Nimble Capital Management Can Help Non-Basel II Adopting Banks Level the Competitive Playing Field

By Thomas W. Killian

There have been a number of developments in the past few years that have dramatically changed the framework for evaluating capital structure alternatives for insured depository institutions of all sizes in the U.S. First, the implementation of FASB 141, effective in 2001, precluded pooling of interest accounting, thereby creating goodwill in premium merger transactions. Second, the adoption of FIN 46 in 2003 disallowed GAAP recognition of minority interest treatment for trust preferred securities in favor of recognition as long-term debt. Third, the Federal Reserve’s final capital rule in April 2005 confirmed the Tier 1 capital treatment of trust preferred, but mandated the deduction of goodwill from core capital elements beginning in 2009. Finally, and most recently, Basel II will permit large, internationally active banks to allocate capital based upon a sophisticated assessment of their credit, operating, and interest rate risk rather than assets outstanding.

Among these developments, the proposed implementation of Basel II may have the greatest impact as it will allow large, internationally active banks to significantly reduce the risk-weighting of their assets and, correspondingly, the capital they must hold to support such assets. Basel II could result in large banks gaining a significant pricing advantage over small- and mid-size banks since they will be able to hold materially less Tier 1 capital relative to risk-weighted assets than their smaller competitors. And while roughly 15 to 20 U.S. bank holding companies are expected to adopt Basel II, the vast majority of U.S. financial institutions will not and, instead, will continue to adhere to Basel I capital and risk-management guidelines.

U.S. regulatory agencies are very concerned about the potential competitive implications of this dichotomy. Their concern was highlighted when the Federal Reserve Board, Office of Comptroller of the Currency, Federal Deposit Insurance Corporation, and Office of Thrift Supervision announced in a joint press release in late April that they were slowing the U.S. adoption of Basel II. They took this position because the preliminary analysis from participating institutions indicated evidence of “material reductions in the aggregate minimum required equity and significant dispersion of results across institutions and portfolio types.”¹ Representatives from America’s Community Bankers and Independent Community Bankers of America reiterated this concern in their testimony before Congress on May 11, 2005.^{2, 3}

Amidst all of this activity, executives and boards of directors at non-Basel II adopting banks should focus on designing an optimal capital structure that provides a cost-effective way to structure Tier 1 capital to lower the weighted average cost of such capital and help offset some of the competitive advantage Basel II-adopting banks will have. To do this effectively, non-Basel II adopting banks need a new framework to develop an optimal capital structure as traditional corporate finance theories, including the Modigliani Miller theorem, are not particularly helpful for evaluating capital structures for insured depository institutions.

This new framework, which is outlined in this article, addresses the four central questions surrounding an optimal capital structure for a bank holding company:

• What form of capital should be issued?
• What is the optimal amount of each type of capital to be issued?
• How should the capital be issued?
• How can non-Basel II banks use capital structure to level the competitive playing field with Basel II adopters?

What Form of Capital?
The type of capital to be issued is very much a function of matching capital needs with the type of capital that most efficiently and cost-effectively meets those needs. The typical objectives of most banks in evaluating capital alternatives and the primary forms of regulatory capital are summarized in the following chart.

In addition to meeting key objectives by matching needs with type of capital, another key determinant of the form of capital to be issued is the after-tax coupon cost of the form of capital under consideration. This is reasonably straightforward for capital instruments that have a stated coupon payment, since this payment is a function of the size and financial strength of the paying institution. For ease of reference, we have assumed for this article that all issuance would be done by non-rated issuers in a pooled transaction. We believe this assumption is reasonable given that about 90% of the more than 8,000 banks in the U.S. have less than $1 billion in assets. Moreover, only about 1.7%, or 133 banks, have an investment-grade, long-term senior debt rating of at least Baa3 or better by Moody’s Investors Service.(4) Based on market conditions in April 2005, the approximate pre-tax coupons for trust-preferred securities and non-cumulative perpetual preferred were three-month LIBOR plus 2.00% and 3.60%, respectively. Assuming a 40% tax rate, the after-tax coupon cost would be approximately 3.12% and 7%, respectively.

