I love to do asset/liability management education with directors. This is commonly the least understood duty of a bank director. As a director, your duty is to assess risk, set risk parameters, monitor risk, and provide management with dynamic tools and models. How can a director comply with this duty if he or she doesn't have a director level of understanding of risk? This series will focus on capital risk, liquidity risk, and earnings at risk. The risk a bank takes directly affects a bank's performance and its value. These risks are intrinsic to the CAMELS ratings.
Capital is your bank's diamond. Like a diamond, you can look at capital from many different angles. There is the equity-to-asset ratio. The national average for banks between $100 million and $5 billion is 9.2%. There is risk-based capital. All banks nationally average a healthy 12.86%. Then you can look at the leverage ratio, which is at 9.05% nationally. And then there is my favorite, economic value of equity (EVE). How do you compare to the national benchmark? Do you have a good understanding of EVE? Are you comfortable with your level of capital?
Dr. Ed Seifried adds another important point to remember: "Capital amounts can be misleading when comparisons are made between and among banks." For example, which of the following banks would you deem to be safer, better capitalized? Bank A has a 9% capital ratio and 1% of its loans classified as nonperforming. Bank B has a 10% capital ratio with 3% of its loans classified as nonperforming. Clearly, on a net basis, Bank A is the stronger bank because it has more net capital (8% versus 7%), assuming a worst-case scenario in which all nonperforming loans had to be written off.
And this is exactly why capital is the core of strategic planning. Capital planning is not short term. I recommend that directors look out 10 years and determine what the bank will be. Typically, directors focus on size. Will there be enough capital to meet the vision? What needs to be achieved or changed today to plan for the future? This can involve changes to how the bank pays dividends. Maybe equity will need to be raised. It is better to set long-term goals on capital versus having unwelcome surprises.
EVE can be used in the strategic planning process to plan what the bank's value will be in 10 years. Of course, as directors, we want our bank to grow in value. EVE is an excellent determinate of share value. EVE places a value on each asset and liability. The board can then determine what value creation would make them happy in 10 years. The EVE model can then be used to monitor if value is being created.