ALPHA, BETA AND BANK VALUE

A banker recently remarked that he feels more like a portfolio manager than a banker these days. Marking to market the balance sheet, more loan trading, looking at risk-adjusted returns, liability structuring and hedging makes this analogy apt, as bankers no longer can get away with putting assets and liabilities on their books and then forgetting about them. These days, should a banker face decreasing profitability, tactics such as selling loans, buying credit protection or calling CDs are all possibilities to help control earnings fluctuations. If truth be told, the modern day bank CEO is closer to a hedge fund manager than ever before. In the early days of hedge funds (back in the late '80s), managers were only concerned about total return in excess of their benchmark or something called "alpha." For banks, let's call the current benchmark an 11.3% return (as of March). If a bank produced a 15.3% return on equity, then they beat the market by 4% - not bad. A problem arises however, because alpha contains no comparative measure of risk. Items like leverage, concentration in speculative land lending and a strict geographical focus all tend to complicate the return picture for banks. To handle risk, fund analysts introduced "beta." Beta is a measure of risk compared to the market. For banking, returns have a variance of about 57bp. Banks that produce returns that have a similar variance are said to have a beta of 1. Like hedge funds, to outperform, managers either must produce positive alpha while maintaining beta, or produce similar returns to the market while having a beta of less than 1. To equate apples to apples, fund managers compare themselves by an "alpha ratio" which is simply the alpha adjusted for beta. For the bank that produced a 4% alpha, excess return is divided by 1 for a ratio of 4. If the bank could lower its risk so that its beta was 0.85, then its alpha ratio would go to 4.7. Conversely, if a bank produced a 10.3% return for an alpha of -1.0% and a beta of 1.1, then its alpha ratio would be negative to the tune of -1.1%. Without risk adjusting the individual asset, liability and fee income cash flows, this calculation is an easy way to see if a bank is adding value or not versus the industry benchmark. Positive alpha banks are deserving of more capital, while negative alpha banks should be allocated less capital in the marketplace. The ironic thing is that most bank investors are an unsophisticated lot and often place capital into a bank that has a negative alpha ratio. If they thought about it, they would be able to garner better long run returns by investing in a bank index, or at least a representative sample of publicly traded banks. Over the next 5Ys, since this bank portfolio concept is really in its infancy, we will see some exciting changes. Better adjustments for correlations, grouping asset classes not just by type or sector, but by alpha ratios and managing loan portfolios with regard to beta will all take place. The beauty of this is that smart community banks (with their knowledge of the local area and small size relative to the market), are in an excellent position to outperform competitors by tracking alpha ratios and allocating resources accordingly.