Hello Excess Capital. Allow Us to Introduce You to Tail Risk?
As simple a post as we can write on a beautiful winter's day in Princeton, New Jersey:
"If you choose to sail upon the seas of banking, build your bank as you would your boat, with the strength to sail safely through any storm." (Joseph Safra, 1 September 1938- 10 December 2020)
When we interact with company managements and institutional investors, without fail, the conversation turns to capital allocation. For capital intensive companies like banks, this means a strong perception that they generate & carry significant excess capital. Moreover, it is deemed crucial in the investment community that this so-called "excess(ive)" capital not be retained. It dulls equity returns, and might "burn a hole" in the pockets of strategically aggressive management teams and their boards.
Investors crave stock buybacks, and to a lesser extent dividends. Certainly the math works. But math can be a tricky thing. Quantitative financial models evoke certainty. Yet, quite to the contrary, the world is INCREASINGLY UNCERTAIN, UNPREDICTABLE and skewed NEGATIVE. This looks to us like structural skewness, hardly fleeting.
Global warming, nuclear missile tests, exploding sovereign balance sheets, even pandemic. Financial market volatility may be temporarily suppressed by the heavily visible hands of governments and monetarists, but important aspects of our world look increasingly volatile -- weather & climate, geology, biology are all tail risks that seem more present and more significant. Frequency and Severity are King and Queen, sitting on the throne of risk underwriting.
So we return to investors who lovingly harangue companies in to short-term capital distributions, and in their wakes leave our companies no longer fortified for tail risks. Although efficiently capitalized in theory, they can not withstand the "shake and bake" of tumult when the ground rolls under their feet, when economies are rocked by contraction, when the weather above brings thunderous calamity, when wild fires rage, and when the biology within threatens all of humanity.
It takes nerves of steel for a management team to stare down the barrel of proxy season and votes from shareholders for a different capital plan. Indeed, capital preservation has long been a distant cousin of wealth creation. Seen but seldom heard. Few look up long enough, and with adequate field of vision, to understand that our financial gains have been fed by a steady diet of a generational decline in interest rates and a weirdly attendant increase in sovereign debts. At no apparent cost. We have played the game well. Or, have we been played?
The world is not in a "normal" place. This (whatever "this" is) is not a new normal, nor an old normal. This is decidedly NOT EQUILIBRIUM. This is ABNORMAL. Capital models and investor sensitivities would be wise to adjust accordingly. Traders will maintain their current track, until circumstances change or incentives have been earned.
You probably have less excess capital than you will want. When the time comes to tap it, you may be tapped. At that moment, Mr. Market (he, she, they, all of them) will exact a heavy price. Just as in the past. Forewarned is forearmed.