How to Design a Winning Capital Management Plan


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.

Sorting Necessary from Noise: How to Focus Your Board’s Time


Director liability has expanded dramatically over the last decade. As pressures on bank boards intensify, their time has become constrained. How can board members protect themselves while building value for their institution? We can win if we play offense; below are 11 focal points for bank boards.

Focus on value creation. Few banks connect executive compensation and return for shareholders. Too many boards accept mediocre performance by executives, who should be enriched for growing tangible book value per share (TBVS), earnings per share (EPS) and franchise value, not the bank’s asset size.

Understand what drives value. An institution’s stock price is driven by multiples of TBVS and EPS, which reflect the market’s perception of the risk profile of the bank. By looking to build value for investors, boards can put in place the proper strategies to achieve their goals, and manage the risk, governance and regulatory environments.

Implement an enterprise risk management program (ERM). An ERM program does more than satisfy regulatory guidelines to establish an internal risk assessment program. The process also aligns the interests of different stakeholders, and improves the bank’s culture by instilling risk management responsibility, accountability and authority throughout the entire organization. It can boost the institution’s ability to raise new capital at higher multiples, fix liquidity and increase earnings. Finally, ERM enhances the strategic planning process by analyzing clearly delineated paths with the associated risk and rewards of each.

Stay educated. Board members have a limited time to stay up-to-date on the issues impacting the banking industry. Custom bank education, using the bank’s data, provides the most flexibility for directors. Topics should include emerging issues, economic developments, capital markets trends and regulatory pressures, as well as each topic’s direct impact to the directors’ institution.

Adopt governing principles. Prevent corporate drift by setting concrete principles which prevail above strategy or tactical solutions. Some examples are to achieve a specified CAMELS rating, eliminate regulatory orders, only consider a sale if market multiples reach a pre-determined level, or to set specific compounded annual return of TBVS over the next 3 years.

Validate corporate infrastructure. An ineffective corporate structure could mean that more regulatory agencies are examining your institution than necessary. Boards should discuss the value of their holding company, registering their stock, the appropriateness of the bank’s charter and target capital composition at least annually.

Commit to talent management. Many senior managers will retire over the next few years, but a proper talent management program encompasses more than succession planning. An annual management review helps the organization prepare for the future, but a robust program further enables banks to attract, retain and motivate employees.

Control the balance sheet. Between 2004 and 2007, the last rate rise, interest expense at depository institutions tripled. While models are necessary to understand the risk, the only way to turn this into a strategic advantage is to conduct price sensitivity analysis, customer retention analysis and customer loyalty studies.

Streamline corporate governance. The board’s primary responsibilities include setting the strategic direction for the bank, creating and updating policies, and establishing a feedback monitoring system for progress. Though conceptually simple, a typical director’s time is strained. Time spent on board matters can be streamlined by centralizing information under one system, using consent agendas, spreading policy approval dates, utilizing video technology, educating the board using bank specific data, and appropriately scheduling committee meetings.

Perform customer segmentation. Historically, banks have analyzed growth opportunities by assessing geographic boundaries. Today, institutions must now know and sell to their customers by identifying target customer profiles, developing products to profitably serve those customers, analyzing where those customers live, understanding how they communicate and building delivery channels specific to those customers.

Have a capital market plan. What is the institution worth on a trading and takeout basis? Who can we buy? Who would want to buy the bank and why? Should the institution consider stock repurchases or higher dividends? Regardless of size, every institution needs to ask itself these questions, and memorialize the discussion in an integrated capital markets plan.

Some Forms of Bank Capital Are Making a Comeback


capital-markets-8-10-15.pngSubordinated debt and preferred equity securities are making a comeback, with small community banks placing private offerings among high net worth investors and pooled investment vehicles alike with greater frequency and ease than in years past.

After years of worrying about whether community banks would survive the economic downturn, investors appear to be willing to tolerate the higher risks of subordinated debt, which falls behind senior debt but ahead of equity instruments in a bankruptcy. Major players like StoneCastle Financial and EJF Capital have established investment vehicles to acquire subordinated debt and other fixed-rate securities from community banks. These funds generally seek investments from $2 million to $15 million per institution, with rates from 6 percent to 8 percent and maturities of five, seven or 10 years.

