Capital Management: Banking’s Trickiest Juggling Act

The long-running boardroom debate over whether a bank’s biggest focus should be on capital and liquidity or on lending and profitability has ended, at least temporarily, with capital and liquidity the clear winners.

“As independent directors, we were always concerned about greater returns on equity,” says Thomas Kennedy, an attorney who is a director of National Penn Bancshares in Boyertown, Pennsylvania. “Now, everyone feels it is wise to remain well capitalized and stay lean and mean.”

To maintain capital-to-asset ratios that meet regulators’ requirements for being well capitalized, and to keep from using capital to help meet loan obligations and expenses, community banks also are facing increased challenges in managing their sources of liquidity. While some solutions can be basic, particularly those that are short term, generally they are more complex.

Executives Kenneth Joyce of State Bank and Trust Co. in Defiance, Ohio and David Seleski of Stonegate Bank in Fort Lauderdale, Florida say they are among community banks that this year have gained core deposits from local customers who are concerned about the health of some larger banks. But most community bankers don’t expect that pace of deposit inflow to continue. With a weak lending market and stiffer regulatory requirements, they realize they need to map new strategies in asset/liability management, along with decisions on preserving capital and finding opportunities to raise more of it.

“The bar has been raised by regulators as to what will be the appropriate levels of capital and what will be the appropriate makeup of that capital,” says Ben Plotkin, executive vice president of the financial institutions group at St. Louis-based investment banking firm Stifel Nicolaus.

“The old 10 is now 12 in many cases for the risk-based-capital ratio,” adds Seleski, Stonegate Bank’s president and CEO. Stonegate had $375 million in assets and a risk-based-capital ratio of 14.75% on June 30, 2009. And while FDIC officials say they are not aware of any situations where the agency is telling banks they must hold 12% capital, the implication for many bankers is clear: They must be more vigilant than ever before when it comes to embracing conservative capital management.

Since late last year, regulators, analysts, and bankers also have been looking more closely at banks’ ratios of tangible common equity to tangible assets. Commonly known as the TCE/TA, this measure has become more important amid lingering concerns about the safety and soundness of the banking industry.

Tangible common equity is common equity minus the other components of Tier 1 capital. Thus, tangible common equity does not include noncumulative perpetual preferred stock, minority interests in consolidated subsidiaries, goodwill, and other intangible assets. The preferred stock that banks obtain in the U.S. Department of the Treasury’s Troubled Asset Relief Program (TARP) is common equity but not tangible common equity.

“Everyone wants to see what the real value is, and determine a value that will not be eroded by losses,” says Plotkin, whose office is in Florham Park, New Jersey.

National Penn Bancshares, which has $9.8 billion in assets, increased its TCE/TA ratio from 4.87% on March 31, 2009 to 5.26% on June 30, 2009. It did that primarily with $52.2 million in proceeds from a common equity offering in the second quarter of 2009. National Penn’s priorities include growing that ratio toward the 6.0% range, said Glenn Moyer, president and CEO of the holding company and its National Penn Bank subsidiary.

“Tangible common equity to tangible assets has taken on a mantra,” says director Kennedy, who is a partner in the law firm Kennedy & Lucadamo in Bloomsburg, Pennsylvania.

The FDIC does not have officials minimums for TCE/TA ratios that are considered adequately capitalized and well capitalized. One comparison is the 5% minimum to be well capitalized for the leverage ratio of core capital to average quarterly assets. But since the middle of 2008, “5 has had no real meaning for community banks,” says Jay Brew, chief bank strategist for consulting firm m.rae resources in Bethlehem, Pennsylvania.

“There is a feeling that regulators eased up on community banks several years ago, and that some took more credit risk,” Brew explains. Now, he says, examiners are using “a sharp stick” and issuing numerous private orders that require higher capital ratios.

Brew and Seleski are among advisers and bankers who expect regulators to raise the requirements for being adequately capitalized and well capitalized. Those changes would come while many banks are striving to improve their ratios-through continued slow paces of lending, more sales of assets, and raises of capital.

That is already leading to questions of how some banks are planning to utilize what might be considered “excess capital” after the recession ends and shareholders resume focusing on return on equity.

