Will Banks Draw a Bust Card on the Economy?

Cover-Story.pngAnyone who has ever played blackjack can appreciate the decision that bank chief executive officers and independent directors face today with the red-hot U.S. economy. There are two decidedly different views on how the economy will perform over the next 18 to 24 months.

One view is that we are in the final stages of what is now the second longest economic expansion in U.S. history. This outlook was best captured in a June 2018 survey by the National Association of Business Economics (NABE), in which roughly half of the 51 participating economists expected a recession by late 2019 or early 2020, and two-thirds by the end of 2020.

The other view comes from experts like J.D. Foster, the chief economist at the U.S. Chamber of Commerce. Foster says the economy will most likely cool off from its strong 3.5 percent growth rate in the third quarter of last year, but should continue to expand at a 2.5 percent rate through 2020-with no recession in sight.

Banks are creatures of the economy, so forming a perspective on how the economy is likely to perform in the future is part and parcel with running a bank. Foster offers a gambling analogy to highlight the situation banks find themselves in today.

“If you just look at history and probabilities, this expansion has been going on for a very long time now,” he says. “Just as a matter of pessimism or realism, you expect that we’re going to have a recession at some point. It’s like having a winning streak at a blackjack table, and you figure eventually you’re going to lose. There’s that intuitive dimension to it. Then you turn to the economics. We look at the economy, and it has done really well. It almost has to slow down a bit from that torrid pace, but slowing down doesn’t mean slow. We went from a 1.6 percent growth rate in 2016 to much faster in 2017 and really much faster in 2018. Suppose we get back down to 2.5 percent. That is slower, but it’s still doing very well.”

You can take the blackjack analogy even further. A bust card is the draw that puts you over 21. So the closer you get to 21, the riskier each successive draw becomes. The trick, of course, is to get as close to 21 as possible without going over. For the player, the crucial decision is always whether to draw another card or stand pat.

That’s basically the dilemma facing banks today as they execute their lending and funding strategies over the next year and a half. Will 2019 be a year of transition as growth slows down, leading to a possible recession in 2020? Bankers subscribing to this pessimistic outlook are likely to be more cautious in their lending and credit management activities in the coming year. Or is Foster correct that a recession is not in the cards for at least the next two years? In this scenario, optimistic bankers are likely to keep pushing for loan growth to sustain their profitability.

Making the right decision on the future of the economy is crucial because of the long-tailed nature of commercial lending, which is where most of the country’s banks make most of their money. It can take up to two years for a commercial loan to “season,” after which the repayment performance of the borrower becomes more predictable and reliable. This is why loans made late in the economic cycle are often the first to go bad when the economy turns down. It’s also why the current lending environment is so tricky to navigate, given that the competition for good credits is fierce, with many banks loosening loan terms and cutting rates to win business.

“The No. 1 thing you [don’t] want to do as a CEO is have your highest loan growth percentage in the year before a recession,” says Kirk Wycoff, managing partner of Patriot Financial Partners, a private equity firm that invests in banks. “If you have 30 percent loan growth and the next year is a recession, that’s a bad set of facts, because loans of the new vintage are more likely to go nonperforming than seasoned loans.”

Former Federal Reserve Vice Chairman Alan Blinder, who teaches economics at Princeton University and also serves as vice chairman at Promontory Interfinancial Network, doesn’t believe that a recession is likely within the next two years-but says bankers should be cautious anyway. “You only know [you’re at] an end of a boom when you look back,” he says. “When you’re living in that period, you don’t realize it’s an end of a boom. People tend to think the good times will roll forever, and that’s one of the ingredients of bad lending. I think every banker should be aware of that risk and be watching out for it and make sure that the lending makes sense. That doesn’t mean you stop lending. But there’s such a thing as well underwritten loans, and there’s such a thing as poorly underwritten loans.”

The U.S. economy was on fire most of 2018, with growth spiking from 2.2 percent in the first quarter to 4.2 percent in the second quarter, then settling down to 3.5 percent in the third quarter. Estimated growth for the fourth quarter (this article went to press in mid-December) was generally in the 2.5 percent range. This would mean that the economy grew at an average annual rate of about 3 percent in 2018, which is an excellent performance compared to the years 2015 through 2017.