For smaller community banks that have largely been frozen out of capital markets since the beginning of the Great Recession, the thaw presents a welcome opportunity because the benefits of such securities are significant for issuers. First, they do not dilute existing shareholders as occurs in any issuance of common stock. Second, for debt securities, interest payments are tax deductible, unlike dividends to holders of common or preferred shares. Finally, the proceeds of such securities, which may qualify as Tier 2 capital at the bank holding company level, are treated as Tier 1 capital when injected into a subsidiary bank if the company qualifies as a “small bank holding company.”

This shift in the market comes as more banks have the opportunity to use holding company debt to finance bank growth thanks to recent amendments to the Federal Reserve’s Small Bank Holding Company Policy Statement, which increase the policy’s consolidated assets threshold from $500 million to $1 billion and extend coverage to savings and loan holding companies.

As bankers consider whether these securities are the right way to boost their balance sheets, there are at least three major legal issues to consider before making an offering:

  • First, does the instrument qualify for capital treatment under Federal Reserve and Federal Deposit Insurance Corp. rules? For subordinated debt securities, there are a number of boxes that need to be checked to ensure an offering will qualify for Tier 2 capital treatment under Federal Reserve rules, such as subordination requirements, the elimination of common acceleration provisions, minimum maturity periods and the absence of other provisions designed to protect debtholders. Likewise, for preferred securities to qualify for favorable capital treatment, dividends must be noncumulative and redemption rights, if any, must be at the option of the issuer only. Federal Reserve regulations and policy statements generally require that redemption of these securities be conditioned upon receipt of prior Reserve Bank approvals.
  • Second, does the offering comply with federal and state securities laws? To qualify for an exemption under the securities laws, it is common to limit subdebt and preferred stock offerings to accredited investors only. However, even under those circumstances, it is important to provide full and fair disclosure to prospective investors to ensure that the offering is eligible for an exemption. As such, an offering memorandum should be prepared for the private offering that complies with applicable federal and state securities laws.
  • Finally, will the subdebt be sold to individuals or to a pooled investment vehicle? The aggregation of community banks’ subdebt into pools that will be sold to institutional buyers bears a striking resemblance to the pools of trust-preferred securities that proved so challenging to deal with during the last financial crisis. If your company’s subdebt will be issued to a pool, it is important to understand the legal mechanisms that will be available and with whom you will be dealing if there is an event that causes a payment to be missed.

Many community banks are seizing the moment, using such offerings to refinance debt, finance growth, redeem the Small Bank Lending Fund or trust-preferred securities, and pursue acquisitions in a way that is not dilutive to holders of common stock.

That said, subdebt or preferred stock may not be the best option available for all banks, particularly those with minimal holding company senior debt. For those that have not exhausted options to obtain bank stock loans, that market also has thawed and offers rates that are often 100 to 200 basis points less than coupons payable on subordinated debt or preferred equity.

Outlook for Banking in the U.S.




During Bank Director’s 2015 Acquire or Be Acquired Conference in January, John Duffy and Thomas Michaud, both from Keefe, Bruyette & Woods, Inc., reviewed capital markets and operating conditions for banks nationwide. Additionally, they looked at how M&A fits within a broad range of strategic alternatives and how M&A can help the bank achieve strategic goals.

Presentation slides

About the speakers

John Duffy, Vice Chairman at Keefe, Bruyette & Woods, Inc., A Stifel Company
John Duffy has been with KBW for 34 years.  He was appointed to the position of vice chairman in October 2011, after having served as chairman and CEO since September 2001.  Prior to that, he was president and co-CEO, a position he assumed in July 1999.  From 1990 to 1999, Mr. Duffy was executive vice president and director of investment banking.  In that role, he was responsible for managing the firm’s substantial merger & acquisition practice in the financial services industry as well as KBW’s corporate finance activities in the equity and debt markets.

Tom Michaud, President and CEO at Keefe, Bruyette & Woods, Inc., A Stifel Company
Under Tom Michaud’s leadership, KBW has become one of the top traders of financial services stocks and developed an industry leading equity research effort. KBW has also emerged as a top manager of small, mid and large cap equity offerings and remains a leading M&A advisor to companies across the financial services industry. KBW became a wholly owned subsidiary of Stifel Financial Corp. in February of 2013. Mr. Michaud also sits on Stifel’s board of directors.

