Friday, March 27, 2015

Perception Versus Reality: Do People Get More From Credit Unions Than Banks?

The Credit Union National Association (CUNA), the credit union equivalent to the American Bankers' Association (ABA), states that credit unions exist to serve members, returning earnings to members in the form of lower loan rates, higher interest on deposits, and lower fees.

Nearly four years ago, I tested the higher interest on deposits claim in a guest post with the exact title on The Financial Brand, an industry publication geared towards marketing executives at banks and credit unions. The reaction that I received, in person, via e-mail, and in the comments were a little sharp-edged. Clearly this remains an emotional issue.

When the going gets tough, go to the facts. In 2011, banks paid higher interest on their interest bearing deposits than credit unions throughout the measurement period. 

When I re-ran the analysis, what was true back in 2011 still holds true (see chart).

There is a difference in my analytics. I searched on banks and credit unions between $500 million and $5 billion in total assets. I took a wider swath in 2011 with institutions between $100 million and $10 billion. Today's analysis reduced the amount of very small financial institutions.

I continued to control for commercially oriented banks by limiting to banks with less than 30% commercial real estate or commercial business loans as a percent of total loans. Those banks tend to have higher level of business deposits, which tend to drive down cost of deposits. However, to further control for this, I only selected interest expense as a percent of interest bearing deposits, not counting checking accounts that pay no interest.

Based on the above, for the sum total of all interest bearing deposits, banks pay higher rates, on average.

Surprisingly, changing the institution size did tell a different story in non-interest expense to average assets, or what is termed the expense ratio (see chart).

Perhaps the financial crisis, which credit unions survived surprisingly well with the exception of corporate credit unions (similar to bankers' banks), woke up credit union leadership to scrutinize operating expense to increase profits. 

Yes, you read profits. Where do you think credit unions get their capital? If credit unions suffered a similar fate to many community banks, they couldn't back up the truck for shareholders to pony up equity to help absorb losses. Becoming more profitable was the logical solution to building up capital positions.

There are probably other reasons at work. In 2011, those expense ratios for credit unions were in the fours (greater than 4%). That was likely due to my going down to institutions with $100 million in assets. While I did the same for banks, many smaller banks are privately owned, one branch operations with very low expense ratios. By raising the bar to $500 million, my analysis likely raised bank expense ratios by excluding those hyper-efficient small banks, and reduced credit union expense ratios by eliminating very small, inefficient institutions.

As the charts show, there is little difference in expense ratios, on average, for the measured institutions. 

I think both trend charts show something that previously happened between thrifts, savings banks, and commercial banks: the homogenization of business models. In the late 1990's, many traditional thrifts entered commercial banking with both feet. The result is falling net interest margins for banks and rising net interest margins for thrifts, long term. Thrift expense ratios began to rise as they took on the more expensive commercial banking teams,

Credit unions are shedding their Select Employer Group (SEG) strategies by adopting community charters or by adding so many SEGs that nearly everyone qualifies to join. They have entered commercial banking to the extent permissible by their regulators. So I expect financial performance ratios to begin looking more and more like their bank competitors.

Except for the shareholders. And the taxes.

Do you thing credit union and bank business models getting more similar?

~ Jeff

Sunday, March 15, 2015

Bank Deals: How Are They Working Out for You?


Bank mergers are picking up steam. Technological change, regulation, and scale are cited most often by sellers. Take a premium now, rather than drift slowly into the abyss of irrelevance.

But what about buyers? I have written about achieving positive operating leverage in the past. In fact, it is one of my most read blog posts. In his most recent Chairman's letter, Warren Buffett weighed in with the following about buyer performance post acquisition:

"We've also suffered financially when this mistake has been committed by companies whose shares Berkshire has owned (with the errors sometimes occurring while I was serving as a director). Too often CEOs seem blind to an elementary reality: The intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive.'

