Publications & Resources

February/March 2007
Focus: Balance Sheet Management

Balance Sheet Restructuring - Proactive or Reactive?

By Donald Ullmann

A number of factors in the current environment have led to a wave of balance sheet restructurings in 2006. We believe that these factors will remain with us well into 2007, and thus we expect this restructuring wave to continue. Many of these factors stem from or are related to the yield curve inversion from Fed Funds and LIBOR out to the five-year note, leading to increased funding pressures and an inability to achieve incremental margin by investing in the securities market. While many banking institutions achieved solid performance gains from adding leverage in 2003 and 2004 when the curve was very steep and spreads were wider, ongoing wholesale exposure has now become a drag on margin and earnings for many of these banks.

The restructurings that we have seen are a direct result of these conditions. All institutions face the same yield curve and the same investment opportunities (or lack thereof), but not all institutions face the same funding pressures, have the same liquidity and cash flow posture, have the same profit and loss constraints, and desire the same asset and liability sensitivity. Therefore, each institution must consider the merits of a balance sheet restructuring on its own. It is our contention that a restructuring, when done properly, is a proactive management move and one that is viewed favorably by stakeholders.

We believe that potential restructurings, like most key decisions faced by senior management, should be viewed with respect to the effect on return-on-equity (ROE) and on share price. We take a “top-down” approach to restructuring analysis, with a template that allows for securities sales with or without current market reinvestment, liability paydowns, or a combination of the two. We can also factor in equity buybacks. A number of scenarios may be run that generate key ratios and performance factors, including securities/assets, borrowings/assets, net interest margin (NIM), return-on-assets, and ROE. In this way, an informed decision may be made regarding trade-offs - i.e. maximizing NIM or ROE - and key measurements may be targeted and assessed.

We then move from macro-level targets to micro-level balance sheet components, in order to optimize each potential strategy. We can assess those securities that are the best sale candidates, considering book yield improvement, payback period, the need to “clean up” certain securities structures, cash flow and pledging needs, and/or overall profit and loss constraints. We also look carefully at the borrowing profile for both cost level and tenor, and payoff penalties, if any. By examining the discrete construction of both assets and liabilities, the composition of the suggested restructuring takes shape.

Returning to our theme that such an exercise should be viewed proactively by stakeholders, what has been our experience to date? A recent study by one of our senior analysts suggests that the stock prices of institutions that undertake these restructurings is generally higher over the succeeding months, and keeps pace with similar institutions that have not undertaken such an action. While we cannot conclude that a restructuring will generally lead to improved relative equity performance, we certainly can conclude that it does not have a detrimental effect, either. Equity investors have suggested to us that such moves are, indeed, viewed to be proactive and it may be that the stock price of a number of these institutions may well have underperformed without such a move, as earnings would continue to be under pressure.

The recent announcement by PNC Financial Services Group, Inc. (PNC) is instructive on a number of these points. PNC underwent a $6 billion restructuring, replacing one-half of the assets sold with new securities, and incurring a pre-tax loss of approximately $200 million. Notably, the stock went up from $70.02 to $71.49 upon the announcement (and is at $74.72 as of this writing). The 8-K filing stated that, “PNC evaluates its portfolio of securities available for sale in light of changing market conditions and…will take steps to improve its overall positioning.” The filing goes on to note: “The rebalancing is expected to modestly improve PNC’s tangible common equity ratio…net interest income…and net interest margin…as a result of an improved yield on the portfolio and the net reduction in earning assets.”

In summary, a balance sheet restructuring may be a complicated exercise that requires thoughtful goal setting and careful execution. We believe that those actions meeting these requirements do help the banking institution position itself better for the future, and that the market welcomes this proactive decision by management.

Donald Ullmann is senior vice president with Keefe, Bruyette and Woods, Inc. in New York , N.Y. He can be reached at 212-887-8997 or dullmann@kbw.com.

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