Managing the value of financial institutions

Winners and losers: What factors determine a bank's value? Representatives from some of the world's largest commercial and retail banks, corporate and investment banks and property and casualty insurers converged during a one-day program to get tips on managing the value of their institutions. Thomas C. Wilson managing director, Mercer Oliver Wyman, moderated three sets of penelists at a conference sponsored by RMA, Mercer Oliver Wyman, PRMIA (Professional Risk Managers International Association), CAS (Casualty Actuarial Society), and Microsoft. This first of three articles introduces the topic and then focuses on what the market looks at when valuing an institution. The second article will look at designing performance frameworks to align with what the market values. The third article will take this information and move from measurement to management.

CFOs and CROs of banks and insurance companies may focus on different types of risk--market, credit, or insurance--but they all have one objective, said Mercer Oliver Wyman's Tom Wilson as he introduced the first set of panelists who spent a snowy day in January addressing the topic "Managing the Value of Financial Institutions. That objective: to help their institutions create greater value for shareholders through disciplined finance and risk management.

Market dynamics, such as the state of the economy, competitors, customers, and regulators, all help to determine whether or not the market is attractive. Ultimately, though, it is the individual institution's strategic and tactical decisions that separate winners from also-rans in terms of shareholder value creation, he continued. Stock market data reveals a wide range of performance for banks in the same market, with the leader more than quadrupling its share price while the laggards barely doubling theirs over the same seven-year period.

Institutions increasingly are using some form of risk-adjusted performance as their information base to develop frameworks linking internal metrics and performance with shareholder value. "lb make these measures understandable and usable for senior management, management must see how the market sets the firm's valuation multiples. Wilson pointed out that shareholder value can be thought of as driven by the firm's market-to-book (M/B) multiple, return on equity (ROE), and its dividend rate.

"While simplistic, [Figure 1] suggests that if ROE is 12%, the dividend rate is 33%, and M/B is 1, share price will double in about 11 years," Wilson said. "This is because retained earnings, which are growing at 8% per annum net of dividends, receive a market lift (M/B) of only 1. On the other hand, if M/B is higher--for example 1.5, implying a higher lift on retained earnings--the institution will double its share price much more quickly. If ROE is 15% with more retained earnings being generated at the higher M/B of 1.5, the reinvestment of retained earnings result in doubling share price in only six years."

[FIGURE 1 OMITTED]

Most managers understand the drivers of ROE; but what drives the firm's market valuation multiple? A simple regression analysis (seen in Figure 2) suggests that the price-to-earnings (P/E) and M/B multiples are determined by the firm's fundamentals: excess returns (or ROE minus the cost of capital) and growth. Adding earnings volatility to the model produces a significant but spurious negative sign, which, corrected for line-of-business effects, disappears completely, said Wilson. "In other words, if you think about disaggregating the overall P/E and M/B into a weighted portfolio of line-of-business P/E and M/B, then earnings volatility no longer influences valuation," said Wilson. "It suggests that the market is actually looking through the corporation as a whole and valuing the institution as a sum of the parts. If growth, ROE, cost of capital, and everything else remain steady, you can think of the value of the firm as being equal to the paid-in capital, or the amount of equity that has been invested, plus some measure of excess profitability--ROE minus cost of capital, which often is called economic profit."

[FIGURE 2 OMITTED]

He summarized by saying that market valuation is determined by the following:

* Competitive positioning and corporate strategy--being in the right place at the right time with the right strategy--for example, enjoying and exploiting the mortgage refinancing boom in an otherwise lackluster economy.

* Operating performance and business model--how well the firm executes its strategy, whether it's focused on the customer, product, or cost efficiency.

* Earnings (not revenue) growth. Today, CFOs and CEOs frequently talk about the growth prospects of their companies in terms of driving their value.

* Capital management, which involves both the denominator for ROE as well as minimizing the cost of capital.

* Market perception and disclosure, versus opacity, to ensure that the market understands the firm's strategy, business model, and execution.