'I've yet to see an investment banker quantify this all-important math when he is presenting a stock-for stock deal to the board of a potential acquirer. Instead, the banker's focus will be on describing "customary" premiums-to-market-price that are currently being paid for acquisitions - an absolutely asinine way to evaluate the attractiveness of an acquisition - or whether the deal will increase the acquirer's earnings-per-share (which in itself should be far from determinative). In striving to achieve the desired per-share number, a panting CEO and his "helpers" will often conjure up fanciful "synergies." (As a director of 19 companies over the years, I've never heard of "dis-synergies" mentioned, though I've witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. The should instead be standard practice."


How can Warren's words be put into practice? To exemplify, I took two of the largest acquisitions in 2011 to back-check if it improved the buying bank's EPS and efficiency ratio. I went back over three years because mergers should be considered and executed with long-term financial improvement and overall bank strategy in the forefront of the "should we buy" decision. Citing the first few "clean" quarters after closing the transaction perpetuates the short-term budgeting culture that plagues our industry and prohibits long-term investing. By looking three plus years after merger announcement, I avoid that self defeating game.

I didn't take the largest deals from 2011, which were: Capital One Financial/ING Bank ($9.0B), PNC/RBC Bank (USA) ($3.5B), and Comerica/Sterling Bancshares ($1.0B). These transactions were so large, and two were foreign banks selling US subs, that it doesn't relate to my readers. But the next two deals in the table certainly relate.

Both deals look like they improved the buyer's EPS, with People's United achieving a 10.8% annual growth rate and Susquehanna achieving an even better 19.9%. People's efficiency ratio, a measure of how much in operating expenses it takes to generate a dollar of revenue, went down slightly. Achieving economies of scale should drive down the efficiency ratio. Although People's decline in this ratio was small, the relative size of Danvers ($2.6B) was only 10% of People's size ($25.0B) at the time the deal was announced.

Susquehanna's efficiency ratio went up. This is counter-intuitive, especially since Tower's relative size ($2.6B) was more significant to Susquehanna's ($14.2B) at the time of announcement. One would think that realizing the necessary cost savings to justify paying a premium would result in a lower efficiency ratio. Susquehanna was unable to achieve this "economy of scale". It is also worth mentioning that Susquehanna's earnings were sub-par at the time they announced the Tower deal. They had a 0.32% ROA at announcement. Not something to include in the shareholders' letter. Nowhere to go but up, right?

People's, on the other hand, had a better ROA (0.84%) when they announced the Danvers deal than in the fourth quarter (0.74%). The primary culprit was a precipitous decline in net interest margin of 116 basis points (yikes!). The fact that their efficiency ratio went down tells me they hit their operating expenses hard. As Warren alluded to above, I bet that wasn't in their post-merger projections.

I don't think it's very complicated to decide to do a transaction or not. What fits your strategy? Can you build it or must you acquire it? If an acquisition, can you afford the premium for the target so your bank is better off for having done the deal than passing?

Once you land a deal, accountability should be equally uncomplicated. My firm once represented a bank that had an activist investor on the Board. All that guy wanted to talk about was the efficiency ratio. Very one dimensional. But I digress.

He did hold management accountable for achieving the cost savings in the projections. So management prepared a spreadsheet of the phase-in of cost savings and the overall cost structure of the combined bank once all synergies were achieved. It wasn't a very complicated spreadsheet, and also gave management some leeway to alter where things were cut, so long as they achieved their aggregate numbers.

At the end of your strategic measurement period post-acquisition, the value of your bank (intrinsic value mentioned by Warren) should be greater for having done the deal than if you went it alone. If People's and Susquehanna could not achieve the earnings growth in the table above, then doing those deals improved their value.

If each could have achieved those numbers on their own, and there are reasons to believe they could have, then why do the deal at all?

Is it a fair question?

~ Jeff



Saturday, March 07, 2015

Say It Ain't So Doug! Square 1 Bank Sells to PacWest

In the name of head scratchers, Square 1 Financial of Durham, NC, one of the most successful startup banks in a generation, is turning over the keys to PacWest, a California bank. The deal left me scratching my head, because at first glance it made little sense that a bank with Square 1's earnings trajectory would sell.

