Following the financial crisis, community banks have seen a material shift in capital management. Before, the goal was to optimize capital with larger and smaller institutions going beyond dividend and share repurchases to manage capital levels. Commonly, these banks used hybrid capital or synthetic securitizations, or executed sale or leaseback transactions with their branches, among other means. During the crisis, the focus shifted to preserving capital, and/or acquiring the capital necessary to survive. Thus, the banking sector experienced an accelerated pace of capital raising for those fortunate enough to be able to do so. These higher capital levels have depressed return on equity (ROE) in the industry and negatively impacted bank valuations, leading banks to deploy capital to create shareholder value. As they seek to manage capital levels, community banks now face new concerns with the changing regulatory environment, as well as those that existed pre-crisis.
In today’s environment, looking forward to determine capital requirements is of greater importance than in the past. Stress testing, even for those institutions below $10 billion in assets, needs to be considered alongside growth capital as banks assess what is truly excess capital. A robust analysis of their capital levels in a downturn is a best-in-class approach for community banks, particularly for those with more than $5 billion in assets. Organic growth needs should also be addressed, taking into account the capital impact of potential acquisitions to determine the amount of “dry powder” required going forward. By using robust forecasting methodologies, banks can create clear plans for their capital needs, and then address opportunities to deploy the excess—that above the bank’s economic and regulatory needs—in order to drive ROE.
While public and private community banks have not yet been limited to a 40 percent dividend payout ratio (a limit imposed on banks above $50 billion in assets), those that cut dividends in the crisis may find it more difficult to exceed that level as they seek regulatory approval of their dividend policy. Dividend limits have been partially offset with share repurchase programs, which have become the preferred capital return mechanism of regulators due to their flexibility in a downturn. However, share repurchases are a more complicated tool for closely held or private institutions. Closely held public companies may be less inclined to use share repurchases due to concerns about public float and the impact on valuation as well as going private considerations. Private banks may have few willing sellers without liquidity needs or other drivers for shareholders. For those limited in their ability to use share repurchases, special dividends may become a more practical alternative. However, special dividends pose more issues for public companies. Public companies may not want to signal the limited growth opportunities available or see a shift in their shareholder base towards more income-oriented investors.
Efforts to control excess common equity levels can be used as an opportunity to address a more optimal capital stack. For example, the idea of issuing less costly preferred equity to maintain regulatory capital ratios and fund share repurchases is slowly gaining favor again with regulators. Although conceptually compelling, few banks have executed such transactions in the post-crisis era. As banks experience constraints on their ability to return capital and create value for shareholders through more traditional means, they will need to examine other alternatives to deploy capital in an accretive manner. Balance sheet repositioning trades and bulk sales of nonperforming assets are additional tools that can also be used to deploy excess capital that would otherwise weigh down ROE while creating more profitable and cleaner banks going forward. Finally, M&A should not be overlooked as a possible capital management tool to be used either by itself or in conjunction with other capital management alternatives. While tangible book value (TBV) dilution and the amount of time it takes to earn back the dilution as a result of acquisitions continues to be a concern for investors, financially attractive acquisitions should address capital management. Deploying excess capital into earnings and return accretive transactions should begin to outweigh concerns over TBV earn-back for investors.
A renewed focus on capital management strategies is a clear differentiator for top performing banks. With a thorough, forward-looking approach, banks can define and understand the dimensions of their excess capital. Those banks that understand their real capital needs will be able to combine the right capital deployment strategies to arrive at a plan that will drive returns and create shareholder value.