Pub. 3 2013-2014 Issue 5

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S March • April 2014 5 Bank Capital… Perhaps Less Might be More In the aftermath of the Great Recession, Congress and bank regulators have, seemingly, attempted to address every conceivable ill by promulgating thousands of pages of new laws, rules and regulations. Dwarfing its historical cousins in both size and regulatory reach, Dodd-Frank imposes vast and complex new “duties and responsibilities” while simultaneously attacking revenue sources (think the Durbin Amendment). Not surprisingly, 40% of Colorado banks are considering exiting the industry, however, increasing capital requirements are equally culpable. For decades, the primary bank capital ratio was the le- verage ratio, but in reaction to the economic volatility of the 1980’s, risk based capital ratios were introduced. After the Great Recession, yet another intense capital debate is raging and has spawned increased capital levels from regulators and from the nearly 1,000 page BASEL III. All with the good intention of pre-identifying both the cause and the solution to the next economic crisis, which of course is impossible. In the not too distant past, a community bank’s lever- age ratio could actually start with the same number as the regulatory minimum. Over time, simply through regulator expectations, the minimum leverage ratios for most commu- nity banks have increased to 8-9%, a 30-50% increase. Yet there are still calls for more capital. How much is enough? How much is too much? Bankers have long supported the need for “skin in the game”. Capital matters, and as it should, provides a neces- sary cushion for a highly cyclical industry. The need for an ever greater cushion is often cited by those calling for more capital, some up to 13-15%. However, not only does excessive capital negatively impact lending and economic activity, it also encourages engagement in higher risk activities in order to generate sufficient shareholder returns. The chart below demonstrates the dilemma posed by the “never enough” capital advocates. Line one of the chart depicts a bank with a well managed leverage ratio of 6%while returning a reasonable 1%ROA and a satisfactory, if unspec- tacular, 16.7% ROE. Today, with an 8.5% leverage ratio, that same bank’s return to its shareholders drops nearly 30% and is rapidly becoming unattractive. Bank investors understand that the industry is susceptible to wild performance swings due to economic cycles. Accord- ingly, to cover the below standard years, banks must generate an ROE in the mid-teens to be nominally interesting. Thus the dilemma: With increasing capital requirements, bank management must chase ever higher profits and ROAs to simply meet shareholder’s minimum expectations. Unfor- tunately, the options are limited due to increasing regulatory cost burdens, low net interest margins and the unceasing attack on fee revenue. Consequently, attracting and retain- ing capital encourages reaching for yield by incrementally increasing loan to deposit ratios, lengthening portfolios, moving into new markets and/or lowering credit quality standards…simply put, increasing risk. This sounds familiar and is very much like the behaviors that led to numerous bank failures over the last few years. A better option is to recognize that there is a sweet spot for bank capital levels. A 6-7% leverage ratio, combined with sound bank management and prudent regulatory supervision, is a sustainable recipe for long term success. Perhaps, less might be more. n Koger Propst, CBA Chairman President, Sturm Financial and ANB Bank Bank Size Capital Earnings ROA ROE $500,000,000 6% $5,000,000 1.0% 16.7% $500,000,000 8.5% $5,000,000 1.0% 11.8% $500,000,000 8.5% $7,100,000 1.4% 16.7% $500,000,000 10% $5,000,000 1.0% 10.0% $500,000,000 10% $8,350,000 1.7% 16.7% $500,000,000 13% $5,000,000 1.0% 7.7% $500,000,000 13% $10,850,000 2.2% 16.7% – = +