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How do you slice up capital?

Allocating capital represents key board duty

From the “Examiner from Hell” to “The director time forgot,” attorney-consultant Jeff Gerrish knows community bankers’ challenges, and provides practical advice and awareness. From the “Examiner from Hell” to “The director time forgot,” attorney-consultant Jeff Gerrish knows community bankers’ challenges, and provides practical advice and awareness.

Most of my clients around the country post-election seem to think that “happy days are here again.”

This apparently means everything from reduced regulation to reduced taxes. Details notwithstanding, the general mood in the community bank sector is upbeat to see what President-Elect Trump does. 

(Personally, I am shocked and mildly disheartened that I have not yet received the knock on my door or e-mail in my inbox informing me that the President-Elect wants to appoint yours truly to some significant financial position. I am, after all, a former employee of the FDIC; a staunch supporter of community banks and local business; and a well of experience and financial acumen. Really, it should be any day now. I will keep you all posted. Mr. President-Elect, if you are reading this, I promise I will act surprised at the nomination.)

Notwithstanding the positive outlook for the future, community banks across the nation still have to deal with their existing issues. One of those major existing issues is capital.

I have said for years now that “capital is king.” This was certainly proven in the Great Recession. Capital, particularly for community banks, was hard to come by—and expensive when it was found. Capital planning was a rigorous and often discouraging exercise for community bank boards.

Today, however, it seems the issue for most banks is not capital planning, as such. That is to say, the issue is not how do we get more capital, but rather, how do we allocate the capital that we already have.

Are you heading where the wind takes you?

For many community banks, capital allocation decisions occur in large part by default. Opportunities arise, and capital flows in that direction.

True capital allocation planning, though, should be much more strategic. Some components may occur by default, but the process should never be reactive.

For every community bank, the first step in the process should be determining the board’s minimum capital comfort level. Whether that minimum threshold is an 8% Tier 1 leverage ratio, 9%, 10%, or otherwise, this decision sets the tone.

If the threshold is above the bank’s current capital level, then earnings must be retained to build up to the targeted level. If, however, the bank’s current capital level is above the minimum amount set by the board, then there exists “excess” capital that needs to be allocated.

Once the minimum capital threshold is set, the first capital allocation has to be to support balance sheet growth.

If your bank’s balance sheet is growing, then capital needs to be there to support it, at whatever level of leverage capital the board has determined.

For example, if the board determines it wants the bank to maintain a 10% capital ratio and the bank grows by $10 million, then the bank is going to need to retain $1 million to support that growth. It is not rocket science, but it is a critical step in the planning process.

If the bank’s asset growth outpaces its capital growth, then the lack of capital provides unnecessary constraint on the growth.

Don’t make the mistake of growing yourself into a shortage of capital. Plan for the growth.

Plan for outflows too

The next step in capital allocation is to determine what fixed costs exist that require capital.

For example, are there interest payments on debt or trust preferred securities at the holding company? For some odd reason, lenders like to be paid back, so that is a fixed-cost capital allocation.

What about distributions in a Subchapter S, particularly the tax distribution? Along the same thought process, shareholders of a Subchapter S organization sure do like to get enough money to pay their tax liability from bank earnings. That is a fixed cost.

What about a dividend?

While a dividend is arguably a variable cost (i.e., a cost that the bank could or could not pay), the reality is most community banks’ dividend policy is “We never want our dividend to go down. We want it to incrementally increase.”

At that point, the dividend has practically become a fixed cost requiring capital.

What gets the remaining slices (if any)?

Once all fixed costs have been accounted for, the next step is determining whether there is any capital left to allocate.

If there is, what are the other alternative choices?

A common allocation alternative these days is the acquisition of another bank. Obviously, that can require a sizeable chunk of capital, so many banks end up stockpiling capital for that “perfect” deal.

In reality, boards of directors need to have a backup plan if that dream deal doesn’t exist in the present or foreseeable future.

One bank I was with recently wanted to allocate its capital toward a bank acquisition. The problem was the board members could not find any bank that either they wanted to acquire or that was in the size parameters that they could acquire using existing excess equity capital and newly obtained debt capital.

In that situation, while the allocation of capital toward acquisitions was the priority, it was not practically feasible.

There always should be a plan B.

Another allocation alternative is the acquisition of a branch—that is, let’s bring on a lot of assets at one time via acquisition rather than organically over time. As with organic growth, the acquired assets need capital support. And there is always the issue of a purchase price premium.

Buy yourself

What about the redemption of the company’s own shares?

This is probably one of the better uses of capital for community banks because it provides a win-win to all shareholders.

• Those shareholders selling receive their cash, pay their taxes, and go on their merry way.

• Those shareholders who do not sell (i.e., those remaining with the holding company), see an increase in their ownership percentage; an increase in earnings per share; an increase in return on equity; and the illusion of share liquidity.

In addition, if the dividend policy happens to be that “We are going to pay a dividend that is a percentage of our earnings,” then remaining shareholders will likely see an increase in the dividend. It’s a win-win for community banks and their shareholders.

Allocation’s a key responsibility

Although “happy” days are seemingly here again (and they will be even happier if the tax rate drop to 15%, which President-Elect Trump has mentioned), the garden variety decision making of allocating capital still needs to occur.

There are capital allocation alternatives other than those mentioned here, but these are some of the bigger ones. Regardless of the specific use, remember that capital must be allocated with the overall goal of enhancing shareholder value for all the community bank holding company shareholders.

That is bank leadership’s real job, after all.

Regardless of who sits in the Oval Office.

Jeff Gerrish

Jeff Gerrish is chairman of the board of Gerrish Smith Tuck Consultants, LLC, and a member of the Memphis-based law firm of Gerrish Smith Tuck, PC, Attorneys. He frequently contributes to Banking Exchange and frequently speaks at industry events.

In mid-2016 Gerrish's blog received a national bronze excellence award from the American Society of Business Publication Editors. This followed his receipt of the regional silver excellence award for the Northeastern Region from the same group.

Gerrish formerly served as regional counsel for the FDIC’s Memphis regional office and with the FDIC in Washington, D.C., where he had nationwide responsibility for litigation against directors of failed banks. Since the firm’s formation in 1988, Gerrish Smith Tuck has assisted over 2,000 community banks in all 50 states across the nation with matters such as strategic planning, mergers and acquisitions, common stock private placements, holding company formation and reorganization, and a wide variety of regulatory matters. Jeff Gerrish can be contacted at [email protected].

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