Pub. 8 2020 Issue 2

www.uba.org 14 GETTING SMALLER MIGHT MAKE YOU STRONGER By Scott Hildenbrand and Matthew Forgotson, Piper Sandler J ust several weeks ago, the pre- vailing wisdom was that banks would enter the next downturn from a position of relative strength, manifest in strong pre-provi- sion earnings profiles, pristine credit quality and an abundance of capital relative to pre-Great Recession levels. Then a black swan named COVID-19 showed up on our doorstep. The economy didn’t slow down — it came to a screeching halt. We are now in a recession. Appropriately, bank management teams and institutional investors are laser-focused on safety and soundness. Banks must prove their capital bases to earn the right to refocus on growth. Against this painful backdrop, we examine how banks can bolster capi- tal ratios by selling select bonds into a strong bid and using the proceeds to remove inefficient wholesale lever- age. Institutions that are comfortable with their capital profiles might choose to return the balance sheet to its original size by releveling at a wider spread. Let’s evaluate these options from the perspective of Bank A, a solidly profit- able community bank. BANK A’S FUNDAMENTAL PROFILE Bank A has assets of $1 billion and its asset-liability profile is effectively neutral. During a recent review, management identifies $25 million of wholesale leverage earning a negative spread. Management decides to evalu- ate two strategies: Strategy 1: sell secu- rities and pay down debt (Delever) and Strategy 2: sell securities, pay down debt, and relever the balance sheet (Delever/Relever).