Navigating Your Bank Through Rising Rates


interest-rates-4-2-18.pngBanks have been lamenting low interest rates for almost a decade. In boardrooms and on earnings calls, low rates have been blamed for shrinking margins, tepid deposit growth and intense loan competition.

With rates now up more than 100 basis points from their lows, we’re about to find out where that was true, and where interest rates were just a convenient scapegoat. Management teams and boards now face a few strategic questions. Among them: How is lending typically impacted by higher rates, and what strategies should my institution consider as rates continue to rise?

First, as the Federal Reserve’s Federal Open Market Committee puts upward pressure on overnight rates, there is typically a follow-on effect further out on the curve. But, these effects are rarely 1:1, resulting in a flattening yield curve. Bear flatteners, in which short-term interest rates increase more quickly than long-term rates, differ in severity, but if this one is anything like the period following the last Fed tightening cycle—from June 2004 through August 2006, as shown in the chart below—banks could be in for some pain.

Second, as rates start to quickly rise, nominal loan yields lag, resulting in declining credit spreads. It takes time for borrowers to adjust to the new reality, and competing banks can be expected to play a game of chicken, waiting to see which will blink first on higher loan rates and face a potential loss of market share.

Taken together, these two phenomena can put intense pressure on loan profitability. Banks are now enjoying an increase in net interest margins, but this comes on the back of rising yields on floating rate loans funded with deposits that have not yet become more expensive. Deposit costs will soon start moving, and once they do, they can move quickly.

This is a time when a rising tide no longer lifts all boats, and the banks that properly navigate the asset side of their balance sheet will start to separate themselves from everyone else. So, what does “proper navigation” look like? It’s not timing the market or outguessing the competition. Instead, winning during pivots in interest rates is all about adhering to a disciplined pricing process.

Trust the Yield Curve
The top performing banks let the yield curve guide pricing. We see evidence of this discipline in the mix between floating and fixed-rate structures. When rates were low, and the yield curve was steep, many banks were tempted to move out on the curve. They instituted arbitrary minimum starting rates on floating structures and saw their share of fixed-rate loans reach record highs. Now that rates are starting rise, these banks fear the exposure those fixed rates created, so they are desperately trying to correct the mix.

Disciplined banks ended up with the opposite scenario. With a steep curve, they found the lower floating-rate structures to be popular with borrowers. Now that the curve is flattening, borrowers are choosing more fixed-rate structures. These banks have large blocks of floating-rate loans that are now repricing higher, and that mix will naturally shift to fixed as rates move higher and the curve flattens, protecting them from dropping yields when the cycle eventually turns again. These banks let the yield curve help them manage their exposure, working in sync with borrower demand instead of against it.

Supercharge Cross-Sell Efforts
We also see top performing banks paying more attention than ever to their cross-selling efforts. In a rising rate environment, low cost deposits become much more valuable. Banks that already have deposit gathering built into their lending function are taking advantage, as their relationship managers can offer more aggressive loan pricing when the deals are accompanied by net new deposits. These banks have well-established processes for measuring the value of these deposits, tracking the delivery of promised new business and properly incentivizing their relationship managers to chase the right kind of new accounts.

When it comes to surviving—and thriving—in a rising rate environment, there is no magic bullet or secret shortcut. Instead, the answer lies in continuing to do what you should have been doing all along: Trusting the process you’ve built, staying disciplined and ignoring all the noise around you in the market.

And if you don’t have a process—a true north that you can use to guide your commercial bank’s pricing strategy—then get one right now. Rough seas may well lie ahead.

Optimistic About Loans But Worried About Deposits


risk-3-5-18.pngThere are a lot of reasons why Greg Steffens is confident about the economy. As the president and CEO of $1.8 billion asset Southern Missouri Bancorp, which is headquartered in the southern Missouri town of Poplar Bluff, he sees that consumers are more confident, wages are growing, most corporations and individuals just got a tax break, and the White House announced a major infrastructure funding plan.

Steffens projects that a strong local economy will help Southern Missouri to grow loans by 8 to 10 percent this year. But he sees the potential for net interest margin compression as well, particularly because competition for loans and deposits has gotten so tight.