The Changing Public Markets for Banks


2-15-13_OTC_Markets.pngIn April of last year, Congress enacted the JOBS (Jumpstart Our Business Startups) Act with the purpose of easing the capital raising process for small and growing companies.  While only some of the provisions have been put into effect, many small banks have already taken advantage of the new registration and deregistration threshold. According to the latest numbers released by SNL Financial, more than 100 banks have deregistered with the Securities and Exchange Commission (SEC) following the passage of the enactment of the JOBS Act. Most of the attention has been placed on the amount of money and resources banks save as a result of deregistration, but what has not been addressed is the flip side, the new threshold that will require registration. Going forward, banks won’t need to register until they have 2,000 shareholders of record. This change opens the door for small to mid-sized banks that in the past were reluctant to raise capital or merge in fear of increasing their regulatory burdens. What’s important to note is that for non-bank and non-bank holding companies, the statutory shareholder threshold remains the same. In writing the new laws, Congress purposefully carved out banks, acknowledging not only the need for banks to access capital but also the highly regulated environment that banks already face.

SEC Registration Versus Public Markets

Even with this statutory easing, many banks still view the capital markets with caution and often the hesitation comes from a dearth of information and misunderstanding of how the public markets function for small companies.  The common perception is that a bank must undergo a costly and time-consuming process to become public, one that requires underwriting, SEC registration, and compliance with Sarbanes-Oxley. While that process still exists, it only applies to banks seeking to do an Initial Public Offering (IPO) and trade on a registered national securities exchange such as NASDAQ.  As long as there are freely tradable shares, banks can have broker-dealers quote and trade those shares on OTC Markets without filing with the SEC.

With greater demand and regulatory pressure to hold more capital, it is no longer efficient for banks to sell stocks by pulling out a list of interested buyers from desk drawers.  However, as a company enters the capital markets, the information gap also begins to widen and it becomes infeasible for companies to know each shareholder and conversely, investors become removed from the daily ins and outs of the companies they are investing in. The classical definition of markets assumes that information is widely available, allowing buyers to make informed decisions, and sellers to have access to the capital they need to grow and expand their businesses. Yet, information is not always widely accessible, or the information availability is asymmetric, meaning that one side has more information than the other, making a marketplace inefficient.

An Efficient Marketplace

There are three elements that make a stock market efficient:

  1. Access for investors with widespread pricing and the ability to easily trade through any broker
  2. Availability of publicly disclosed information to allow for fair valuation of the stock
  3. Confidence from investors that companies are reputable and information is trustworthy

All three elements above address the problem of asymmetric information in a marketplace by bridging the knowledge gap between company management and investors. Transparent pricing facilitates the assessment process, letting companies and investors determine whether the valuation is fair and actionable. Markets are self-regulating, and when information is widely available, prices will adjust to reflect a combination of company performance, investor demand, and overall economic conditions. Intrinsically, SEC filings are meant to eliminate the discrepancy of information between companies and their investors, yet the high cost associated with registration doesn’t always seem to match the intended benefits. Banks on a quarterly basis already produce call reports to their regulators, and many of them also publish additional financials and disclosures to their shareholders via public portals such as www.OTCMarkets.com, through SNL, or on their own shareholder relations page. For a small bank, the cost of SEC reporting typically ranges from $150,000 to $200,000 per year, and on annual net income of $1 million, that’s a very significant amount.

The Implication

In the U.S., there are roughly 7,000 banks, a majority of which are small community banks with under $1 billion in assets.  Of the 7,000, about 15 percent are publicly traded, around 450 on registered national securities exchanges such as New York Stock Exchange and NASDAQ, and 600 over-the-counter, primarily on the OTCQB marketplace operated by OTC Markets Group. Fifteen percent is a relatively small fraction, especially given the current economic climate and disposition towards mergers and acquisitions. In general, banks are viewed more favorably and are in better positions to be acquired when the bank’s stock is publicly traded. There is always going to be greater confidence in a deal when valuation is publicly derived (even if the price/book is less than 100 percent).

