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.