His thoughts about the future, a mixture of optimism and concern, are typical of bankers these days as shown by Promontory Interfinancial Network’s latest Bank Executive Business Outlook Survey. Although bankers report higher funding costs and increased competition for deposits, their optimism about the future has improved, and economic conditions for their banks are better now than they were a year ago.

Top-Lines-Q4-2017-long-version.pngAlong with a generally improving national economy and improvements in the banking sector, the passage of the Tax Cuts and Jobs Act shortly before the survey was taken likely influenced the increase in optimism among many bankers. The emailed survey, conducted from Jan. 16 through Jan. 30, included responses from bank CEOs, presidents and chief financial officers from more than 370 banks.

Some highlights include:

  • Sixty-three percent say economic conditions have improved compared to a year ago, while 5 percent say things have gotten worse, compared to 49 percent last quarter who said conditions improved and 9 percent who said things had gotten worse.
  • Slightly more than 58 percent report a recent increase in loan demand, up 7.5 percentage points from last quarter.
  • Bankers think the future will be even better with 64 percent projecting an increase in loan demand in 2018, compared to just 51.2 percent who projected annual loan growth in the fourth quarter 2017 survey.
  • The Bank Confidence IndexSM, which measures forward-looking projections about access to capital, loan demand, funding costs and deposit competition, improved by 2.4 percentage points from last quarter to 50.5, the highest rating for the index since the second quarter of 2016.
  • Regionally, the highest percentage of bankers expecting loan growth is from the South at 71.9 percent. But the biggest improvement in expectations for loan growth is in the Northeast, which climbed 27.1 percentage points from last quarter to 64.1 percent expecting loan growth in 2018.

Charlie Funk, the president and CEO of MidwestOne Financial Group, a $3.2 billion asset banking company in Iowa City, Iowa, says he expects the tax cuts will lead to higher commercial loan growth, although he hasn’t seen evidence of that yet.

He’s worried now about another factor on his balance sheet: deposit competition. “Deposits are going to be where the major battles are fought,’’ he says. The bank already is paying some large corporate depositors more than 1 percent APR on money market accounts, compared to 30 basis points just after the financial crisis. He expects the bank’s net interest margin to narrow somewhat this year as deposit costs increase faster than loan yields.

Other bankers report higher levels of deposit competition as well. In the Promontory Interfinancial Network survey, 80 percent of respondents expect competition for deposits to increase during the year, compared to 77.4 percent who thought so last quarter. The overwhelming majority have seen higher funding costs this year at 78.1 percent, compared to 68.4 percent last quarter who experienced higher funding costs. Nearly 89 percent of respondents expect funding costs to increase this year.

Representatives from larger community banks, with $1 billion to $10 billion in assets, were more likely to say funding costs will increase. The Northeast had the highest percentage of respondents saying funding costs will moderately or significantly increase, at 92.3 percent.

One of those Northeastern banks is Souderton, Pennsylvania-based Univest Corp. of Pennsylvania. With $4.6 billion in assets and a 100 percent loan-to-deposit ratio, the highly competitive deposit market is putting pressure on the bank to match loan growth with deposits. Univest Senior Executive Vice President and Chief Financial Officer Roger Deacon says funding costs have inched up, partly driven by competition for deposits. “The competition is almost as high on the deposit side as on the loan side,’’ he says.

The good news is that the bank is asset sensitive, meaning that when rates rise, its loans are expected to reprice faster than its deposits. “I’m cautiously optimistic about the impact of rising rates on our business,’’ Deacon says.

FASB Update Removes Roadblock to Hedging With Derivatives


derivatives-11-13-17.pngComplex hedge accounting rules are high on the list of reasons that community banks have chosen to avoid derivatives as risk management tools. But the Financial Accounting Standards Board (FASB) created a stir a little over a year ago, when it promised to improve accounting for hedging activities. That stir turned into a wave of fanfare from community banks in August 2017, when the final Accounting Standards Update (ASU 2017-12) was issued for ASC 815 – Derivatives and Hedging, the standard formerly known as FAS 133. In order to appreciate the excitement surrounding the new hedging guidance from FASB, it helps to take a quick look at the history behind the accounting standard that is widely considered to be the most complex the accounting organization has ever issued.