The determination of the after-tax cost of equity, however, is a bit more challenging. While there are many ways to estimate this figure, three of the most frequently used are the Capital Asset Pricing Model, Normalized Return on Equity, and Dividend Growth methods.⁵ In fact, the Federal Reserve Bank uses versions of these three methods to determine the cost of equity to estimate reimbursement of cost of capital amounts for services provided to the Fed.⁶

Of these three methods, the most traditional and widely accepted approach is the Capital Asset Pricing Model (CAPM), which posits that the cost of equity is equal to the risk-free rate plus a market-risk premium adjusted for the volatility of a particular company relative to the market. Typically, issuers have used the 10-year U.S. Treasury as a proxy for the risk-free rate, 600 basis points as a proxy for the market-risk premium, and the beta of the issuer’s common stock as a proxy for the volatility of the particular company relative to the market. However, the majority of depository financial institutions in the U.S. are small- and mid-size banks that may have limited trading activity in their common stock. As such, the beta of the common stock may not be a particularly accurate gauge of the volatility of the common stock of these smaller institutions. Thus, this method has some limitations, but it is still one of the most widely used models for calculating the cost of capital in the financial industry. As of April 2005, the CAPM cost of equity for the banking industry was about 10.26%.⁷

The Normalized Return on Equity (ROE) method, otherwise known as the comparable accounting earnings model, is a more practical way to evaluate the implied cost of equity. This approach simply uses the bank’s targeted level of ROE as a proxy for its after-tax cost of equity, with the reasoning that every dollar of equity invested has to yield that threshold amount, lest the targeted ROE will decline. As of April 2005 and based on the median ROAE for more than 800 banks with assets of $100 million to $10 billion, the cost of equity using this method approximated 11.25%.⁸

The Dividend Growth method, otherwise known as the Gordon growth model, is yet another way of estimating the implied cost of equity based on a future series of dividends that grow at a constant rate. This method uses the current dividend yield on the common stock and the expected growth rate in earnings per share (EPS). For banking companies not paying a dividend, this approach is obviously less helpful in determining an implied cost of equity. As of April 2005 and based on the median dividend yield and growth rate for more than 800 banks with assets of $100 million to $10 billion, the cost of equity using this method approximated 13.12%.⁹

Based on the three methods described above, the after-tax cost of equity ranges from 10.26% to over 13%. For purposes of our analysis, we have assumed 12% as a proxy for the after-tax cost of equity for depository financial institutions.

How Much?
The two most important steps in answering this next question are to: (1) examine the key components of current regulatory capital guidelines, and then (2) minimize the weighted average cost of Tier 1 capital. Since trust preferred securities represent the lowest after-tax cost of Tier 1 capital, the optimal amount of such capital would seem to be the maximum amount that an issuer would be permitted to count as Tier 1 capital. However, the analysis is more complicated than that because for Tier 1 capital calculation purposes, the Federal Reserve’s final capital rule of April 2005 noted that bank holding companies were limited to a combination of trust preferred securities and non-cumulative perpetual preferred not exceeding voting common equity.

We have conservatively assumed that the combination of trust preferred and non-cumulative perpetual preferred may not exceed 40% of Tier 1 capital. Therefore, the determination of the optimal amount requires an iterative model that accounts for: (1) trust preferred being limited to 25% of core capital elements (less goodwill net of deferred tax liability beginning in April 2009), (2) non-cumulative perpetual preferred increasing core capital elements and, as a result, the permitted amount of trust preferred, and (3) the 40% limitation mentioned above.

