Bankers have been building capital above and beyond regulatory requirements for some time, raising the question: What exactly is excess capital?
Regulators set minimum capital ratios as a way to determine whether a given company is "well capitalized" or merely "adequate," but not all capital a bank has above that minimum can be considered "excess."
Most banks set their own internal benchmarks and targets that are well above the regulatory guidelines, and so only count as excess any capital above these numbers. Typical benchmark ratios include Tier 1 capital ratio - which is common stock and certain preferred stock divided by risk-adjusted assets - or tangible common equity divided by tangible assets.
Ruchi Madan and Keith Horowitz of Citigroup Inc.'s Smith Barney wrote in a July 30 report that the 23 banking companies they covered had $4.4 billion of excess capital, and appeared on track to generate another $25 billion over the next 12 months.
By those analysts' calculations, at this time next year Comerica Inc. and Wells Fargo & Co. would have the most excess capital not already earmarked for use.
To be sure, capital levels have eased off this year, in many cases because of acquisitions or because rising interest rates took a toll on bank securities portfolios.
"In the second quarter, capital ratios more often than not came down a little bit, and they came down, principally but not entirely, because of writedowns in available-for-sale securities portfolios," said Diane Merdian, the bank equity strategist at Keefe, Bruyette & Woods Inc.
The trend is likely to continue in the coming quarters, she said, mainly because the gains bankers generate from their securities portfolios shrink or turn to losses when interest rates rise.
According to Goldman Sachs analyst Lori Appelbaum, Wells Fargo's capital fell 38 basis points in the second quarter from the first, to 11.8%, but it is still 118 basis points ahead of its internal target. Fifth Third Bancorp is one of the best-capitalized companies, with a tangible common equity ratio of 8.77%, but that is down 68 basis points from the first quarter and 123 basis points below its own target.
With many banks projected to build capital above their own stated targets, the question is how will they put this capital to use? Demand for loans, especially in the commercial sector, would provide one opportunity, though the outlook for commercial and industrial loan growth remains sketchy.
Share buybacks are a popular way to absorb excess capital, as are acquisitions. And a number of bankers have already committed themselves to share repurchase programs that would use up much, if not all, their excess capital over the next year.
Almost 60% of the excess capital that will be generated over the next 12 months will be used for share buybacks, Ms. Madan wrote in her report.
M&T Bank Corp. is one company that does buybacks.
"We tend to manage capital very closely and if we don't have a good use for it, we buy back stock and return it to our shareholders," said Michael P. Pinto, M&T's chief financial officer, in a telephone interview Friday. "It's irresponsible for us to keep capital if we have no use for it."
Over the last 20 years the Buffalo company has generated $3.6 billion of capital, and has returned half of that to shareholders through dividends and share buybacks, Mr. Pinto said.
"Our capital has to earn at least 12%" of return, he said. If the company does not see that coming, in either its organic growth opportunities or through acquisitions, "then we are better off not doing that business and return the capital," he said.
M&T's benchmark is tangible common equity, the company's book value excluding goodwill. It manages its balance sheet so that tangible common equity is around 5%, which already includes the dividend. Capital exceeding that will be used for buybacks.
Meanwhile, James Dimon, the new president and chief operating officer of J.P. Morgan Chase & Co., told investors last month that they should not count on buybacks in the near term as JPM rebuilds its capital ratios after the July 1 acquisition of Bank One Corp. and a large charge taken to boost litigation reserves.
JPMorgan Chase's Tier 1 ratio, its internal benchmark, was 8% at June 30. The company wants that to be slightly higher, 8.5%, and will retain earnings over the next two quarter to get there. Next year JPM Chase will generate capital of $4 billion to $5 billion, and it will spend that on stock buybacks and to "invest in the business," Mr. Dimon told analysts during a call on second-quarter earnings.
For the industry as a whole, growing without big acquisitions is a bit of a challenge right now, and some banks may push the envelope to generate earnings growth through securities gains or sharp increases of home equity and commercial real estate lending, Ms. Merdian said. Those activities add risk, and more risk requires more capital.
The amount of capital banks are generating currently is necessary to provide for that added risk, Ms. Meridian and other analysts said. So again, is there a lot of excess capital out there?
"People's notion of us having excess capital is probably exaggerated," Ms. Merdian said, speaking of the banking industry in the first person. "I don't think we have a lot." Tangible capital ratios peaked in 1993, though many observers seem to assume that the industry has never had more excess capital than now, she said.
Sharon Haas, an analyst with Fitch Inc., said she agreed with the Smith Barney analysts that more capital beyond management's targets can be considered excess. But she laughed as she said that from a bondholder's perspective a company cannot have enough capital.
Over all, Ms. Haas said, the banking industry's capital levels are "adequate." Moody's Investors Service Inc. analyst Allen Tischler also said he cannot find much excess capital around.
But it all goes back to how excess capital is defined.
"The real issue is the industry generates more capital than it can deploy," Ms. Meridian said. "And how we handle that is more important than whether we create too much risk to manage." Good managers, she said, can see when they have run out of organic options and when acquisitions have become too expensive, and instead they return capital to shareholders, preferably through buybacks.
A typical bank increases capital by 20% each year, Ms. Meridian said. "Because we are generating so much, we don't feel capital restrained. And that's an important point."
