The recession of 2008 and lingering aftermath have resulted in a completely new definition and application of capital adequacy, imposing new responsibilities on bank management teams and boards.
Most bankers are aware of the structure and mandates inherent in the stress tests of 30 large banks, Dodd-Frank and the latest Basel III propositions. In deciphering this maze of propositions, one fundamental change is ignored by all parties. Yet this change, if properly utilized, can have a profound impact on bank strategic planning and capital adequacy analysis.
The FFABC form (Federal Form for Analysing Bank Capital) of the 1970s, Basel I and Basel II were all based on formulae derived directly from historical loan performance ratios. The stress tests, Dodd-Frank and, indirectly, Basel III are all based on a two-year what-if forecast developed under a "severely adverse scenario."
Unfortunately, practically all research analysts, rating agencies and many investment bankers have missed the implications of this change, as is evidenced by their reports on banks and transactions for banks.
In the new post-recession world, capital adequacy has been redefined as follows:
• A clear recognition that the post-recession world economy has shown that any extrapolation of historical experience is misleading and dangerous;
• A shift in regulatory focus from analyzing historical performance to reviewing present-day bank capital adequacy in the context of two-year what-if forecasts; and
• The use of a "severely adverse scenario" to describe the two-year period.
In working with banking clients and regulators, my firm has developed a metric, which we call Free Capital, to reflect the new regulatory philosophy. We define this as the difference between the capital on a bank's balance sheet and its regulatory minimum capital requirements calculated under the two-year severely adverse scenario.
Free Capital is directly derived from stress testing, which is no longer a passive activity relegated to a bank's enterprise risk management department. Because stress testing now concerns itself with pro forma quantification of Free Capital – which affects all proactive efforts by the bank and the required regulatory approvals – it has been elevated to the executive and board levels and is now a critical component of strategic planning.
The calculation of free capital involves the proper approach to stress testing. Thus, stress testing loan portfolios absolutely must take into account when a loan was made. The reality, as understood by experienced bankers, is that factors such as loan vintage, loan history, pricing and repayment structures are far more relevant and important in evaluating risk than attempting a statistical correlation between economist-based macro stress factors and loan performance and risk.
In particular, vintage has more impact on a loan's present and pro forma risk profile than any other single variable, followed by the amortization schedule. Vintage defines loan structure dictated by the then-prevalent economic conditions. Any what-if stress scenarios must be measured against the relative change from the then-prevalent economic conditions for each loan subgroup within each portfolio.
This relative change is highly significant. Any pro forma scenario reflects changes in economic factors. These factors must be evaluated according to their change from the original vintage dates of the loans or loan groups, not just the change from the present. Applying statistical economic rules to a portfolio homogeneously and ignoring the vintage layers that comprise it is ludicrous.
This subtle but important difference cannot be ignored; otherwise the stress testing exercise is useless. Properly determined, the changes in economic factors from the date of loan origination will provide a more accurate forecast for earnings, capital and consequently Free Capital, which enables management to review and analyze strategic plans within the constraints of regulatory capital adequacy. It also provides an excellent means for communicating with investors and directors while setting targets for maximizing shareholder value and minimizing risk.
Banks with negative Free Capital have to be focused on raising new capital, reducing expenses and/or deleveraging assets. Banks with minimal levels of Free Capital have limited operating and strategic options. Acquisitions are outside their purview. Their ability to implement aggressive organic growth or undertake operating actions to meet competitive pressures are constrained.
Banks with excess Free Capital have considerable room to maneuver, expand, and make deals. However, the very nature of excess Free Capital can imply a potentially lower return on capital. Here, the analysis of marginal returns on Free Capital becomes an important part of strategic planning. In all cases, Free Capital allows management to differentiate and analyze the impact of changes in financial leverage on the bank's overall return on capital.
Asset purchases, stock buybacks, dividend policies, etc., should be reviewed subject to Free Capital. Mergers and acquisitions should take into the account the inherent Free Capital (positive or negative) of target banks. Likewise, investor evaluation of banks ought to consider the significant implications of this metric rather than just year-to-date financial performance.
Kamal Mustafa is the CEO of Invictus Consulting Group LLC and the former head of global M&A at Citibank.