Don’t give leverage risk short shrift

Any lender presumably has had a good dose of credit analysis in his or her background and so should understand financial leverage, right? 

Yet, as a credit administrator, lender, workout manager, and loan committee chairman, I’ve run into lenders and credit staff who really don’t fully appreciate what leverage is, nor what it can do.

There are several ways to adjust the leverage contained on a bank’s balance sheet over time—eight for the sake of today’s discussion.

I like to think of them this way:

• Three are old-fashioned, “text book” ways of doing it: sell new equity to existing or new owners; adjust the deposit levels (e.g., more loans, less deposits or vice versa); and adjust the dividend payout ratio.

• Some are completely invisible and represent the degree of credit risk we accept into the loan portfolio. I’ve identified four for this discussion.

• And one is new to industry thinking and is a result of Dodd-Frank: Shrink the bank due to Too Big To Fail constraints or concerns.

Looking into leverage

Last month in a blog called “Sin Of Loan Risk Isn’t The Risk” I discussed how credit standards might be under assault as banks struggle to increase lending volume in an environment where high-quality credit opportunities are still relatively scarce.

Subsequently I was drawn into a discussion with a lender that indicated he and I were not on the same wavelength. He has a narrower view of leverage than I do and as a result, I suspect that he can unknowingly increase or decrease the amount of leverage on his bank’s balance sheet.

The point comes down to this: How much risk is a bank willing to accept? Ultimately it leads one to a value judgment on how much leverage is enough and how much may likely be too much.

Equity absorbs losses. How else can a balance sheet balance?

If an asset shrinks in value, the offset to the other side of the balance sheet is equity. That’s a simple concept and it’s really easy to both understand and explain.

In my early days in the Bank of New York’s training program, my fellow trainees and I were taught that banks are relatively highly leveraged enterprises. Many industrial firms have debt-to-worth (equity) ratios of, say, two to one.

Put into a simple declarative sentence it says that a debt-to-equity ratio of 2 to 1 means that for every two dollars of debt, there’s a dollar of equity (or for every dollar of debt, there’s 50 cents of equity).

Banks, however, routinely have debt-to-equity ratios of 10 to 1 and sometimes more than that. The simple consequence of that relatively high ratio, compared to an enterprise with a ratio of 2 to 1, is that a bank’s balance sheet is no place for assets that represent significant degrees of risk. Our assets have to be deliberately pristine in the risk sense.

In other words, not all risks are for banks. We just don’t have a big shock absorber.

The ultimate quality of a bank’s profitability over time is its return on equity. This is simply the return that a bank makes on its equity capital. The ratio is calculated by dividing income by average total equity. For many years, banks had ROE ratios in the middle teens. In the years running up to the financial crisis of 2007-2008, some of the very large banks enjoyed ROE ratios in the low to mid-20s.

“How do they do that?” I occasionally wondered. 

Well, in hindsight we now know that they really couldn’t.

To improve ROE, one can increase the numerator (income) or decrease the denominator (equity). Some banks were doing both simultaneously. Over time, that produces higher levels of risk.

The level of equity on the bank’s balance sheet broadly measures the bank’s ability to absorb shrinkage in the carrying values of assets. When loans become uncollectible in whole or in part, there’s a diminution of value. And this directly relates to my comment above that asset quality of banks, owing to the degree of leverage on their balance sheets, should be pristine.

The way that my age cohorts and I were trained, this was both the expectation and the reality and the concept is still an honored and observed one at many banks—but not necessarily all of them.

The broad brush way of examining a bank’s leverage is the debt-to-worth ratio, but it can’t be uncoupled from the calculations of ROE. If equity levels proportionately are stable over time, one can still juice up the ROE by juicing up interest income through higher risk levels or by funding more loans at the expense of liquidity.

Three “classic” ways of adjusting bank leverage

We can sell new equity.

We can increase or decrease the dividend payout ratio.

And we can deliberately modify the mix of loans and deposits (e.g., more loans and fewer deposits or vice versa).

Selling new equity usually dilutes the value of the current shareholders’ investment, while limiting the dividend payout ratio to stockholders tends to depress the total return on our shareholders’ investment.

Bankers would rather do neither, of course. But for a bank to grow and remain properly capitalized, we sometimes have to raise new equity or retain more of our earnings to support growth.

Invisible growth of leverage

While there are many ways that this can occur, I’ll mention four ways that we can modify credit terms that I think are fairly common today and will ultimately lead to higher levels of balance sheet leverage. These are:

1. Higher collateral advance ratios

2. Longer amortization schedules

3. Less-restrictive loan agreement covenants of either an affirmative or negative nature

4. Limitations on or simply waiving of the guaranties of the borrowers’ principals.

“Brave New World” option

In the wake of Dodd-Frank’s passage, there is another way: Shrink the bank.

This is really what the Too Big To Fail issue is all about.

• If a bank is too big, make it smaller.

• If it’s too complicated, make it less complicated. (Which is perhaps a distinction without a difference if you’re the stockholder of a large, systemically important institution).

Lenders are any bank’s front-line sales people and shrinking the institution is not normally a component of a lender’s DNA. We are constituted and trained to think that more of just about anything is better—deposits, assets, loans, customers, etc.

Come to think of it, that probably includes financial leverage, too.

Take leverage seriously

To sum up: I’ve identified eight ways that a bank can adjust its financial leverage. It can raise new equity; adjust dividend payout levels; expand or shrink the bank’s asset base and its composition; shrink the bank down; plus four ways to tighten up or relax key deal points on loans. Each of these categories of options has its share of proponents and opponents.

The common industry-wide discussion points are that we don’t want to dilute the current owners; we prefer to increase the dividend to our shareholders; we face enormous competitive pressures for loan business; and who wants to shrink the bank?

These are not easy choices that management and directors face. But they are the current ones on our plate now.

It’s important to understand—and acknowledge—that some of us may be increasing our financial leverage by compromising lending terms and that these are a currently invisible phenomenon.

The practical long-term effect of more leverage is a reduced ability to absorb loss in asset values—those periodic shocks to the balance sheet that can arise from a variety of sources including a hyper competitive loan environment or from a period of negative earnings.

Bankers do understand the principles of leverage, although they don’t always think the issue through very thoroughly. To the extent that relaxing loan standards is seen as increasing leverage, perhaps some institutions will realize what they are facilitating with their attitudes and practices.

My urgent point is that we are shifting the needle on risk in ways that we had never considered nor are currently measuring.

As I observed last month, the sin isn’t accepting the risk.

It’s not recognizing the risk in the first place.