| To control their own destiny, managers
of financial institutions must satisfy shareholders with a fair return on their equity
investment. By James Eibel, consulting
manager, assistant vice president
During 1995, 661 acquisitions were consummated among
commercial banks alone (Gart, pp.74). Failing to maximize shareholder value makes a
company a takeover candidate. For financial institutions, high capital-to-assets ratios
are often inconsistent with the maximization of shareholder wealth. High capitalization
levels suggest the inefficient use of capital and depress firm market valuations.
Ultimately, these factors may trigger corrective action through the acquisition market
(Adkisson and Frazier, pp.26).
To control their own destiny, managers of financial
institutions must satisfy shareholders with a fair return for their equity investment.
This requires the efficient deployment of capital in profitable investments. In recent
years, most financial institutions have not grown fast enough to invest their retained
earnings fully. In Indiana and Michigan this has caused the median bank’s
capital-to-assets ratio level to rise from 8% in 1992 to nearly 9.5% in 1995, as shown
above. Predictably, returns on equity (ROEs) also fell during the period. The presence of
underutilized capital represents a potential threat to both future shareholder returns
and, ultimately, independence.
Due to the relatively thin margins in banking, financial
institutions must leverage a relatively small amount of equity capital with a large amount
of debt (deposits and other borrowings) in order to provide a market rate of return to
shareholders. In theory, financial institutions should leverage their capital down to
regulatory minimums plus a margin of safety to accommodate earnings fluctuations if they
seek to maximize ROE and shareholder return.
For the majority of business strategies, a 7%
capital-to-assets ratio is sufficient to maintain the regulatory distinction of being
"well capitalized" and to support future growth opportunities. However, as of
second quarter 1996 77% of banks in Indiana and Michigan had capital ratios in excess
of 8%! To illustrate the impact of an institution’s capital-to-assets ratio,
consider a hypothetical institution which faces the average investment opportunities and
cost structure faced by banks in Indiana and Michigan as of second quarter 1996. The graph
on page two charts this average institution’s ROE and ROA for various levels of
capital to assets.
Both ROE and ROA are impacted by the capital structure and
the degree of leverage that the institution adopts. The hypothetical average
institution’s ROE could have ranged from 8.24% to 19.92% during the second quarter
based only on varying the level of capital from 15%-5%. It should be noted that the impact
of leverage on ROE is not linear. At lower capital-to-assets ratios, the impact of
additional leverage is most dramatic. Reducing capitalization from 15% to 14% only results
in a 0.22% increase in ROE. However, reducing capitalization from 6% to 5% results in a
2.92% increase in ROE. In other words, increasing leverage has an increasing marginal
impact on ROE. Thus, even a small amount of underutilized capital can have a tremendous
impact on shareholder returns.
ROA is an important measure of profitability, but it
provides incentives which run counter to maximizing shareholder returns. While increasing
leverage was beneficial to ROE and shareholder value, it had a negative effect on ROA. The
ROA measure has the deficiency of rewarding the accumulation of excess capital. For this
reason, ROA should never be used in isolation to judge financial performance.
Ultimately, the future of community banking will hinge on
the ability of institutions to provide shareholders with market rates of return on their
equity investments. For portfolio lenders, this will require full utilization of the
capital resource via prudent asset growth. While some capital above safety and soundness
requirements may be viewed as necessary for future growth and acquisitions, even a small
amount depresses ROE and ultimately shareholder returns. Any decision to accumulate
capital in excess of regulatory minimums must be analyzed for its drag on the
institution’s potential ROE and the ultimate return to shareholders.
References:
Gart, Allen, "Merger and Acquisition Waves:
Banking Dominated the Fifth Wave," The Irwin Professional Community Banker,
Third Quarter 1996, Volume 1, Issue VIII.
Adkisson, J. Amanda and Frazier, Donald R., "The
Ineluctable Lure of Lofty Leverage," Journal of Retail Banking, Fall 1990,
Volume XII, No. 3.
This article has been presented for
educational purposes only. The FHLBI is not a financial or investment advisor.
It is solely the reader's responsibility to evaluate the risk and merits of any
funding strategy or business proposal.
|