The fuel most responsible for powering this rapid expansion, it seems reasonable to conclude, was the Tax Cut and Jobs Act of 2017. It dropped the top corporate tax rate from 35 percent down to 21 percent, helping to drive corporate profits across the economy, including banking.

In many respects, the U.S economy appears to be amazingly healthy this late in the cycle. The unemployment rate was at 3.7 percent in October of last year, which is very low by historical standards-particularly compared to the years following the financial crisis. Low unemployment often leads to higher inflation as companies are forced to raise salaries to attract workers, but inflation remains steady at the Federal Reserve’s long-term target rate of 2 percent.

Even Fed Chair Jerome Powell finds the economy’s strong performance since last year to be remarkable. “This historically rare pairing of steady, low inflation and very low unemployment is a testament to the fact that we remain in extraordinary times,” said Powell in a speech at the NABE’s annual meeting last October. Citing a number of forecasts by the Fed and others that unemployment will stay below 4 percent and inflation around 2 percent through 2020, Powell added that it was “a reasonable question” whether these forecasts “were too good to be true.”

Not to Foster, however, who forecasts 2.5 percent growth and 2 percent inflation through 2020. “Until there’s some [monetary] policy on the radar screen that makes me start to worry, that will be the forecast,” he says. “If I talked to you this time next year, absent something on the radar, that would continue to be the forecast.”

Mark Vitner, a senior economist at Wells Fargo & Co., is also bullish on the economy over the next 24 months, although his projected growth rates are different-2.8 percent in 2019, then dropping down to 2 percent in 2020.

Neither economist anticipates a downturn occurring over the next two years. “We don’t see a recession lurking around the corner despite some volatility in the financial markets,” says Vitner. Foster concurs. “The natural tendency of the economy is to continue to grow,” he says. “It only goes into a recession if we end up doing something really terrible in terms of economic policy. Right now there’s no indication of that.”

The economy might be performing well at the moment, but there is enough noise to give any pessimist plenty to worry about. Extreme volatility in the stock market last fall shows that investors are skittish, and while the market doesn’t drive the economy it does tend to reflect it. Other potential problems include the Trump administration’s ongoing trade war with China, Canada and the European Union, as well as a general slowdown in the global economy. The tax cut also added to the U.S. budget deficit, which according to a Treasury Department report was projected to come in at $779 billion at year-end 2018, a 17 percent increase over 2017. While none of these things seem to directly threaten the U.S. economy today, they feed into a downbeat narrative about the country’s future prospects.

Another concern is the Federal Reserve’s ongoing tightening of monetary policy, which began in 2015 and has accelerated since then. The central bank raised the fed funds rate three times in 2018, to 2.25 percent, and was expected to raise it again at its scheduled December meeting. Additional rate hikes are possible in 2019. Although he doesn’t expect a recession any time soon, Foster does see some risk in the execution of the Fed’s policy as it both raises rates and shrinks its balance sheet that had ballooned in the years following the financial crisis, when it pumped money into the economy by purchasing securities. “The Fed may well overshoot at some point,” he says. “Nobody knows what a neutral fed funds rate looks like. Nobody knows what the balance sheet should look like, so the Fed could make a mistake.”

It’s also unclear whether the tax cut will be a permanent factor in driving growth, or turn out to be a sugar high that will last a few quarters and then dissipate. The Trump administration sold the tax cut as a boon to capital spending, and while business investment did go up in the first half of 2018, large U.S. corporations spent even more money on stock buybacks. What remains unclear is whether U.S. companies will continue to invest in their businesses this year and next if they think the economy is heading for a downturn, or will they retrench like General Motors Co. did in late November, when it announced the closing of five manufacturing plants and the termination of 15 percent of its salaried employees.

If Foster and Vitner give voice to the optimistic outlook, Chief Economist Joe Brusuelas at the consulting firm RSM takes a dimmer view of the economy’s likely performance over the next two years. Brusuelas forecasts the U.S. economy to grow between 2.2 percent and 2.5 percent in 2019, and then drop to 1.8 percent in 2020. “My sense is that the [tax cut], which in part is responsible for the strong growth we’re having, has already peaked,” he says.

