Risk-Based Return on TARP

November 11, 2008 by Guest Contributor

By: Tom Hannagan

In my last post, I addressed the need for banks to advance their management of risk to include the relationship between capital and risk in their internal decisions and actions. While it is difficult for me to make this topic very exciting, it can’t be ignored. It very nearly resulted in bankrupting the global financial system.

Beyond profitability, bank executives must measure and monitor their risk-based capital because: 1) equity capital represents the ownership interest in a bank; 2) equity capital is by far the most expensive source of funding; and 3) the risk associated with capital sufficiency and continued solvency is important. As Colonel Jessup might confirm, “Yes, we’re talking about mortal danger”.

Many are scrambling to apply for the TARP (Troubled Asset Relief Program) capital infusion – and most are getting approved for these windfall funds. (Today’s investment advice from the experts: don’t buy common shares in any bank that applied and was turned down.)

Let’s take a look at the impact of these funds. If we were, for example, a $10 billion total asset bank, with say $800 million in equity capital prior to TARP and had roughly $700 million in risk-weighted assets, we might get approved for $200 million in TARP-related preferred shares at a cost of 5 percent (after tax) for the next five years. If, our make believe $10 billion bank was earning an average pre-2008 economic-and-credit-crisis return on assets of 1 percent, or $100 million per annum, what are the implications of the added $200 million in capital on future earnings?

That $100 million in “pre-crisis” earnings represented a return on equity of 12.5 percent on our original capital of $800 million. (Stay with me, now…)   Since we need to pay the Feds (our new shareholders) $10 million in preferred dividends per annum in after-tax money, we need to earn an added $16 million in pre-tax operating income just to break even on the deal. That would mean, in our otherwise static model, that earnings need to move from $100 million to $110 million. More importantly, pre-tax income needs to move from say $150 million to $166 million, assuming about a 33 percent effective tax rate.

We’ve got the fresh $200 million to work with, assuming we don’t need part of it to cover credit charge-offs or other asset write-downs. To earn $16 million from that $200 million investment, we would need an 8  percent pre-tax operating income (that’s after expenses, folks).

I’m open to suggestions at this point…And you thought banking was easy.

You do that the old fashion way — with leverage. You use the $200 million to get someone (depositors, the Federal Home Loan Bank, a Federal Reserve Bank, or anyone else) to give you more money to invest (at a critically important tax-deductible cost) along with your fresh $200 million in preferred equity. Remember, our bank is already operating with leverage, supporting $7 billion in risk-weighted assets, and $10 billion in total assets, with the pre-existing $800 million in capital. Unfortunately, leverage involves at least liquidity risk, and probably market risk — on top of whatever direct (credit, market, operational) risks are associated with whatever end investment you choose (…and the Feds hope you choose loans). Obviously, the fastest way to get the added leverage, along with a quick addition to earnings assets, is to go buy another bank (and absorb them more successfully than the two of you ran separately). Thus, a new round of consolidation has begun.

Regardless of the method used to grow into the TARP money, any bank that doesn’t take into account the risks associated with these decisions/actions is merely kidding itself. TARP funding will not make any real headway in improving risk-adjusted earnings going forward.

There is (and always has been) a direct relationship between actual risk and risk-adjusted return.  It is now more important than ever for bank management to monitor and measure their organization’s activities (loan pricing and profitability, investing, deposit taking, investment management, credit risk modeling, buying other banks…and anything else they do) based on the relative risk of those activities and based on the equity capital realistically required to support those risks. This means using return on equity measurement internally as well as at the entity level.

I look forward to your comments.