|
|
Insight Newsletter
The Bank Capital Shortage
Financial distress among lenders has left middle-market companies with fewer options.
by Michael T. Newsome and William S. Hanneman
Credit is the lifeblood of the economy. Access to debt capital allows businesses
to invest in growth initiatives and refinance existing indebtedness. Thanks to the
fallout from a period of aggressive lending and the subsequent financial distress
among lenders, the middle market has gone from feasting on financing options to
a starvation diet almost overnight. While credit market conditions have improved
markedly in recent months, as compared to the dark days of 2009, we are not yet
out of the woods. Bank capital shortages will continue to define how, at what price,
and which businesses will have access to the credit markets in 2010.
2010 - THE YEAR OF THE BANK DELEVERAGING
A shortage of bank capital will persist in 2010, which has implications for business
credit. To understand the linkage, a bit of background is required on how banks
fund their lending activities. Funding comes principally from three broad categories:
- Capital – common and preferred equity, together with retained earnings;
- Debt – short- and long-term notes; and
- Deposits – purchased funds, and interest - and non-interest-bearing accounts.
Credit losses have depleted bank capital. As a result, both regulators and investors
have pressured banks to shift funding away from debt and brokered, or "hot money,"
deposits in favor of a combination of government-provided TARP preferred and common
equity raised in the public capital markets and stable deposits. In fact, the federal
government sought to bolster availability of stable low-cost deposits by according
unlimited FDIC insurance coverage to all non-interest-bearing deposits.
From a regulatory perspective, the definition of "capital" seems to have been bifurcated,
with the smaller regional/community limit lending banks being measured using Tier-1
Capital (TC), while large national or super-regional banks are viewed relative to
a more stringent Tier-1 Common Equity (TCE) standard. The adequacy of TC or TCE
is assessed based on its ratio to total risk-weighted assets.
1 TC is generally defined as the sum of common equity + non-cumulative preferred
equity + retained earnings + deferred tax assets _ goodwill and intangible assets.
2 TCE is generally defined as the sum of common equity + retained earnings + deferred
tax assets.
3 Total risk-weighted assets are calculated based upon a complex formula that weighs
different classes of balance sheet assets and off-balance sheet contracts and commitments.
There continues to be considerable uncertainty with regard to minimum capital standards
that Congress and regulators will impose on banks. Current thinking seems to be
that a Tier-1 TCE ratio in the 5% to 8% range is appropriate for large banks. Unfortunately,
as of the end of Q3-09, only one of the major banks active in the Northwest (JPMorgan)
exceeds the 8.0% standard.
A regional or community bank is expected to maintain a TC ratio of at least 6% in
order to be considered "well-capitalized" (the regulatory euphemism for minimum
capitalization). There is much talk among bank regulators and Congress about increasing
the capital requirement, perhaps to as high as 10%. Even when measured against these
higher standards, Northwest regional banks (except for Frontier) don't look too
bad.
But, in reality, regional bank capital positions are weak when viewed in the context
of their non-performing asset loads. Both Frontier and Sterling are buried in problem
credit, which leaves little doubt as to why they are under the gun to raise capital.
The other regional banks have significant credit challenges, relative to any historical
norm. Even under these conditions, most were able to raise additional
equity in 2009 to supplement the TARP funding they received. What's not reflected
in the adjacent charts are the 20-plus Washington community banks, with nearly $14
billion in assets, that are operating under regulatory cease-and-desist orders or
similar corrective agreements. Most of these banks are burdened by non-performing
real estate portfolios and capital deficiencies.
.........
Of course, new capital is
costly in terms of shareholder
dilution. For even modestly
troubled regional/community
banks, it may be nearly impossible
to go back to the well for
additional capital. There is no
easy answer to this problem.
The path of least resistance
for many banks has been, and
continues to be, to shrink by
eliminating higher-cost deposits
and by shedding assets in an
effort to improve capital ratios.
..........
Of course, new capital is costly in terms of shareholder dilution. For even modestly
troubled regional/community banks, it may be nearly impossible to go back to the
well for additional capital. There is no easy answer to this problem. The path of
least resistance for many banks has been, and continues to be, to shrink by eliminating
higher-cost deposits and by shedding assets in an effort to improve capital ratios.
Unfortunately, the capital arithmetic is harsh, as illustrated by a $100 million
bank with capital of $10 million (10%) that suffers $5.0 million of loan charge-offs.
This translates into a 50% capital reduction supporting $95 million of assets, for
a capital ratio of just 5.3%. In the absence of fresh capital, restoring the desired
10% ratio demands an additional $45 million asset contraction. Further credit losses
perpetuate the downward spiral of eroding capital.
IMPACT ON CREDIT CREATION
A crucial consequence of deleveraging has been a reduced ability of the entire financial
system to lend money. According to the Federal Reserve, lending to businesses has
plummeted from a peak of $1.65 trillion in October 2008 to around $1.35 trillion
at the end of 2009. This is the most significant business-credit contraction since
the government began tracking the statistic. Since September 2008, the loan portfolios
of the major banks shrank by $264 billion (11.2%), after factoring out the impact
of major acquisitions. During the same time frame, Northwest regional bank-loan
portfolios declined by $2.83 billion (7.3%). To be sure, this is not just erosion
of commercial and industrial loans. Banks have rolled back consumer credit and real
estate lending, and many borrowers are not using available credit lines to the same
degree as previously. Only US Bank and Umpqua appear to have originated more credit
than they charged off over the past year.
The struggle to deleverage is hampering a more vigorous economic rebound and portends
a vexing dilemma for lenders. At the same time that politicians are castigating
banks for failing to bolster credit availability for small businesses, and Congress
is threatening to impose punitive taxes that will diminish bank earnings retained
as capital and increase the cost of credit to borrowers, the regulatory
screws turn tighter on bankers to lend evermore prudently and carry larger capital
cushions against future losses. These conflicting demands are not easily reconciled
and may, in fact, grow worse. The FDIC recently finalized new accounting standards
that mandate inclusion of securitized assets on bank balance sheets, rather than
as disclosures in the footnotes. These new standards usher in more pressure on banks
to build capital and limit lending.
To be sure, this is not just
erosion of commercial and
industrial loans. Banks have
rolled back consumer credit
and real estate lending, and
many borrowers are not using
available credit lines to
the same degree as previously.
Only US Bank and Umpqua
appear to have originated more
credit than they charged off
over the past year.
..........
COMPETITION FOR CAPITAL ACCESS
The implications of insufficient bank capital are potentially daunting for corporate
borrowers – tighter money and higher borrowing costs. As we described in some detail
in the Fall 2009 edition of IN$IGHT, a wave of credit maturities looms. Much of
this credit was originated in the five-year run up to the financial crisis and funded
by securitizations. These assets cannot be rolled over at maturity and, by necessity,
will compete vigorously for scarce bank capital. As essentially the only game in
town, banks will be in a position to be highly selective in the risks they underwrite
and can charge dearly for doing so. Businesses will need to compete for access to
credit. Although higher-priced credit may not be roundly appreciated by the businesses
dependent upon it, the capital retained as a result of higher margins, over time,
will restore bank balance sheet health and improve prospective borrowers' access
to funding.
|