Retaining Earnings in a Recession

Bankers who, for years, have been letting the good times roll now should be focusing on their strategic plan just in case the economy starts to waiver. Perhaps it’s time to take a hard look at how solid the foundation really isu00e2u20ac”and prepare to shore up the bottom-line fundamentals.

That’s the advice of economists and consultants who caution that the unprecedented profitability enjoyed by the banking industry can’t and won’t last forever. When the economic downturn comesu00e2u20ac”be it next quarter, next year, or next centuryu00e2u20ac”how many financial institutions will be in a position to weather the storm?

The 1990s have been a dream decade for banks. Overall, net income for the industry was $59.2 billion in 1997, the sixth consecutive record year. Return on assets topped 1.0% for the first time ever in 1993 and bankers have never looked back. ROA reached 1.23% in 1997, an all-time high. Though the final numbers aren’t in, 1998 is likely to rank among the industry’s best years. The result is that this nineties bonanza has most financial institutions in good shape to stay afloat in an economic downturn.

“The string of record years certainly has contributed to a healthier balance sheet” heading into a possible recession, says Ross Waldrop, senior financial analyst for the Federal Deposit Insurance Corp.

What’s behind the industry’s juggernaut? To borrow a political phrase, it’s been the economy, stupid. Banks have been riding the crest of a strong economy now in its eighth consecutive year of expansion. Unemployment and inflation haven’t budged from historic lows, and this rising tide has lifted all boats.

Still, no one expects the good times to last forever, and there’s increasing evidence that tougher times are ahead. And as history has shown, what the economy giveth to the banking industry it can just as quickly taketh away.

Choppy waters

Consumer confidence, for example, which reached euphoric levels last summer, beat a steady four-month retreat until three interest rate cuts and a revived stock market reversed the trend in November. Because GDP is largely composed of consumer spending, economists consider consumer sentiment a leading economic indicator able to predict the direction of the economy by three to six months.

Another cause for concern on the consumer side is bankruptcy filings, which set a new record in 1997 with more than 1.4 million new cases, roughly one per 70 U.S. households, according to the American Bankruptcy Institute. There were 1.1 million new filings through the first three quarters of 1998, on pace to set a new record.

Perhaps most significant, beyond U.S. shores 40% of the world is in recession, with a handful of countriesu00e2u20ac”Malaysia, Thailand, Indonesia, and South Korea includedu00e2u20ac”in outright depressions. That’s bad news for American farmers, factory owners, computer makers, and other exporters and is reflected in the 50% increase in the U.S. trade deficit over 1997 levels. Furthermore, the third quarter witnessed the worst year-to-year drop in quarterly profits in nearly nine years, while business investment in new plants and equipment declined for the first time since 1991.

The probability that a recessionu00e2u20ac”a decline in the gross national product for at least two quartersu00e2u20ac”will start in any given year, without regard to particular economic conditions, is 20%, says James Coons, chief economist for Huntington National Bank of Columbus, Ohio. Given the economic warning signals already cited, “the chances for a recession appear to be higher than that today,” he says.

And what a difference a recession makes. In the recessionary years of 1990 and 1991, the banking industry posted a collective ROA of 0.48% and 0.53%, respectively, and profits of $15.9 billion and $17.9 billion, according to the FDIC. Those numbers improved to 0.93 percent and $31.9 billion in the recovery year of 1992.

So with economic storm clouds gathering, can anything be done short of reaching for an umbrella? Experts say there are several areas over which bank directors can have influence when a recession hits. We’ve boiled down their recommendations to the three most important things directors should be examining closely before good times go bad.

Asset quality

Far and away the number-one area of concern for the board should be the quality of loans and other assets.

“When I think about a recession, I think about the impact on banks’ credit portfolios,” says Joseph Fitzgerald, managing director of The Secura Group, a Falls Church, Virginia consulting firm.

“As a director, they have to be mindful of the strengths of the credit controls within the organization.”

Industrywide, credit standards have declined in recent years, Fitzgerald says, due to increased competition for commercial loans, consumer loans, and collateralized mortgage obligations. Last August, the Comptroller of the Currency issued a supervisory letter to bank managements warning them to review their loan loss reserves in the wake of “weaker loan underwriting standards.” Three months later, the Federal Reserve reported that one-third of U.S. banks had tightened their lending standards for large and small customers alike, the most extensive tightening since the last credit crunch in 1990.

Banks choosing not to tighten might have done so for competitive reasons, to lessen the risk of losing customers.

“You’ve got greater bank competition for fewer loan customers,” Waldrop says. “It pushes interest rates lower for creditworthy customers, and margins begin to drop.”

The temptation is great in a competitive loan marketplace to loosen credit standards and continue to build loan portfolios. It becomes risky business when a recession is lurking.

“This is [the time] when banks need to be real careful,” says Douglas Walouke, senior portfolio manager for Fifth Third/The Ohio Company, a regional brokerage firm. “Business clients may look like good credits today, but six months from now, sales figures aren’t being achieved, business dries up, and they aren’t repaying their loans.” When such a scenario happens, he warns, “it happens quickly.”

“When times are good,” adds Fitzgerald, “you tend to forget how your loans can get you into trouble.”

To stay on top of asset-quality issues, directors need to ask the right questions of management.

“A bank director doesn’t really see individual transactions looking at lending reportsu00e2u20ac”they’re hidden,” Fitzgerald says. “What directors can do is make sure management is providing them with reports on credit standards. Look for the number of loans that include exceptions to policy.”

Trouble spots to monitor early in a recession include syndicated and consumer loans.

