There was a time in the distant past—say, the late 1980s—when banking was considered to be a growth industry and a return on equity in the neighborhood of 18 percent was deemed to be pretty respectable. What a difference a couple of decades make, with three recessions, a scary banking crisis in the early 1990s and again in 2008, and enough new regulations to sink a battleship. Banking most definitely is not considered to be a growth industry today, and ROEs of 18 percent or better are now quite exceptional.
Commercial banks and thrifts are now being required to maintain much higher levels of capital, thanks to the dictates of the Dodd-Frank Act and behind-the-scenes pressure from bank regulators. And these higher capital requirements have significantly altered the calculus of shareholder returns for most publically traded depository institutions. Returns are down throughout the industry, in part because of a widespread deterioration in asset quality, as well as slack loan demand in a tepid economy—but also because the underlying math has changed. As leverage decreases, so must returns—right?
Well, yes and no. For most banks and thrifts, that is indeed the case. But there are some institutions that have managed to deliver above average returns despite being highly capitalized, proof that performance doesn’t necessarily have to be sacrificed on the altar of a strong balance sheet.
In an effort to identify who the best users of capital are in today’s more conservative regulatory environment, Bank Director magazine and the New York-based investment banking firm Sandler O’Neill + Partners teamed up to rank the 484 U.S. banks traded on the NYSE, NYSE Amex and NASDAQ OMX stock exchanges on two financial metrics: core return on tangible common equity (ROTCE) and the ratio of average tangible common equity (TCE) to tangible assets. The two individual scores for all the institutions were then combined to produce a final score.
To reduce the distortionary effects of quarter-to-quarter volatility, the ranking was based on data from eight consecutive quarters ending June 30, 2011. Sandler O’Neill did the calculations using data provided by SNL Financial. The 50 best scores from all 484 institutions are displayed on the companion table.
The rationale behind the Nifty 50 ranking is simple. If two banks have identical ROEs but one has a higher level of capitalization than the other, the bank with the higher capital ratio is making better use of its shareholders’ money. It’s an important distinction because banks that aren’t able to post above-average returns on a higher capital base will find it increasingly difficult to maintain investor support over the long haul. In the good old days, when banks were able to operate with significantly more leverage than they can today, it was much easier to post ROEs in the high teens and even low twenties. Attaining that level of performance today is a truer test of a bank’s strategy, business model and the operating skill of its management team.
“The ranking is a good measurement of how companies are deploying their capital and those companies that are better at getting a return on that capital,” says Mark Fitzgibbon, the director of research at Sandler.
The winner of the Nifty 50 capital ranking was Republic Bancorp Inc., a Louisville, Kentucky-based bank with $3 billion in assets. Republic had the 12th best ROTCE out of all 484 institutions in the ranking, at a truly impressive 21.79 percent, and the 73rd best capital ratio, at 11.34 percent. Finishing in second place was Abilene, Texas-based First Financial Bankshares Inc., followed closely by National Bankshares Inc., in Blacksburg, Virginia; Commercial National Financial Corp. in Latrobe, Pennsylvania; and State Bank Financial Corp. in Atlanta. The 2nd through 5th place finishers were separated by just eight points on the ranking.
Not surprisingly, three of the top five Nifty 50 finishers also scored in the top five of Bank Director magazine’s 2011 Bank Performance Scorecard, which is a broad measurement of bank performance that looks at profitability, capital adequacy and asset quality. State Bank Financial placed 1st on the Scorecard, followed by First Financial at number two and Republic at number five.
The top five finishers on the Nifty 50 also ranged in size from $3.8-billion asset First Financial to $382-million asset Commercial National, a category of bank that tends to be more manageable than larger institutions, and which often outperforms them on standard metrics like ROE. In fact, the largest institution to make the Nifty 50 list was People’s United Financial Inc., a $25.3-billion asset thrift located in Bridgeport, Connecticut—which is hardly a giant among U.S. banks. (It has since purchased Danvers Bancorp and is now at $29 billion in assets.)
Fitzgibbon points out several other similarities between the ranking’s top finishers. Most of them are located in smaller urban markets where business conditions are probably better. “They may have an environment where there’s less competition and better pricing,” he says. Other commonalities that Fitzgibbon notes are the fact that many of the top ranked banks are highly efficient with low expense ratios, tend to have very attractive net interest margins—a reflection probably of their pricing advantages compared to banks in more competitive markets—and have low credit costs, which suggests that they are better lenders.
