In a few short years, capital levels of American banks have risen dramatically. Banks that were pushed by regulators to increase capital as a cushion against losses, now face pressure from investors to maintain high returns on equity. Salomon Brothers Inc. managing director Carole S. Berger, who has issued a series of reports on how share repurchases are being used to meet that goal, discussed the phenomenon in a recent interview.
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Is the banking industry overcapitalized?
BERGER: Banks are better capitalized than they have been in decades. If you look at most risk adjusted capital models, they would suggest that there is excess capital
How do you define excess capital?
BERGER: It has to be done on a case-by-case basis. Most banks determine how much capital to hold against various classes of assets based on the historic credit losses and interest rate risk of these assets. However, interestingly one finds that over time the best-managed banks, with the highest level of profitability, have supported high levels of equity-to- assets, far in excess of that necessitated by their balance sheets risks.
Excess capital to me is that amount of cash flow - earnings plus noncash items - over and above the need to grow assets or pay dividends.
From an investor's perspective, what is the preferable use of excess capital?
BERGER: By defining it as excess, you are saying that there no asset that you'd like to invest in that will meet your return hurdle rates. If you could find a loan or security where you could get an acceptable rate of return, you would grow assets.
Signet Bank, for example, returned 15% on equity, but they had over 20% asset growth, and they paid out 34% of earnings in the way of cash dividend. They were a net user of capital: They used it to invest in earnings growth.
Only when the alternative investment in a loan or security is not available do you make the decision to pay common dividends or return capital to shareholder in a share repurchase.
As an investor, I want the guy who understands the process. If you enhance my value by growing assets in a profitable way, by all means do so. But if you're in a market and you don't have a product type that provides that return, then return it in common dividends or share repurchase.
Why would a share repurchase be preferable to dividends?
BERGER: You don't get any future earnings-per-share pickup by paying common dividends.
When I look at the economics of share repurchase, its a question of the stock's valuation relative to returns available from asset growth.
If an average-profitability bank sold at five times book, I would say you probably don't get enough earnings pickup to offset the book-value dilution - making share purchase uneconomic.
But all of the banks in our universe, at current share prices, have been creating positive value through share repurchase.
In the past, banks have invested their capital unwisely in real estate and other risky assets. Does the high level of capital in the industry mean that another bad-debt problem is on the horizon?
BERGER: In previous cycles, high capital ratios usually led to excessive lending practices. Many cycles were created by banks being awash with funds, not just on the capital side, but also on the deposit side. Share repurchase may help mitigate such a problem but is unlikely to eliminate credit cycles.
Will high levels of capital lead to more mergers?
BERGER: I don't think capital ratios drive M&A per se. What we have seen, though, is that in many instances you can take two banks, merge them, and it tends to free up capital. We hear bankers talk all the time about how after they configure a merged bank, down the road they'll be free to buy back shares.
Under recent Security and Exchange Commission rulings, you can't make share repurchase a part and parcel of a consolidation if you intend to use pooling accounting. But that is not to say you can't come back later and decide to do it because conditions had changed.
