Contrary to popular belief, risk isn’t something to avoid. Risk is not even an element to minimize. This is counterintuitive as most bankers are taught to avoid and minimize risk. For that matter, most regulators, board members, and investors also reinforce this notion. Take for instance the dozen of credit parameters like maximum loan-to-value (LTV) that are hard and fast rules regardless of the quality or trend of the collateral value and absent of any analysis on pricing. If your limit is 80%, then you will not likely approve many loans that have LTVs above 80%. But what happens if that 82% LTV loan had much better pricing and structure that resulted in lower risk than the average 75% LTV loan. Shouldn’t a bank approve the lower risk loan? In this article, we challenge the commonly held view on risk with the hopes of deepening bankers understanding that risk, like capital, is available for investment and that getting the risk/reward equation right creates a virtual cycle that attracts capital.
Residual Risk That Meet Strategic Goals
Every decision a banker makes has an impact on risk and return. Some decisions create franchise value, while some decisions destroy franchise value. For any given risk there are mitigants leaving the bank with “residual risk.” The goal of bankers should be to take as much residual risk as possible to the extent they get paid for it AND the risk is in-line with the bank’s strategic goals.
That approach is starkly different than how many banks operate in our industry today. Some take risk because it is a good opportunity and not because it furthers their strategic or even tactical goals. More often, bankers look at the gross risk in a vacuum not taking into account risk mitigants or the return generated by such a risk. Finding this optimal risk zone is central to enterprise risk management and should be part of the daily conversation for every bank no matter their asset size or orientation.
Proactively Taking Risk
Just like your bank decides where it wants to invest its capital next year, it needs to proactively state what risk it wants to take on and what risks it wants to avoid. Communicating your management team’s risk view, not only makes sure everyone is on the same page but helps support a risk-centric culture that speeds decisioning, lowers the drama around decisions and makes sure there is a dynamic and consistent dialogue about risk within the bank. Does your bank want to drive alpha from certain business lines, by taking credit risk, interest rate risk, operational risk or something else?
The question is key to strategic execution because back in 2010 you might have wanted to take more interest rate risk and more credit risk given the state of asset prices, cash flow, and interest rates. Now, for 2017 and beyond, it could be a very different picture. Take for example a $1mm, seven-year fixed rate loan with a 75% LTV and 1.35x debt service coverage (DSC) in Texas priced at 4.25%. Here, unless you have a particular rate view, the market can tell you exactly what that interest rate risk is worth, in this case, it is worth 188 basis points. In similar fashion, we can also quantify liquidity risk as we can see the difference between loans and securities for major corporations and rated asset-backed transactions. This “liquidity premium” is somewhere between 10 basis points and 100 basis points with an average somewhere around 30 basis points. The rest of the risk components, operational, reputational, regulatory and legal risk combined are somewhere around 20 basis points. You can argue with these numbers, but there is almost total agreement that these total something greater than zero.
Assuming this quantification is correct in this example, we are left with a remaining 1.87% that can be attributed to credit risk. Given the LTV and DSC, a 1.87% spread is likely too low. Even given today’s lower credit risk environment and depending on the location of the property in Texas and the tenant mix, the correct spread should be in the 2.30% range. Anything above that would generate an excess return and build franchise value. Below that pricing level and franchise value is likely to be hurt.
Usually, bankers get the credit spread right but misjudge interest rate and liquidity risk. In this case, at 1.88% the banker should be indifferent to making a fixed or floating rate loan. This is the level where you could come to us or any other counterparty and hedge (swap) that loan should you want. The fact that you can do that means that the risk is priced accurately and is optimized.
The key point here is to have a working knowledge of your component parts that compose different functions within the bank to understand where you want to drive return. To optimize risk taking, bankers need to know what risks they want to take and where they want to take those risks within the bank.
If a bank is a better lender, a better deposit gatherer or has a niche business where they can generate excess return given the risk, then likely they are “generating alpha” or creating excess returns above the bank’s cost of capital. Similar to what risks a bank wants to take, a bank needs to understand where it wants to take those risks. Some banks do very well just focused on deposit gathering and then leverage those deposits by making investments. Other banks focus on the lending side while other focus on payments, trust, mortgage or some other operational line.
By looking at the returns for each department, bank management can then compare those returns to their peers to have a clear view of where they excel and where they underperform. Capital and risk should be allocated to those areas where a bank wants to expand. This adds another dimension as not only should management be clear on what investment is needed to expand the business, but if the business does expand, what is the increase in risk and does this risk generate enough of a return to compensate for the capital invested AND the risk.
Of course, the opposite can be done. For example, a five-year total return for a large bank index fund has been a compounded return of 15.6% . This is pretty good and it is better than the market (S&P 500) that produced a total return for the same period at 14.3%. Here, we are proud to say that we are producing sufficient alpha given our cost of capital. However, the real equation is - how?
Alpha From Various Functions
At CenterState, we generate alpha in a variety of ways. While pinpointing alpha can be difficult, as pure quantitative comparisons cannot always be done, we can get in the right ballpark. Are we generating alpha from being in Florida? The answer is no, as we can look at those banks that also focus on Florida and find that their total return for the same period is approximately 8.3%, or lower than that of the market. We can also look at banks that specialize in mortgage vs. commercial banking and find that our commercial orientation is a slight contributor to our alpha. In addition, we can look at those banks that are acquisitive and those that are not, and find that we generate a substantial amount of alpha from our acquisitions.
Other aspects of our alpha generation are our deposits. We have a 19 basis point cost of funds which ranks in the top 15% of all banks in the nation. We have above average risk-adjusted return on loans with an average yield of 4.42%, or in the top 30% of all banks. We can break this down further and see our deposit mix, customer segmentation, local market relationship focus and lower than average cost structure all play a role in generating alpha.
Putting This Into Action - Alpha From Strategic Planning
During this time a year, we ask ourselves, “Is this where we want to generate our alpha going forward?” We obviously want to keep our focus on Florida, on customer management, on loans/deposits and want to keep acquiring when good opportunities present themselves. We also know we don’t want to take interest rate or liquidity risk and want to focus on those lending areas where we can generate excess returns and minimize those areas that, in our opinion, we cannot get the returns we need to compensate us for the residual risk. We also believe we can take more risk in certain areas in order to generate more fee income and so we will be looking to expand several fee generating lines of business.
Our risk management framework is still evolving, but one concept that works for us is being proactive about where, when and how to take risks. Each capital decision should be tied to a risk decision as you can invest capital to increase or decrease risk or you can choose to reduce capital to increase or decrease risk. This is a four-option decision that is very different than how most banks think of risk management. By using this methodology, you can increase or decrease both capital and risk until you feel your investment moves into the sweet spot of risk optimization. By doing so, you will find that you can generate more alpha which, in turn, be able to attract more capital, which will then lower your risk so you can then invest that risk to generate more alpha. This is what is called the virtuous cycle of risk management.
Submitted by Chris Nichols on November 14, 2016