Frontier State Bank has been involved with a dispute with the Federal Deposit Insurance Corp. over its business model. Let's take a look at how the bank appeared on the IRA Bank Monitor, both with respect to its current financial performance and in terms of how it looks based on a measure called "economic capital," which looks at the type of risks the bank takes under a stress-test scenario.

The IRA Bank Monitor, my company's bank performance and risk analytics engine, rated Frontier A-plus, with one of the lowest current stress-index scores in the entire industry at 0.3 vs. 2.4 for all FDIC-insured banks. (All data in this profile is for Q1 2009 unless otherwise labeled.) The bank is hyperprofitable and very efficient, with a return on equity that is almost two standard deviations above the peer average ROE.

The base year in the IRA Bank Stress Index is 1995, which has a score of 1 for each category shown in the chart above. All of the industry indicators of bank stress except capital (0.9) and lending capacity (1.0) are above 1995 levels, with ROE and loan defaults the leading stress factors behind the overall industry score of 2.4 for Q1 2009. So based on its current performance, Frontier is below the industry average stress levels for the 1995 base year in every category save capital.

Though Frontier has an excellent stress rating, the analysis does not stop by merely looking at current performance. The very high ROE is an outlier, a flag that demands explanation. The financial analyst always treats a flag as neither good nor bad, but merely an outlier that must be understood.

So next we test the bank's business model to understand the drivers of this remarkable profitability under a stressed economic scenario. To do this, we complete the second ratings perspective, namely economic capital or EC. Think of EC as answering the question: what business does this bank operate? Is this bank a classical lender or an investment-driven institution? We then compare EC with nominal income, to generate risk-adjusted return on capital or RAROC.

Several aspects of Frontier's profile are obvious outliers in regard to its business model. First, the bank has just 20% of its business focused on lending, while 70% is focused on investing activities. Almost 40% of total assets were funded off advances from the Federal Home Loan banks as of Q1, nearly three times the 15% threshold set by regulators as "safe and sound." This high ratio of FHLB advances to assets has been normal for Frontier going back some time.

When we calculate EC for Frontier looking at lending, trading and investing activities, virtually all of the risk is assigned to investing activities by the IRA Bank Monitor. In this model, EC represents the maximum probable loss to the bank in a very stressed economic scenario for lending, trading and investing assets reported to the FDIC. Because of the large size and composition of the investing activities, the resulting EC for Frontier is $398 million, or almost half of total assets.

We then compare this EC figure to Frontier's Tier 1 risk-based capital and the result is a ratio of EC to T1RBC of over 7:1, suggesting that based on stressed measures such as EC, Frontier is one of the more risky banking institutions in the entire FDIC universe. Compare the 7:1 ratio for Frontier with ratios of EC to T1RBC of over 4:1 for JPMorgan Chase and Bank of America, and 3:1 for Wells Fargo.

Despite the high risk from its investing activities suggested by the EC measures, however, Frontier still generates a RAROC of over 4%, making it one of the most profitable banks in the U.S. based on this classical measure of EC vs. income. In terms of risk and reward, Frontier seems to be creating value for its owners — albeit with a seemingly high-risk approach. There are a number of institutions with similar business models and EC profiles, but Frontier is identified by the IRA Bank Monitor as an outlier.

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