That said, good measurement alone is simply not enough: the most important consideration is management. "Someone once said that they would prefer a C-rated model and A-rated management to an A-rated model and C-rated management," Wilson said. "I have seen institutions with very elaborate, extensive, and 'accurate' measurement frameworks that nonetheless failed to get the ball over the goal because they lacked the necessary business insights and ability to make the necessary tough decisions. Equally as important, the firm's key decision-making process and organization--such as strategic planning and capital management--must be aligned to support effective decision clearing."

Four panelists took on the first topic of what the market looks for in performance--hard numbers, soft numbers, and more--when valuing an institution. Wilson put the following questions to the panel:

* Does the market value financial institutions fairly?

* What financial characteristics drive a superior market valuation or rating?

* Do a company's financials provide sufficient and accurate information? How can we remove opacity?

* What economic adjustments are required or should be considered?

* What softer factors drive toward superior market valuation?

* At the end of the day, what can management do about it?

The Shareholder Perspective in Market Valuation

SuNOVA Capital, LP, invests only in financial services companies. Felice Gelman, managing director and co-founder, who presented the equity investor perspective, has observed the industry's ups and downs over the past 20 years. While it can be tempting to do so, Gelman tries to ensure that SuNOVA never "falls in love" with a company, its product, its management, or its strategy. "I'm not saying we can't be swept off our feet like any other investor," but the ensuing affair often can end up in an ugly breakup, she said. For example, in the early 1990s State Street Bank was a market darling with the unique strategy of presenting itself as a technology company. However, at a certain point State Street stopped growing earnings by 18-20% and did not have positive operating leverage. They were working to correct that, but the day State Street missed its earnings estimate for the first time, the stock fell from 55 to 35. "That is not what you expect to see happen in a bank stock. They didn't lose money; they didn't blow up; and they weren't arrested and dragged out in handcuffs," she said. "They just disappointed their new friends, tech-oriented investors."

There are both uncontrollable and controllable factors that play into value. Examples of uncontrollable factors:

* From 2001-2003, small-cap banks outperformed large-cap banks, mostly because small-caps were in favor and money was flowing in. Some had spectacular earnings growth, and all the others got to go along for the ride. "Thrifts that couldn't earn their way out of a paper bag were selling for 20 to 25 times earnings--thus, an uncontrollable factor," she said.

* Conventional wisdom is that banks trade at 60-80% of the market multiple. Once stock prices start to move higher, it's difficult to make progress. "Why? I don't know," Gelman said. "Perhaps value investors look elsewhere, and so there's less money devoted to bank stocks. When a bank falls below the magic 60% number, more money comes into the stocks."

* During periods of great uncertainty in the market, technical trading predominates. Basically, Gelman said, when investors don't know what to do, they do nothing. Marginal investors are looking at charts and can move stocks when no one else is putting their money to work.

Examples of controllable factors--regulatory risk:

* Regulatory risk in 2005 is perhaps as high as it was from 1989 to 1991. During the earlier period, banks were going bankrupt, and high regulatory risk was to be expected. The current degree of risk without such an easily definable reason concerns investors. "Some financial institutions are not going to be able to achieve compliance with all the new requirements," said Gelman. "And I honestly don't know how investors will react to that. They may simply yawn and wait until the next accounting period to see if the noncompliant institutions can catch up. Or they may dump those stocks." Corporate governance remains a critical issue for financial institutions. "MBNA is a tremendously successful company that has rewarded its shareholders," Gelman said. "It has managed its business well, has a great strategy, and has been growing nicely. But its founder, Charlie Cawley, who built the company literally piece by piece, had to retire in 2003 because of changes in corporate governance standards."

* The regulators are limiting banks' growth and strategic flexibility if they are not able to pass the Bank Secrecy Act examination, which Gelman called an arbitrary test of the ability to manage hundreds of thousands of transactions that go through a bank every day. One example is a small bank that failed its BSA examination and was given a cease-and-desist order, in part because it did not use fireproof bags for transfers of funds. It's very hard to manage those issues, Gelman said, but the investor expects companies to take them seriously and manage them seriously.

Examples of controllable factors--balance sheet:

* After 23 years of fairly consecutive decreases, interest rates are on the rise. "Like anything else people become accustomed to, declining interest rates became embedded in every corporate balance sheet and strategy," Gelman said. "And the assumptions related to declining rates also are embedded in every investor's head. So people haven't come to terms yet with what it's going to mean for interest rates to rise."

