Bankers: What's Your "Well Capitalized"?

Prediction: The Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) and its complementary Dodd-Frank Act Stress Testing (DFAST) will meet its intended purpose, to better ensure financial institutions have sufficient capital during times of economic duress.

But not why you think.

If you look at Citigroup's or BofA's leverage ratio today versus 2006 or 2007, it is clear that they carry far more capital than before the financial crisis. And that, my readers, was the intended purpose. 

But it is not because CCAR or DFAST are properly assessing risk. The models are too complex and theoretical. An investment banker from a very large financial institution told me his bank submitted an 11,000 page CCAR to the Fed and they turned it down. Another prediction: nobody read an 11,000 page document. Nobody. And nobody understood it. That doesn't mean somebody didn't understand page 5,387, but the entire document? C'mon.

As long as the answer was, carry more capital, complex banks will be better prepared to weather economic storms. Perhaps regulators would save banks time, resources, and money if they took the age-old parent response to why banks should carry more capital... Because I said so!

As feared, DFAST schemes are being pushed down to smaller organizations. Regulators are asking for capital plans, and an assessment of risk in the bank's strategy to determine capital needs. In other words, what's your well capitalized? My firm wrote a newsletter on the issue. But I want to break it down to an even simpler form. 

Call it the Marsico Method. Because I'm a narcissist and want something named after me.

The below table shows the Marsico Method in its simplest form.

Currently, a bank is required to have a Leverage Ratio of 5% to be considered "well capitalized" by US regulators. So the Marsico Method begins with 5% applied to each asset category. No application of the 5% to liabilities, since capital ratios are calculated off of assets. That doesn't mean that liabilities don't carry risk, as you will see with the Risk Buffer.

The Risk Buffer column is similar to the buffer concept applied by Basel III, except that scheme applies a straight up 2.5% buffer to a common equity tier 1 (CET1) minimum of 4.5%, for a total CET1 ratio of 7%, to be fully phased in by 2018.

But in the Marsico Method, the Risk Buffer is an assessment of the potential loss estimate of each balance sheet item, based on a rational analysis by the financial institution. The table above is a high level balance sheet. Hypothetical? Not really. It is Cape Cod Five Cent Savings Bank's balance sheet. And according to the analysis, their well capitalized is 7.90%. Meaning that if they experienced stress and began taking losses, the 2.9% buffer above the 5% should be sufficient to staunch the bleeding.

There would be more detail provided by specific loan, deposit, and other balance sheet categories to come up with the overall Risk Buffer per category. For example, upon analysis of the performance of the home equity line of credit portfolio during past downturns and rapid interest rate changes, the bank determines that the loss potential is 1.85%... hence the Risk Buffer for that particular balance sheet category.

Banks should not limit themselves to on balance sheet items. There is risk in pass through residential mortgage lending, loan commitments, and fee-based businesses to account for. And there is risk on the liability side of the balance sheet such as interest rate and liquidity risk, fraud, etc. That is why there is a Risk Buffer applied to those categories as well, although the risk is typically less than the asset side.

Using the Marsico Method, banks can then project the impact to the balance sheet and therefore Required Equity based on their strategy. This would flow nicely into their Capital Plan that identifies actions to augment capital should the bank experience a stress scenario. 

It also provides a nice answer to your regulators, Board of Directors, and other constituencies when they ask, what's your "well capitalized"?

I'd love to hear your thoughts on this approach!

~ Jeff

Guest Post: Year End Economic Commentary by Dorothy Jaworski

2014’s Biggest Surprise

It never fails.  The markets provide us with completely unexpected surprises and leave us scrambling to update our projections for rates and economic growth.  And so it was in the latter part of 2014.  Oil prices began a massive plunge, down 46% for the year to $53 per barrel.  And who expected this?  Well- no one.  Now we all have to adjust to this new reality.  What are the implications of the crash in oil prices?  And why did they plunge?

