Before developing courses of action, military planners perform a detailed analysis of the terrain on which they'll be fighting. In so doing, they begin to understand the boundaries that define their battlespace. Political, geographical, and man-made boundaries limit the range of options available to the commander.
Likewise, your bank's ability to create shareholder value is defined by the boundaries of its cost of equity, capital requirements and limits on earnings. Together, these factors form a construct that management can use to map out an institution's value-adding combinations of earnings and capital.
Whether through dividends or capital gains, your investors expect to be rewarded at some point. Thus equity has a cost.The cost of equity is the rate of return that appropriately compensates investors for the level of risk that they have taken.
Consider Bank of Bob, a $500 million fictional bank with $47.5 million of equity capital and net income of $4.5 million, producing a 9.4% return on equity. The industry's average cost of equity of 11% is represented by the blue diagonal line, which connects all points where earnings are 11% of equity capital. The red dot represents the bank's return on equity. Above-the-line plots represent returns below the cost of equity, which erode shareholder value. Likewise, below-the-line plots add value.
However, for a given institution, the real range of value-adding combinations of earnings and capital is much smaller than simply the area below the diagonal line.
The region is further defined by a horizontal line representing your bank's minimum capital requirement, as seen in the chart above. This boundary eliminates combinations of earnings and capital that exceed your board's tolerance for capital risk. Bank of Bob's policy defines minimum capital as 10% of total assets, or $50 million. At this level, they will need to generate earnings of greater than $5.5 million to produce ROE above their cost of equity. However, at any earnings level, they still remain undercapitalized according to policy.
A vertical line can be drawn to represent practical limits on earnings. Bank of Bob defines this limit as two standard deviations above 1%, the average ROA for their peer group.
Defining these boundaries can help safeguard against the reckless pursuit of ROE. Once defined, the task of management is to get the red dot inside the triangle, thereby creating value.There are three ways to do this:
Lower cost of equity. This method lowers the amount of return required to compensate your investors for their risk while holding ROE constant. It increases the slope of the diagonal line, increasing the area within the triangle. Lowering the cost of equity implies taking less financial risk perhaps less than your investors are willing to take. What's more, lowering risk could result in lower returns, which shifts your plot to the left.
Return capital. Some banks are sitting on too much capital because of limited growth prospects, negative provisions and gains on the disposal of foreclosed assets. Returning capital lowers the plot vertically and could involve increasing dividends, repurchasing stock, or one-time distributions to right-size capital. This approach assumes that your shareholders can reinvest the proceeds elsewhere, yielding a superior value. For closely-held banks, superior value is not limited to investment alternatives; it could take on the form of vacation homes, goodwill, or the pride of owning a community bank.
Given the difficulty of raising capital from a compromised position, returning capital is not a decision to be taken lightly. On the other hand, the better our systems for measuring, monitoring, and managing risk, the less capital we need to get by safely.
Consideration should also be given to the impact that returning capital would have on liquidity and on concentration and lending limits. Since concentrations are usually measured as a percentage of capital, lowering capital may cause your bank to sell off earning assets, which can lower returns. Conversely, holding too much capital can allow concentration limits to build to dangerous levels, as a percentage of total assets.
After seven years of rough seas, capital has become a life raft that we are reluctant to downsize. But our raft is someone else's investment. If we can't provide value, our investors should sell, and this argument bears out in the continuing trend of M&A activity since 2011.
Improve Earnings. The first step to improving earnings is to stop using the economy, margin compression and regulatory burden as a scapegoat for mediocrity. Within every peer group and market area, there are banks that continue to deliver superior value.
The road to victory is not lined with budget inputs and assumptions, but rather, with real changes to your business plan. Start with the end goal of shareholder value in mind and work backwards, analyzing capital requirements first, and then earnings. Earnings should not be considered during the last dying breath of your budget process, but instead drive meaningful (even passionate) discussion.
After carefully analyzing several courses of action, Bank of Bob adopted a plan to restore value. Management noted that while the bank was undercapitalized according to its policy, bringing in more capital would require even greater earnings than they felt they were capable of.
Instead, management reassessed their capital requirements, starting with the 5% regulatory minimum. They added an additional 1% for interest rate risk, 1% for credit risk and 1% to support future growth, coming to an 8% requirement. Defining this requirement allowed them to reduce capital by $2.5 million over the next twelve months through a combination of dividends and stock repurchases.
Next, they consulted their board to estimate the bank's cost of equity. After reviewing the 10-year Treasury rate, cost of equity figures from several highly-traded banks and returns from various stock market indices, they concluded that 9% was an appropriate return, given the bank's risk profile. These measures put less pressure on earnings to make up the difference. By secretly replacing their Starbucks coffee with Folgers Crystals, management was able to improve the spread between ROE and cost of equity.
With budget season upon us, now is a good a time to spend some time defining your bank's value boundaries, reflecting on the results, and using it to drive useful discussion that focuses your budgeting and strategic planning efforts. See you on the high ground.
Patrick Gehring is the chief financial officer of Town & Country Bank in Las Vegas. He is a third-year student at the Pacific Coast Banking School and a major in the Army Reserve.