Pub. 8 2020 Issue 2

ISSUE 2. 2020 15 STRATEGY 1: REMOVE $25 MILLION OF INEFFICIENT LEVERAGE Bank A has $25 million of securities yielding 2.25% funded with wholesale borrowings costing 2.35%, as shown in the table below. This segment of the balance sheet is “upside-down” by 10 basis points, which results in a pretax earnings drag of $25k and an after-tax drag of $20k, assuming a 21% effective tax rate. Merely removing the negative spread would be a penny accretive to EPS, four basis points accretive to ROA, and 12 basis points accretive to NIM. The transaction also shrinks the bal- ance sheet, nudging the TCE ratio from 12.00% to 12.31%. Simultaneously, management completes a granular review of the loan portfolio, securities portfolio, loan loss reserve and other real estate owned. Management anticipates that a weakening economy will necessitate elevated loan loss provi- sions. Still, management observes that even in the most draconian economic scenario, the bank would remain solidly profitable. Thus, management is open to utilizing the 31 basis points for improve- ment in the TCE ratio. BEFORE PRESSING ON, THREE NOTES TO CONSIDER: 1. For illustrative purposes, we assume that the gain on the sale of securi- ties offsets the debt extinguishment charge. This is convenient, but not always the case. Importantly, the relative size of these accruals dictates the impact on GAAP and regulatory capital. The realized gains on the sale of securities are accretive to regula- tory capital, but most likely neutral to GAAP capital because most of the gain already lives in OCI. Alternatively, the debt extinguish- ment charge reduces both regulatory capital and GAAP capital. It’s also worth mentioning that investors tend to strip both accruals out of core earn- ings. Today, banks can sell agency MBS and agency CMBS (DUS and GNPLs) into the Federal Reserve’s strong bid to source gains that offset the debt extinguishment charge. 2. It is self-evident that wholesale leverage earning a negative spread is inefficient. However, wholesale leverage earning a positive spread can also be inefficient if it steers the asset-liability profile away from neutral in a meaningful way, clouds earnings or relative profit- ability metrics, weighs disproportion- ately on capital metrics, or precludes alternative uses of capital that could create franchise value or foment incre- mental demand for the shares. 3. We assume that we’re removing match-funded wholesale leverage. Thus, there is no impact on the bank’s asset-liability profile. Again, conve- nient, but not always the case. Before greenlighting a delever, measure the im- pact on credit, convexity and liquidity. STRATEGY 2: REMOVE $25 MILLION OF INEFFICIENT LEVERAGE AND RELEVER AT A WIDER SPREAD Management might choose to leverage the 31 basis points of capital by adding →