When derivatives were introduced in the mid-1980s, they were known as “off-balance sheet” instruments because there was not a neat way to fit them onto a firm’s financial statements. Derivatives were instead relegated to the footnotes. As derivative structures became more complex and began to be used more aggressively by treasurers who often viewed derivatives as profit centers, a sharp unexpected rate hike in 1994 led to large derivative losses at Procter & Gamble and others. With speculative trades buried deep in the footnotes, demands for transparency from the investor community led to FAS 133 which, starting in 2000, required for the first time that derivatives be carried at fair value on the balance sheet.

In order to prevent having on-balance sheet derivative values lead to wild swings in earnings, hedge accounting rules were created as a shock absorber. But while the original intent of hedge accounting was to be helpful, in practice it was difficult to apply and unforgiving when applied incorrectly. It also lacked viable solutions for some of the most common challenges facing community banks.

With that as a backdrop, here are three changes included in ASU 2017-12 that will make hedging with derivatives much more practical and worry-free for community banks.

1. Portfolio Hedging of Fixed-Rate Assets
What made hedging a portfolio of fixed-rate mortgages impractical under the original standard was the caveat that almost every loan in the pool needed to be homogeneous with regard to origination date, maturity date and prepayment characteristics. Some banks would occasionally hedge larger commercial loans one at a time, but this very common source of interest rate risk was either hedged in a different manner or ignored in the past. The newly introduced “last-of-layer” designation eliminates this unattainable caveat and will enable liability-sensitive banks to hedge a portion of an identified closed portfolio of prepayable assets. As a result of this new strategy, banks will have a one-time opportunity to reclassify held-to-maturity securities as available for sale if they are eligible for the last-of-layer designation. Mitigating interest rate risk in both the loan and securities portfolios will now be squarely on the table for community banks’ consideration.

2. Impact of Hedging on NIM
Most banks undertaking a derivative strategy are looking to protect or enhance the bank’s net interest margin (NIM). The original standard required that hedge ineffectiveness be measured, which sometimes created unwanted accounting surprises. By eliminating the concept of ineffectiveness from the hedging framework, FASB will reduce complexity associated with interpreting hedging results. Hedge mismatches will no longer need to be separately measured and reported in financial statements. The economic impact from mismatches between the hedge and the hedged item will be reported in the same income statement line item when the hedged item affects earnings. For banks, this will enable typical hedging activities to impact NIM as intended.

3. Reduced Restatement Risk
In the past, some banks attempted to reduce the burden of hedging through the use of the “shortcut method,” where the assumption of a perfectly effective hedge was permitted by FASB when specific conditions were met. But the breach of any shortcut criterion, due to a minor missed detail or an unexpected change in business conditions, led to a loss of hedge accounting privileges and sometimes an embarrassing accounting restatement. The new ASU introduces an improvement to the shortcut method of assessing effectiveness by allowing for a fallback, long-haul method to be documented at the time of designation. This change will significantly reduce the risk of a restatement, and banks will be able to pursue prudent hedging activities with less fear of an accounting misstep.

By reducing complexity and making more hedging strategies viable, the new guidance is expected to be adopted prior to the mandatory 2019 deadline by most banks who actively hedge. In addition, more community banks are likely to consider installing hedging capabilities for the first time thanks to FASB clearing this long-time roadblock.

Why Every Basis Point Matters Now


derivatives-2-17-17.pngAfter eight years of waiting for interest rates to make a meaningful move higher, the fed funds rate is making a slow creep towards 2 percent. With a more volatile yield curve expected in the upcoming years and continued competition for loans, net interest margins (NIM) may continue to compress for many financial institutions. The key to achieve NIM expansion will involve strong loan pricing discipline and the full toolkit of financial products to harvest every available basis point.

Where to look on the balance sheet? Here are some suggestions.

Loan Portfolio
The loan portfolio is a great place to look for opportunities to improve the profitability. Being able to win loans and thus grow earning assets is critical to long-term success. A common problem, however, is the mismatch between market demand for long-term, fixed rate loans and the institution’s reluctance to offer the same.

Oftentimes, a financial institution’s interest rate risk position is not aligned to make long-term, fixed rate loans. A few alternatives are available to provide a win-win for the bank and the borrower:

  • Match funding long-term loans with wholesale funding sources
  • Offer long-term loans and hedge them with interest rate swaps
  • Offer a floating rate loan and an interest rate swap to the borrower and offset the interest rate swap with a swap dealer to recognize fee income upfront

With the ability to offer long-term fixed rate loans, the financial institution will open the door to greater loan volumes, improved NIM, and profitability.

