Who would ever think that banks could have too much capital? And yet a capital surplus threatens shareholder value - which has the industry focusing on capital management as never before.

It was only two years ago that U.S. banks had a capital problem. Still cleaning up after a lending debacle the previous decade, banks were struggling to appease regulators. The FDIC Improvement Act, which mandates that certain capital levels be strictly obeyed, had just kicked in. And some of the biggest and best had barely managed to meet the minimum requirements of the new law.

Estimates varied wildly as to how many banks would fail to meet FDICIA's standard and be shut down as a result. But the worst scenarios never came to pass, and memories of that nervous time are growing fainter. In that environment, the last thing on anyone's mind was the problem of having too much capital.

It is very much on the minds of bankers today. A strong recovery in asset quality, coupled with favorable business conditions for banking in recent years, has placated regulators and removed any doubt about the industry's stability.

But ironically, the industry still has a capital problem. Banks are generating capital faster today than they can find ways to reinvest it, threatening lower earnings per share and return on equity ratios and signaling shareholders that their money might best be put to work elsewhere. "To retain excess capital is to destroy shareholder value," says First Bank System's chief financial officer, Richard Z. Zona. "It is an admission that you can't make a sufficient rate of return."

Response to what Zona calls the industry's "good problem" has been widespread and varied. Banks have embarked on stock repurchase programs that reduce the number of shares outstanding and boost EPS, and have raised dividend payouts substantially in an effort to return capital to shareholders. Some have invested in capital-intensive businesses; others have been innovative in using cash for their acquisitions.

With these strategies comes an implied admission - that prospects for returns in banking are limited. "Banking is inherently a slow-growth industry," says Moshe Orenbuch, a research analyst for Sanford C. Bernstein & Co. "Management has been reluctant to recognize that, but buybacks and dividend increases are telling."

Shifting from Asset Growth

Underlying this new attitude is a fundamental shift in banking from growing assets to expanding capital. With the past decade's heyday of asset growth slowing, banks are challenged to find ways to use this ocean of capital, which began with a regulatory crackdown and later took on a momentum of its own.

That momentum is substantial. At the present rate of growth, First Manhattan Consulting Group estimates that excess capital could almost equal necessary capital within the next 10 years. The firm's research found that total common equity at the end of 1993 was $296 billion, but that the figure would grow to $490 billion by the year 2000 - or $150 billion in excess of the $340 billion banks will need to cover their risks. By 2005, total equity would reach $705 billion, with only $375 billion needed to maintain a strong capital position and $330 billion in excess capital.

That internal capital generation is outstripping asset growth is not a new phenomenon for banking. The industry, in fact, faced a capital surplus as recently as the mid-80s, and banks dealt with the problem then by plunging whole hog into the most promising area for returns - commercial real estate lending. "Banks have a very good history of turning surplus capital into surplus loan losses," says Alden Toevs, a managing vice president at First Manhattan.

Bankers learned a hard lesson from that particular fiasco, and they appear determined not to repeat the mistake. While their best and most immediate prospects for asset growth and attractive returns are still in lending, bankers are more cautious than ever about putting too many credits in any one basket. (With loan volume up by double digits last year, though, bad loans are assuredly being booked even as bankers express caution.) "So far, banks have been loathe to chase loans too far," notes Richard Fredericks, senior managing director for Montgomery Securities in San Francisco.

What's different this time around? Bankers are recognizing that there are better ways to deal with excess capital than to mash the gas pedal and hope for the best. There is a new emphasis on capital management that bodes well for the industry. Chief financial officers are emerging from routine numbers-crunching duties to become integral players in the strategic planning process. Banking is "integrating capital management into other strategic planning," says CFO Robert Rosholt at First Chicago Corp. "Capital management is becoming more important because the banking industry is increasingly becoming oriented toward shareholder value."

That's a relatively new attitude for the industry. "Ten years ago, bankers didn't think too much about their shareholders. But we've been through some difficult times, and now we know we must treat them well," says Tom Marrie, CFO at First Interstate Bancorp. In the past, bankers have viewed capital levels from the standpoint of liquidation, with regulators foremost in mind. "Now bankers are looking at capital vis-a-vis risk management," says Norwest Corp. CFO John Thornton. "The issue now is, 'How do I use my capital to the best advantage of my investors?'"