* Banks have not addressed how they will fund goodwill from acquisitions, a charge that now must stay on the balance sheet. Low interest rates have helped fund goodwill to date but as rates rise, goodwill will need to be funded almost entirely with equity. "Goodwill is almost an unhedgeable exposure to rising rates unless it's funded with equity," said Gelman.

* Investors are very focused on how banks plan to manage funding. "Of the top three large banks--Citigroup, JPMorgan Chase, and Bank of America--only Bank of America has shown the ability to manage the interest rate environment, at least to date," said Gelman. Bank of America has carefully managed its leverage through derivatives and also managed its business mix very carefully. "Both Citi and JP Morgan are demonstrating that they have some margin pressure they have yet to deal with," said Gelman.

Example of controllable factors--earnings risk:

* Earnings risk is "a real test of management," said Gelman, referring to companies that stumble, are punished with a permanently lower P/E multiple, and therefore face increased cost of capital. Companies taking on more risk to earnings than investors anticipate are disadvantaged over time, and it can take years to reverse the situation.

The Privileged Insider Perspective in Market Valuation

Joy Schwartzman is principal and consulting actuary with Milliman. While her comments focused primarily on property and casualty insurance providers, they can apply to other financial services institutions as well.

After investors have looked over the public financials or other information provided to them, they look for indications that the institution can achieve the type of return on equity they target, Schwartzman said. They seek answers to the following questions:

* Is there a good management team in place that can execute the business plans?

* Are there solid monitoring systems that can evaluate changes in business on a timely basis? Insurance results may not be known with certainty for many years after the business is written. Good monitoring systems can evaluate changes in rate levels, policy terms, and conditions--by market segment--to serve as leading indicators for changes in profitability.

* Are the balance sheets realistic? Are reserve requirements changing because of past misjudgments that affect current business profitability?

* Is the institution in control of its expenses? Schwartzman said that in property and casualty insurance, about 25% of premiums are consumed by expenses for acquisition costs, broker's commissions, overhead, and taxes paid to the insurance departments.

* Is the institution willing to retract when product pricing does not generate targeted loss ratios? Earnings growth is on the minds of those valuing stocks, but for P&C, growth in earnings does not always correlate with growth in premiums. Companies that can take a step back and decline accounts because they think that they're not adequately priced will fare better, but it's difficult to do that because underwriting units initially evaluate performance based on the top line--premium production.

* What is unique about the business? "The last thing you want to be is a commodity," Schwartzman said. "A commodity must go with market pricing and there's little that can be done to exceed market results other than to lower expenses. Some of the smaller companies that we've worked with were able to write risks at a little higher rate than their competitors because 1) their customers felt they helped them do a better job managing their business or 2) they had some engineering expertise or special expertise in claims handling.

Among the earnings challenges for P&C insurance companies are underfunded claim liabilities. The industry took a $47 billion reserve hit causing an increase in loss ratios an average of four loss ratio points over the period 2001-2003. "Studies we've read indicate that reserves remain deficient by about $67 billion," which means the industry will need to incur 17 loss ratio points at today's premium to pay for it. Much of the perceived shortfall stems from continued asbestos and environmental claims. Meanwhile, start-up insurers in a hard market that are not faced with underfunded liabilities quickly become aggressive in pricing. "They don't need to fund those average four loss ratio points per year reserve deficiencies of some established companies."

Rate increases from 2001 to 2004 meant higher profits for companies, enabling them to begin to fund reserve deficiencies. However, after a three-year hard market, rates began to decline for certain businesses in 2004. "Not every company will look good when rates come down," said Schwartzman. "That's when we see which companies are best able to measure early on if they're making smart underwriting decisions and to react accordingly."

Liability awards have risen so dramatically that even extremely well-managed companies have been forced to make unprecedented increases in reserves. "Certain lines of business, such as D&O (directors and officers), have experienced unprecedented claim frequency and severity rises, which is not surprising in light of corporate governance scandals," said Schwartzman. "We were seeing 20% annual increases in claims severity over a two-year period."

