Banking KPI Insights: Year-End Metrics of Note

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Executives can glean actionable insights from understanding the benchmarks and trends within key performance indicators, or KPI. Here were some of the highlights from 2020 to help you understand trends and benchmark your organization. 

Inhibited Earnings Capacity
The coronavirus pandemic, and the resulting changes in fiscal policy and economic behavior have measurably inhibited earnings capacity for most community banks. Bank balance sheets have grown principally due to government stimulus payments, limited capital investment by small and mid-sized businesses and a general flight to quality by consumers.

The fourth quarter of 2020 recorded continued strong capital levels — along with challenges in earnings growth due to historically low net interest margins. Expectations that the pandemic will persist well into 2021, assurances of continued government assistance and the continuation of low interest rates into the foreseeable future mean that change is unlikely in the coming months.

Return on Average Equity
Community bank profitability of 8.90%, in relation to average equity, was relatively stable when compared to the previous three quarters of 2020, as well as the fourth quarter of 2019. For most community banks, continued low interest rates, excess liquidity and limited loan demand all restricted profitability. In addition, cost reduction opportunities arising from technology investments and staff reductions appear to have stabilized. Loan loss provisions continued to be relatively low; credit quality remained favorable, in part due to the benefits of government stimulus.

Non-interest Income to Net Income
Non-interest income grew to 13.17% of total income during the fourth quarter of 2020, compared to an average of 11.60% for the trailing four quarters. This reflects the combination of continued downward pressure on net interest margin, which remained constant at 3.35%, and efforts to expand fee-based income, such as higher fee levels on deposit accounts. Given the Federal Reserve’s intention to keep interest rates low for the foreseeable future and the likelihood of tempered loan demand, this trend should continue throughout 2021.

Credit, Credit Quality
Credit demand for community banks continued to decline through the fourth quarter. Keeping in mind that that the second round of the Paycheck Protection Program (PPP2) didn’t launch until January 2021, the community bank space saw loan to deposit ratios decline to 74.15% at the end of 2020. This compares to 82.09% at the end of 2019, and an average of 79.4% for full-year 2020. The decline is somewhat muted by the first round of PPP (PPP1) loans issued by community banks, although the majority of PPP1 loans were issued by large banks.

Credit quality remains favorable, due to the benefits of government stimulus and limited loan demand. Nonperforming loans totaled just 0.53% of loans. Average loan loss allowance levels held steady at 1.30% of total loans at the end of 2020. In some instances, banks recaptured provisions for loan losses recognized during the first half of 2020.  We anticipate a more-normalized loan loss provision curve in 2021, subject to the duration of the pandemic, the effectiveness of government stimulus and fiscal policy.

Efficiency Ratio
Cost management continues to be a challenge. Notably, the benefits of technology investments have either been fully realized or limited due to the absence of loan demand. The operating inefficiency of branches in an increasingly virtual environment drove the largest increase in the industry’s efficiency ratio, from an average of 63.35% for the previous two quarters to 66.82% in the forth quarter of 2020. As community banks continue assessing the shift to digital banking and the emergence of nonbank alternatives, we expect more changes to branch networks and technology investments as a way to increase operating efficiency.

Merger and acquisition (M&A) insights
Certainly, 2020 represented the quietest year in recent history as to the number and size of community bank acquisitions. For the most part, both buyers and sellers paused to assess the strategic and economic value of deals, as well as to focus on the uncertainties and operational demands arising from the pandemic and the political and regulatory landscape.

We believe 2021 will represent the restart of the rapid consolidation of the community bank sector based on recent elections, the promise of an economic recovery fueled by continued government stimulus and a  successful distribution of vaccines. We believe more appealing pricing dynamics for both buyers and sellers will emerge as the economy stabilizes and small and mid-sized businesses  reopen. Lastly, the evolution of fintechs and the broader acceptance of these solutions by consumers, businesses and regulators will likely motivate community bankers to engage in targeted and strategic transactions.