We all have been reading for years how the United States was dramatically increasing energy production, especially from a method of extracting oil and natural gas in shale regions of the country known as hydraulic fracturing or “fracking.”  Suddenly the US was the world leader in oil production.  Suddenly the world realized that there was a supply glut.  OPEC members and Russia stand to suffer the most from lower oil prices, but have continually sworn to keep production at current levels, perhaps using low prices to stall US investment and production.  While the US economy is growing slowly and steadily, this is not the case in China, Europe, and Japan, who are experiencing low growth, no growth, and outright recession, respectively.  This is a recipe for weak demand which, when combined with a supply glut, means lower prices.  Also, the US dollar has been strengthening, with a 12% increase in 2014, further pushing oil prices lower as oil is typically traded as a dollar denominated commodity.

Think back, too, as to when oil prices were close to $100 per barrel earlier in 2014.  Geopolitical tensions were running rampant as fighting was ongoing in Israel-Gaza, Russia-Ukraine-Crimea, and Syria with ISIS stepping up as a huge threat.  Supply disruptions were the typical fear but the tensions have since subsided.  These tensions could reappear if unrest rises in Russia, Iran, Saudi Arabia, Venezuela, and other countries that are highly dependent on oil for revenues.  Now US consumers can be the biggest beneficiary of falling gasoline prices, which recently peaked at $3.69 per gallon in April, 2014 and ended the year at $2.23.  Consumers rejoice!  And don’t forget that heating oil prices have plunged, too, just in time for another polar vortex.  I have always believed that cheaper oil and gas prices are like a tax cut that helps consumers save money on their “taxes” and spend it on other discretionary goods and services.  I was gratified to hear Janet Yellen reiterate this same point.  Consumer can and will rejoice and spend.  Economists revised their projections to include new assumptions that consumers will save between $70 billion and $100 billion annually on gas and will spend most of the savings, perhaps increasing real GDP by at least a net +.5%.  Yeah, finally!  A 3% GDP number! Happy 2015!

The Economy in 2015

Most economists were projecting +2.5% in real GDP growth in 2015, prior to the windfall from plunging oil prices.  As mentioned, they have increased projections to +3.0%.  Over the past five years, GDP has averaged +2.2%, which is quite disappointing compared to the average growth of +4.6% for the past ten recoveries.  If we make it to +3.0% in 2015, it will be the first time in six years of recovery that we have touched +3.0%.  Perhaps that is why former Federal Reserve Chairman Alan Greenspan just proclaimed that “we still have a sluggish economy,” which will not fully recover until there is more investment in long lived, productive assets and the housing market recovers.  Despite all the euphoria over a lower unemployment rate of 5.8% (down in 2014 from 7.0%), the fact that many of the jobs created have been part-time, lower wage ones and many experienced workers are dropping out of the labor force.  I do see millions of jobs being created in 2015, but still many are part-time, thanks mainly to Obamacare and other regulations.

Who projected that interest rates would fall in 2014?  Well- no one- except maybe Dr. Lacy Hunt of Hoisington Management, who has been on top of trends most of us do not see.  I read his quarterly newsletters with great interest and you should, too.  The ten year Treasury yield topped 3% at the end of 2013 and fell to 2.20% by the end of 2014.  Why?  Falling inflation and falling inflationary expectations will do the trick.  Falling inflation confounds the Philips Curvers, who read their textbooks and expected higher inflation from the falling unemployment rate.  I’ll bet John Taylor is a little upset, too, with trying to use inflation in his Taylor Rule formula.  Weakness in most world economies other than the US is keeping inflation under control with weak demand- especially as seen with commodity prices.  US rates continue to be substantially higher than rates in Europe and Japan with less risk.  That upsets me, because it is not normal.  Yet, the Federal Reserve stubbornly continues to proclaim that they will raise interest rates by mid-2015.  I say, go ahead.  The Fed will just end up lowering them shortly thereafter when they realize they have tightened prematurely.  New York Fed President William Dudley recently warned of just this risk, when he spoke of the historical classic case of premature tightening in 1937 by the Fed, when recession and deflation followed.   

Risks to Growth

I’m an optimist at heart, but I feel obligated to point out the risks to economic growth.  Measuring and managing risk has been my specialty in a banking career that is now 40 years old, of which 29 years have been spent dealing with risk.  The aforementioned risk of a Fed policy error of premature tightening tops the list.  Economies around the world are struggling and their policy makers are still easing monetary policy, making the spread between US rates and those economies’ rates unnaturally wide.  The ever rising US dollar could contribute to weaker and weaker currencies around the world, leaving countries to struggle and have to raise rates.  We have geopolitical (the word made famous by Greenspan in the early 2000s) risks of war, terrorism, epidemics such as ebola and influenza, and cyber attacks.