However, should banks become publicly traded solely for the fact that they would be “more attractive” in an acquisition? Without a doubt being traded on a public market exposes the company to potential market volatility, and there are inherent risks and costs associated with being publicly traded, even with the recent changes outlined in the JOBS Act. A common impediment delaying and preventing companies from going public is the fear that the public valuation will be less than the management’s internally perceived price.  A parent will believe that his or her child is the best, but unfortunately we live in society where individuals are subject to comparison and ability is often determined by some form of standardized testing or arbitrary measurements.  Public scrutiny is hard to swallow, but public acknowledgement can be equally, if not more, gratifying.

Since the financial crisis in 2008, markets have been perceived as the big bad wolf, the visible scapegoat for why companies go bankrupt and why shareholders lose millions of dollars in their investments. However, despite the recent ups and downs, they still remain the best indicator of good investments and the most efficient way to access capital. If the company has a sustainable and profitable business, if a bank’s loan portfolio has consistently provided high returns with minimal default risks, then the well-informed markets should adjust to reflect those successes. 

Whatever happened to the small-cap IPO? Capital Markets and the Impact on Community Banks


dead-king.jpgFor decades in this country, the vast majority of Initial Public Offerings (IPOs) were for companies raising $50 million or less.  Smaller public companies, including community banks, could thrive in the public markets, with equity research coverage and retail brokers driving investor interest in growth-stage companies.  However, in recent years, the market structure changed and the public markets became inhospitable to smaller public companies.

Today, thousands of public companies—including many community banks—are simply ignored by investors in the public markets.  Investors in these companies have discovered that the stock rarely trades or simply does not trade.  These companies essentially endure all of the costs and burdens associated with the public markets without experiencing the benefits. 

So what happened?  Industry observers point to a series of events over the past 15 years that have effectively killed the small company IPO:   

Sarbanes-Oxley Act – The legislation is a popular punching bag in Washington and often blamed for the lack of IPOs; however, many observers believe it is not the most significant factor in companies electing to remain private.  Nonetheless, corporate compliance with the Sarbanes-Oxley Act has certainly increased costs for public companies, particularly smaller ones. 

Online Brokers – Although the introduction of online brokerages helped to make trading less expensive, these online brokers replaced retail brokers who helped buy, sell and market small-cap public companies to investors.  Stockbrokers collectively made hundreds of thousands of calls per day to their clients to discuss under-the-radar small-cap equity opportunities.    

Decimalization – Stock prices used to be quoted in fractions (e.g., the price of Company A was 10¼ or 10½).  The difference between fractions created profit for firms providing market making, research and sales support.  When the markets began quoting prices in dollars and cents, trading spreads were reduced and profits were significantly cut.  It became unprofitable to cover small-cap equity because there was inadequate trading volume in the small-cap companies. 

Global Research Settlement – After decimalization began, in an effort to continue writing research reports, Wall Street began funding research with investment banking profits.  Not surprisingly, conflicts of interest emerged and positive equity reports began to be written for undesirable companies.  State attorneys general got involved and ruled that investment banking divisions could not pay research analysts.  The result was that it once again became unprofitable to cover small-cap companies and research reports stopped being written.

High-Frequency Trading – Although high-frequency traders bring significant liquidity to the public markets, they require the volume and velocity that can only be found in trading stock of larger public companies.  As a result, high-frequency traders essentially ignore small-cap companies because there is insufficient liquidity in small companies to support high-frequency trading objectives. This trend is particularly damaging as a recent report stated that high-frequency traders conduct nearly 75 percent of the trades in the U.S. equity market– thus three-quarters of the public markets ignore small-cap companies.  

Taken in the aggregate, these (and other) factors have made the public markets undesirable, even hostile, for small companies

As a result, the public markets no longer provide the solution for investors who need liquidity, and the systemic failure of the U.S. capital markets to support healthy IPOs inhibits our economy’s ability to create jobs, innovate and grow.  For community banks, it has a significant impact on their ability to attract capital and lend money to small businesses which, over time, will disadvantage these banks and damage their local communities.   

Clearly, a new, stronger growth market must emerge.