by weak internal revenue growth, a bank's ability to outperform its peers in stock valuation has become critical in determining whether it becomes an acquirer or a historical footnote.
The stock market has given significant premiums to those that have been able to drive growth in return on equity and earnings per share by successfully pursuing consolidation and low-cost producer strategies, as well as by achieving material fee-income growth. This has put pressure on managements to adopt more proactive and aggressive earnings and capitalization management strategies -- strategies that are obviously accompanied by their own set of rewards, but also their own risks.
Management has found that the best way to spur ROE growth has been to cut costs in existing and acquired operations. The efficiency ratio, which measures overhead as a percentage of revenue, has been driven down to under 50% at more efficient operators, creating substantial earnings gains. However, leading cost-cutters are now finding that reductions below this level may not be efficient, hurting customer service quality and retention. Some may be underinvesting in new businesses and technology just as the industry is waking up to a new crop of competitors using an Internet-based platform that promises to radically change the manner in which financial services are delivered.
The second major strategy to boost earnings has been diversification into non-lending-related areas that produce fee income or market-related gains through businesses such as securities underwriting, brokerage, and fund management.
Though earnings at the more successful banks have been spurred by cost efficiencies as well as revenue growth, these earnings have not been sufficient to preclude the need for acquisitions. The demand for acquisition targets has posed a growing challenge for consolidators. It has led to increasing risk in consolidation as a strategy, as industry competition and the stock market boom have driven acquisition premiums to unprecedented levels.
As premiums have climbed, cost-saving targets have had to be more aggressive, increasing the possibility of shortfalls in earnings-per-share projections.
Acquisition targets have also become more efficient prior to purchase, reducing costs in an effort to stave off takeover. This has resulted in a decline in acquisition efficiency/cost-saving potential in many cases. All these factors have heightened merger-execution risk.
There has also been a revolution in balance sheet management, aimed at bringing down regulatory equity-capital levels that affect the denominator in the ROE ratio. This involves a variety of means to reduce assets requiring regulatory capital. Often it results in retaining only those assets that require less regulatory capital than economic capital, that is, the most risky assets.
Regulatory capital requirements do not currently differentiate among risk levels in separate loan and investment classes, as economic risk models do. At larger banks, management has aggressively moved risk of higher-quality assets off the balance sheet so that regulatory risk-based capital measures are often no longer a good indicator of overall capital adequacy.
Securitization, another strategy for improving ROE, does not always reduce the need for economic capital. The nonlending business lines also pose risks -- market, liquidity, operational, legal, and reputational -- that are not encompassed by regulatory risk capital.
In this complex environment, a major challenge facing bank executives is finding a balance between the short-term stock-valuation benefits of aggressive earnings, balance-sheet and equity management, and the long-term need for robust earnings quality. Standard & Poor's believes that a disciplined and integrated strategic and capital planning process, built on robust risk management, offers the best approach to analyzing and managing these often conflicting pressures. Key to this is stress testing and scenario analysis of risk variables, which can negatively affect earnings, and the level of appropriate economic capital to support these variables.
The Federal Reserve Board recently published supervisory directives for assessing whether "large complex banking organizations" are adequately capitalized. It directs bank management to better "integrate its assessment of an institution's capital adequacy with a comprehensive view of the risk it takes." The regulatory letter notes that institutions need to establish explicit goals for capitalization that can "reflect a desired level of risk coverage or, alternatively, a desired credit rating for the institution that reflects a desired degree of creditworthiness and thus access to funding sources."
The U.S. initiative comes on the heels of the Basel Committee on Banking Supervision's proposed new capital adequacy framework. If implemented close to its current form, it would materially improve the current rudimentary risk-adjustment process for calculating regulatory minimum capital levels, and would incorporate market discipline into regulatory bank monitoring.
The proposal considers risk adjustment through three separate approaches: the use of credit ratings provided by third-party agencies; the use of internal scoring systems provided by sophisticated banks; and the use of credit portfolio modeling.
Standard & Poor's process for evaluating capital requirements is forward looking. It forms an integral part of a methodology that has been developed from the experience of rating more than 1,000 institutions globally. It focuses on the level of capital necessary to sustain a bank's various business lines through the business cycle. Standard & Poor's not only looks at capital necessary to support credit, market, and interest-rate risk, but also levels to support business and operating risk.
Unlike some risk-based capital methodologies, Standard & Poor's evaluation is not tied exclusively to analysis of historic credit default, interest rate, and market-price data in pertinent asset and liability classes. Though historic regression analysis of this type can be useful in assessing capital adequacy levels, it is necessary to understand that its utility is limited to the degree to which historic experience is plausibly predictive of future volatility. For example, sole reliance on historic default data on asset classes that have not been seasoned through a full credit cycle can lead to undercapitalization. Similarly, historic data that does not reach back into recessionary cycles can underestimate the need for capital.
Standard & Poor's assesses creditworthiness in the context of economic and industry risks, competitive/market position and strategy, diversification, and quality of management. The level of credit, market, and interest rate risk on and off balance sheets is merely an outgrowth of these macro factors.
Thus, evaluation of capital needs begins with an analysis, scoring, and weighting of the softer, nonfinancial determinants. This process is coupled with the identification and analysis of components and drivers of a bank's earnings. We believe the in-depth analysis of earnings quality and outlook is critical in understanding underlying business and financial risks and related capital requirements. Components of earnings are identified and analyzed as a basis for forming an opinion as to the long-term capital needs of individual business lines and the franchise as a whole.
The level, mix, and generation of capital are also determinants of financial flexibility. Economic capital serves not only to support credit and market risk, but also franchise risk. It is required to sustain investment to maintain competitiveness in existing operations as well as to permit ongoing investment, restructuring, or diversification into new lines of business when profit margins in core businesses come under competitive pressure.
Standard & Poor's bank rating and capital analysis methodology can play a role in the strategic planning process, helping to determine how to efficiently structure and allocate capital in support of various business lines and strategic initiatives. Assessing the business and capital mix necessary to support a given rating level can assist in evaluating alternative scenarios and plans prepared by management, with credit-rating opinions available on the implications of any given opportunity. This discipline can be focused on the rating and capital impact of a broad spectrum of internal and external possibilities, including expansion into new lines of business or asset classes through acquisition or in-house growth, as well as potential divestments and recapitalizations.
