The banking industry—by most measures—has improved markedly from the depths of the credit crisis. The industry’s return on average assets (ROAA) has increased through additional noninterest income and fewer charge-offs; credit quality is stronger; capital reserves are at all-time highs; and the number of banks on the Federal Deposit Insurance Corp.’s (FDIC) problem list has declined for the past seven quarters. Additionally, public bank stocks either have tracked or outperformed the S&P 500 in recent years.
Despite these positive trends, banking’s business model is significantly challenged in today’s interest rate environment. With deposit costs near zero and fierce competition for loans driving down yields, many banks are running on fumes.
As higher yielding loans mature, banks are replacing them with lower yielding assets, resulting in significant net interest margin (NIM) compression across the industry. Regardless of whether the Federal Reserve’s accommodative monetary policy has helped or hurt the economy, it is wreaking havoc on banks’ profit models. Indeed, it would be nearly impossible to start a de novo bank today and make money through traditional means.
According to the FDIC, the industry’s NIM in Q4 2012 was 3.32 percent—the 3rd lowest quarterly NIM since 1990. Since Q1 2010, net interest margins have declined each quarter except one, with no sign of near-term relief. To combat the NIM squeeze, some banks are taking more interest rate and credit risk. By venturing further out on the yield curve and underwriting riskier assets, banks can generate more revenue; however, the risks may not justify the returns. In the short-term, the strategy could increase profits. In the long-term, it could create less stable institutions and the conditions for another credit crisis.
Yet loan growth will be critical to maintaining earnings over the next several years if the Fed continues its low interest rate policy. Unfortunately, most regions of the country have not recovered sufficiently to support such growth. Since 2009, the banking industry’s net loans have grown at a compounded annual rate of 2.2 percent compared to 7.0 percent between 1990 and 2007, and during this time, many banks have experienced loan declines. Furthermore, competition for the few available high quality loans is intense and driving yields even lower.
Even if a bank were able to grow its loan portfolio, it would take exceptional growth just to maintain current net income levels if NIMs continue to deteriorate. Consider the following example: if net interest margins were to decline by 15 basis points per year, a bank with $500 million in assets and a current NIM of 4.0 percent would need to grow loans by $50 million each year just to maintain the same level of net income (assuming all other profitability measures remained static). Under these circumstances, the bank’s ROA would decline each year, and the present value of the franchise would decrease. Furthermore, there are very few, if any, banks that can achieve 10 percent year-over-year loan growth today.
In addition to the sobering interest rate environment, regulatory changes—including BASEL III, the Dodd-Frank Act, and the Consumer Financial Protection Bureau—are looming large over the decisions of bank management and boards. Compliance costs associated with the new regulations remain uncertain, but undoubtedly will increase.
The one-two punch of the interest rate environment and increased compliance costs could prove too painful for many banks—particularly smaller institutions with older management teams who may be frustrated and don’t want to slog out any more years of lackluster performance and regulatory scrutiny.
Industry observers have been awaiting a renewed wave of bank M&A activity, and growing frustration just might be the catalyst. With organic loan growth almost nonexistent, strategic M&A is the only other way to amass scale today. Banks hoping to enhance franchise value will need to grow through acquisition, and there could be a large supply of frustrated sellers coming to the market. Unfortunately, if this occurs there is likely to be a supply and demand imbalance between sellers and buyers, which will hurt smaller, community banks the most. Active buyers have moved upstream and are looking for acquisitions that “move the needle.” Many buyers simply won’t bother with sellers under a certain asset size. This attitude could prompt smaller banks to consider a “strategic merger” in which they join together in a stock exchange to increase scale and attractiveness to buyers down the road.
Other banks may be content to grind it out knowing earnings are likely to suffer in the near-term. If rates rise, those banks with deep core deposit franchises will once again become more valuable, but the wait could be painful.
Until then, banking’s operating model remains impaired, if not broken.