How much does a financial institution leave on the table when prepayment penalties are waived? A common comment from lenders is that borrowers are rejecting prepayment language in the loan.

How much is this foregone prepayment language worth? As you can see from the table below, for a 5-year loan using a 20-year amortization, the value of not including prepayment language is 90 basis points per year.

Swap-chart.PNG

At a minimum, financial institutions should look to write into the loan at least a 1- to 2-year lock out on prepayment, which drops the value of that option from 90 basis points to 54 basis points for a 1-year lock out or 34 basis points for a 2-year lock out. That may be more workable while staying competitive.

Investment Portfolio
The investment portfolio typically makes up 20 percent to 25 percent of earning assets for many institutions. Given its importance to the financial institution’s earnings, bond trade execution efficiency may be a way to pick up a basis point or two in NIM.

A financial institution investing in new issue bonds should look at the prospectus and determine the underwriting fees and sales concessions for the issuance. There are many examples in which the underwriting fees and sales concessions are 50 to 100 basis points higher between two bonds from the same issuer with the same characteristics, with both issued at par. To put that in yield terms, on a 5-year bond, the yield difference can be anywhere between 10 and 20 basis points per year.

If you are purchasing agency debentures in the secondary market, you can access all the information you need from the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE) to determine the mark up of the bonds you purchased. Using Bloomberg’s trade history function (TDH), in many cases, it is easy to determine where you bought the bond and how much the broker marked up the bond. Similar to the new issue example above, a mark-up of 25 to 50 basis points more than you could have transacted would equate to 5 to 10 basis points in yield on a 5-year bond.

For a typical investment portfolio, executing the more efficient transactions would increase NIM by 1.5 to 5 basis points. For many institutions, simply executing bond transactions more efficiently equates to a 1 percent to 3 percent improvement in return on assets and return on equity.

Wholesale Funding
A financial institution can use short-term Federal Home Loan Bank (FHLB) advances combined with an interest rate swap to lock in the funding for the desired term. By entering into a swap coupled with borrowing short-term from the FHLB, an institution can save a significant amount of interest expense. Here is an example below:

borrowing-chart.PNG

Derivatives
As you can see from a few of the previous examples, derivatives can be useful tools. Getting established to use derivatives takes some time, but once in place, management will have a tool that can quickly be used to take advantage of inefficient market pricing or to change the interest rate risk profile of the institution.

Number of Community Banks Using Derivatives, by Year

derivatives-chart.png

Conclusion
In a low interest-rate environment and with increased volatility in rates across the yield curve, net interest margins are projected to continue to be under pressure. The above suggestions could be crucial to ensuring long-term success. Offering longer-term loans and instilling more efficient loan pricing is the start to improved financial performance.

Who Are the Top Growth Banks?


bank-growth-5-20-16.pngTo every rule there is an exception—or in this case, 10 of them.

Conventional wisdom says that revenue growth at commercial banks and thrifts in the current environment is challenged by continued downward pressure on net interest margins as the competition for loans remains fierce. But there is a group of banks that are thriving in today’s banking market despite the competitive pressures facing the industry. Working with Atlanta-based Bank Intelligence Solutions, a Fiserv subsidiary that collects and analyzes performance data on depository institutions, Bank Director identified 10 banks and thrifts that exhibited strong top line growth over a five quarter period ending March 31. Bank Intelligence Solutions CEO Kevin Tweddle admits that the industry’s growth performance over that period of time has not exactly been stellar. “These aren’t numbers that jump off the page,” says Tweddle. “It’s a really tough environment.” Still, these companies have been able to rise above the environment and post strong performances—which are all the more impressive given the economic headwinds that most banks have to deal with. The ranking includes public and private institutions over $1 billion in assets.

The issue of growth will be addressed at Bank Director’s Growing the Bank conference, which is scheduled for May 23-24 in Dallas. Included on the agenda are sessions on how to grow your business through smart branching decisions, collaboration, partnerships and acquisitions.

