Falling ROEs and Excess Capital

Transcription

1 Falling ROEs and Excess Capital AmbassadorAlert 4th Quarter 2014 In 10 years, we are likely to remember 2012 as the best year in banking since the economic crisis ended; 2012 was the year bank returns on equity (ROEs) peaked. It also marks the beginning of the need for community bank CEOs to figure out how to best manage excess capital, as leveraging capital by making new loans to drive balance sheet growth is, for most bankers, a thing of the past. Over the first and second quarters of 2014, Ambassador s Quarterly Community Bank Report has highlighted these two trends for the banks in the middle-atlantic and Midwest. In our reports, we traced back the history of today s community banks back to 2012 and 2009 to show the percentage of banks that have good ROEs (over 10%) and the percentage of banks that have excess capital (over 9%). It is important to note that the historical data from 2009 and 2012 includes only banks that exist today and includes only banks with assets under $5 billion. That means the results accurately reflect the history of banks that exist today (banks that sold or failed are not included) and the only banks included are community banks. Before discussing the decline in ROEs since 2012, we should first focus on one of the causes, the increase in excess equity. Certainly, we can all agree that as equity increases, unless earnings keep pace, ROEs will fall. Where we are sure to disagree is on how much leverage is the right amount. Considering that the FDIC holds only de novo banks to 8% leverage (for their first seven years), we chose 9% to give us a little cushion for what we define as excess equity. I m sure there will be those that disagree. Table 1: Change in ROEs and Leverage Full Year 2009 Full Year 2012 First Half 2014 % of banks with an ROE over 10% Middle Atlantic 21.4% 26.7% 17.5% Midwest % of banks with over 9% leverage Middle Atlantic 51.4% 66.4% 69.3% Midwest Source: SNL Securities continued on page 2 AmbassadorAlert 4th Quarter 2014 Falling ROEs and Excess Capital 1

2 In the preceding table on page 1, the percentage of banks with excess equity is increasing in both regions. In 2009, immediately after the crisis, 51.4% and 61.1% of banks in the two regions had a leverage ratio over 9%. Over the next few years, as banks were no longer forced to contribute large sums to reserves and earnings picked up, there was a substantial increase and by June 30, 2014, the percentages were a much higher 69.3% for middle-atlantic banks and 78.1% for Midwest banks. Consider that second percentage again: 78.1% of Midwest banks have more than 9% equity, and this percentage is increasing. Why is this happening? Since the peak of the economic crisis, bankers have been concerned with not having enough capital. In 2009 and 2010, it was difficult to raise capital at prices that were acceptable to bankers. Even though capital markets have significantly improved, many bankers remain cautious about approaching the market for capital. In more recent years, bankers worried about rising rates creating large losses in their available-for-sale (AFS) portfolios, which could significantly lower their equity (even if it doesn t show up on the income statement). This fear was not unfounded, as a rate rise in mid-2013 did reduce capital for many banks. Additionally, bankers worried about changes in regulatory capital levels. This was also not unfounded, with Basel III on the immediate horizon, and a Federal Accounting Standards Board (FASB) proposal regarding changes in the computation for reserves is on deck for 2017/18. continued on page 3 AmbassadorAlert 4th Quarter 2014 Falling ROEs and Excess Capital 2