Download the full KPI report
Understanding how your bank measures up within the industry is critical to achieving long-term success. Download Baker Tilly’s most recent banking industry benchmarking report to give you meaning behind the numbers.

Getting a Return on Relationship Profitability

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profitability-7-8-19.pngHow profitable are your bank’s commercial relationships?

That may seem like a strange question, given that banks are in the relationship business. But relationship profitability is a complex issue that many banks struggle to master. A bank’s ability to accurately measure the profitability of its relationships may determine whether it’s a market leader or a stagnant institution just trying to survive. In my experience, the market leaders use the right profitability metrics, measure it at the right time and distribute that information to the right people.

Should Your Bank Use ROE or ROA? Yes.
Many banks use return on assets, or ROA, to measure their portfolio’s overall profitability. It’s a great way to compare a bank’s performance relative to others, but it can disguise credit issues hidden within the portfolio. To address that concern, the best-performing banks combine an ROA review with a more precise discussion on return on equity, or ROE. While ROA gives executives a view from above, ROE helps banks understand the value, and risk, associated with each deal.

ROA and ROE both begin with the same numerator: net income. But the denominator for ROA is the average balance; ROE considers the equity, or capital that is employed by the loan.

If your bank applies an average equity position to every booked loan, then this approach may not be for you. But banks that strive to apply a true risk-based approach that allocates more capital for riskier deals and less capital for stronger credits should consider how they could use this approach to help them calculate relationship profitability.

Take a $500,000 interest-only loan that will generate $5,000 of net income. The ROA on this deal will be 1 percent [$5,000 of net income divided by the $500,000 average balance]. The interest-only repayment helps simplify the outstanding balance discussion and replicates the same principles in amortizing deals.

You can assume there is a personal guarantee that can be added. It’s not enough to change the risk rating of the deal, but that additional coverage is always desirable. The addition of the guarantee does not reduce the outstanding balance, so the ROA calculation remains unchanged. The math says there is no value that comes from adding the additional protection.

That changes when a bank uses ROE.

Let’s say a bank initially allocated $50,000 of capital to support this deal, generating a 10 percent ROE [$5,000 of net income divided by the $50,000 capital].

The new guarantee changes the potential loss given default. A $1,000 reduction in the capital required to support this deal, because of the guarantee, increases ROE 20 basis points, to 10.20 percent [$5,000 of net income divided by the $49,000 of capital]. The additional guarantee reduced risk and improved returns on equity.

The ROA calculation is unchanged by a reduction in risk; ROE paints a more accurate picture of the deal’s profitability.

The Case for Strategic Value
Assume your bank won that deal and three years have now passed. When calculating that relationship’s profitability, knowing what you’ve earned to-date has a purpose; however, your competitors care only about what that deal looks like today and if they can win away that customer and all those future payments.

That’s why the best-performing banks consider what’s in front of them to lose, not what has been earned up to this point. This is called the relationship’s “strategic value.” It’s the value your competition understands.

When assessing a relationship’s strategic value, banks may identify vulnerable deals that they preemptively reprice on terms that are more favorable to the customer. That sounds heretical, but if your bank’s not making that offer, rest assured your competitors will.

The Right Information, to the Right People, at the Right Time
Once your bank has decided how it will measure profitability, you then need to consider who should get that information—and when. Banks often have good discussions about pricing tactics during exception request reviews, but by then the terms of the deal are usually set. It can be difficult to go back to ask for more.

The best-positioned banks use technology systems that can provide easily digestible profitability data to their relationship managers in a timely fashion. Relationship managers receive these insights as they negotiate the terms of the deal, not after they’ve asked for an exception.

Arming relationship managers with a clear understanding of both the loan and relationship profitability allows them to better price, and win, a deal that provides genuine value for the bank.

Then you can start answering other questions, like “What’s the secret to your bank’s success?”

