Bankers: Who Has These Three Drivers of Value?

Two years ago bank stock analysts from investment banking firm Boenning & Scattergood identified three attributes in a financial institution that investors should look for. I wrote a blog post on it that is currently my third most read post of all time.

The three attributes were:

1. Superior Growth Prospects

2. Excess Capital

3. Strong Deposit Franchises

I can get behind these three. Can you?

Who Has "It"?

In 2018, I searched for individual financial institutions that met each of these criteria. In this post, I would like to search all publicly traded financial institutions between $1 billion and $10 billion in total assets to ensure I get adequate trading volumes to be able to compare trading multiples of banks that qualify as having these attributes and their financial performance. This resulted in 292 financial institutions (the "Measured Banks").

From there, I defined superior growth prospects as top quartile asset growth over a three year period. I defined excess capital as top quartile tangible equity to assets for the most recent year ended 2019. Strong deposit franchise was defined as top quartile non-interest bearing deposits to total deposits for that same period. 

The following table identifies all of the financial institutions that met at least two of the three criteria.

Is That a Risky Bank Customer?

Customer risk assessments are a fact of life in banking. Banks must determine how a new customer will affect its overall risk profile. Most, in my experience, do it in the form of a Q&A form, to be filed with the rest of the customer paperwork. What I see as papering the file.

But let's think about how it could and should be.

It is prudent to determine the risk profile of a customer and how it will impact your bank. Taken alone, it is highly unlikely one customer will impact the bank in a significant way. But grouped together, customers with similar profiles that act similarly within the economy can elevate risk. Think loan concentrations. As a matter of course we measure loan concentrations by loan type, such as construction or non-owner occupied real estate.

And there are red-flag industries that elevate risk, such as check cashing or marijuana businesses.

I have written about banks determining their own well-capitalized by allocating capital to different balance sheet categories based on the bank's perceived risk of those categories. It is a top down approach. But what if this analysis starts at the most granular level... every customer? And the bank uses its customer risk assessment process to determine the amount of capital allocated to that customer?

If built appropriately, it could be a desktop app the lender, branch, or call center employee could complete in front of the customer. See a sample of what I am talking about in the accompanying table.

Multiply this times every customer and every account and you would be able to calculate the capital required to support your balance sheet from the bottom up.

You can integrate ROE hurdles to feed pricing models in order to meet or exceed the hurdle. You can calculate customer profitability in terms of ROE, and create actionable customer tiers, giving platinum service to top tier, active cross-sell to middle tier, and efficient service to lower tier. And when regulators review your customer risk assessment process, and see that it is integrated into your pricing and profit models, capital plan, and strategic plan, trumpets will sound.

Sure, there will be challenges. I'm no compliance or risk expert so I'm not sure what other risk information should be collected on the customer. And what if Joe's year over year profit picture changes, or reality determines that Joe is bringing in bags of cash twice per week. A well designed system could send ticklers to the relationship officer to revisit the customer risk assessment based on the new information.

A disciplined, yet simple design that is integrated into your systems and processes could yield more accurate capital needs based on the sum total risk by each of the bank's customers. 

Do you think this is how it should be?

~ Jeff

Bankers: What's Your "Well Capitalized"?

Prediction: The Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) and its complementary Dodd-Frank Act Stress Testing (DFAST) will meet its intended purpose, to better ensure financial institutions have sufficient capital during times of economic duress.

But not why you think.

If you look at Citigroup's or BofA's leverage ratio today versus 2006 or 2007, it is clear that they carry far more capital than before the financial crisis. And that, my readers, was the intended purpose. 

But it is not because CCAR or DFAST are properly assessing risk. The models are too complex and theoretical. An investment banker from a very large financial institution told me his bank submitted an 11,000 page CCAR to the Fed and they turned it down. Another prediction: nobody read an 11,000 page document. Nobody. And nobody understood it. That doesn't mean somebody didn't understand page 5,387, but the entire document? C'mon.

As long as the answer was, carry more capital, complex banks will be better prepared to weather economic storms. Perhaps regulators would save banks time, resources, and money if they took the age-old parent response to why banks should carry more capital... Because I said so!

As feared, DFAST schemes are being pushed down to smaller organizations. Regulators are asking for capital plans, and an assessment of risk in the bank's strategy to determine capital needs. In other words, what's your well capitalized? My firm wrote a newsletter on the issue. But I want to break it down to an even simpler form. 

Call it the Marsico Method. Because I'm a narcissist and want something named after me.

The below table shows the Marsico Method in its simplest form.