Brusuelas believes the risk of a recession is greatest between mid-2020 to mid-2021, particularly if the Federal Reserve continues to raise interest rates. Other risk factors include the impact of the tariffs on the U.S. economy if the standoff with China continues to escalate; weakness in various emerging market countries that could weigh on the global economy; the ongoing financial crisis in Italy, which poses a serious threat to the financial stability of the European Union; and the EU’s other ongoing concern-the United Kingdom’s withdrawal from the EU, otherwise known as Brexit-which remained unresolved in mid-December. Any of these problems could pose a harmful external shock to the U.S. economy, particularly if they occur in combination, Brusuelas warns.

“My sense is that we’re going to see a natural slowdown,” he says. “But it’s not just going to be one thing,” he adds. “[It could be] an external shock, a policy error [by] the Fed, or the lagged impact of the tax cuts not carrying any significance and just being a sugar high. Then we start looking at that and say, ‘Yeah, you [have] the recipe for a recession.’”

Most bank CEOs aren’t economists (and most small banks don’t even employ them), but they do need to have an informed view on the economy and factor that into their strategic plans. Before he became a private equity investor, Wycoff was the CEO at three financial institutions over a 25-year period. Today, Patriot has about $700 million invested in 28 banks, so Wycoff watches the economy closely, and he likes what he sees. “The economy is strong and balanced,” he says. “Our forecast from our economist would say the earliest we’re likely to see a recession would be ’21 or ’22.”

Nor does Wycoff necessarily agree that the economy has reached the final stage of the current expansion even though certain metrics, such as the low unemployment rate, would suggest that. From his perspective, the tax cut, along with the Trump administration’s regulatory policies, have taken us to a place where we’ve never been before. “We have no experience with a much lower tax rate and a regulatory-friendly administration” this late in the cycle, he says. “So we don’t know whether we’re in the fourth or fifth inning, or the eighth or ninth inning. It’s clearly not early stage, because unemployment is high and corporate profit growth is anemic in the early stages of a recovery. There’s no reason why this expansion can’t last 20 years instead of 10, except that everyone says it’s never happened before.”

Wycoff wants his portfolio banks to adhere to good loan underwriting practices, but he also doesn’t want their management teams to be afraid to take on credit risk when they are being paid appropriately. “I think in a strong economy there is more opportunity to take prudent risk, be regulatory compliant and make higher returns,” he says. “I absolutely believe that. And if you look at our portfolio companies, guess what, they’re doing it.”

One veteran bank CEO who has lived through several economic cycles during the course of his long career is Joe Evans at State Bank Financial Corp., a $4.9 billion asset bank holding company headquartered in Atlanta. Evans built State Bank after the financial crisis, when he acquired an existing bank charter and then did a series of assisted transactions with the Federal Deposit Insurance Corp. He has seen recessions come and go. “I’ve said this for years, I don’t know when the next recession is, but it’s a day closer than it was yesterday. I feel we’re in a mature phase of the economic cycle,” says Evans. As evidence, he points to the commercial loan market. In the initial years after the crisis, healthy banks with lending capacity “had the ability to be very selective on customers, projects, terms,” he says. “It was basically a lender’s market.” Fast-forward to 2018. The banking industry has recovered from the crisis, and now it’s essentially a borrower’s market. “It’s an inherent evolution of the cycle that as the lending environment becomes more competitive, the risk in lending escalates,” Evans says.

Evans certainly understands economic data and can easily digest a forecast, but he also goes by intuition that is the product of experience. All veteran CEOs do that to a certain extent, including Claude Davis, the executive chairman at $13.8 billion asset First Financial Bancorp in Cincinnati, and previously its CEO until a recent merger, after which he moved into his current role. “I see [the economy] as mid-to-late stage,” Davis says. “Things are going well, [and] the economy is strong. We’re not seeing any major storm clouds on the horizon, but I’ve been in the business for 31 years now, and I’ve seen enough cycles through that time that you just feel that we’re later in the stage of the economy.”