Since trust preferred represents the lowest after-tax cost form of Tier 1 capital and the permitted issuance amount is limited to 25% of Core Capital Elements, the optimal amount to issue may be simplified as (1/3) x Core Capital Elements. Similarly, since non-cumulative perpetual preferred represents the next lowest cost form of Tier 1 capital, the calculation for the optimal amount may be simplified as non-cumulative perpetual preferred = (1/4) x (Common Equity + Goodwill – Deferred Tax Liability).

By combining this framework for amounts of each type of capital with a calculation of the after-tax coupon cost and after-tax cost of equity, small- and mid-size banks can develop an optimal capital mix that results in a lower weighted average cost of Tier 1 capital. By lowering the weighted average after-tax cost of Tier 1 capital while complying with the Federal Reserve’s capital rules to remain well-capitalized, a banking company can increase its competitiveness and the value of the cash flows available to its shareholders.

How to Issue?
With respect to the issuance of subordinated debt, trust preferred stock, or non-cumulative perpetual preferred stock, there are three primary ways in which financial institutions can access the financial markets to raise capital: public market, pooled market, and private market.

Public market access is generally available only to issuers with asset sizes greater than $5 billion, securities ratings of at least investment grade BBB- (or equivalent), and at least five years or more of satisfactory operating experience. Consequently, the pooled market has rapidly emerged as the preferred option for middle-market banks (i.e., those with between $100 million and $5 billion in assets). Indeed, since 2000, when the pooled trust preferred market first began, through 2006, there have been 70 pooled transactions aggregating about $37 billion in total CDO issuance amount with the majority of the collateral consisting of trust-preferred and subordinated debt for middle-market financial institutions.¹⁰ This market is generally available to bank and thrift holding company issuers with investment-grade financial strength ratings and at least four to five years of satisfactory operating history. For those issuers that require rapid turnaround, have less than $100 million in assets, or do not have sufficient operating history or financial results, the private market can be an attractive alternative.

For the issuance of common stock, the primary determinant of how to raise capital is the size of the offering. Typically, when offering amounts are less than $20 million, the transaction is private. A pooled market for common equity issuance has not yet developed due to the lack of homogeneity in valuing such equity securities. However, a pooled market has recently developed for non-cumulative perpetual preferred securities of middle-market banks, as evidenced by the launch by Nuveen Asset Management and Spectrum Asset Management of the first-ever, closed-end funds focused on purchasing these types of securities.

How to Use Capital Structure to Level the Competitive Playing Field?
Large, internationally active bank holding companies that adopt Basel II and lower their risk-weighting of assets accordingly, can potentially gain a pricing advantage over non-adopting banks. For example, if a large, internationally active bank can lower its risk-weighting of assets from 75% to 50% and, assuming a cost of Tier 1 capital of 12% (100% equity funded), also lower the required return from 90 basis points to 60 basis points, it would gain 30 basis points (i.e., 25% x 12%) in after-tax pricing advantage, or 50 basis points in pre-tax pricing advantage (assuming a 40% tax rate) over a non-adopting bank. As every community banker knows, strong customer service may allow his or her bank to charge some premium, but 50 basis points tests that limit.

So, the key question is: how can non-Basel II adopters use nimble capital management to help offset some of the pricing disadvantage? The answer boils down to reducing the weighted average cost of Tier 1 capital.

For example, if a community or regional bank lowered its weighted average cost of Tier 1 capital from 12% to 9% while keeping the risk-weighting of its assets constant at 75%, its required return would drop from 90 basis points to 67.5 basis points (i.e., 75% x 9%). The Basel II-adopting bank would still have a pricing advantage of 7.5 basis points over the non-adopting bank, but the price difference would be dramatically reduced. As a result, the community bank would be better able to compete based on its higher service level and other competitive advantages over a larger bank.

Also, keep in mind that starting in April 2009, large, internationally active banks will be limited to 15% of restricted core capital elements, such as trust preferred securities, to the sum of core capital elements, including restricted core capital elements (net of goodwill). All other bank holding companies will be permitted to have 25% of restricted core capital elements. Since coupon payments on trust preferred securities are tax deductible, such capital generally represents the lowest after-tax cost of Tier 1 capital. Therefore, banks that are not subject to this 15% limitation will have a potential advantage over large, internationally active banks.

