Publications & Resources
March/April 2008
Focus: Building Franchise Value
Making Smart Long-term Decisions
By
A bank executive works hard for years and seemingly effectively. Profitability is good. The institution is a pillar in its community.
And yet shareholders are frustrated. The return on their investment falls well short of their expectations, souring their view of long-term independence. At the same time, the bank isn’t so attractive to prospective buyers. It can’t realistically gain share in the slow-growth markets it dominates. And it doesn’t have a presence in faster-growing markets. On top of that, it struggles to attract young talent.
The scenario isn’t every bank’s, of course. It is common enough, however, to raise a question about what really counts as boards and management teams chart their courses.
Sometimes the choices facing bank CEO’s are bewildering: Should a bank add new service fees? Should it build new branches? Cut staffing? Increase cash dividends? Buy another bank? Or perhaps sell? It’s no wonder that bankers say they have trouble deciding what to tackle next. Sophisticated modeling can estimate the impact that different moves will have on earnings and share price. Before that, however, a few guidelines can help determine which among the many possibilities will pay off the best.
First of all, it’s important to step back from the trees to see the forest. In the thick of daily challenges, many bankers will say that boosting profitability is their top job. Squeezing incremental revenue from existing businesses and keeping a lid on expenses look awfully important to these bankers. And they are. The view from a few steps back, however, should be a bit different. Most of all, it should be clearer that business leadership really is about building shareholder value. And that suggests different priorities.
Sure, boosting fee income is important at a time when margin pressure is relentless. But the incremental gain of additional revenue is nothing compared to the benefits that flow from improving use of a bank’s capital, positioning an institution in growing markets and focusing on the sustainability of revenue, whether independence or selling at an attractive price is the long-term goal.
Capital management starts with leveraging a bank’s equity base to an appropriate level. After all, the business of bank at its core is about leverage.
Often owned by patient investors with low expectations for dividend income, many closely held banks in slow-growing markets retain most of their earnings. Fueled by strong earnings, the capital bases expand to levels well north of 10 percent of assets. While a strong capital position is always good, too much capital can greatly reduce shareholders’ returns. Basic mathematics tells us that the more equity capital a bank has, the poorer its return on equity must be. A bank with capital in excess of 10 percent of assets is going to have a very difficult time achieving the 13 percent to 15 percent returns that investors deserve.
The surest way for many banks to boost shareholder value is to find ways to leverage their capital toward a goal equity-to-assets ratio of around 7 percent. Increasing the size of the bank can often provide a larger lift to return on equity than simply squeezing out a few more basis points of ROA. In other words, many banks will do themselves a great favor by settling for a somewhat lower return on assets if it’s in pursuit of a bigger asset base and a stronger return on equity.
Capital management tools include dividend payment levels, share re-purchases and conversion to S corporations. Forward looking banks are especially intent on using capital in pursuit of growth opportunities and development of businesses that provide annuity-like income. They understand that belt tightening will improve results only for a short while.
The biggest obstacle to growth for many modest-sized banks is geographic. Banks that do business predominantly in slow-growth markets have limited prospects for a couple of reasons. It’s tougher to take business from competitors in a market with little growth than to capture a small percentage share of the growth in a rapidly expanding market. And attracting talent to slow-growth, rural areas is especially difficult. It is similar to trying to convince grown children to come home to run the family farm after they’ve moved to the big city.
Figuring out a way to get a foothold in faster-growing markets, usually more urban markets, is therefore awfully important for banks in rural and agricultural areas. Building branches and bank acquisitions are the most obvious routes for banks in this situation. Neither comes cheaply, of course. But with all the competition that banks face today, hunkering down and holding onto capital will result every time in sinking returns on equity. And that won’t possibly provide the kind of rewards that employees and owners of community banks deserve.
Curtis Carpenter is the managing director of Sheshunoff & Co. Investment Banking in Austin, Texas. He can be reached at (800) 279-2241.
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