“Second mortgages worth 125% of equity are just bombs waiting to go offu00e2u20ac”they are a very vulnerable product in a recession,” Fitzgerald says.

Zuheir Sofia, a former Huntington Bancshares president who now runs Sofia & Co., an investment banking boutique, says a concentration of loans is especially dangerous in a recession. Problems arise when loans to farmers, real estate developers, or others dominate a particular bank’s portfolio and those sectors head south. Thus, bank directors should pay close attention in board meetings to asset quality and loan concentration, recommends Sofia.

Experts say perhaps the sector that has the greatest loan liability for most banks in a recession will be large commercial loans, because it only takes a few of these to do serious damage to the bottom line.

The exact opposite is true of retail loans, where the risk is much more diverse, Waldrop notes. “A default by one or two [commercial] borrowers can have a significant impact on a bank’s reserves, earnings, or capital.”

In a recession, however, Waldrop says the concern would be less that one of a bank’s large commercial borrowers would default than of new business drying up. But he predicts that if there are to be defaults, banks will see their share of them among builders putting up speculative commercial buildings or residential developments.

Diversified business mix

When banking industry profits were drying up in the late 1980s, the business mix was far more one-dimensional than it is today. In recent years, banks have added significantly to their product offerings, which now include brokerage services, financial planning, and insurance.

Another big difference from the last economic downturn is the growth in fee income, which now accounts for 40% of net operating revenue. This is up from 31.2% in 1989 and 24.6% in 1984.

Will new product lines and fees sustain banks in a recession? Most people believe such diversification can’t hurt. And it’s a strategy that should be well under way at most every financial institution. If there are banks out there waiting for the next recession to begin offering brokerage services, for example, they just might have waited too long.

“Diversification is a process that has been going on for the last 10 years,” Walouke says. “It should help, but it will help some more than others.”

In a recession, income from brokerage services and commercial leasing would be expected to decline, while profits from insurance sales and asset management should hold steady, Walouke predicts.

Most banks are well into forays into nontraditional lines of business. “We’re certainly looking for tie-ins to generate growth,” says Marie Izzo Cartwright, a director for FFY Financial Corp., a midwestern holding company for a 12-branch savings bank. “We do a lot of home loans, so we’ve purchased a real estate company. We’re hoping the broker funnels business to the bank. We’ve also partnered with an insurance company to cover those homes.”

Fees have been the fastest-growing profit center for banks in recent years. Will noninterest revenue hold up in a recession? Can fees be counted on to make up for losses in other areas? In theory, the answer is yes.

“Noninterest income should be a noncyclical revenue source, but the notion hasn’t been tested by a recession,” Waldrop notes.

Some of the services generating fee income are discretionary on the part of corporate customers. These include issuing letters of credit, data processing, and consulting services. Whether they will hold up in an economic downturn is anyone’s guess.

But other types of fee revenue should prove more sustainable. “ATM fees and other transaction fees that come from moving money around should continue in a recession,” Waldrop says. Overall, these fees should have a cushioning effect on bank profits in the next recession, which marks a large difference from eight years ago.

Of course, as with anything, there’s a downside to fees. In November, acting Comptroller of the Currency Julie L. Williams warned banks that ever-increasing fees run the risk of damaging their reputation and eroding their customer base.

“Institutions have to be customer-friendly,” Cartwright of FFY Financial agrees. “Raising fees in a recessionary period may be the right thing to do, but the bottom line is, you’re not going to increase your business through fee income alone.”

The key, experts conclude, is making customers feel as if they are receiving something of value for their fees, be it a product or a service.

Asset liability management

Asset liability managementu00e2u20ac”how banks manage liquidity, interest rate risk, and the net interest marginu00e2u20ac”can have a large impact on a bank’s solidity when the economy turns south.

Heading into a recession, liquid assets are the ones to have, according to Sofia, because being able to liquidate assets quickly to raise funds for loan losses or other purposes will be vital.

“If you’re stronger in liquidity, you can sell your investment portfolio to raise extra cash,” he explains. “This is always important, but in a recession, you need that extra liquidity to withstand any credit losses or prevent any loss in confidence.”

For example, an investment portfolio consisting of 80% mortgage-backed securities or their derivatives is not the one to have in a down-turn. Better to be invested more heavily in government securities and short-term money market funds.

“If a bank gets hit with loan losses and it needs liquidity, these are a lot easier to sell and minimize any losses,” Sofia says.

“Directors can’t always be experts in banking, Sofia concedes, but they need to ask this question: How liquid is our investment portfolio?”

Managing spread income, or maintaining a healthy net interest margin, is a critical component of asset liability management. Banks have enjoyed a positive yield curve for most of this decade, a situation in which the short-term rates banks pay for their funds and for customers’ time deposits are comfortably below the rates at which they can lend.

Competition for deposits from mutual funds and money market funds has narrowed spreads and will continue to do so. And in a recession, presumed cuts in long-term ratesu00e2u20ac”the rate at which banks lendu00e2u20ac”will be hard to pass along in the form of savings account and CD-rate cuts.

“Today’s consumer is demanding you pay the higher rates because they have other options,” Sofia says.

On the bright side, a recession isn’t likely to accelerate the loss of core deposits, unless consumers begin to draw down savings to pay bills.

“If the stock market declines, which tends to happen in recessions, some investors might move that money out of stocks and into savings accounts and CDs, which could help banks in the short term,” Waldrop says.

In the long-term, however, and regardless of economic conditions, experts agree that directors have to be mindful of replacing traditional core deposits.

“For banks, the fundamental trend is going to continue to play itself outu00e2u20ac”less reliance on deposits for funding,” Waldrop says.