Niche banks are a growing part of our financial institutions landscape. I often cited Square 1 for their focus and success. In their own words, "Square 1 is a financial service company focused primarily on serving entrepreneurs and their investors." A bank with a focused strategy! Brings a tear of joy to my eye.

It had one banking office (in Durham), and twelve loan production offices located in key innovation hubs across the US. Its Chairman and CEO, Doug Bowers, was a 30-year BofA vet and more recently a member of a private equity firm. So the niche Square 1 adopted made sense.

But why sell Doug?

An industry reporter hypothesized that it was the price... 22x earnings, 262% of tangible book... c'mon?! But that was close to where Square 1 was trading at announcement. So there was no price premium. In fact, the below chart demonstrates that if Square 1 remained independent, their stock price would soar past the value received in this merger.

Like most projected performance, the devil's in the details. What I did was assume Square 1's 3-year compound annual growth rate in EPS (86%) linearly came down to earth to 12% by the end of the projection period, which is PacWest's 3-year EPS CAGR. I assumed PacWest's 12% would continue throughout the projection period. If all were true, it would have been more beneficial for Square 1 to go it alone. It is what I term "earning their right to remain independent."

So if future valuation wasn't the reason, then why? Perhaps they are receiving an outsized portion of the resulting bank than their current contribution. As I mentioned above, Square 1 did not receive a price premium from PacWest. So their pro forma ownership of PacWest is pretty much in line with their contribution (see table). Usually in a merger the seller receives a larger pro forma ownership stake because they receive a premium on their stock and they are relinquishing control. Not so, in this case.


So why did they sell? Here is what Bowers said in the press release: "Joining PacWest will be a terrific opportunity for our clients, employees, and stockholders. Square 1 offers PacWest a complementary line of business and significant core deposit growth. As part of PacWest, we will maintain our steadfast commitment to the entrepreneurial and venture communities, will be able to offer clients a wider array of products and will be well-positioned to continue to serve them through all stages of their growth."

That seems to tell us why PacWest bought Square 1, not why Square 1 sold to PacWest. So with Doug silent on the issue, here are my opinions on why one of my darling niche banks turned over the keys:

1. Institutional Ownership - Square 1 went public last March, raising $52 million at $18 per share from primarily institutional owners. The company was 70% institutionally owned with such names as Patriot Financial Partners, Castle Creek Capital, Endicott Opportunity Partners and other notables. Some had 5%-10% stakes, or about two million shares. Square 1 traded about 30,000-40,000 shares per day until around February 24th, when volumes soared (a fact that will not be lost on FINRA, although increased volumes prior to a merger announcement are not uncommon due to speculation). With such significant institutional ownership and relatively light normal trading volume, it would have been very difficult for those investors to lock in the trading gains experienced by Square 1 from November-February. How do you lock it in.... sell. Even if you are paid no premium. You can still lock in the price appreciation since you bought into the IPO.

2. Law of Large Numbers - As Square 1 grew larger, it would have to generate larger and larger amounts of business volume just to keep pace. For example, they had a $1.3 billion loan portfolio, the vast majority of which was commercial business loans. If 25% of that portfolio turned over every year, and I suspect it was more because business loans churn faster than commercial real estate loans, they would have to originate >$400 million of new/renewed loans per year to keep pace. Never mind growth. Which brings me to my third potential reason for selling...

3. Growth Trajectory - Square 1 was trading at 22x earnings when they sold. Banks their size typically trade around 13x-14x earnings. The premium was most likely the result of their balance sheet and earnings growth. Perhaps Doug and his senior management team were staring down the barrel of normalized growth. As investors began to recognize the slower growth, multiples would intuitively come down to the planet earth, suppressing stock price appreciation until the multiple normalized. That could have meant trading in a tight price range for a number of years. Why not lock in your tremendous gain since the IPO, and move on?

