Banks face a difficult operating environment in 2020.
That might seem counter-intuitive, given the current strength of the U.S. economy and a benign credit environment, but an anticipated decline in overall loan volume will pose a significant obstacle to bank profitability this year.
“I think overall we’re looking for about 7% loan growth out of our coverage universe, which is fine on the surface but would represent another year of [declining growth],” says Scott Siefers, a veteran securities analyst who covers regional banks for Piper Sandler Cos.
Loan yields will also be under pressure this year, which adds to the anticipated pain. Between two-thirds to three-fourths of a typical bank’s revenue stream comes from net interest income, Siefers explains. “As a group, we foresee only a couple of percentage points in net interest income growth this year, which is going to be the group’s worst performance in several years.”
The declining loan volume and margins will be somewhat offset by an easing in upward pressure on deposit pricing, thanks to the Federal Reserve’s abrupt change in monetary policy last year. After nine successive rate increases dating back to December 2015, the Fed cut the federal funds rate three times in 2019, stabilizing deposit pricing in the third quarter.
The industry should benefit from the continuation of a positive credit environment that has blessed it in recent years, especially if the economy remains healthy. “We’ve been pretty consistently too pessimistic about what would happen in a given year with overall credit costs … so hopefully that will be the case this year,” says Siefers.
The great majority of banks also continue to be well capitalized, with “overall solid dividend yields,” Siefers adds. “I think capital return will continue to be a pretty important part of the group’s story as we look forward.”
Banks that manage to prosper this year will most likely be highly efficient — and those that aren’t already efficient will find themselves under pressure to cut costs. “All investors seem to be looking for cost programs that allow banks to improve efficiency and generate positive operating leverage despite the tough operating environment,” Siefers says. “I think investors look at the cost base as the most controllable factor that a management team has, whereas whatever happens with interest rates, macro [economic] growth and even fees — a lot of that is subject to the ebb and flow of the economy.”
Since personnel accounts for about half of the average bank’s cost base, we could see a decline in the industry’s full-time employee headcount as banks look for efficiency gains to offset declining loan volume. Another strategy to reduce costs would be to accelerate the trend towards fewer — and smaller — branches. “I think what we’re looking for in terms of themes is less infrastructure, fewer people staffing that infrastructure and smaller remaining infrastructure,” Siefers says.
Banks that have protected themselves against unexpected movement in interest rates — either up or down — are also more likely to find more favor with investors this year than institutions that have positioned themselves to be either asset or liability sensitive. Remember, the Federal Reserve unexpectedly reduced the fed funds rate last year after hiking it for several consecutive years. “I don’t think the market is interested in banks that are making rate bets right now,” Siefers says. “Investors are looking for those institutions that have protected themselves against [rate] volatility.”
The industry’s overall fee income performance isn’t expected to markedly improve this year, but banks that have large fee-based businesses like trust, insurance or payments could prosper if loans decline as expected. “Anytime you have a tough net interest income environment overall, a lot of investors try to hide out in names that have steady, annuity-like fee income streams,” points out Siefers.
If there’s a silver bullet for some banks in 2020, it could be an in-market merger that expands the participants market share and accelerates their top-line growth while simultaneously providing an opportunity to significantly cut overlapping costs. Forty-four percent of respondents to Bank Director’s 2020 Bank M&A Survey say their institution is likely to acquire a bank this year. “We think things are set up pretty well for a strong 2020,” says Siefers, referring to the M&A market. “There’s a lot of capital but limited growth. So banks are going to be looking for every opportunity to generate improved returns.”