The Call to Action
With the adoption of Basel II on the near-term horizon, the time for small- to mid-size bank executives and boards of directors to think about and develop optimal capital structures is now. Clearly, American Community Bankers and Independent Community Bankers are very concerned about the competitive landscape given their recent testimony in Congress on the potential anti-competitive impact of Basel II. It is now critically important that all bankers understand the linkage between weighted average cost of capital and risk-based capital ratio, and the opportunity to enhance competitiveness with optimal capital management.

Large banks historically have had more options at their disposal than small- and mid-size banks in developing optimal capital structures, but thankfully this is changing. Mid-size banks, for example, now have the option of utilizing the pooled market for trust-preferred securities or the recently developed pooled market for non-cumulative perpetual preferred securities.

Regardless of size, by carefully selecting the appropriate mix of trust-preferred, non-cumulative perpetual preferred, and common stock, a financial institution can lower its weighted average cost of Tier 1 capital and, as a result, increase its franchise valuation. Surely, this is something that all constituents of bank holding companies—from executives, to shareholders, to regulators—should and will welcome.

References
¹ Press Release, Federal Reserve Board (April 29, 2005).
² Testimony of America’s Community Bankers before the United States House of Representatives, Subcommittee on Financial Institutions and Consumer Credit and the Subcommittee on Domestic and International Monetary Policy, Trade and Technology, Mr. William J. Small, (May 11, 2005).
³ Statement of Independent Community Bankers of America on “Basel II: Capital Changes in the U.S. Banking System and the Results of the Impact Study” before the United States House of Representatives, Subcommittee on Financial Institutions and Consumer Credit and the Subcommittee on Domestic and International Monetary Policy, Trade and Technology (May 11, 2005).
⁴ Remarks by Governor Susan Schmidt Bies at the American Bankers Association Chief Financial Officers Exchange Conference, Chicago, Illinois, (June 7, 2005).
⁵ Moody’s Banking Statistical Supplement: United States, Bank Screen (by Long-Term Debt Rating), (November 2004), pp. 804-817.
⁶ Edward J. Green, Jose A. Lopez, Zhenyu Wang, The Federal Reserve Banks’ Imputed Cost of Equity Capital, (January 10, 2001), pp. 1-56.
⁷ Calculations by Sandler O’Neill & Partners, L.P.
⁸ Ibid.
⁹ Ibid.
¹⁰ 2006 Trust Preferred CDO Performance Summary – Structured Credit Special Report, Fitch Ratings Ltd and its subsidiaries, as of December 19, 2006, pp 15 – 28. Updated through December 31, 2006 by Sandler O’Neill & Partners, L.P.

By Thomas W. Killian.

Thomas W. Killian is a Principal of the Investment Banking Group of Sandler O’Neill & Partners, L.P. A 26-year commercial and investment banking professional, Mr. Killian advises banks, thrifts, and insurance companies on a variety of capital markets, strategic advisory, and M&A assignments. At Sandler O'Neill, Mr. Killian has managed the successful execution of over $8.4 billion of capital raising transactions. He has co-managed the Sandler O'Neill team responsible for successfully completing 18 pooled trust-preferred transactions, which collectively raised over $6.9 billion for approximately 650 financial institutions. He has been a speaker at industry and regulatory conferences (including the Federal Reserve Bank, the FDIC, Western Independent Bankers and the China Banking Regulatory Commission) on issues impacting financial institutions and capital markets. His articles have appeared in the journal of Bank Accounting and Finance, U.S. Banker, Western Banking and Modern Bankers, a publication of the Peoples Bank of China. Mr. Killian is a graduate of the University of North Carolina at Chapel Hill and Northwestern University's J.L. Kellogg Graduate School of Management.

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