Currently, a bank is required to have a Leverage Ratio of 5% to be considered "well capitalized" by US regulators. So the Marsico Method begins with 5% applied to each asset category. No application of the 5% to liabilities, since capital ratios are calculated off of assets. That doesn't mean that liabilities don't carry risk, as you will see with the Risk Buffer.

The Risk Buffer column is similar to the buffer concept applied by Basel III, except that scheme applies a straight up 2.5% buffer to a common equity tier 1 (CET1) minimum of 4.5%, for a total CET1 ratio of 7%, to be fully phased in by 2018.

But in the Marsico Method, the Risk Buffer is an assessment of the potential loss estimate of each balance sheet item, based on a rational analysis by the financial institution. The table above is a high level balance sheet. Hypothetical? Not really. It is Cape Cod Five Cent Savings Bank's balance sheet. And according to the analysis, their well capitalized is 7.90%. Meaning that if they experienced stress and began taking losses, the 2.9% buffer above the 5% should be sufficient to staunch the bleeding.

There would be more detail provided by specific loan, deposit, and other balance sheet categories to come up with the overall Risk Buffer per category. For example, upon analysis of the performance of the home equity line of credit portfolio during past downturns and rapid interest rate changes, the bank determines that the loss potential is 1.85%... hence the Risk Buffer for that particular balance sheet category.

Banks should not limit themselves to on balance sheet items. There is risk in pass through residential mortgage lending, loan commitments, and fee-based businesses to account for. And there is risk on the liability side of the balance sheet such as interest rate and liquidity risk, fraud, etc. That is why there is a Risk Buffer applied to those categories as well, although the risk is typically less than the asset side.

Using the Marsico Method, banks can then project the impact to the balance sheet and therefore Required Equity based on their strategy. This would flow nicely into their Capital Plan that identifies actions to augment capital should the bank experience a stress scenario. 

It also provides a nice answer to your regulators, Board of Directors, and other constituencies when they ask, what's your "well capitalized"?

I'd love to hear your thoughts on this approach!

~ Jeff

Capital and More of It!

The regulatory definition of "well capitalized" has not changed post financial crisis.

Tier 1 leverage ratio: 5%

Tier 1 risk-based ratio: 6%

Total risk-based ratio: 10%

So where is all of this belly aching about capital requirements coming from? It has come from three places, in my opinion.

1. IMCRs

When the financial crisis struck, and FIs began to falter, regulators were issuing regulatory orders (supervisory agreements, written agreements, cease & desist orders, and memorandum of understandings, collectively "ROs") faster than my daughters point out that I'm wrong. If you are not familiar with my family, it happens a lot.

A typical article in an RO requires an FI to increase its capital based on perceived risk. The only relevant perceiver, in this case, is the regulator. The FDIC IMCR commonly required a Tier 1 leverage ratio of 8%, and total risk-based ratio of 12%. The OCC, not to be trumped by their arch nemesis, opted for 9% and 13% respectively.

But this technique to raise the capital bar only applied to FIs under ROs. So the next shoe to drop was...

2. Capital Plans

Regulators began requiring formal capital plans during routine exam cycles. I knew this trend was going to stay when a bank with a 16% leverage ratio called me for help developing their capital plan. My response: you need a plan to say what you are going to do with it all? But I digress.

In 2009 as a result of the crisis, the Fed performed a Supervisory Capital Assessment Program (SCAP) on our 19 largest bank holding companies to see if they required more capital under adverse conditions. What adverse conditions do you say? Look at the table below that shows loss rate assumptions applied to specific loan portfolios.

In other words, the banks had to assume they would lose 25% of their home equity loans in a stress scenario. The Fed never intended to apply these loss rates to traditional community FIs. But regulators are increasingly tightening the noose on FIs for applying more aggressive loss rates to their stress scenarios in developing capital plans. In addition, they are requiring Boards, based on the results of the stress scenarios, to set their own minimum capital ratios.

This was step 2 of the increasing capital requirements without actually increasing the capital requirements. And the next step...

3. Basel III

And now the trifecta of capital pressures, Basel III. Deferring to international regulators, US regulators get their way. Adopt Basel III, and suddenly that Tier 1 leverage ratio goes from 5% to 7%, and qualifying Tier 1 capital is re-defined. Total risk-based capital goes from 10% to 10.5%. Not bad you might think. But the risk weightings of certain asset classes change, and will be more difficult to track.

Basel III puts pressure on the numerator (what qualifies as Tier 1 capital) and the denominator (risk weights of certain asset classes).  If Basel is adopted according to its timetable, FIs will have to be in full compliance by the end of 2018. Better get your popcorn.

The solutions: Greater earnings, lower dividends, greater amounts of common equity... and lower returns on equity.

Is your FI making changes to increase capital?

~ Jeff