How to Safely Generate Bank Income Through SBA Loans

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sba-loans-8-19-15.pngSmall Business Administration (SBA) lending is one of the key lending activities that can quickly and dramatically improve the bottom line of a community bank. It is not that difficult for a bank to generate $20 million in SBA loans, which will earn the institution between $1.0 to $1.2 million in pretax net income, if the loan guarantees are sold. Some bankers get concerned because they have heard stories of the SBA denying loan guarantees and that the SBA loan process is too time consuming and complex.

Sourcing SBA Loans
The basic strategies that most successful SBA lenders use to source SBA loans are as follows:

  1. Hire an experienced SBA Business Development Officer (BDO), who can find loans that fit your credit parameters and geography.
  2. Source loans from brokers or businesses that specialize in finding SBA loans.
  3. Utilize a call center to target SBA borrowers.
  4. Train your existing staff to identify and market to SBA loan prospects.

I have put these in the order of which approach is likely to be the most successful. However, ultimately it is the speed of execution that enables one lender to beat out another in the SBA business. So if you want to hire that high producing SBA BDO, the bank needs to have a clear idea of the types of credits that they will approve and a process that can quickly get them approved.

This can create a catch 22 for the lender, since in order to justify hiring SBA underwriters and processing personnel, you have to make sure that you generate loans. But in order to recruit those top performing SBA BDOs, you will need to show them that you have a way of getting their loans closed quickly.

The most effective solution for solving these problems is to hire a quality SBA Lender Service Provider (LSP).  This is the quickest way to add an experienced SBA back shop that will warranty its work and handle the loan eligibility determination, underwriting, processing, closing, loan sale and servicing. This gives the bank a variable cost solution, and allows them to have personnel to process 100s of loans per year. While some of the better LSPs will help the lender with the underwriting of the loan, it is solely the bank that makes the credit approval decision. SBA outsourcing is very cost effective and allows a bank to begin participating and making money with these programs immediately, even if they only do a few loans.

Making a Profit
Let us look at the bank’s profits from a $1.0 million SBA 7(a) loan that is priced at prime plus 2.0 percent with a 25-year term.

Loan amount $1,000,000  
Guaranteed portion $ 750,000  
Unguaranteed portion $ 250,000  
Gain on the sale of the SBA guaranteed portion $ 90,000 (12% net 14% gross)
Net interest income(5.25%-0.75% COF = 4.5%) $ 11,250 (NII on $250,000)
Servicing Income ($750,000 X 1.0%) $ 7,500  
Total gross income $ 108,750  
     
Loan acquisition cost (assumed to be 2.5%) $25,000 (BDO comp, etc.)
Outsource cost (approximately 2.0%) $ 20,000 (per SBA guidelines)
Annual servicing cost (assumed to be 0.50%) $ 5,000  
Loan loss provision (2.0% of $250,000) $ 5,000  
Total expenses $ 55,000  
Net pretax income $ 53,750  
ROE ($53,750/$25,000 risk based capital) 215%  
ROA ($53,750/$250,000) 21.5%  

In this example the bank made a $1.0 million SBA loan and sold the $750,000 guaranteed piece and made a $90,000 gain on sale. The bank earned $11,250 of net interest income on the $250,000 unguaranteed piece of that loan that the bank retained. When an SBA guaranty is sold, the investor buys it at a 1.0 percent discount, so the lender earns a 1.0 percent  ongoing fee on the guaranteed piece of the loan for the life of the loan. This example  did not account for the amortization of the loan through the year.

I believe that the expenses are self explanatory, but you can see if the bank made $20 million of SBA loans using these assumptions, they would earn $1.075 million in the first year.

Conclusion
As you can see, SBA lending can add a substantial additional income stream to your bank; however, you need a certain amount of loan production and a high quality staff, or you need an SBA outsource solution to underwrite and process the loans. As you can see, the ROE and ROA for SBA loans is much higher than conventional financing, which is why you see community banks that have an SBA focus generate higher returns.