Square 1 was truly an extraordinary financial institution and I am sorry to see them go because I held them up as a premier example of how focused effort can lead to superior results.

If Doug Bowers and team were facing normalized growth and stock price appreciation, they could have decided to "cash cow" the bank, turning over a significant part of their earnings to investors in the form of dividends. In 2014, they enjoyed a 1.25% ROA and a 12.85% ROE. A great candidate for a cash cow. 

But alas that ship may have sailed when they backed up the truck to the institutional investor loading dock. They were numbers on a spreadsheet and were supposed to deliver the fund managers a big win. 

They did.

What else could Square 1 have done to satisfy their investors?

~ Jeff


Saturday, February 21, 2015

Breaking Branch Mediocrity

Another day, another convoluted organizational structure that includes “small business bankers” that are dispersed into the branch network to shore up branch capabilities. If not small business bankers, it’s “cash management officers”, or “business development officers”. Why add a protective wrap of additional employees around your branches?

Because branch staff are too busy with operational duties to go out into the community and pro-actively hunt for business. I’ve been to a lot of branches as I travel the land looking for opportunities for banks to improve profits. I rarely see a “busy” branch. One time I saw a line for a teller and was so amazed at the site that I snapped a photo. The bank security officer set me straight. Don’t case the joint.

If bankers were truthful to themselves, they would recognize that these branch wraps, i.e. additional employees with fancy titles, are nothing more than covering up for the perceived shortfall in branch staff skills to be the face of the bank in our communities and pro-active business developers. If you are nodding your head in agreement, read on. 

If you are irritated at the theory and are scrunching your eyebrows like you bit into a lemon, then continue to add the layers to your organizational structure and move on to an article about the “branch of the future”.

Instead of adding staff and layering the cost onto an already burdened branch network (who pays for the compliance analyst you just hired?), why don’t you get the most from the investment you already make in your branches? I have four suggestions for you to improve the abilities of these critical profit centers.


1. Hire to execute your strategy. This assumes you have a strategy that is more focused than “we’re a bank”. If your strategy is to be the number one business bank in the markets that you serve, then hire branch employees that can speak intelligently to business owners about how your bank can better serve them. If those employees are inept at balancing a teller drawer, then so be it. If your staff is highly capable at ATM replenishment but cringe at the thought of speaking to a small business owner about a sweep account, read on…


2. Develop your branch staff. In my experience, the percent of banks that have specific training curricula for branch staff that goes beyond operations and compliance is somewhere south of Pi, if Pi were a percent, and I actually knew what Pi is. But you get the picture. When I was in the military, we had a training calendar for every functional position that included on-the-job (OJT), computer based, self-taught/correspondence, and classroom training. Each sailor was responsible for matriculating through the training program when they were not forward deployed. When they completed certain stages, they received certificates and were deemed “South-East Asia qualified”, or whatever designation the training was intended to accomplish. Do we have a “Small Business Qualified” designation in your training curriculum? If you are not satisfied with branch staff abilities to execute your strategy, and have invested the time and energy into developing them without results, then perhaps you have the wrong staff.  But don’t complain about staff capabilities if you have done nothing to improve them.


3.  Provide meaningful incentives. If you have heard me speak, I bang the drum loudly about branch incentives. You want branch staff to be the tip of the spear for small business relationship acquisition but give those that succeed a 4% raise and a $500 holiday bonus while those that are not successful a 3% raise and a $400 bonus? Why are we surprised that we have to build a “wrap” of different employees around branch staff? Instead of providing incentives based on deposit balances, how about branch profitability? Imagine the behavior differences if branch managers were charged with improving their deposit spreads, fee income generation, and managing their expenses? Would you get the desperate phone call for a rate exception for a $200,000 CD for a single-service customer to “keep the money at the bank”? Doubt it, because that $200,000 would be generating far less spread than the $40,000 operating account from Joe’s Tire and Battery. Even though Joe leaves grease at your teller counter every time he comes in. Why not pay branch managers for the important position that they hold in executing your strategy? Would it be beneficial to make variable compensation a greater and more meaningful component to the overall compensation package?


