A Financial Institution Investment Banker Had Questions. Here Are My Answers.
My colleagues and I are frequent speakers at industry events. At one such event, a financial institution investment banker approached my colleague and handed him a list of questions he would like answered during his speech. My colleague gave it to me the next day, and I provided my answers thinking he wanted them. Not really. Just thought I would be interested in the questions. So I think: Blog Post!
The list of questions read like the script used to convince banks they can’t go it alone. But I’m a cynic. And should give the investment banker the benefit of the doubt. Here we go…
1. What should a financial institution’s target levels be in the following?
Return on Tangible Equity (ROTE): ROTE is a crap ratio. Not my term, but one told to me by a bank stock analyst, and I agree with him. If you don’t want intangibles, don’t do premium deals. If it was such a good deal, then measure ROE. ROTE is just an investment banker talking buyers into doing expensive deals and to not be accountable for the intangible.
But to answer the ROE question, the long-term average should be >10%. Why? Because an investor in an equity security should expect a 10+% total return. So it serves as a proxy, of sorts. It is different, for each bank however. What if a bank trades at 125% of book? Then a slightly greater than 10% ROE would be required to deliver a 10% total return. It’s math.
Note that I said long-term ROE because it should be better in a strong, expanding economy and worse in recessions AND periods of strategic investment. Dropping ROE to 8% to make strategic investments so the financial institution can elevate it to 11% makes total sense to the CEO and Board that manages for long-term performance. Not so much to the CEO and Board worried about his/her next analysts’ call.
Tangible Equity/Assets: This depends on the financial institution’s risk profile. They should calculate their unique “well-capitalized” by estimating the risk on their balance sheet per balance sheet item, now and as projected. I like the Basel III approach of setting a base level that they don’t want to go below (4.5% in Basel III’s case) with a 2.5% buffer in place in good times so when times are not so good, the buffer serves its purpose. But the risk buffer should be set by each institution based on the risk on their balance sheet and projected to be on their balance sheet. My guess is that if every bank did this, their target capital range (base + buffer) would be between 7%-9%.
ROA: Greater than 1% should be achievable by most financial institutions, as so many are currently doing it. For institutions with meaningful fee-based businesses, the number should be greater because a profitable fee-based business will deliver “return”, without adding “assets”.
Efficiency Ratio: This is totally dependent on the business model and growth trajectory. Not many investors complained about the old Commerce Bank (NJ) efficiency ratio of 70+% when they were delivering 20+% profit growth.
Organic Growth Rates: If they exceed their markets, then they are above average, right? So it depends, in large part on their markets. Earnings growth should exceed balance sheet growth. That’s positive operating leverage that so many financial institutions struggle with. Earnings growth plus dividend yield should be close to or exceed 10%, in my opinion. If markets can’t support it, expand, take it from the competition, or acquire!
2. What is the total non-interest expense to have full internal staffing?
I have no idea how to answer this one Mr. Investment Banker.
3. What is a financial institution’s cost of equity?
I bet he was looking for a CAPM calculation, as I see this often in investment bankers’ presentations. But no. I’m a simple man.
For slower growth, conservatively run banks I would estimate ~10%. For fast growth and/or banks pursuing a higher risk strategy, I would estimate 13%+ for common equity, as investors should demand more for that business model. For convertible preferred, I would estimate the coupon until the conversion date, then the cost of common equity. If it is not mandatorily convertible, then it’s the coupon plus the cost of common equity mentioned above. Convertible preferreds are ridiculously expensive because they dilute common returns while sitting back clipping coupons, in my opinion.
4. What asset size is critical mass?
You know when there is a rule, and someone throws up an exception to the rule that might represent 1% of the total universe subject to that rule? Banking has plenty of exceptions to the critical mass asset size estimates bandied about by bankers, consultants, and investment bankers. My firm’s first podcast highlighted the average size of all Sub S banks in the US as $273 million. Small. Yet their average ROA was 1.36%. Sub S banks represent ~ 1/3 of all financial institutions in the US.
So there are myriads of exceptions to the economies of scale conventional wisdom. I would say, however, that banks with <$500MM in total assets have unique challenges relating to technology investments, stock liquidity, and management succession that will make things difficult. They also suffer significant stock trading discounts to larger banks, even though they may perform better. The change in community bank shareholders from retail to institutional also works against smaller banks, as institutional shareholders typically have float requirements (i.e. so many shares must trade per day). That’s where the small banks challenges lie, in my opinion. Not in their ability to deliver superior financial performance. Because they are doing it.
5. Should banks form a bank holding company (BHC)?
I’ve already taken up enough of my readers’ time than to answer this boring investment banker question.
What are your opinions of the above questions?