“I think it is hard to determine what is going to be excess capital,” Seleski says. “In my opinion, it is highly probable that the regulators are going to require higher capital ratios going forward.” He adds that Stonegate would consider using any excess capital for acquisitions or other expansion. “If you are overcapitalized, you can use it to take advantage of opportunities with distressed institutions,” he points out. On July 31, Stonegate acquired the $102 million in deposits and $52 million of the assets of Jupiter, Florida-based Integrity Bank after it was closed by the Florida Office of Financial Regulation and placed into FDIC receivership.

Raising capital

With the number of bank failures expected to grow, banks that do not have capital problems could find more opportunities. To be in that position, banks should review their options for raising capital and understand current challenges in capital management, liquidity, and asset/liability management.

Investment bankers and advisers emphasize that banks seeking capital fall into two categories.

In one, banks that are struggling to meet regulatory capital requirements and have problems in credit quality and other areas can expect continued difficulty in any capital-raising efforts. “Investors need to feel that a bank has enough capital after the raise that it will be able to weather the storm and not need any more,” says William Hickey, a principal and co-head of investment banking at New York-based Sandler O’Neill & Partners LP.

For many banks that meet the criteria for existing investors, Hickey notes that “the market has been opening up” since the May 7 announcement of regulators’ stress tests on 19 large holding companies showed better overall results than some investors expected.

Banks that raise capital should realize that many pricings of offerings will be lower than those of previous issues, says Jacob Eisen, president of Capital Insight, a Chicago-based investment banking and advisory firm. Amid regulators’ tight monitoring of capital, Eisen cautions banks to be hesitant about not raising capital because of the concern that it will be dilutive. “Yes, you dilute,” he concedes. “But you maintain the ratios and can have growth potential.”

TARP funds, common equity, trust-preferred securities, and rights offerings are among available options for banks. Among the four banks whose CEOs were interviewed by Bank Director for this story, two took TARP money and two did not, although they were eligible.

State Bank and Trust and Stonegate did not take TARP funds. Joyce and Seleski noted that they are among bankers with concerns about the government possibly changing the program’s rules. TARP already has restrictions on payments of bonuses and increases in dividends.

State Bank and Trust is considering an offering of authorized shares to directors and other designated investors, says Joyce, who is chairman, president, and CEO of the bank’s holding company Rurban Financial Corp. However, if timing is not right for a capital raise, Joyce says sale/leasebacks of branches are among steps that State Bank and Trust could take to help bolster its capital ratios.

Stonegate is considering a stock offering that would be available primarily to existing shareholders, Seleski says.

Banks can accept TARP funds equal to between 1% and 3% of risk-weighted assets. First NBC Bank, which is based in New Orleans, late last year took its maximum permitted $17.8 million in TARP funds, notes Ashton Ryan Jr., the bank’s chairman, CEO, and president. Because First NBC took less than $25 million, it is restricted from paying an annual bonus only to its most highly compensated employee-namely Ryan.

“If we were bigger, and had to take at least $25 million, we would not have taken TARP,” Ryan says. “I think it would be unconscionable to not be able to pay bonuses to other officers, especially at a nonpublic bank like ours where we don’t have stock options.” Ryan, who owns about 6% of First NBC stock, says, “I don’t mind being the only one restricted.”

First NBC, which as of early fall had grown to $960 million in total assets, is using TARP funds to help leverage its lending. “Absent the restrictions, I think it has been a fabulous program for banks and the government,” Ryan says.

National Penn last December took $150 million in TARP funds, about 70% of its permissible maximum. “We viewed it then and now as timely and cost-efficient regulatory capital,” Moyer says. “We do not view it as a long-term part of our capital structure. We are doing an analysis on when to repay it in whole or in part.”

In an increase of what it considers long-term capital, National Penn since last November has raised $72.4 million through a common stock offering at a 10% price discount under its dividend reinvestment and stock purchase plan.

Hickey says some Sandler O’Neill clients “are trying to determine how to raise more capital so that they can pay back TARP.” Eisen expects that rights offerings and other stock offers where existing shareholders are given total specific allotments will be among the most widely used capital-raising structures during the current cycle. A rights offering “puts pressure on shareholders to step up to the plate” and can help reduce concerns about dilution, he says.