4. Communicate your strategyThat is, communicate it if you actually have a strategy. Being everything banking to everyone in the markets where you have branches is not a strategy, dear reader. If your strategy is the beef stew of all strategies (i.e. throw everything into the pot), then expect to be average. Wouldn’t that make a great epithet? Here lies Jeff, he was average. But assuming you have a strategy that clearly identifies the bank you strive to become, then communicate it to your employees! Who else do you expect to execute on the strategy day to day? If your strategy is to be the number one business bank, as ranked by the regional business journal, then identify objectives to achieve it and have your employees march a straight line to get there. Maybe then your branch manager will know that you want more customers like Joe’s Tire and Battery, regardless of having to use Mr. Clean on your teller counter after he leaves.



There you have it! Four concrete steps you can take to make branches more effective at achieving your strategic objectives. Did I miss anything?

~ Jeff


Note: This post first appeared as a guest post on Deluxe Corp's Forward Banker Blog in July 2014.

Saturday, February 07, 2015

Say on Pay for Financial Institutions


Researchers at Rice University performed a study on CEO compensation, including bank CEOs, relative to average employee compensation. The study was in reaction to the media's often cited pay disparity between the CEO's of the largest institutions and their rank and file employees.

As for banks, the Dodd-Frank Act mandates that all corporations administer a non-binding shareholder vote on the compensation of its executives. For publicly traded banking institutions, the study found the mean pay ratio was 16.6x, well within the 25x bounds identified by Peter Drucker in 1977.  

Not leaving well-enough alone, I did some digging into the matter on my own, knowing that when you move up the banking food chain (i.e. asset size), the disparity, or ratio, will get larger. But most community financial institutions don't live in that world, or so I thought. 

So I searched for publicly traded financial institutions with total assets between $1 billion and $3 billion that reported their CEO's total compensation (i.e. was not "NA"). The search yielded 148 financial institutions. I then took their annualized salary and benefits expense for their last reporting period and divided by their full-time equivalent employees ("FTEs") to come up with average salary and benefits per employee, and compared to the CEO's total compensation. 

The results are in the following table:


Although not the exact methodology of the Rice study, the table indicates that publicly traded community bank CEOs are not excessively compensated.

Since I went that far, I decided to see if there was a correlation between the CEO compensation multiple and financial performance, such as Return on Average Assets (ROAA). 

I took my search of $1 billion - $3 billion financial institutions and narrowed it down to $1 billion to $1.2 billion to keep a tight range, yet yield a decent sized sample. I eliminated companies with multiple bank subsidiaries, because the granular salary plus benefits and FTE data is typically at the bank-level. Plus I had to look and calculate manually. The search resulted in 36 financial institutions. 

I separated them into quartiles based on ROAA. The results are in the below table.



Each quartile had nine financial institutions. Interestingly, the bottom quartile performer had the greatest CEO to average employee pay disparity, the highest CEO total compensation, and the highest average employee salary. But I'm not certain the message here is to not pay employees well. Perhaps the bottom performers have too many employees AND pay them well, lacking the expense discipline to elevate financial performance.

The middle quartiles are similar in total CEO compensation and average employee compensation. In fact, the top through the third quartile are intuitive in their financial performance versus compensation versus the pay multiplier. 

In my experience, there are some financial institutions that pay executives well regardless of their relative financial performance. This was the main logic behind Dodd-Frank's Say on Pay.

The answer may not be in reducing executive compensation, although some Boards should consider it based on the facts. The answer, in my opinion, is to find ways to increase the compensation of rank and file employees. If we were socialists, we would mandate it and everyone would gravitate towards the lowest common denominator in employee productivity and financial performance would plummet.

But we're capitalists. And the way to increase real compensation is to improve productivity. That means instead of needing ten people in a department with average wages, we do it with seven people and pay above average wages. 

