Pub. 6 2015 Issue 2

www.wvbankers.org 22 West Virginia Banker EPS is increased Booking a 9% loan may hurt your ROE and ROA, but it will help your earnings per share. This is a clear case of being clear what your goals are. Is it a divi- dend? Capital efficiency? Or, is your goal another metric? EPS is likely what your shareholders are really concerned about. While we are big fans of capital produc- tivity, we would argue that under-de- ployed efficient capital is not as good as fully deployed non-efficient capital. If you have under-leveraged deposits and capital, then that 9% ROE loan should be considered. Abank is not the sumof its loans A bunch of 9% ROE loans can produce a 20% ROE bank. If constructed the right way, a well-engineered balance sheet produces greater excess return than the sum of its parts. Build a diversified portfolio and the sum of your risk is decreased thereby increasing the ROE on all loans. In fact, proper construction can add approximately 20% more return making that group of 9% loans closer to an 11% return. Further, interest income is just one part of the equation. That loan also represents fee income, refer- rals, deposits and other future business that you may or may not be capturing. Additional income may not only come from future cross-sell, but from future growth in the relationship, as those $50k of balances turn into $150k in two years. Add these streams in and your bank can easily take those 9% loans and turn them into a 20% relationship. In fact, while a bank is not the sum if its loans, the sum of its relationship profitability would yield something closer to aggregate ROE. You are measuring risk wrong Almost every bank measures risk at its highest point – at inception. The reality is that risk changes over time. Busi- nesses grow, property appreciates and loan balances get paid down. All things being equal, the risk of a loan peaks somewhere between years two and five of a life of a loan and then trails down. Of course risk can increase at any time, but the odds are with you that the risks decrease if you pick the right manage- ment team. Few risk systems capture the profile of credit exposure over time and so approximate the probability of default at the time of booking. As sea- soning occurs, spreads tightened giving that loan more value and increasing the return substantially above that 9%. It is also important to realize that most likely you are counting your loan reserve as an expense when it is capital. You might include a 2% reserve now resulting in 9% return, but the reality is you will likely reduce your loan loss reserve in the future, particularly as credit quality improves. You are ignoring operating leverage and the time value of money You might be allocating your capital, funding cost and direct loan mainte- nance expenses to the loan, but that says nothing of the fixed investment you have in your infrastructure. Even if you are one of those sophisticated banks that have a state-of-the-art funds transfer methodology, it is doubtful that you take into account the opportunity cost of resource slack. You may want to hold out for that 20% ROE loan, but while you do you have excess capacity and under-deployed resources that could be producing income. Better to use your loan system, branch, risk management system and other fixed resources with excess capacity to drive dollars to the bottom line today. A dollar today, means much more than a dollar tomorrow. 7 Reasons Why You May Want To Book That 2% Margin Loan By Chris Nichols, Center State Bank As loan pricing becomes more competitive, the opportunity to book high quality credits at thin margins presents itself more and more. A 2% margined loan represents about a 9% risk-adjusted return on equity (depending on your cost structure), which is below most bank’s cost of capital. As such, there is every reason to pass on the credit and let another bank book the loan. However, before you do, consider the following points: