In a Challenging Earnings Climate, There Is No Room for Lazy Capital

The persistently challenging earnings environment stemming from a stubbornly flat yield curve requires bank management teams examine all avenues for maximizing earnings through active capital management.

The challenge to grow earnings per share has been a major driver behind more broadly based capital management plans and playbooks as part of larger strategic planning. Management teams 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 predicated on staying disciplined also needs to retain enough nimbleness to address the unforeseen and inevitable curveballs. 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. In our work with clients, we discuss and model a range of capital management techniques to help them understand the costs and benefits of each strategy, the potential impact on earnings per share and capital and, ultimately, the potential impact on value creation for shareholders.

Bank acquisitions. M&A continues to offer banks the most significant strategic and financial use of capital. As internal growth slows, external growth via acquisitions has the ability to leverage capital and significantly improve the pro forma company’s earnings stream. While materially improved earnings per share should help drive stock valuation, it is important to note that the market’s reaction to transactions over the last several years has been much more focused on the pro forma impact to capital, as represented by the reported dilution to tangible book value per share and the estimate of recapturing that dilution over time, alternatively known as the “earnback period”.

Share repurchases. Share repurchases are an effective and tax-efficient way to return excess capital to shareholders, compared to cash dividends. Repurchases generally lift the value of a stock through the reduction in shares outstanding, which should increase earnings per share and the stock price. They’re generally favored by institutional owners, and can make tremendous sense for broadly held and liquid stocks. They can also be very effective capital management tools for more thinly traded community banks with growing capital levels, limited growth prospects and attractive stock valuations.

Cash dividends. Returning capital to shareholders in the form of cash dividends is generally viewed very positively both by the industry and by investors. 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. Cash dividends are often viewed as more attractive to individual shareholders, where quarterly income can be a more meaningful objective in managing their returns.

Business line investment. Community banking at its core is a spread dependent business. The ability to diversify the revenue stream through 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, insurance and the lift out of lending teams. A recent development for some is investing 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.  Community banks need to remain alert to market conditions and investor appetite. Over the past couple of years, the most common forms of capital available have been preferred equity and subordinated debt. It’s our view that for banks of a certain size and market cap, it’s a prudent capital management strategy to file a shelf registration, or Form S-3. 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.

There are a couple of guidelines that managements should bear in mind as they develop their capital management plans. First, the plan needs to be realistic and achievable; there is limited value in building a plan around an outcome that is unrealistic. Second, don’t look a gift horse in the mouth. If there is credible information from trusted sources indicating that capital is available, get it.

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 position a company to manage through the good times and maybe, more importantly, the challenging times.