Many banks operate under the false pretense that because they are deemed a “conservative bank,” there isn’t a lot of risk in their business model. I often remind boards of directors that they sit on a highly leveraged, regulated hedge fund. Would they lend money to a finance company leveraged 10 times or more, while trying to manage a 3.5 percent spread? That’s your average bank. So it might be a good idea to consider an opportunity to reduce risk, even by an incremental amount.
The first thing to do is identify the area with the greatest risk. Most banks view it as credit risk, and vigorously address this with underwriting, loan committee, loan reviews, regulatory exams, reserves, limits and diversification. Banks do a great job of this. However, in our experience, the greatest area of risk, receiving the least amount of attention, is a bank’s “bond-like risk,” which shows up in the structure of securities, loans and deposits.
This risk is basically interest rate risk, and the devil is in such details as yield curves, repricing risk and maturities. While asset/liability management strategies may help, they don’t reduce the problem banks have with their dependence on duration (which is the measurement of the sensitivity of a bond to interest rate fluctuations) in exchange for a decent return. Over 80 percent of risk factor contribution to the price volatility on a bank’s balance sheet is caused by nominal duration. What this means is loans, securities and deposits all have the same structured risk which is caused by maturities and cash flows. In light of this enormous risk concentration, pension funds, endowments, foundations and other institutions diversify this risk via stock and private equity allocations. For example, private equity allocations can reduce risk and increase returns through:
- Lower volatility of returns over time compared to duration-based assets like loans and bonds. Yes, private equity has a lower volatility risk than a two-year Treasury note.
- Higher Sharpe Ratios than bonds or loans, which means higher returns per unit of risk. (William F. Sharpe first introduced returns-based style analysis in the late 1980s, hence the name “Sharpe Ratio.”)
- Very low correlation coefficients to bonds and loans, meaning the returns don’t track those of bonds or loans which will help your bank diversify its earnings stream. Banks currently try to do this through non-interest income.
- Economic cycle diversification benefits for banks that can only lend money even when pressed by market forces on pricing and structure. Private equity mitigates this by investing in different parts of the capital structure than loans, and by less stringent investing periods than banks. Banks need to lend or invest their depositors’ funds immediately. Private equity funds can be more patient because they typically have a three- to five-year window in which to put their investors’ money to work.
Banks aren’t allowed to invest in private equity funds, so why am I telling you this? While banks are prohibited from investing in private equity funds, there is an exception in the Dodd-Frank Act’s Volcker Rule for Small Business Investment Companies (SBICs), which are funds that invest in small businesses and private companies. Hundreds of banks have taken advantage of this program since 1958. There are several benefits to these investment vehicles. Banks can:
- Help create jobs and expand the economy.
- Get Community Reinvestment Act (CRA) credit.
- Get CRA service credit by serving on an advisory board.
- Create opportunities for senior C&I loans.
- Create opportunities for commercial deposits.
- Offer solutions to customers who need a liquidity event, more equity in their business or support for a senior loan.
- Earn a nice return.
SBICs, like private equity, also help reduce the aforementioned risks of volatility, duration, correlations, Sharpe Ratios, economic cycle timing and diversification, which theoretically should increase portfolio returns. SBICs can make a bank safer and more profitable. Top quartile returns (returns in the top 25 percent) for SBICs from 1998 to 2010 were higher than 15 percent, while even the bottom quartile was 6.3 percent. So even a poor performing SBIC has produced higher returns than most any other asset opportunity available to a bank during this time frame. To reduce the risk of investing in a poor performing SBIC, a bank can do the following:
- Develop underwriting practices, like a bank does on loans, tailored to SBICs, targeting top quartile returns.
- Create a portfolio of multiple SBICs based on the 5 percent capital limit for bank investments to diversify company and fund manager exposure.
- Seek the advice of financial advisory firm.
Being conservative doesn’t mean not doing anything new, it means constantly trying to find ways to decrease risk. Any time one can reduce risk and increase profitability, it should be strongly evaluated.