Rising medical costs also have a significant impact on the industry. The worker's compensation line of insurance--arguably one of the least profitable lines--is particularly hard hit, owing to inflation in medical costs. Although managed care stanched the flow of dollars for a while, medical inflation has resumed and is resulting in high combined ratios along with estimates that the line is under-reserved.

Finally, investment yields are at a 40-year low. "To achieve the same ROE you've enjoyed after losing 100 basis points of earnings yield, you need to improve your loss ratio by 1.5 points," said Schwartzman.

Schwartzman then discussed the popularity of transactions that involved purchasing the renewal rights to business.

Factors contributing to the popularity of these transactions include the following:

* Avoiding the inheritance of an uncertain balance sheet (since the purchase does not involve the existing liabilities).

* Spreading some fixed expenses over a larger premium base if the company is already writing that line of business, thereby lowering your expense ratio due to economies of scale.

* Avoiding the obligation to renew if the business does not meet the company's terms. This generally results in a less expensive transaction.

Debtholder Perspective of Market Valuation

Ratings agencies take a longer perspective than other investors when valuing companies, said Victoria Wagner, a director in Financial Service Ratings at Standard & Poor's. S&P's ratings outlooks reflect trends anywhere from three months to two years of performance.

A number of factors contribute to strong performance, beginning with a clearly defined and well-executed strategy--whether it's mergers and acquisitions, internal growth, specialization, or something else. "How does the institution perform against projections presented to the marketplace?" asked Wagner. "How clear is the strategic direction, and what is the likelihood of success? For example, if a consumer bank wants to enter the commercial business, how is it going to do it?"

The next factor S&P examines is critical infrastructure to support sustainable growth. "Infrastructure covers many areas--management team, systems, the retail breadth, and network," Wagner continued. "Does the institution have a presence in the necessary critical markets to drive sustainable growth?"

Capital management practices are a major factor as well. Does the institution take on a higher dividend or share repurchase strategy to maximize stock performance? "We feel that executing share repurchases offers more financial flexibility than paying higher dividends," said Wagner. "Clearly, it would be better in the long run to have a critical capital base that allows the institution to capitalize on growth opportunities as they arise. The cyclical trends of the past 10 years have tended to vary in length from what we might have anticipated. Thus, an institution is far better off from a capital standpoint if it's able to grow during key opportunistic points in the cycle or hold back and let the business sit until the opportunities are there."

Volatility is being driven by sources not seen before. For example, accounting volatility is showing up more frequently, said Wagner, and it's becoming harder for investors and analysts to differentiate accounting volatility from economic volatility in the income statement. Accounting for derivatives is particularly challenging, and the asymmetric mark-to-market of derivative assets is creating enormous volatility. "For some institutions, that's meaningless when it gets down to bottom-line true economic performance, so we try to carve that out and uncover the true volatility," she said. Volatility in itself is not necessarily a bad thing--it just depends on the driver. What's important is the management team's ability to contain it, communicate whether it was expected or unexpected, and identify the bands of the expected volatility, which really translates into earnings performance. Also the team should be able to identify volatile asset quality performance--for example, whether it was a new risk-scoring system in a particular consumer asset class that drove a particular volatility or the inherent characteristic of the assets. The goal is for the institution to say, "We identified the problem, we've contained it, and it won't happen again (or, it will happen again and explain why)."

Diversification is another consideration, because while everyone agrees that it's a good thing, the path to diversification is not necessarily good. It gets back to the execution of that particular strategy and what is behind the institution's drive to diversify. "I think the benefits of diversification will be tested in a cycle," said Wagner. "That's something we keep in the back of our minds. And by diversification, we mean revenue diversification, fee-based revenue, different types of spread income in terms of the sources that are driving that growth, the geographic diversification, and business-line diversification."

Management of credit and market risk is always a factor in driving higher ratings. As with other factors, the key is to identify, manage, and communicate.

