Many community banks may want to devote more attention to capital management.
Under the old squeaking-wheel-gets-the-grease theory, it is easy to overlook the relationships between capital and deposits or total assets. Unless the regulators come in and say you need more capital, it is convenient to ignore the topic.
But by ignoring these ratios, a bank may be denying itself the best performance possible in the area that shareholders care about most: return on capital. Having too much capital is as wasteful as excess liquidity or not making the most profitable loans.
What should a bank do if it has excess capital?
One answer, of course, is to take a more aggressive lending posture. I remember the head of one overcapitalized New England bank used to tell his officers that he could not stand pessimism. His motto was: "Quit your moaning; get out loaning."
But as we saw in the failure of many New England thrifts that expanded lending indiscriminately after going public with excess capital, reducing lending standards can be a dangerous step. One banker said his institution got so aggressive that it would lend money to any man wearing overalls with a hammer in the loop as a potential home builder.
What, then, is a better way to solve the excess capital problem if the opportunities to expand assets are not strong? Buy back stock.
This strategy however, has its pitfalls.
If the stock is selling below book value, buying it in can improve its value and thus benefit all shareholders. But if it is selling above book, the buyback needs more thorough examination.
Buying above book value naturally dilutes the shareholder base. This is only worthwhile if management thinks the price is low relative to the bank's peers or to what earnings multiples should soon justify.
I remember a bank that bought back stock at a price well above both its book value and the multiples of its peers, solely because management held large positions on margin and had to keep the share price up to avoid margin calls.
But if the management can justify it and has the liquidity available, the buy-in is a good idea. Even if it does not have the liquidity, it is a good step if the bank can raise money by selling bonds and loans yielding below-market rates. Though a capital loss has to be taken on the sale, the bank would then have a much better net operating income by ridding itself of assets that drag down its return.If a bank can sell underperforming assets and use the proceeds for a stock buy-in to boost return on capital, it becomes a double win for its performance and profitability.
Mr. Nadler, an American Banker contributing editor, is a professor of finance at Rutgers University Graduate School of Management in Newark, N.J.