How to Design a Winning Capital Management Plan

April 22nd, 2019

capital-4-22-19.pngThe significant downturn in bank stock prices witnessed during the fourth quarter of 2018 prompted a number of boards and managements to authorize share repurchase plans, to increase the amounts authorized under existing plans and to revive activity under existing plans. And in several instances, repurchases have been accomplished through accelerated plans.

Beyond the generally bullish sentiment behind these actions, the activity shines a light on the value of a proactive capital management strategy to a board and management.

The importance of a strong capital management plan can’t be overstated and shouldn’t be confused with a capital management policy. A capital management policy is required by regulators, while a capital management plan is strategic. Effective capital management is, in large part, an exercise in identifying and understanding future risks today. Capital and strategy are tightly linked — a bank’s strategic plan is highly dependent on its capital levels and its ability to generate and manage it.

There are a couple of guidelines that executives should bear in mind as they develop their capital management plans. First, the plan needs to be realistic and achievable. The windows for accessing capital are highly cyclical. There’s limited value in building a plan around an outcome that is unrealistic. Second, if there is credible information from trusted sources indicating that capital is available – go get it! Certain banks, by virtue of their outstanding and sustained performance, may be able to manage the just-in-time model of capital, but that’s a perilous strategy for most.

Managements have a number of levers available to manage capital. The key as to when and which lever to pull are a function of the strategic plan. A strong plan is predicated on staying disciplined but it also needs to retain enough nimbleness to address the unforeseen curveballs that are inevitable.

Share Repurchases
Share repurchases are an effective way to return excess capital to shareholders. They are a more tax-efficient way to return capital when compared to cash dividends. Moreover, a repurchase will generally lift the value of a stock through the reduction in shares outstanding, which should increase earnings per share and the stock price itself. Share repurchases are generally the favored mechanism of institutional owners and can make tremendous sense for broadly held and liquid stocks.

Cash Dividends
Returning capital to shareholders in the form of cash dividends is generally viewed very positively in the banking industry. Banks historically have been known as cash-dividend paying entities, and the ability and willingness to pay them is often perceived as a mark of a healthy and stable company. A company’s decision regarding whether to increase a cash dividend or to repurchase shares can be driven by the composition of the shareholder base. Cash dividends are generally valued more by individual shareholders than institutional shareholders.

Business Line Investment
Community banking at its core is a spread dependent business. The ability to diversify the revenue stream through the development or acquisition of a fee generating business can be an effective and worthwhile use of capital. Common areas of investment include mortgage banking, wealth management, investment products and services and insurance. Funding the lift out of lending teams can also be a legitimate use of capital. A recent development for some is investment in technology as an offensive play rather than a defensive measure.

Capital Markets Access
Effective capital management plans also consider the ability to access the capital markets. In the community banking space, accessing capital is not always a foregone conclusion. Over the past couple of years, the most common forms of capital available have been common equity and subordinated debt. For banks of a certain size and market cap, it’s a prudent capital management strategy to file a shelf registration, also known as form S-3, which provides companies with flexibility as to how and when they access the capital markets. The optionality provided by having a shelf registration far outweighs the concern that the shelf itself suggests a shareholder dilutive activity is on the horizon.

It’s important to note that these capital management activities can be utilized individually or in combination. An acquisition may necessitate the need to access the capital markets. Or given the relative inexpensiveness of sub debt, raising some for the purpose of a share repurchase could make sense. A strong capital management plan can allow a management team to be ready both offensively and defensively to drive their businesses forward in optimal fashion.

Information contained herein is from sources we consider reliable, but is not guaranteed, and we are not soliciting any action based upon it. Any opinions expressed are those of the author, based on interpretation of data available at the time of original publication of this article. These opinions are subject to change at any time without notice.

jjunior

Jay Junior is a managing director for D.A. Davidson & Co., with more than 25 years of investment banking experience serving financial institutions in the Mid-Atlantic. He has completed over 125 transactions including both buy-side and sell-side M&A transactions, public and private offerings of debt and equity, branch purchases and sales, valuations and financial advisory services for clients in the following industries: commercial banks and thrifts, insurance companies, specialty finance companies and asset management firms.