Metrics:

* S&P uses net-interest-margin (NIM) stability as a key metric in reviewing the ratings factors. "While kind of an old-fashioned ratio, NIM provides insight into a company's performance and management of risk," said Wagner. "We look at the stability of NIM through various volatile rate cycles. Some companies have rock-solid margins that will modestly wax and wane with interest rates. So the NIM is a window to management of interest rate risk and credit risk. Obviously, the more stable the margin, the better from a ratings perspective."

* Expense structure relative to revenues is used to determine which side is growing faster than the other and whether revenue growth is moving at a faster pace than expense growth. "This has been a struggle for institutions in various banking sectors over the past couple of years with the low-rate cycle," said Wagner. "Our key capital measure is tangible common equity--growth relative to the risk assets of an organization. Reaction to the retail banking competitive squeeze among large complex banks indicates they have fully embraced retail banking and the sustainability that the institution feels this line of business brings to its overall performance. Large banks jumping into this business are trampling the turf of what used to be the domain of the regional and super-regional banks. Those banks are now struggling to spread their growing expense structure over a stall in their revenue growth. The FDIC shows that clearly the number of institutions is declining, but the number of total branches is on an astronomical growth curve. Clearly, expenses are front loaded. The revenue benefit will come somewhere down the line, and we remain uncertain whether these new retail sites will generate new business that will drive higher revenues."

* A third metric is the market position of an entity and its franchise value--that is, the capacity of both the asset and the funding side from a franchise perspective to generate strong growth in existing markets as opposed to having to reach outside consistently during periods of high loan growth. How strong is the retail deposit base to cover funding of the loan portfolio? "Even during the good deposit growth of the past couple years, that metric (loans/deposits) has remained one that is not coming near its historically low liquid measures," Wagner said.

* Retail growth is valued more than wholesale growth on the loan origination side. "Anyone can buy a loan," she said. "That's not adding much to franchise value. What does add value is the extent to which the institution can directly originate, grow, and control their origination process."

* Asset quality is a final, and obvious, metric. S&P keys in on nonperforming assets and net credit loss to see how the institution is being paid for the risk it takes. Having high net charge-offs is not necessarily a bad thing if the bank is making a 2% return on assets and its margin is 5%.

Key challenges:

* S&P is observing the push for retail deposits and the accompanying pricing challenges. "I think we're starting to see some deposit pricing wars percolating with short-term rates rising," Wagner said. "Right now the flattening of the yield curve is a tremendous challenge for higher profitability, no matter what size the institution."

* A second challenge is the consumer debt situation and what happens to variable-rate consumer credit in a rising-interest-rate environment, particularly on the long end of the curve.

* Rising compliance costs are of great concern as well. "Institutions are telling us that what was fine for last year's Bank Secrecy Act compliance review resulted in failing scores this year," Wagner said. The regulators have raised the bar in their scrutiny of certain aspects of banks' business, she said. Also, the SEC is demanding that institutions make critical changes to their application of accounting. Rising legal costs paired with a shrinking revenue base "doesn't make banking that much fun these days."

* Overall, in 2005 S&P is watching profitability more than asset quality. "I think the institutions entered 2005 with phenomenally and unsustainably low asset quality metrics," Wagner said. "But still, that's not our concern at this point in the cycle."

The "Spin Doctor" Perspective on Market Valuation

When in doubt, start with a sports analogy. James T. MacGregor, president of Abernathy MacGregor, an investor relations consulting firm, related a tale from his high school days. "The basketball coach took a bunch of us to the old Madison Square Garden to see the Boston Celtics play," he began. "I remember Bob Cousey bringing the ball up, crossing the mid-court line, slowing down, and then lifting his hand. I asked the coach what he was doing. Watch, the coach said, he's calling play number-four. So players move, the ball passes among players, and suddenly there's a guy in green standing all alone with the ball. He shoots. He scores.

"Later on in the game, play number-four came up three or four more times. This didn't make sense. Everybody could see the play he was calling, including the other team, and they knew at that point how it worked. The coach told me that everybody in the league knew the Celtics' plays, but the execution was so perfect the other team couldn't hope to stop them. They just hoped the guy who's open at the end missed his shot.

"Fifteen years later I went to see the Celtics play again. Different players, but play number-four was still alive and well. Last year, I saw the Celtics again, but there was no play number-four, no play number-two--just five guys who look like terrific athletes making it up as they go along. No championship."

