Pub. 11 2020 Issue 3

www.wvbankers.org 14 West Virginia Banker J ust a couple months ago, the prevailing wisdom was that banks would enter the next downturn from a position of relative strength, manifest in strong pre-provision earnings, pristine credit quali- ty, and an abundance of capital relative to pre-Great Recession levels. Then a black swan named COVID-19 showed up on our doorstep. We are now bracing for a deep recession. Against this painful backdrop, we examine how banks can bolster capital ratios by selling select bonds into a strong bid and using the proceeds to remove ineffi- cient wholesale leverage. Some institutions might re- turn the balance sheet to its original size by relevering at a wider spread. Let’s evaluate these options from the perspective of our friends at Bank A. Bank A’s Fundamental Profile Bank A has assets of $500 million and its asset-liability profile is effectively neutral. During a recent review, management identifies $25 million of wholesale lever- age earning a negative spread. Management decides to evaluate two strategies: Strategy 1: sell securities and pay down debt and Strategy 2: sell securities, pay down debt, and relever the balance sheet. Strategy 1: Remove $25 Million of Inefficient Leverage Bank A has $25 million of securities yielding 2.15% fund- ed with wholesale borrowings costing 2.35%, as shown in the table below. This segment of the balance sheet is “upside down” by 20 basis points, resulting in a pre- tax earnings drag of $50k and an after-tax earnings drag of $40k, assuming a 21% effective tax rate. Simply removing the negative spread would be a penny accretive to EPS, six basis points accretive to ROA, and 24 basis points accretive to NIM. The transaction also shrinks the balance sheet, nudging the TCE ratio from 11.00% to 11.58%. Simultaneously, management completes a granular review of the loan portfolio, securities portfolio, loan loss reserve, and other real estate owned. Management anticipates that a weakening economy will result in stubbornly high credit costs. Still, management deter- mines that even in the most draconian economic sce- nario, the bank would remain solidly profitable. Thus, management is open to utilizing the 58 basis points improvement in the TCE ratio. Addition by Subtraction: Thoughts for Creating Non-Dilutive Capital By Scott Hildenbrand and Matthew Forgotson, Piper Sandler