Building A Strong Foundation
Seven steps to integrate capital planning throughout the strategic planning process
If strategic planning lays the foundation for a financial institution’s success, then capital planning is the mortar that holds it all together. Branch and portfolio acquisitions, organic growth into new areas, and significant investments in technology are all common strategic goals that heavily impact capital. “Strategically, you need to position your balance sheet to be ready for all of these things,” said John Behringer, CPA, partner at RSM US, LLP, a WBA Gold Associate Member. To do so, everyone involved in creating or refreshing the bank’s strategic plan must keep capital top-of-mind throughout the process. “Capital should always be an overarching—if not the overarching—consideration in the strategic planning process,” said Jon Bruss, managing principal and CEO, Fortress Partners Capital Management. Though the process will vary from bank to bank, generally, there are seven key steps to achieving synergy between the bank’s capital plan and strategic plan.
1» Identify a Capital Champion
During the bank’s strategic planning process, someone must be responsible for ensuring that capital is considered every step of the way. While the board of directors should be heavily involved, Kirk Hovde, CPA, vice president at Hovde Group, recommends starting the process with bank management. “Usually it’s easiest to start with the management team, because they’re more involved in the day-to-day operations of the bank,” he said. Though in some instances the CFO (or even CIO) may take the lead, typically integrating capital into the strategic planning process falls to the bank CEO. “The CEO must set the standards and tone for the strategic planning process,” said Bruss. “He’s ultimately responsible to the board of directors, who are in turn responsible to shareholders for the stewardship of the capital account of the bank.”
2» Weigh Shareholder Expectations
Any capital planning must include consideration of the bank’s shareholder base and their expectations with regard to ROI and share value. Strategies that will require additional or higher levels of capital need to be weighed against the possibility of diluting shareholder value. “It’s important to consider your shareholders’ appetite,” said Hovde. “You don’t want your strategic plan to pigeon-hole you into needing capital at a less-than-attractive price, because that dilutes your shareholder value.” These expectations will vary depending on the bank’s shareholder base, as well. For example, a bank with shareholders who are interested in near-term liquidity should not raise common equity as a first choice because that could dilute share value, but a closely held family bank may not have those same short-term concerns.
3» Select a Starting Point
Capital both impacts and is impacted by the bank’s other strategic goals. Therefore, management and the board must begin the planning process by selecting their starting point: capital goals or other strategic goals. “In my experience, it’s best for the board of directors and management to sit down and identify what sources of capital are readily available to them and at what cost,” said Hovde. “Your access to capital is one of the most important parts of strategic planning.” However, the capital-first strategy isn’t a one-size-fits-all solution. Behringer says that strategic planning can begin with identifying two or three primary goals for the institution, provided the board and management team recognize how capital fits into those goals. “Look at the pro forma balance sheet and come up a couple of options based on what is achievable given the restraints you have,” he recommends. Capital is a common restraint, but available resources, time and competing strategic objectives are others.
4» Assess the Budget
“The first thing any management team should look at is budgeting,” Hovde advised, cautioning bankers to be aware of its limitations, as well. “It’s a great tool, but as you get further into the future it becomes less accurate.” With that in mind, an analysis of the institution’s budget provides an excellent short-term scope of the bank’s capital needs. For example, imminent infrastructure needs or anticipated investments in technology both indicate short-term future capital needs that should be accounted for in the planning process.
5» Forecast Multiple Scenarios
To augment budgeting’s limitations, management should leverage forecasting tools that will help determine the future sources of funding needed to sustain growth. “There has to be a process of creating or forecasting the balance sheet and profit and loss statement,” said Bruss. He recommends the CFO prepare a balance sheet analysis for best-case, worst-case, and base-case scenarios for each of the strategies in order to determine what the impact on capital will be. That exercise, combined with an analysis of the balance sheet and profit and loss statement will be the best way to understand what the capital changes will be. “Having a reliable forecasting process is critical,” Behringer said, noting that the asset/liability model and economic value of equity are also important. “It helps you be ready for opportunities when you know what your options are.”
6» Measure Against Benchmarks
Regulatory requirements are the most obvious (and significant) benchmarks for banks to measure their capital plan against, as they can impact the bank’s potential for growth. “Banks should always be cognizant of where their regulatory capital levels are and how their growth will affect those,” said Hovde. “We’ve seen lots of organizations who had to slow down growth because of regulatory pressure.” However, shareholder expectations are also a key benchmark to use in order to ensure the strategic plan is leveraging the bank’s capital effectively. “Look at the common GAAP measurements that will be considered by people who want to own shares of the bank,” Bruss advised. Behringer recommended comparing the bank’s ROE to peer averages to manage what shareholder expectations and assess tolerance for deviations.
7» Consider Multiple Sources of Capital
If the board determines raising capital is the best way to achieve the bank’s strategic goals and increase shareholder value, keep in mind solutions other than raising common equity. “There is a veritable plethora of strategies to deal specifically with capital before you get to the point of needing to get an investment banker to assist in raising capital,” said Bruss. “You may need a third party to objectively look at everything the bank is doing and advise the bank on what balance sheet maneuvers can be taken without the need to go into the market to raise more capital.”
One of these options Behringer recommends is for banks to regularly evaluate if they are effectively allocating their existing capital. This requires the bank to examine if it is investing in assets for which the return is not adequately compensating them for the corresponding regulatory capital requirement. An example of this involves lines of credit extended to C&I borrowers. BASEL III requires banks to assign a 20 percent risk weighting to unfunded commitments with an original maturity date of one year or less that is not unconditionally cancellable by the bank. For unused lines of credit banks should regularly evaluate to determine if these amounts are required by the borrower and to the extent they are not at the next renewal date the notional amount of the line should be adjusted or an unused line fee charged to compensate the bank for the “use” of their capital by the borrower.
If none of those options are viable and additional capital is required, Hovde recommends initiating conversation with an investment bank to explore a variety of options. “If a bank has readily available capital around the board table, that’s a great source to turn to first,” he said. “If that’s not readily available, an investment banker can help you gain access to a broader market, and therefore better pricing.”
A general guide to follow, the steps outlined in this article will not be a fit for every institution. The capital and strategic planning process should be tailored to each individual institution and its needs, as well as the unique makeup of its directors and management team. More importantly, the most successful strategy is one that allows for adaptation, especially in today’s capricious economic and regulatory landscape. “The key is to remember this is all planning,” Behringer advised. “It will provide a framework and roadmap, but it shouldn’t necessarily dictate your actions.”