The shift in emphasis from regulators' approval to investors' approval is a natural occurrence in a consolidating industry where the value of stock is growth's currency. This recognition has come easily. What's much more difficult is managing capital in the best interest of shareholders, thus keeping stock valuation high.

Banks are maneuvering as never before in this quest for what First Manhattan dubs capital's "sweet spot." Generally, the sweet spot is that level of capital needed to cover a bank's risk profile, which is very low at this time. With an average non-performing assets ratio of about 1.3%, asset quality has returned to normal levels; some banks are even booking negative loan-loss provisions because their reserves are already substantially higher than the risk in their portfolios. Keefe, Bruyette & Woods Inc. estimates that the median ratio of loan-loss reserves to non-performing loans is now in excess of 200%. Indeed, the fact that banks are over-reserved means that their capital levels are even higher than they appear to be on the surface.

There is no magic formula that determines a bank's sweet spot; it differs dramatically from bank to bank depending on individual risk profiles. "The difficult question to answer is, what is that prudent level of capital?" says First Fidelity Bancorp CFO Wolfgang Schoellkopf. What bankers are certain of now is that they must return excess capital to shareholders until they can find new asset growth opportunities.

Their first line of defense has been share repurchase programs, which boost EPS by reducing the number of shares outstanding. The New York law firm of Wachtell, Lipton, Rosen & Katz estimates that open-market share repurchase programs have been instituted by 45 bank holding companies this year alone, including many of the nation's largest banks, for buybacks totalling some $7 billion.

Variety of Buybacks

Buybacks have ranged from less than 2% of outstanding shares to as much as 10% at Wells Fargo & Co. and 12% at BankAmerica Corp. Generally, they fall into a range of 3% to 5%. For Bank of Hawaii, the decision to repurchase up to $20 million in stock was simple: "We saw that our ability to build capital through retained earnings exceeded our ability to redeploy it at an attractive rate to our shareholders," says CFO David Houle.

(Banks aren't the only businesses buying back stock. Wachtell, Lipton estimates that U.S. corporations repurchased some $50 billion worth of equity in 1994, making the year one of the biggest ever for share repurchase programs. Such events usually signal that the issuer believes its shares are undervalued, and banking is no exception.)

While the buybacks generally have been a good strategy, there are pitfalls, and such programs should not be considered a panacea for the long-term ramifications of excess capital. One consideration is that repurchased shares will taint the pool of stock a bank maintains to make acquisitions, because there are legal constraints on how quickly the repurchased shares may be used for this purpose.

[Expanded Picture]Banks often insist that the shares they are repurchasing will be ear-marked for employee stock ownership programs, though some observers privately express doubts about how clean bankers are keeping their various pools of stock. "Sometimes it's a subterfuge," says one analyst. And as stock buybacks proliferate, as most believe will occur, it will become more and more difficult to keep transactions within the limits of the law.

Banks contemplating share repurchases must also consider a possible dilution of book value per share, because any purchase above book value dilutes the remaining equity per share. But despite the drawbacks, bankers are expressing satisfaction with repurchase programs, saying that their returns on equity would have been much lower without such actions. Most CFOs estimate that their ROE's would have been up to 200 basis points lower without buybacks. The boost in earnings per share depends largely on how big the repurchase was.

Capital management strategies being employed by banks are keeping ROEs from dropping as precipitously as expected. With the interest rate spreads that have so boosted bank earnings over the past few years narrowing, ROEs were expected to drop to the low double-digits again, though the decline is proving slower than expected. Sanford Bernstein expects the 50 banks in its universe of coverage to post average ROE for 1994 of between 16% and 17%, compared with the long-term average (1969-1989) of 12-13%. As capital decreases and assets grow in a strengthening business cycle, the firm believes that the temptation to misuse capital will diminish.

Increasing Payouts

In conjunction with share repurchase programs, banks have also been increasing their dividend payouts, but this strategy, too, requires careful planning. "Rising dividends are hard to reverse, for one thing," says James McCormick, president of First Manhattan. "And setting the payout ratio quite high also sends a signal to shareholders that you don't expect internal growth."

