Or at least regulatory expectation of it.

I recently spoke at the American Bankers' Association Conference for Community Bankers regarding risk appetite statements in a presentation called Leave Nothing Unspoken. Drop me your e-mail if you would like me to send the presentation. One slide, however, dealt with this very issue of "what's your well-capitalized." Because developing your risk guardrails for executing strategy, which is what a risk appetite statement should be, is far less effective if you don't build the culture and accountabilities throughout the organization to be consistent with your risk appetite.

Exhibit number 1 is a bank whose main incentive for lenders is volume. This creates the incentive to do deals based on size, regardless of structure, duration or rate. What does it matter if the lender does a thinly priced $4 million, 7-year commercial real estate deal with a 25-year amortization and lite covenants or a fairly priced, 5-year deal with standard covenants? If their goal is $20 million of annual production, they are 20% there regardless. Right? 

In comes risk adjusted return on capital, or RAROC. Most loan pricing tools use an ROE hurdle rate to determine what the rate should be. Aside from proper use of these tools and any manipulating that might go on to get deals done, the goal is a good one. Assign capital to a pending loan deal based on risk to the institution. Like the slide I showed to attendees at the ABA conference.

These capital allocation tables should be done in advance, be simple and understandable, and be transparent to all that use them. I imagine a small risk committee that develops these lookup tables and assigns capital to every balance sheet item. And for many categories, such as loans and investment securities, which carry the most risk to a financial institution, have necessary granularity so a 5-rated, 5-year and 20-year amortizing commercial real estate loan gets a lower capital allocation than a 6-rated, 7-year deal. Now the lender has to seek a better yield to get the same RAROC. And perhaps the ROE for the riskier deal is also higher. Further aligning risk versus reward.

Other major asset categories such as "Cash & Due", "buildings", and "BOLI" can be assigned capital at the balance sheet level, such as "buildings" receive a capital buffer of 1%. Naysayers might argue that a building is a 100% risk-weighted, and therefore needs to carry 10% capital (5% well capitalized under the Leverage Ratio, plus a 5% buffer). But that assumes, as prompt corrective action capital requirements must assume, that liabilities do not have risk.

Ask former Silicon Valley Bank executives if that is true.

For sure there is no 5% Leverage Ratio requirement for liabilities, but buffers should also be assigned to them based on the bank's perceived risk of those liabilities. Deposits and borrowings (i.e. the bank's funding) should create greater granularity based on product and product characteristics and the attendant risk of the instrument, much like loans and investments. 

Some may say that the above model is overly simplistic. I'm a simple man. And there is beauty in simplicity. No matter how complex a model you make, it will be some form of wrong as it stands the test of time. Being simply off is far better than building a highly complex black box to be as off, or even a little less off, than a simple one. Because users of the information will be less motivated to adhere to it if they don't understand how it was made.

This, in my opinion, should be done to identify what is your well capitalized. Because you have evaluated risk by balance sheet category and assigned capital based on risk. You can then determine if you have enough capital to support your current balance sheet and your strategically projected balance sheet. You know what buffer you have to withstand stress events.

If your strategic plan calls for a 15% ROE, now you can create a threshold by loan type for lenders to pursue and fairly price to be consistent with your strategy goal and risk appetite. Plus you would create the cultural discipline to manage risk from your first line of defense, the front line.

As I told attendees to my presentation, all banks should do this.

Do you?

~ Jeff

For Financial Institutions, What Drives Value?

Not all financial institutions are publicly traded. But there are enough of them to help those that do not trade to measure what metrics drive the value of their franchise. 

So what metrics drive value? Umrai Gill, Managing Director of Performance Trust in Chicago presented his findings to the Financial Managers Society at their East Coast Regional Conference this month. Some results were surprising.

He first cited a survey performed by PT, asking their clients "what are the generally accepted drivers of institutional value?" Without identifying ranking or more details about their survey, the preponderance of responses were as follows, in no particular order: loan-to-deposit ratio, investment portfolio size, net interest margin, efficiency ratio, return on average assets (ROAA), return on average tangible equity (ROATE), capitalization, and asset size. 

Some were not very interesting to me, such as investment portfolio size, which might have been influenced by PT's specialty. Others might have been too investment community-like, such as ROATE, which doesn't count high premiums bank buyers pay for bank sellers that results in goodwill on the buyers' books, which is deducted from their regulatory capital. But others struck my curiosity to see if there were correlations between the metric and market valuations. 

And I thought I would share with my readers.The charts in the slides below was PT's analysis of data from S&P Global Market Intelligence based on June 30, 2018 financial information using market data from 08/17/18.

First, the metrics that showed correlation to price to tangible book values. Not surprising, in my opinion.

Asset Size

Efficiency Ratio

Profitability / ROAA

Next, the ratio that did not show a correlation to price to tangible book multiples, at least not over 3.5%. I was a little surprised at this one.

Net Interest Margin

Lastly, and most interesting from my point of view, were ratios that showed mixed results. In other words, they showed positive correlation to price-to-tangible book ratios, up to a point. After which, they showed a correlation, but not what bankers would hope for.

Tangible Common Equity / Tangible Assets

Loan-to-Deposit Ratio

The highest market multiples were afforded to banks with a 70%-80% loan to deposit ratio. Now that may be related to size of institution, as the very largest, JPMorgan Chase (67% loan/deposit ratio) and Wells Fargo (76%) tend to have lower ratios. But there is likely something to the fact that a bank that still has strong liquidity as represented by a relatively lower loan-to-deposit ratio in a good economy has room to improve earnings by growing loans faster than deposits. While the less liquid must price up their deposits to get funding.

And capital, well, I refer you to a prior post where I clearly stated there was such a thing as too much capital. Investors will not pay a premium for hoarded capital. Performance Trust's research puts that sweet spot in the 9%-10% tangible common equity / tangible assets range. Enough capital to grow and/or absorb recessionary losses without selling off assets at a discount to bolster capital during hard times.

Where are your sweet spots?


~ Jeff

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