As I have previously pointed out to both the company and other stockholders, National Bankshares (Nasdaq:NKSH) has too much capital.
Obviously, all banks need a certain amount of capital and having a little extra, particularly if a bank has strong growth prospects, is generally pretty desirable. However, with capital, just like many other things, more of a good thing is not necessarily better and too much of a good thing can be bad. When a bank has more extra capital than it needs to support reasonably achievable future growth, that excess capital becomes a drag on returns. In addition, to the extent that the market does not believe that a bank is likely to deploy its excess capital in a reasonable time frame, it becomes a drag on valuation.
From a corporate finance perspective, there is obviously a cost of equity, or a level of return on equity that stockholders expect in return for putting capital at risk. Having more equity doesn’t lower its theoretical cost, but it does lower the return on that equity (where return on equity is earnings divided by equity, more equity means lower returns). As a result, over capitalized banks, like National Bankshares (who reported a return on average equity for 1Q18 of 8.85%, despite, according to Bloomberg, having a cost of equity of 9.0%), often fail to “earn” their cost of equity.
As a matter of stewardship, hoarding excess capital is hardly either optimal or admirable. Stockpiling capital beyond that which is reasonably required (by regulators, as a buffer thereon and to support realistic growth) benefits no one, least of all stockholders, and to the extent that it cannot be deployed, should be returned.
Leaving aside banks with either strong growth prospects or anticipated near term losses, why would a bank operate with capital levels well in excess of accepted norms? There could be a number of reasons, none of which are particularly compelling.
Perhaps a management team views excessive capital levels as a mark of achievement, particularly if the capital is generated through retained earnings. Strong and sustained earnings are obviously a good thing, but should then be either reinvested in the business or distributed to stockholders. Taking a miserly approach to earnings and hoarding them as underutilized and excessive capital benefits no one and reflects negatively on the management team that was so successful in originally producing the earnings.
Maybe a management team has some nebulous and ill-defined dread of an economic downturn or other potential events or circumstances that might cause significant credit issues. Conservative views on credit and risk taking are obviously pretty common in banking and not necessarily a bad thing, but those views are better expressed through modifying underwriting standards and other business practices to reflect low risk tolerances and appetites as well as robust (to the extent permitted by auditors) loan loss reserves. A large “catch all” capital buffer in excess of current norms is just an excuse for poor and/or lazy risk management.
Of course, a management team might be holding out hopes of future opportunities to deploy capital, whether through organic growth or acquisitions. Clearly, in an ideal world, banks with significant levels of excess capital would be able to find new or greater avenues for growth—acquisition targets, new business lines, geographic expansion, greater market penetration, etc—but management teams should be realistic in their assessment of their prospects. Rarely does a bank with a history negligible growth and no recent acquisitions reverse those trends (successfully) overnight. Rather, banks with more capital than growth opportunities should heed Jamie Dimon’s advice and return the excess to stockholders who can put it to a “higher and better use.”
However, I think that there is another reason why a bank might operate with excessive capital levels that is both less likely to be acknowledged and significantly less defensible—to deter potential suitors. Significant amounts of excess capital not only mask the true earnings power of a bank, but it can also provide a convenient obstacle to a sale. Conventional wisdom holds that acquirers will not pay a premium on excess capital, on the theory that each dollar of excess capital is properly worth one dollar, so it is harder for a buyer to pay a meaningful premium for a bank that has a large amount of excess capital.
However, given the significant expansion of many banks’ price to tangible book value (“TBV”) multiples, particularly since the fall of 2016, the merger math for buying an overcapitalized bank has gotten significantly better. Since most overcapitalized banks trade a lower price to TBV multiple (because they have a lot of tangible book value) relative to would be acquirers, such deals could be expected to accretive to tangible book value. While I am not a big fan of judging bank mergers by whether they are accretive or dilutive to TBV (and if dilutive, how long it will take the acquirer to “earn back” the dilution), it is clearly important to the broader market.
Turning back to National Bankshares, as of June 12, 2018, they are trading for around 1.8x TBV. Given that there are a number of obvious buyers trading north of 2.5x TBV, I would imagine that many of these potential buyers might be able to pay a market standard premium for National Bankshares and still be able to announce to investors that the transaction is accretive to tangible book value. I would also imagine that any buyer would also then, after the closing, use National Bankshares’ excess capital to buy back their own stock, likely improving earnings per share, return on equity and, presumably, their own stock price.