The banks that succeed with investors are really good at play number-four, MacGregor argued. And companies like SuNOVA Capital make money for their customers because they recognize a good play number-four when they see one. They aren't wooed by corporate athletes who think they can make it up as they go and get a slam dunk.

MacGregor's firm did some research into the best predictors of future earnings-per-share performance, using the five-year period from 1996 to 2000 to review performance of every bank and insurance company with a market cap over $500 million. The goal was to use information that was available in 1996 to identify the factor that best correlated with subsequent earnings performance. That factor wasn't past history, size, number of customers, assets, return on assets, or return on equity. The only statistic that correlated validly was the price-to-earnings multiple.

"I hated this result," MacGregor said. "The idea that the efficient market really exists? It can't be. So I asked the guys to perform the analysis with a new timeframe--1999 to 2003. Same result. It appears we have (gasp) a sort of efficient market out there."

But what does that really mean? The same research on securities analysts' earnings estimates revealed that they cluster around the midpoint of the range. One or two analysts were successful in their picks. But as a group, the sell side missed all the top-quartile performers and all the bottom-quartile performers. A study by McKinsey & Company showed that market price is really driven by the top 30 to 50 institutional investors. "It's not management and it's not the retail investors," MacGregor said. "It's a small group of companies that really make the calls. It's important to realize these companies all know one another, attend the same conferences, and hear the same thing. They all are privy to the same conventional wisdom, and they each have their own way of interpreting and dealing with that conventional wisdom. So that's where we begin."

Conventional wisdom in this case is that value in financial institutions is found in earnings-per-share growth in the high single digits, which comes as no surprise. In general, the market is not expecting outstanding performance among banks, although some will do better and some will do worse. So other than a review of the numbers, an institution's value may be perceived by what it says about itself, and the investor can use that to give some context to the numbers going forward.

MacGregor attended 20 investor presentations by banks and 14 investor presentations by insurance companies in the four months preceding his presentation. Afterward, comparing what mainstream institutions were saying, what high P/E institutions were saying, and what the "turkeys" were saying, he found material differences.

* Mainstream institutions all have "strong balance sheets"--the term "fortress balance sheet" was quite popular--but they do not explain whether they are strong enough, and those with a great deal of excess capital are not good at explaining why excess capital is a good thing. All of these institutions have "disciplined" underwriters or lenders, although it's difficult to use this as a basis of comparison, since none of the institutions visited admitted to being "undisciplined." They all have "balance," but again, it's just a claim giving the listener no way to know how that's a good thing. They all have "sales cultures" and are "cross selling" to achieve a larger "share of wallet." And they quote metrics that show the areas they are focused on growing, but if they're growing some areas, what's happening to the others? They are all "award winning," have "customer focus," and are focused on "relationships" and "execution." They have all commissioned customer satisfaction surveys, which, not surprisingly, are worded to ensure a fairly high level of satisfaction because, while created for "internal use," everyone knows the information may slip out. Finally, they all have discovered small business.

* The "turkeys" say the same things as mentioned above, as well as two more things they say are "important."

1) A plan to fix the problems or to boost revenues. A typical comment would be "We have put in place a series of marketing initiatives that will return us to double-digit growth over a three-year period." Besides not telling the investor what those initiatives are, it becomes clear that the initiatives are not going to pay off in the next year and perhaps not even the next.

2) They give a good deal of "earnings guidance" because they must continually correct it. Interestingly, studies show that earnings guidance generally results in lower P/E at a higher share-price volatility. So the institution seems to be saying it doesn't have a good grip on its operations or that it does but it doesn't mind lying to the investors.

* The winners all talk about play number-four--more specifically, their business model. The investor comes away with a good handle on what business the institution believes it's in and its approach to the business--how it works, how it differs from other institutions, and how the investor is able to tell whether the model is working or not. So what constitutes a good model? "Darned if I know," said MacGregor. "But I've often observed that the better companies seem to think about technology and risk differently from other companies."

Contact Beverly Foster by e-mail at [email protected].

Beverly Foster is editor of The RMA Journal.

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