For now, rising bank payouts are seen as helping to boost stock performance. Bernstein estimates that dividends will increase at an annual rate of 23% from 1993 through 1995, and at a 14% rate from then through 1998. But the market's dividend rates are projected to increase by only some 7% over this period. At this rate, by 1997-98 the relative yield for bank stocks will exceed the S&P 500 by 170%.

A rosy picture, to be sure. Bankers concede that while stock repurchases and higher dividends are enhancing the value of their stock today, they know these strategies will go only so far in dealing with capital surplus. Of more lasting duration, of course, would be to find asset growth through new business opportunities. Buybacks, for instance, "demonstrate to shareholders that you are managing the company in their best interests, but the downside is that it would be much better if you could find returns on capital elsewhere," says Bank of Hawaii's Houle. Adds First Chicago's Rosholt: "These measures should be viewed as bridging a gap until future opportunities arise."

Zona at First Bank System says the bank "has been using every tool available to reduce excess capital," including share repurchases and dividend increases. But First Bank has also been investing in business lines where it sees growth opportunities, such as merchant card processing, data processing for automatic teller machines and other electronic banking businesses, and trust and investment management activities. "You can't get earnings growth from too many banking businesses these days, but there are some opportunities available," he adds.

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The key to effective use of surplus capital is targeting those businesses that will provide good returns. Excess capital has given SunTrust Corp. "the ability to do some things in a business strategy sense that we might not have been able to do otherwise," says CFO John Speigel. "But what we have been careful to do is avoid business that we wouldn't otherwise do just because we have excess capital."

Many banks have even begun to integrate capital management into their entire planning process. First Interstate, for example, increased dividends and repurchased stock - after careful consideration of its business plan. "We know exactly what businesses we want to focus on, so the question for us became, 'What level of capital do we need to support these activities?'" says CFO Marrie.

Boost from Securitization

Another idea is securitization, which Zions Bancorp. in Salt Lake City has employed to help manage capital. By securitizing receivables in its auto lending, credit card portfolio and other businesses, the $5.2-billion-asset bank has managed to reduce the need for capital with off-balance-sheet financing. Capital management boils down to "minimizing the cost of financing assets," says chief executive Harris Simmons, who was formerly the bank's CFO. "We are great believers in maximizing the use of our capital." What the securitization of some $600 million in loans has done for Zions is "turned net interest income into a stream of fee income," adds Simmons.

Robert McCoy, CFO at Wachovia Corp., a bank that epitomizes the proverbial fortress-like balance sheet, believes that banks are getting better at integrating capital management into overall planning and strategy. He attributes this to "recognition that there is a lack of growth opportunities for banking and that markets will penalize banks for maintaining too much capital."

For some banks, the ability to manage capital well is "an ace in the hole," says David Berry, director of research at KBW. He notes that banks are beginning to realize that they can raise capital as needed, citing NationsBank Corp. as a prime example. The industry "is in a quasi-liquidation mode," he adds.

It is also in a transition stage, one that calls for continued capital management efforts. "Finding the sweet spot of capital is a dynamic process," says First Chicago's Rosholt. "Banks have to determine their risk profiles and growth needs over the next few years. Proper capital management calls for looking out over the cycle."

RELATED ARTICLE: How They Rate as Capital Managers

Sanford C. Bernstein & Co. last year ranked banks on their stewardship of shareholders' funds by considering four areas in which banks may distinguish themselves in terms of capital management. They are: prices paid for acquisitions; whether the deals were done for cash or stock; dividend policies; and share repurchases.

[Expanded Picture][Expanded Picture]The firm rated each company in each dimension and totalled their scores across the four categories. Scores ranged from a plus 25 to a negative 14. Here's how they fared:Rank Bank Score 1 PNC 25.062 First Fidelity 16.003 SunTrust 15.504 NationsBank 15.315 Banc One 13.106 First Union 12.817 Bankers Trust 10.108 JP Morgan 9.609 Mellon 6.5510 BankAmerica 3.7311 Fleet 1.6012 Signet 0.7513 First Interstate 0.4014 Bank of Boston 0.3815 Wells Fargo 0.0016 Chemical Bank (1.00)17 Chase (2.00)18 First Chicago (3.10)19 Citicorp (4.00)20 Shawmut (6.10)21 Bank of New York (12.60)22 Barnett (14.00) Source: Sanford C. Bernstein & Co.

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