Keys to Community Bank Success: Utilizing Management Information to Make Informed Decisions-Capital Assignment

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As financial markets, investors, and regulators have become increasingly intolerant of both inadequate financial returns and risk exposures, which jeopardize safety and soundness, capital assignment and the various techniques for assigning capital have become extremely important. Return on Equity ("ROE") now overshadows the banking industry's more traditional Return on Assets ("ROA") ratio. This requires better capital management as well as capital returns. Financial institutions are now realizing that capital is not only necessary to safeguard credit risk, but is also necessary for maintaining lines of business and products on both sides of the balance sheet, as well as off-balance sheet products and services. Consequently, capital assignment has become a significant part of profitability analysis and reporting.

The following three sections review issues necessary to better assign and manage capital:

1. The Market Perception of Capital and Return on Equity

2. Risk Factors in Assigning Capital

3. Capital Assignment Options and Techniques

The Market Perception of Capital and Return on Equity

Today, public companies are more cognizant than ever of their stock price performance and the key factors affecting the value of their company. These include:

* Financial condition and performance, both absolute and relative to peers, with a focus on Return on Equity

* Perceived growth potential for earnings per share (EPS) and dividends

* Demographics of the served market areas

* General market for financial industry stocks, especially peer institutions

* General stock market conditions

Old ratios such as ROA and Price-to-Book Value are fading away, and the new world order is placing increasing importance on ROE and Priceto-Earnings. Remember, "shareholders are concerned about return on their equity, not return on your banks assets."While this is certainly true, banks cannot lose sight of the "113" component in ROA and ROE. The "R" in this example means REVENUE. Capital can be managed up or down, and/or balance sheets can be leveraged to create adequate return in the short term, but over the long haul true spread and feebased revenue opportunities must be developed to create and sustain long term value.

The old benchmark of 12%-15% ROE is no longer good enough. The market is increasingly rewarding those institutions with diversified forms of revenue and ROEs in excess of 18%. This is evident in the Price-toEarnings trading multiples in today's financial industry.

Risk Factors in Assigning Capital

As discussed in CHAPTER 2, risk management has grown beyond the traditional view of credit risk and asset-based risk. From a regulatory perspective a question often asked is, 'What do regulators mean when they talk about risk management?" In essence, the various regulatory supervisors are interested in how a bank prepares itself for expected and unexpected events that could adversely affect capital and earnings. Examples of this would include, (1) is the bank ready for a one-point (100 BP) rise or fall in interest rates; (2) does it have adequate credit and underwriting standards; (3) is it prepared for new competition from its various rivals; (4) is it technologically and operationally sound (i.e., Y2K, system conversions); (5) does it have disaster recovery procedures and testing; and (6) can it detect and recover from fraud committed by customers, vendors, and/or employees?

A definition of the OCC's risk categories is as follows:

* CREDIT-Risk that borrowers will default

* LIQUIDITY-Risk that the institution won't be capable of meeting its obligations without selling assets at below market rates

* INTEREST RATE-Risk from fluctuating interest rates

* PRICE-Risk from changing values in a securities portfolio

* REPUTATION-Risk of bad publicity

* STRATEGIC-Risk of making bad business decisions

* TRANSACTION-Risk from product delivery problems

* FOREIGN EXCHANGE-Risk from changing exchange rates

* COMPLIANCE-Risk of violating laws and/or regulations

A definition of the FRB's risk categories is as follows:

* CREDIT-Risk that borrowers will default

* MARKET-Risk from shifts in interest rates and foreign exchange rates

* LIQUIDITY-Risk that a bank won't be able to meet its obligations without selling assets at below market rates

* REPUTATION-Risk of bad publicity

* LEGAL-Risk of violating laws and/or regulations

* OPERATIONAL-Risk of trouble from regular business practices

In the final analysis, regulators are really not concerned about shareholder returns; they are concerned about safety and soundness. …