And there are two more risks that are not getting a lot of press- deflation- which can lead to deferred demand, declining wages, and slowing GDP- and liquidity risk- where restrictions and regulations have nearly strangled the life out of financial institution market makers, who seem increasingly unwilling or unable to take bonds into inventory and hedge them, instead opting to act like brokers, taking too much time to execute trades and too wide a bid-ask spread.  Market makers are not alone in this regulatory nightmare; 79,000 proposal and final rule pages were published in the Federal Register in 2014 affecting all industries, with a cumulative total of 468,500 since the recovery began in 2009.  Once again, I digress.  But, that’s what I am here for.  Stay tuned!  

Thanks for reading!  01/05/15


Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004. She is the author of Just Another Good Soldier, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure.

Leadership: In My Own Words

With all of the scholarship on leadership, what could I add to the conversation? I have my ideas. And if we reflect on the decline of our industry, an honest in-the-mirror assessment of bank leadership merits discussion.

In 2004 I wrote an article for a banking industry association entitled Lead Like Lincoln. The article identified three traits that were critical to Lincoln's success: Vision, Communication, and Commitment. Ten years later, I stand by those traits.

At this stage of the post, I could cite studies, books, and management luminaries on what makes great leaders. Instead, I will give you my slightly varnished view, straight from the gut. Slightly varnished because I grew up in Scranton, where directness has greater value than tact. Not always an admirable trait for a consultant, or a leader.

A great leader has a vision for the future. This is particularly important and challenging in rapidly changing industries like technology and media. It was not particularly important in slow moving industries like banking. 

But that has changed. The greatest banking leaders can see their bank several years into the future, and organize resources around making that vision a reality.

A great leader is humble. As with any general statement on leadership traits, there are exceptions. Say what you will about Steve Jobs. Humble he was not. But hard charging, egotistical leaders can only move an organization so far, and to a certain size, before the ego starts to become a liability. Recall that Jobs got fired from the company he founded. Not an easy task to accomplish. 

The humble leader, on the other hand, takes counsel from his/her people and understands that no human being is all knowing, or even close to it. A great leader does not judge his/her importance by an org chart or the size of paycheck, but by the happiness of their people (sum total of all of their people, not just keeping an individual happy) and the purpose of their work. 

A great leader does not fear failure. Failure is the lesson plan for success. Avoid failure, and the leader understands that their company is destined for the ash heap of irrelevance. In banking, failure is clearly a dirty word when relating to the overall bank. But the most innovative and sustainable business models in our industry are moving farther away from business as usual into less tried and true paths. If there was ever a need for great leaders in banking, now is the time.

A great leader has great followers. When the Navy trained me on leadership, an early lesson was that before becoming a great leader, a sailor must be a great follower. So before assuming leadership, a future leader supports their current leader, working with purpose for the betterment of the company, with no interest in highlighting shortcomings of their leader or those around them in order to move them up the organizational ladder.

Surrounding yourself with great followers implies hiring those that can step into your shoes, or that have such potential and you are dedicated to ensuring their development. Great followers are smart, motivated, humble, forward looking, and care about their colleagues and the company. 

Great followers give the leader informed information and opinions, and if the leader, after careful reflection, decides to go against the follower's recommendation, the great follower charges forward lock-step with the leader.

Poor leaders don't want great followers for fear that they can easily slip into the leader's shoes. Great leaders cheer their followers and prepare them to slip into the leader's shoes.

Great leaders are committed. If a vision is worth pursuing, should it be abandoned when obstacles rear their inevitable head? Weak leaders cut their losses. Great leaders forge forward.

Great leaders are likable. By this I don't mean liked by everyone at all times. They can make the difficult decisions, counsel employees, and be firm when necessary. But if a leader must motivate employees to challenge their boundaries and create great companies, employees must believe in the man or woman. 

Can a person with wavering honor or integrity, or is generally a jerk get the entire company to move as one in a direction that has great risk yet may lead to great reward for a sustainable period of time? 

I think not. 

What are your thoughts on leadership in financial services?

~ Jeff