Evans sees a lot of strength in the economy today and doesn’t expect a recession to occur over the next two years. But he also says the experience of the financial crisis has made him wary. “We’re always worrying about, ‘What are we missing?’” he says. Davis does worry about the budget deficit, because it could have an impact on long-term inflation. And he is concerned about the political fight over immigration that is playing out in the nation’s capital. “We see it with a lot of our clients [where] the lack of a policy is really starting to mute growth because of the availability of labor,” he says.

How should bank CEOs and directors interpret the economic data and conflicting forecasts, and how should they react? Clearly the economy is slowing down-even the bulls expect that to happen. But where and when it will bottom out-which is what everyone wants to know-is unknowable. There are only estimates, even if they are informed estimates.

“If I’m at Citibank and they pull me into the executive office, and they want to know where the economy is going, I’m telling them it’s past the peak,” says Brusuelas. “This is the time to balance well-reasoned risk taking with extreme prudence.”

One factor that all banks should be concerned about is the quality of the commercial loans that are being written in today’s highly competitive environment. Scott Dueser, chairman and CEO at $7.5 billion asset First Financial Bankshares in Abilene, Texas, says that he is seeing a troublesome deterioration in credit standards and risk-based pricing in his market. “Not having proper loan agreements, not taking collateral as they should,” Dueser says. “You’re seeing people getting cash back out of projects after they’ve put cash in when another bank comes and says, ‘We’ll give your equity back that you’ve put into this project.’ When the economy turns, there are going to be some losses there, some strong losses. The industry is making its next set of problem loans today.”

This is where the timing of the next downturn becomes important, because a loan underwritten today has an opportunity to season if the next recession isn’t until 2021 or later. Poorly structured and underpriced loans written in the final stages of an expansion are more likely to go bad in a downturn. “As one of my bank examiners always said, ‘When the bullet is in the body, it’s too late,’” says Eugene Ludwig, CEO of the Promontory Financial Group and Comptroller of the Currency from 1993 to 1998. “When you make a loan, whether it’s a bad loan or in a bad sector, it does take 24 months before that begins to show in the downturn territory. That’s the time frame we’re talking about.”

There are certain credit management strategies that all banks should be employing with greater diligence as the economy begins to slow down. They should be looking even more intently for concentrations of risk and risk correlations in their loan portfolios. Stress testing will also become increasingly important if 2019 does turn out to be a transition year for the economy. “I think it is ever more important to be looking for ways to improve how we look at the risk in our long portfolios,” says John Eggemeyer, managing partner at the private equity firm Castle Creek Capital, which has over $900 million invested in community banks. “I think that the stress testing that the largest banks are doing, albeit in many cases very theoretical, are still things that need to be done at community banks.”

This would also be a good time for banks to keep in close communication with their borrowers. Rene Jones, president and CEO at $117 billion asset M&T Bank Corp. in Buffalo, New York, says his regional institution does pay attention to the economic cycle and what that might portend for the future. “We clearly look at national trends,” Jones says. “But the thing that gives us the most confidence is conversations with our customers. What we have found over time is because we’re a financial intermediary, the things our customers tell us, if we focus on them, give us a faster picture of what the country as a whole is facing. Most of the time we’re hearing things from our customers before we ever hear them in the national news.”

While M&T employs all of the credit monitoring tools that one would expect of a large regional bank, Jones doesn’t try to anticipate where the economy is heading and then adjust the bank’s strategy accordingly. It doesn’t, in other words, play blackjack with the economy.

“You can’t predict what events will happen that will create a change in consumer confidence,” Jones says. “What we do is prepare ourselves for any economy.”

M&T made it through the financial crisis with a net charge-off ratio that peaked at 1.01 percent because of a conservative approach to credit that doesn’t change with the economic cycle. It doesn’t compete with other banks when the loan market softens. And Jones doesn’t worry that M&T’s top line growth might slow if it fails to match the poorly structured and underpriced deals of its competitors.

“In the banking industry, revenue growth is the easiest thing to produce,” Jones says. “It’s just a question of what happens afterwards.”


Jack Milligan


Jack Milligan is editor-at-large of Bank Director magazine, a position to which he brings over 40 years of experience in financial journalism organizations. Mr. Milligan directs Bank Director’s editorial coverage and leads its director training efforts. He has a master’s degree in Journalism from The Ohio State University.

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