By: Gary J. Young, Founder and CEO
The most critical component of every strategic plan is a thorough understanding of your position on capital adequacy and your target for capital. They are not the same.
The Regulator View of Capital
As community bankers, we have all heard the mantra that we need to increase capital. It may be an over simplification, but to the regulator more is always better. The regulator does not have interest in your shareholders. And as I will discuss later in this article, an increase in capital lowers the return on equity, or the return to shareholders. The regulator’s #1 job is to ensure a safe and sound banking system. Your job is to satisfy the regulators and your shareholders. You have to balance the interests of both. You need to proactively communicate your bank’s opinion regarding capital.
An example of the need to balance is shown below. There are four banks with a 1% ROA. However, the equity/asset ratio at each is different ranging from an 8.0% leverage ratio to a 12.0% leverage ratio. By dividing the ROA by the leverage ratio, you get the ROE. By multiplying the ROE by an assumed PE, you get the multiple of book. In this example, the bank with an 8.0% leverage ratio has a value of $30 million while the bank with a 12.0% leverage ratio has a value of $20 million. The amount of capital provides a significant difference in the return to shareholders.
I agree with the OCC. Capital adequacy at each bank is uniquely based on the current and planned risk within the bank. And, it is the responsibility of the bank board to determine capital adequacy with the input from executive management. Capital adequacy is the point that if capital falls below, the Capital Contingency Plan must be implemented. In other words, let’s assume capital adequacy has been defined as a 7.5% leverage ratio, or an 11.25% total risk-based ratio. If actual capital falls below either measure the bank should implement the methodology for improving capital as described in the Capital Contingency Plan.
A bank’s target or goal for capital is higher than capital adequacy. It is an estimate of the amount the board of directors has decided is desired to take advantage of opportunities such as additional organic growth, branch expansion, purchase of a bank or branch, stock repurchase, etc., or to use as additional insurance or protection against negative events that could hurt profitability and capital. As an example, a 7.5% leverage ratio could be defined as capital adequacy, but the target level of capital is 9.0%.
The Right Amount
There is no right amount. The average $300 million – $1 billion bank has a 10.3% leverage ratio and a 15.4% total risk-based capital ratio. Most everyone would agree that banks do not need that level of capital. But, every bank is unique with different levels of risk and different levels of risk appetite. The important thing is that executive management and the board of directors understand that there is a shareholder cost to holding excess capital. That doesn’t make it wrong. The board of directors has multiple responsibilities and at times these can be conflicting. From the shareholder perspective, you want to maximize the return on equity and shareholder value which assumes leveraging capital, but you must also oversee the operation of a safe and sound bank. And, at the heart of safety is capital adequacy. It takes balance and awareness of both to determine the right level of capital for your bank. My concern is that through the Great Recession and after, the capital mantra has been more is better. Well frankly, more is not necessarily better. I am suggesting that it is time to balance the capital need for risk management with the capital need for improving shareholder value.
After there is agreement on capital based on risk, planning can begin on the methodology or methodologies to best utilize any existing or planned excess capital. The recommended considerations that follow do not address all of the issues within your mission statement or vision statement. Rather, these address your desire to maximize shareholder return and to maintain your bank’s independence.
Consider the following:
- Ways to generate additional organic growth. This means growth from your market without any significant increases in infrastructure. This is normally the most profitable short-term methodology.
- Expansion opportunities. I would suggest looking for opportunities that begin turning a profit in two years or less. While this is long-term, most bankers are in for the long haul. Remember, a branch that increases net income by $500,000 increases shareholder value by $6,500,000, assuming a 13 price-earnings ratio.
- The purchase of another bank or branches. This can significantly impact capital, but once the target is effectively absorbed by your bank, the value rewards can be great. But, also make sure you adequately consider the risks.
- A stock repurchase plan. This is a win for the shareholders that want to sell and the shareholders that want to hold. Everyone wins and shareholder value should increase. I look at this as buying your bank as opposed to buying another bank. I recommend to every client that has a tier-1 leverage ratio in excess of 9% that they should at least consider a stock repurchase.
- A slow, steady increase in dividends to shareholders. If after all other approaches to capital utilization excess capital remains, then increase the dividend. This will increase dividend income to shareholders without jeopardizing capital adequacy.
Consider how all of these items might impact your capital adequacy, return on equity, and shareholder value over a 3-5 year period. Remember, the goal of executive management is to maximize profitability and shareholder value within capital guidelines approved by your board of directors.
If you would like to discuss this article with me, you can reach me by phone at 330.422.3480 or e-mail at email@example.com.