Publications & Resources

February/March 2007
Focus: Balance Sheet Management

Could you use some more capital?

By John Gosser

By coincidence, I spoke to three separate banks from different parts of the country recently, and they all had one thing in common - they were growing fast enough that their capital ratios were becoming a little strained. We spoke about the choices available to attract more capital and some of the costs/benefits of each.

One of the institutions was about $100 million in size with about $7.5 million in capital. They expect to be $125 million within the next two years, possibly even sooner. Management expressed some concerns about selling more stock at this time, and wanted to discuss the Trust Preferred option in some detail, starting with the cost.

A Trust Preferred is a hybrid instrument that is counted as Tier 1 capital by the banking regulators (up to a point) and yet looks like a debt security to the IRS, so the interest paid on the instrument is a tax deductible expense. For this reason the Trust Preferred can be one of the best choices for banks looking for some additional capital.

The cost of issuing Trust Preferred Securities has come down substantially since the concept was introduced just a few years ago. When Trust Preferred Securities were new, the issuing bank paid a 3% underwriting commission and suffered considerable out-of-pocket expenses for legal expenses and trustee fees. The cost of funds was about 350 basis points over LIBOR as well. Despite these costs, Trust Preferred was considered to be a relatively inexpensive source of Tier 1 capital. As a result, billions of dollars of capital have been issued in this form, and the market has matured.

At this point, a bank can expect to pay virtually no origination expenses and can issue Trust Preferred securities at about 175 basis points over LIBOR. Currently, there is a lot of interest in this product, from both issuers and from the money managers who purchase the securities. The issuing process is fast and relatively pain-free.

Making Money with this Capital

At 175 basis points over LIBOR the current cost would be about 7.00%. This rate would change quarterly. While most people expect that the Federal Reserve has almost completed its current round of rate increases, no immediate decline in rates is expected either. Therefore, a legitimate question would be “How do I make money with funding that costs 7.00% in this market?” Clearly there is no easy “arbitrage” into securities earning more than 7.00% today.

Leverage is the Answer

The solution lies in the leverage capacity of the Tier 1 capital raised by the issuance of the Trust Preferred security. The money raised is not “borrowed money”, it is capital, and can be used to grow the bank. Let’s go back to our example:

Our bank is currently $100 million in total assets with $7.5 million in capital. Under the rules of the game, the bank could issue up to $2.5 million in Trust Preferred securities. This would bring total capital up to $10 million. The Trust Preferred portion would represent 25% of the total capital of the bank at that point. The maximum percentage that Trust Preferred can represent of capital is 25 percent.

Once the “new” capital is in place, the bank can grow to support total assets of $125 million and still have a Tier 1 capital leverage ratio of 8.00%. ($10 million capital/$125 million in total assets)

Assuming the bank has sufficient liquidity, it could add up to $25 million in loans and $22.5 million in deposits to the balance sheet. Let’s take a look at the pro forma balance sheets:

Today:	Assets		Liabilities
Cash	$0	Deposits	$92.5 million
Securities	$20 million
Loans	$80 million	Capital	$7.5 million
Total Assets	$100 million	Total Liab + Cap	$100 million

To begin, we issue $2.5 million in Trust Preferred Securities:

Add $2.5 million Trust Preferred	Assets		Liabilities
Cash	$2.5 million	Deposits	$92.5 million
Securities	$20 million
Loans	$80 million	Capital (7.5 + 2.5)	$10 million
Total Assets	$102.5 million	Total Liab + Cap	$102.5 million

We then gather up to $22.5 million in additional deposits in the local market:

Add $22.5 million in Deposits	Assets		Liabilities
Cash	$25 million	Deposits	$115 million
Securities	$20 million
Loans	$80 million	Capital	$10 million
Total Assets	$125 million	Total Liab + Cap	$125 million

Finally, we make $25 million in new loans:

Make $25 million in new Loans	Assets		Liabilities
Cash	$0	Deposits	$115 million
Securities	$20 million
Loans	$105 million	Capital	$10 million
Total Assets	$125 million	Total Liab + Cap	$125 million

(In the real world we would of course be making loans at the same time as we gather the new deposits. This pro forma analysis is presented in a simplified form to clarify the sources and uses of cash flow.)

How Much Could We Earn on the Additional Balances?

Assume that the new loans earn 6.00%, the deposits cost 4.00% and that we do not need to add any marginal expenses to do this increased amount of business. (In the real world, we would be looking for a Net Interest Spread of more than 2.00% on the new loans and deposits, and we would probably have some additional expenses related to increasing the size of the institution by 25%)

	Rate	Income/expense
$25 million in New Loans	6.00%	$1,500,000
New Interest Income		$1,500,000
$22.5 million in Deposits	4.00%	$900,000
$2.5 million in new Capital	7.00%	$175,000
New Interest Expense		$1,075,000
Net Interest Income		$425,000
Net additional Tax (34%)		$144,500
Net Income Impact		$280,500

If the institution had been earning 1.00% ROAA it would have earned about $1 million per year on total assets of $100 million. The Return on Equity was 13.33% ($1 million/$7.5 million).

By adding this leverage (made possible by the addition of the extra Tier 1 capital), the earnings would be increased by about $280,500 after tax. The ROAA would be increased to 1.024%. ($1,280,500/$125,000,000)

The Return on Equity would improve as well. This is one additional place that the Trust Preferred security has an advantage. The Trust Preferred security investors will receive a dividend that is pre-determined. The shares of Trust Preferred that are issued to the investors do not have any voting rights, and the investors do not participate in the long term increases in the franchise value that should result from the additional loans and deposits.

Therefore, the Return on Equity is calculated by taking the current earnings (Now $1,280,500) divided by the owners’ equity (The original $7.5 million). This results in a Return on Equity of 17.07%, an increase of almost 375 basis points!

Conclusion

There are many choices available to a fast growing institution which could use some additional capital. The Trust Preferred security is just one of the choices, but a powerful and very efficient option. Management of any institution looking for additional capital should carefully consider this choice as part of the deliberative process.

John Gosser is senior partner of Shay Financial Services in Irving , Tex. He can be reached at 800-442-9825 or jgosser@shay.com.