The median ROTCE for the top 50 banks over the eight linked quarters was 9.94 percent, which might not seem all that impressive in an historical context, but is well above a median of just 3.94 percent for the 484 exchange traded banks and thrifts over the same period. Similarly, the median TCE ratio for the Nifty 50 was 10.71 percent, compared to 7.97 percent for all institutions in the ranking. Fitzgibbon says that an industry average ROTCE prior to the financial crisis was probably in the range of 6.5 percent, and has climbed to approximately 8 percent today.
While higher capital ratios do have the effect of driving down returns for most banks, there are some clear advantages to having a strong balance sheet in the current environment. “Regulators are highly focused on capital adequacy,” says John Kanas, chairman and CEO at Miami Lakes, Florida-based BankUnited Inc., which finished 7th on the Nifty 50 ranking. “When you have a more than adequate level of capital, it gives the regulators a lot of comfort about the bank. It brings us credibility.” In BankUnited’s case, that extra credibility allows Kanas to pay the bank’s shareholders a dividend—something which undercapitalized banks today are not permitted to do by their regulators.
Republic Bancorp CEO Steve Trager says that his institution’s high TCE ratio is central to its business strategy. “We pump a lot of our earnings back into the business,” Trager says. “We don’t pay high dividends. We want to manage Republic Bancorp for the long term.”
Republic looks for non-traditional product opportunities where the returns are much higher. For example, Republic is the largest bank processor of income tax returns in the country, a high-return business. Unfortunately for the bank, the FDIC forced it to scale back the product after 2012—citing its riskiness.
A high level of capital also allows Republic to react quickly to opportunities when they arise, whether it’s a potential acquisition or a new product that meets a need in the market. “The things that have enabled us to be successful have been things that were reactive,” Trager says.
Trager says he would like to make a “meaningful, large acquisition” at some point in the future, and will continue to explore other non-traditional forms of business. “It’s nice to know that we can pursue opportunity without depending on others to raise capital, because raising capital when you need it is tough,” he says.
At 2nd place finisher First Financial, the importance of having plenty of capital on the balance sheet is deeply engrained in the 121-year-old bank’s culture. “We were the only bank that made it through the depression in Abilene, Texas,” says chairman and CEO Scott Dueser. The bank also survived the collapse of the Texas oil industry in the 1980s and the financial crisis of 2008 because it has always maintained a strong capital position. “Our board’s approach has always been to maintain high levels of capital because capital is what got us through the hard times,” Dueser adds.
Like Republic, First Financial invests most of its earnings back into the company. “We’ve never raised capital since the initial investment 121 years ago,” says Dueser.
Regulators aren’t the only people who pay close attention to bank capital ratios—large depositors do, too. First Financial has had a lot of success gathering low cost commercial deposits, which reduces its funding costs and helps drive its profitability. “[Business] customers look at your capital,” he says. “Yes, FDIC insurance is good. But the large customers that put $50 million in your bank look at your capital.”
First Financial also has been an active acquirer in recent years and Dueser would like to deploy some of the bank’s capital in a deal. With organic growth stymied by an uncertain economy, Dueser is counting on takeovers to help drive the company’s profitability for the foreseeable future. “To continue to grow earnings like we want, we have to utilize that capital better,” he says. “That’s why we need to do some acquisitions.”
While banking is a cyclical business and regulatory priorities might change over time, it’s safe to assume that depository institutions will have to maintain high capital levels for the next few years at least. Terre Haute, Indiana-based First Financial Corp., which finished 8th on the Nifty 50 ranking, had a TCE ratio of 12.53 percent for the eight quarter period—nearly 200 basis points higher than the other Nifty 50 institutions, and more than 3,600 basis points higher than the median for all 484 institutions in the ranking.
Vice Chairman and CEO Norman Lowery doesn’t anticipate that First Financial’s TCE ratio will decline much any time soon. “There is some expectation in our industry of even higher capital requirements,” he says. “The end of that story has not yet been told.”
And if the industry’s capital requirements go even higher, “then we’ll be able to meet them.”