Time and again my firm reviews departmental processes that are outdated and unnecessary, technologies that are underutilized, and managers that protect "the way we've always done it".  If executives don't assume a leadership position in removing inefficiencies and elevating real wages while improving financial performance, perhaps their compensation should be evaluated.

As technology changes, it is difficult to keep up with process change. But the cost of doing business should decline as industries and the technologies that support them become more mature. When I performed my research, even though the asset size of the financial institutions was tight, the amount of FTEs per institution varied widely. One had 130 FTEs, another had 521. And average salary plus benefits varied, with the top payer averaging $135k, and the bottom payer averaging $45k. 

The top payer, by the way, was in the bottom quartile financial performer, and the lowest payer was the last bank in the second quartile. Somewhere in between lies the answer for your financial institution.

Any thoughts on pay philosophy?

~ Jeff



Note: The below SNL Financial article by Kiah Lau Haslett alerted me to the Rice study. It may require a subscription to view:

https://www.snl.com/InteractiveX/article.aspx?ID=30979109&KPLT=4



Sunday, February 01, 2015

Stupid Bank Names

In the mid to late 1990's, my employer, First National Bank of Maryland based in Baltimore, bought Harrisburg, Pennsylvania based Dauphin Deposit Bank. They put together a transition team. I was on
that team. One of our responsibilities was coming up with a new name. After thousands of hours and millions of dollars, Allfirst was born. And hence the title for this blog post.

Are you going through a similar exercise? With Allfirst still fresh in my psyche, I occasionally throw stupid bank names at bankers contemplating a name change to increase the likelihood they won't make the same mistake. Here is what I came up with so far...


Allfirst - My poster child for stupid bank names. They didn't even include bank in their marketing materials, leaving customers and potential customers wondering, who?


Open Bank - I featured Open Bank in my annual total return top 5. Kudos for delivering value to their shareholders. As for their name... what if they are closed?


First Bank - The context of this blog post is for considering a new name. I know many of you may be named First Bank because that's the way it was 100 years ago, or your name was First Savings Bank and you dumped the Savings or First National Bank and you dumped the OCC. But there are 77 other First Banks in the country. If your brand strives for assimilation, then go with it.


Rabobank - Not a large leap to Rob A Bank.


IndyMac Bank, FSB - Sound like a burger joint to anyone else?


First Integrity Bank - This Minnesota bank failed in 2008. If you have to put integrity in your name, well... The same with Honest, Fair, or any other similar name describing behavior that should be part of the culture. The exception being Trust, since this is a distinct charter and/or service offering. I may get a call from my friends at a similarly named bank near my home on this one. But they should've given me a call before printing the letterhead.


Bank of Bird In Hand - This is an Amish focused bank. Named for the town where it is located. So they probably don't view the name with the same smirk as me. And no, for my non-Pennsylvania friends, you cannot drive from Blue Ball, through Bird In Hand, on to Intercourse, and arrive in Paradise. All Central Pennsylvania towns. But not lined up in that order. My point here is, not every town name should be on your billboard.


MutualBank - On the surface, not a bad name. And I may get an e-mail from my FMS friend, Chris Cook. But truth be told, MutualFirst Financial of Muncie, Indiana, the holding company for MutualBank, is publicly traded. It's not a mutual.


BestBank - A distinction earned, not bestowed. Same with Superior Bank, etc.


Excel Bank - A spreadsheet?


K Bank - In today's abbreviated texting and social media world, this is a bad name, K?


Innovative Bank - Through the worst banking crisis since the Great Depression, only about 5% of FDIC-insured financial institutions failed. Could being in the 5% group qualify you as innovative?


This is only a small list of banks based on my personal knowledge and some database searches. I'm sure there are more out there.