Trust-preferred securities, which are usually issued through pools, can be counted as debt by banks for tax purposes. Those securities are treated as common equity, but not as tangible common equity, for regulatory purposes. As preferred stock, trust-preferred shares do not dilute common shareholders. But the number of new trust-preferred issues has dropped significantly since last year. A main reason is that some banks have deferred interest payments on trust-preferred stock, thus making investors hesitant about any new issues, Eisen says.

First NBC Bank was considering a trust-preferred issue before that market dried up, Ryan says. In August, the bank was considering an accredited offering of common shares. Under federal securities laws, that offering would be available to institutional investors and to individuals who have $1 million or more in net worth or had income of $200,000 or more in each of the past two years.

Also in August, two investment banks that Ryan declined to identify contacted him to talk about a possible public offering for First NBC. “That’s a sign that funds and other investors that have been on the sidelines are thinking of getting into banking,” Ryan says. And Plotkin of Stifel Nicolaus is finding that some institutional funds whose banking plans began with buying failed banks or other distressed banks are showing interest in putting new equity into healthier banks.

Capital management and liquidity

Banks are entering 2010 with lingering concerns over the real estate crisis on the residential and construction sides, including how severe a spillover effect it might have on the commercial real estate market. Many still face decisions each quarter about setting aside reserves for possible loan losses-thus cutting into earnings.

Meanwhile, bankers and advisers are making assert/liability plans for changes in pricing that will be coming when interest rates start rising from the past year’s historically low levels. Brew of m.rae resources says that scenario makes it vital for banks to undertake strategic studies, over five years or even longer, on the impact of interest rate and credit risk changes. He is among advisers who recommend that shrinkage can be in the shorter-term portion of that planning. Those steps can help improve capital ratios and partially reduce the costs of funds.

“You need to draw a line in the sand with high-rate CDs,” Brew says. “If someone does not have their checking with you, say ‘goodbye.’ “

On the asset side of the balance sheet, he suggests banks can shrink and also help capital ratios by selling some tax-exempt securities and other assets that have high risk-based requirements. As part of any liquidity adjustments and shrinkage, Brew is also among advisers who are urging banks to find ways to reduce their brokered deposits. For several years, numerous banks have turned to brokered deposits because they were finding limited opportunities for other long-term funding.

Alternatives can start with some basic business development tactics, suggests National Penn’s Moyer. Now, perhaps more than ever, directors can use their community contacts “to ask consumers and small business owners for their deposit business,” he says.

Options also include deposit products with 2009 style innovations. For example, since early this year, National Penn has been offering a fee-based checking account that has identity theft protection along with traditional transaction services.

Ryan, an accountant who was a bank auditor prior to beginning his banking career in the early 1990s, notes that numerous banks “went long” on the lending side last year amid the low-rate environment. “That will become a problem when the economy begins recovery,” he says. “The forces today are enormous to boost the economy. I am not against the [Obama administration] stimulus. But the result will be a sustained increase in rates for the longer period.”

Other than attempting to move to shorter-term lending and aggressive repricing of CDs, Ryan says “if you are big enough and sophisticated enough, you can do some sort of hedging.” Smaller banks, he notes, should be prepared to give up some shorter-term earnings.

Liability concerns

Bankers and directors who were interviewed for this story represent banks that are making adjustments due to the financial crisis, but that are not on any FDIC lists of troubled banks. Thus, they are not feeling huge pressure about increased potential liabilities for directors. Still, they agree that it’s wise to denote more time and money to training programs for directors. Some banks also are holding more special meetings for directors and officers with local real estate market experts. “This is a period where directors need to take time to be certain that we understand the issues,” says National Penn’s Kennedy.

“You need to keep acting in good faith,” he says. “If you are a director and are worried about liability or being sued, you will never take the necessary risk to help lead the institution to success.”

Speaking of risk, John Tomlinson, a director of Stonegate and previously a director of two other Florida banks, notes that about half the time at the bank’s board meetings is now spent on asset quality and credit issues, including specific loans. That is more than the long-standing norm for banks, says Tomlinson, a partner in the Fort Lauderdale-based accounting firm John L. Tomlinson, CPA. Stonegate is devoting that time to credit quality even though its nonperforming loan ratio has been extremely low for a Florida bank-0.86% on June 30, 2009.

That is the kind of diligence that indicates why the debate over the relative merit of return on equity likely will remain dormant for at least several more quarters. It’s all about capital, these days.