One of the best things about a dog is their firmly held belief that licking is the appropriate action for all problems. If dogs ran a bank today, they would lick their financial statements.
We have long held the belief that the amount of leverage a bank employs is a mathematical equation. Since we never really could quantify loan underwriting accuracy, our methodology revolved around a banks ability to fund itself with below-market core deposits. The cheaper the bank could raise deposits below Libor (the assumed funding baseline index) and the lower the correlation the funding had to Libor, the more the bank should leverage (according to our formula in order to optimize ROE).
Unfortunately, many banks leveraged their loans when credit quality was at an all-time high. Now, as credit quality reverts to the mean, banks are finding their earnings are falling at a faster rate. The trend doesn't stop at banks, either, as deleveraging has become the hottest thing since dog toys. Investment banks, CDOs, REITs, hedge funds and even corporations are reducing leverage at an unprecedented rate.
One of the structural legacies the subprime crisis will leave with us (at least for the next 3Ys) is the need to carry less leverage. More stringent write downs of credit, greater loan loss allowances and a higher recommended capital cushion will automatically reduce the ROE of banks for the foreseeable future. The question bankers should ask themselves is how sensitive their earnings are to leverage?
To answer the question, we will take an average top performing bank that produced an ROE of greater than 12% for 1Q 2008. Since the relationship of leverage to earnings is not linear (a topic for another time), we will assume an average amount of leverage for the example bank is 11% risk-based capital ratio. To simplify things, let's just define "leverage" as straight equity-to-total assets - which for our sample bank is a little above 12%. Let us further assume that leverage travels a similar path as it did in the 4Q of 2007 and 1Q of 2008. Now let's assume this bank reduces leverage to 13%. That 1% change in leverage would result in a corresponding 1.6% change in ROE (from 12% down to 10.4%). Should leverage continue to decrease, the effect to ROE would be less (because of the non-linear nature of leverage). The opposite is also true that if a bank already employs less leverage (then the effect will be greater). Moving equity-to-total assets from 11% to 12% would result in almost a 2% decrease in ROE.
Understanding your bank's sensitivity to equity leverage will be increasingly important in the coming months. Bank management must make decisions regarding the fine-line of taking an "abundance of caution" when it comes to holding more capital and ROE targets. For those banks "forced" to hold more capital (by their regulators) plan on ROE changing 2% for every 1% change in leverage.