Now that the economy has healed, liquidity is plentiful and bank performance is on the verge of getting back to normal, we thought we would revisit what a bank’s capital structure looks like and the associated loss given defaults for each. In 2015, we sit in the middle of an ideal story that can be told about banking that goes along the lines of record credit quality for new origination, the highest barriers to entry the industry has ever seen, higher interest rates, better bank regulatory supervision and enhanced risk management. Given that we are just going into the time when most banks update their capital plan, this information could be timely and help bank management understand their options.
Given where we are in the credit cycle, every bank should be at least considering whether it needs more offensive capital for growth and acquisition, or more defensive capital to mitigate any concentration and portfolio risks. Part and parcel with this discussion on capital, every bank should also have an in-depth discussion on the alternatives to raising capital which might include asset sales, securitizations, participations, enhanced risk monitoring and other risk mitigation moves.
Metrics That Matter When Pricing Capital
In addition, the Board should have a frank discussion of bank performance in order to better understand the cost of raising capital. The higher the cost of capital, the more dilution the existing shareholders will face so it is important to not only get the capital structure right, but also the bank’s story and timing. A bank’s ability to generate above its cost of capital is a key factor. Those banks that can generate a 9% or better return on equity, will find a much easier time than those banks that have a current track record of something lower. In similar fashion, the data shows that those banks that have less than 2% non-performing assets to total assets will also receive a significantly better price for their debt or equity. After overall performance and credit quality, cost of funds, deposit sensitivity, funding mix, asset diversification and overhead cost structure all play a key role (in roughly that order) in pricing capital.
The Bank Capital Stack
Unlike many entities, banks have the ability to have debt and both the bank level and the holding company level. Here it is important to realize that the probability of defaults differs between the capital structure at the bank level and the capital structure at the holding company level. To the extent that it is a one bank holding company, the probabilities are going to be correlated and similar. To the extent that the holding company has other diversified assets, the probability of default will likely be lower (but not necessarily).
Within the bank operating company, the loss given default ranges from less than 1% on deposits/secured obligations to approximately 56% for senior debt and 77% for subordinated debt. The standard deviation varies greatly (26%) so investors (and bankers) must take into account by looking at the amount of capital and the factors mentioned above. Loss given defaults at the holding company are usually riskier and, on average, about 10% or greater under a payment default and about 40% higher under a liquidation. In addition, the standard deviation is often twice as much as the loss given default volatility at the operating company level.
Talk to your investment banker, lawyer or other professional about what might be the best capital structure for your bank given the current state of the industry and the market. Almost every bank benefits from a mix of both debt and equity and structural features like maturity, amortization, conversion/exchangeability, deferral options and callability can all play a material role in price. Whatever the structure, in the next year, we will likely be back to one of the cheapest periods of times to raise bank capital, so now is a great time to plan.
Submitted by Chris Nichols on June 09, 2015