3 Another reason that capital ratios increased was at least an optimistic one. The thought was that, when the economic crisis finally ended and asset quality issues were worked out, the economy would recover and loan demand would increase. Unfortunately, the recovery remained weak and the loan demand never materialized. Thus, the capital that would have been deployed remained idle. This is more of an issue for banks in good markets that in the past were accustomed to growth than banks in more rural markets that were much less affected by the downturn in real estate values and did not have much growth before the crisis hit. Finally, capital ratios increased because almost all banks are back to making money. In the first half of 2014, about 93% of all banks were reporting profits and these earnings are now consistently contributing to the capital base. The banks that remain unprofitable today are true outliers and tend to have very unique issues. Thus, over the past six years, bankers have been trained to preserve and increase capital. At first, this was a good thing, but as we move forward into 2015, the excess capital will continue to build as earnings pile up and loans remain elusive. All this will have a negative effect on ROEs and potentially make it more difficult to attract or maintain investors. The table at the beginning of this article also shows that ROEs peaked in 2012 and have begun heading down. In 2012, roughly 26% of the banks in the two regions had ROEs over 10%. In the first half of 2014, the percentages slipped to 17.5% in the middle-atlantic and 24.5% in the Midwest. The larger fall was in the middle Atlantic region, which of the two regions has a more competition from the nation s largest banks and several foreign banks as well as much higher costs for personnel and branches. While it is too early to consider the decline in ROEs a long-term trend, it is difficult to see how the trend will reverse itself. With lower demand for loans and continued profitability, the excess equity that is building will remain undeployed. This means that over the next few years, bankers are going to have to find ways to manage excess capital. There are essentially four options: 1. Increase payout ratios by declaring higher dividends or repurchase shares. 2. Use excess capital for acquisitions (consider using more cash in the deal, acquiring an institution that uses more leverage, or acquire a branch along with some loans). 3. Increase loans by lowering credit standards and/or competing on rate. 4. Let the capital pile up and accept a lower ROE. The easiest option is the first increase payout ratios by declaring higher dividends or repurchasing shares. Increasing the dividend rewards your shareholders and also creates a strong dividend yield to attract investors and stabilize stock prices. This has been something more mature banks in low growth markets have done for decades by paying out 50% or more of earnings. For younger banks or banks in growth markets this will be a major change, transitioning to a more mature lower growth company. Stock repurchases have the additional benefit of increasing earnings per share (EPS) for the remaining shareholders. If the bank s value is based on earnings, this may help boost value, but if the value of the bank is based on tangible book, it may not translate into more shareholder value. continued on page 4 AmbassadorAlert 4th Quarter 2014 Falling ROEs and Excess Capital 3

4 The second option, using capital for acquisitions, is obviously not as easy as paying out dividends, but the rewards can be significant in terms of boosting earnings. With loan growth stunted, the only way to significantly increase earnings is by cutting costs, and with most banks having already cut costs as far as they can, the only way to achieve significant earnings growth is through the acquisition of another bank and achieving 25%-to-50% cost savings on the seller s overhead. Acquisitions that use cash further contribute to earnings by reducing the number of shares issued. This increases EPS going forward, and for those with good earnings who trade on a price to earnings multiple, this can lead to increased value to shareholders. Using cash also may help reduce the number of shareholders wanting to exit post-merger, which can put downward pressure on a buyer s stock. The third option, increasing loans by reducing credit standards, is not appealing but is already well under way. With loan demand weak, often the only way to originate a loan is to offer better rates and terms. Additionally, larger banks with huge cash positions on which they earn almost nothing are now actively competing for the good commercial loan customers of community banks. The final option, to let the capital pile up and accept a lower ROE, is also unappealing, but that is what the table at the beginning of this article shows is starting to happen. If this becomes the norm, it will begin to drive off investors who become frustrated with share values tied to tangible book values that are only slowly increasing and/or dividends that are too low to be competitive with other investments. The bottom line is that capital management has changed over the past few years from capital preservation to capital deployment, Those banks that excel are going to be those that figure out whether capital is best deployed within the bank, in an acquisition, or by returning it to shareholders. David G. Danielson Head of Investment Banking AmbassadorAlert 4th Quarter 2014 Falling ROEs and Excess Capital 4

5 THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA (toll-free) East West Highway Suite 305 Bethesda, MD (toll-free) Joshua A. Albright, CFA Allen R. Collins Chief Compliance Officer Arnold G. Danielson Chairman Emeritus, Danielson David G. Danielson Head of Investment Banking Christopher B. Donahue Financial Analyst Jacob Eisen Head of Capital Markets Ryan G. Epler Tad Gage Managing Director Heidi Geist Administrative Assistant James R. Gillen Business Development Belle Gutschick Administrative Assistant Mike Harrison Vice President Karl J. Ostby Investment Banking Robert J. Pachence, Jr. Co-Founder & Managing Principal John D. Putman Senior Vice President Michael Rasmussen Investment Banking Matthew T. Resch, CFA Co-Founder & Managing Principal Eric R. Tesche Managing Director Mark B. Trinkle John S. Walker, Ph.D., CFA Director of Research & Chief Economist The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc., a current member of FINRA/SIPC. For more information contact us at Ambassador Financial Group, Inc.