You may be surprised that I excluded some names such as the often lampooned poster child for stupid bank names, Fifth Third Bank. But it is a distinctive name, that has been around for a long, long time. I also respect some old school bank names, such as Old Second, etc. And banks with small town names that don't result in sophomoric snickers are also fine, in my opinion. Even affinity branded banks, like Red Neck Bank (actual division of a bank), have some merit.

So if you are grappling with the bank name issue, make sure that when you are presented with options as to what to call your bank, take a step back, and think. Ask somebody outside of the re-branding process. Common sense trumps a marketing study.


What other stupid bank names are out there or were out there?

~ Jeff


P.S. If I offended anyone, I apologize.



Saturday, January 24, 2015

Bankers: What's Your "Well Capitalized"?

Prediction: The Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) and its complementary Dodd-Frank Act Stress Testing (DFAST) will meet its intended purpose, to better ensure financial institutions have sufficient capital during times of economic duress.

But not why you think.

If you look at Citigroup's or BofA's leverage ratio today versus 2006 or 2007, it is clear that they carry far more capital than before the financial crisis. And that, my readers, was the intended purpose. 

But it is not because CCAR or DFAST are properly assessing risk. The models are too complex and theoretical. An investment banker from a very large financial institution told me his bank submitted an 11,000 page CCAR to the Fed and they turned it down. Another prediction: nobody read an 11,000 page document. Nobody. And nobody understood it. That doesn't mean somebody didn't understand page 5,387, but the entire document? C'mon.

As long as the answer was, carry more capital, complex banks will be better prepared to weather economic storms. Perhaps regulators would save banks time, resources, and money if they took the age-old parent response to why banks should carry more capital... Because I said so!

As feared, DFAST schemes are being pushed down to smaller organizations. Regulators are asking for capital plans, and an assessment of risk in the bank's strategy to determine capital needs. In other words, what's your well capitalized? My firm wrote a newsletter on the issue. But I want to break it down to an even simpler form. 

Call it the Marsico Method. Because I'm a narcissist and want something named after me.

The below table shows the Marsico Method in its simplest form.


Currently, a bank is required to have a Leverage Ratio of 5% to be considered "well capitalized" by US regulators. So the Marsico Method begins with 5% applied to each asset category. No application of the 5% to liabilities, since capital ratios are calculated off of assets. That doesn't mean that liabilities don't carry risk, as you will see with the Risk Buffer.

The Risk Buffer column is similar to the buffer concept applied by Basel III, except that scheme applies a straight up 2.5% buffer to a common equity tier 1 (CET1) minimum of 4.5%, for a total CET1 ratio of 7%, to be fully phased in by 2018.

But in the Marsico Method, the Risk Buffer is an assessment of the potential loss estimate of each balance sheet item, based on a rational analysis by the financial institution. The table above is a high level balance sheet. Hypothetical? Not really. It is Cape Cod Five Cent Savings Bank's balance sheet. And according to the analysis, their well capitalized is 7.90%. Meaning that if they experienced stress and began taking losses, the 2.9% buffer above the 5% should be sufficient to staunch the bleeding.

There would be more detail provided by specific loan, deposit, and other balance sheet categories to come up with the overall Risk Buffer per category. For example, upon analysis of the performance of the home equity line of credit portfolio during past downturns and rapid interest rate changes, the bank determines that the loss potential is 1.85%... hence the Risk Buffer for that particular balance sheet category.

Banks should not limit themselves to on balance sheet items. There is risk in pass through residential mortgage lending, loan commitments, and fee-based businesses to account for. And there is risk on the liability side of the balance sheet such as interest rate and liquidity risk, fraud, etc. That is why there is a Risk Buffer applied to those categories as well, although the risk is typically less than the asset side.

Using the Marsico Method, banks can then project the impact to the balance sheet and therefore Required Equity based on their strategy. This would flow nicely into their Capital Plan that identifies actions to augment capital should the bank experience a stress scenario. 

It also provides a nice answer to your regulators, Board of Directors, and other constituencies when they ask, what's your "well capitalized"?

I'd love to hear your thoughts on this approach!

~ Jeff



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