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Your question:

What do you do with excess capitalization? This question was asked by a Financial Institution Director after my session on ‘Finance 2.0 for Directors: Beyond Check-the-Box to Good Governance’ at their Association Conference.

Linda says:

Great question! And first, let me congratulate you that you have excess capital on hand. Many financial institutions wish they were in your shoes.

Actually, many financial institutions are in your shoes and have the same question…when can we let go of the extra cushion we created during the recession.

Consider your Allowance for Loan and Lease Losses (ALLL)

Ask your CEO if s/he is confident that the Allowance for Loan and Lease Losses is adequate. The ALLL reduces the Loans Receivable on the balance sheet to the amount realistically expected to be collected.

The calculation is somewhat complex and relies on a careful review of any non-performing loans as well as a consideration of the relevant historical loss experience on the loans that are currently performing. There is judgement involved and the better the guess, the more accurate your financial institution’s balance sheet.

And since the offset to the Allowance is an expense, Provision for Loan Losses, if management determined the financial institution needs to increase the Allowance this would decrease profit, and thus impact Capital.

Before I go on, this is a great time to remind you that if this explanation does not make sense to you, find time to ask your CEO to invite your CFO to make a mini-presentation to the Board on ALLL and it’s impact on the balance sheet, income statement and capitalization.

If the ALLL is good to go and you still have excess capital…

Reconsider your target capital level. Discuss with your management and the other directors what a safe target is at this time. Consider the economic situation generally, in your community and how it is impacting your customers/members.

If the ALLL is good, your target is a good choice and you still have excess capital…

Way to go. You have some options that other financial institutions do not have. Here are a few:

  • Loosen underwriting standards. You may run the risk of increasing losses but you have excess capital to absorb the risk. And you’ll be offering loans to customers/members who your tight underwriting standards did not accommodate.

    Actually, this may backfire in a good way. If the new loans pay as agreed, you will have shifted assets from a lower income producing category (investments) to a higher income-producing category (loans).

    You just may end up even more profitable which will add to capital. But you can deal with that challenge when you come to it.

  • Take back some of the cuts in staff and other operating costs that you cut when times were more tight. This will reduce profitability but with excess capital you can afford it.

    Direct management as to your new capital target and to monitor profitability carefully as they add back operating expenses.

    Be cautious with this strategy though. Ask your CEO which of the cutbacks are good to keep and which s/he would like to reverse. Many businesses found that some of the cutbacks they made did not damage the company at all.

  • Increase product or service offerings to customers/members. Be sure they fit with your strategic plan. But if you have been holding off launching a needed product or service, and your management is confident that the financial institution’s situation is steady or improving, your excess capital may allow you to move forward.

  • Dust off that strategic initiative. Perhaps your credit union has identified attracting younger members as a needed effort. Or your community bank has identified a niche you’d like to go after.

    With your excess capital, you may be able to make some expenditures in that direction like an up-to-date website or a social media marketing staff-person.

    Perhaps you need a new member/customer survey to be clear on your constituent’s needs.

  • Consider riskier investments. If loan volume still is not back you might consider moving some of your investments into a higher risk category.

    Of course, with higher risk comes higher income, so won’t it be great if this approach backfires, too? If the investments still pay off, you’ll have higher profitability. It is your excess capital, though, that allows you to take this risk.

Just like in the hotels…

Sometimes the pillow is just right, but sometimes it is too plump.

If your capital (your cushion) is too plump now is the time to take advantage of the excess capital to spend money or take chances in service of your customers/members. Just be sure the cushion really is too plump!

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.