Getting capital levels right

How much capital a bank should have is one of the overriding questions in the industry today. In this blog I’m going to suggest an approach to how to think about the question in the community bank context and show how this process can produce a reasoned answer.

The beginning: Why?

Let’s start with why we need capital in the first place. “Regulators” is the first answer that comes to my mind!

Indeed, throughout the industry, for the largest and smallest institutions, regulatory pressure tends to drive up capital levels. In the big banks, there are quantified methods in place; in community banks, beyond the basic minimum ratios, there really aren’t.

In addition to regulators, though, capital is also important to other actors and stakeholders. Market participants, including creditors, stockholders, and counterparties, have capital expectations. And so, of course, does management and the board. Peace of mind for these groups is of great value.

Why is there such emphasis on capital in the first place, though?

The answer may well be that there are safety nets built into the financial system to provide liquidity in the event of crisis. Ultimately, there is the Federal Reserve System’s discount window, which is designed to be the lender of last resort to a solvent bank experiencing a liquidity crisis. That means a bank with good, but illiquid loans, that has inadequate cash on hand.

There are no such safety nets for insolvent banks.

A bank heading below minimum capital levels that wants to stay in business needs to go to the market to raise capital. And that’s just the time when the bank is least attractive. And when existing stockholders will experience maximum, perhaps close to complete, dilution.

A similar scenario plays out if the strategy is a voluntary sale.

So having sufficient capital to suffer through the worst of times means we don’t have to be a seller when there is blood in the streets, even if it’s just on our street.

Capital is meant to maintain balance sheet solvency. Of course, mere solvency is not enough. We need to think of maintaining minimum levels of capital to satisfy regulatory and market pressures. Counter to that is the need to provide the earnings per share and return on equity that stockholders expect, and to drive growth in either or both metrics.

Capital based strategy and performance

The basic safety that capital gives is the ability to absorb bad times so we are around to enjoy the good times. But the world is unpredictable, and so the amount of capital we need too is uncertain.

If everything were predictable, we would know just how much capital is necessary.

That is the equivalent of capping the downside, a strategy we employ in portions of our operations through insurance or insurance-like contracts. But there is no such solution for a bank as an entity.

The right amount of capital therefore starts with thinking about how volatile, and ultimately unpredictable, our performance is likely to be.

History is a good place to start. Does our business strategy show large swings in performance? 

Think also about how confident you are that you understand the forces leading to the level of volatility observed. We generically use the term “risk,” but often we are dealing with uncertainty?

Risk is typically measurable and capable of being diversified, while uncertainty arises in the face of the unknown. Both factors are in play when we consider the appropriate level of capital.

A caution worth considering here is that our own experience may be anomalous, leading us to underestimate or overestimate the riskiness in our strategy. So look at what others have experienced with similar approaches. Then reconcile that with your own.

Taking a page from larger players

One approach to capital that the larger organizations consider is known as “economic capital.”

Simply put, this is the amount of capital we need over a full business cycle to drive to a very high degree of certainty the likelihood of staying solvent. (Think 99.95% or higher.) 

That’s fine, but solvent isn’t good enough. No banker wants to run significant risk of falling below a certain minimum capital level. That’s where the metrics begin to be less informative, although entirely calculable. Instead, management judgment plays a larger role.

As a practical approach, consider benchmarking your capital level, or target amount, to current industry levels. The current average is about 9%. That is historically high, but that is the state of affairs in our post-crisis world, the result of regulatory pressure.

Consider your bank in the risk spectrum compared to community banks generally:

• Is your loan portfolio high quality and well diversified?

• Is the investment portfolio low risk and of modest duration?

• Are income streams consistent? 

• How does your growth plan stack up against market growth? 

Review all of this, as well as other comparisons that you believe make sense and provide insight.

Then benchmark. If your bank is at the lower range of risk, think of targeting 8% -  8.5%. If you’re at the upper range, think more in the area of 9.5%. It’s my view that the historically high levels in the industry today in the community banking world will dissipate slightly over time, so consider only modest adjustments to the upside.

Put it all down on paper

Build triggers into your capital plans appropriate to the targets adopted. Build in regular review mechanisms, of course, probably as part of your annual strategic plan.

Have you CFO or CRO lay out your analysis in writing as part of the plan. That way, when regulators ask why you chose a particular capital target, your answer will be ready to produce.

For more about risk and regulators, see Dan Rothstein’s “Talking To Regulators About Risk”