The conference attendees could also learn a thing or two from the 10 banks on our ranking, where the order was determined by their compound average growth rate in revenues over the five linked quarters. The top ranked bank—Sioux Falls, South Dakota-based MetaBank—led the pack with a growth rate of 19.3 percent over that period. The $3 billion asset bank is well diversified across multiple business lines, although lending still accounts for a significant part of its growth and profitability. MetaBank operates from 10 branches in Iowa and South Dakota, and reported 22 percent loan growth in its most recent fiscal year, which concluded September 30, 2015.The bank also saw 10 percent loan growth in the first two quarters of its 2016 fiscal year, which ran through March 31. Loan growth was particularly strong in commercial and agricultural sectors, although MetaBank also benefited from its December 2014 acquisition of AFS/IBEX, then the seventh largest U.S. insurance premium finance company. This unit makes loans to commercial businesses to fund their property/casualty insurance premiums, and it grew at an annualized rate of 52 percent between the date of acquisition and Meta’s fiscal year end in September of last year. MetaBank’s is also one of the country’s largest prepaid card issuers in the country, and in fiscal year 2015, that business grew its deposits by 25 percent and fees by 16 percent.

MetaBank also has a significant tax related business following its September 2015 purchase of Refund Advantage, which provides tax refund transfer software to electronic return originators (EROs) and their customers. An ERO is a tax preparer who has been authorized by Internal Revenue Service to submit tax returns to the IRS in an electronic format, and MetaBank earned significant software usage fees during its second quarter which ended March 31. Although the prepaid card and tax related operations are run as separate businesses from the retail bank, they are included in MetaBank’s overall results for reporting purposes.

The third ranked bank on our growth list, San Diego-based BofI Federal Bank, is a digital bank that operates nationwide through online and mobile platforms. The bank’s compound average growth rate through the five-quarter period was 11.93 percent. Of late, BofI has been seeing considerable growth in jumbo single family loans, small balance commercial real estate and commercial and industrial loans. It has also benefited from its August 2015 acquisition of H&R Block Bank, which provided BofI with 257,000 new deposit accounts and the opportunity to cross-sell its products to that bank’s customers.

Growing revenues in the current economic environment is a challenge even for most of the banks on this list, although their performance shows that strong growth can be achieved. One thing that MetaBank and BofI have in common is a degree of specialization—agricultural loans and prepaid debit cards for MetaBank, jumbo mortgage loans for BofI. And if there’s one secret to cracking the revenue growth code, it might be having a niche that differentiates your bank from the rest of the pack.

The Top 10 Banks for Growth
Rank Bank Headquarters Assets (millions) Growth Percentage*
1 MetaBank SD 3,071 19.3
2 Academy Bank, N.A. CO 1,034 18.13
3 BofI Federal Bank CA 7,696 11.93
4 HarborOne Bank MA 2,246 11.49
5 Sterling Bank and Trust FSB CA 1,766 11.21
6 Beverly Bank & Trust, N.A. IL 1,012 10.62
7 WashingtonFirst Bank VA 1,755 9.74
8 First Foundation Bank CA 2685 9.7
9 Franklin Synergy Bank TN 2,298 9.7
10 TD Bank USA N.A. NJ 19,675 8.6

Source: Bank Intelligence Solutions and bank call reports
* CAGR based on revenue for bank for five trailing quarters through March 31, 2016
** MetaBank’s results include significant fee income from card and tax service related activities that are reported as part of its results.

Midyear Update: Current Trends in Bank M&A


Bank mergers and acquisitions (M&A) in the first half of 2015 can be summed up with a single word: consistency. Each of the first seven months of the year has seen the announcement of approximately 25 deals per month with the exception of January, when only 20 deals were announced. The results have been a robust M&A market consistent with the one experienced in 2014.

How well 2015 turns out will depend on consistency in the remaining months. As shown below, 2014 deal volume was influenced substantially by the very strong fourth quarter. That quarter was fairly weak, though, until the last two weeks of December, when numerous unexpected deal announcements resulted in the strongest fourth quarter in years.

Based on the current pace for bank acquisitions, 2015 should end just slightly below 2014’s totals. To quantify that, the chart below shows the rate of consolidation based on the number of bank charters in use at the beginning of a period and then shows the number of announced bank deals for that period divided by the charters. The average rate of consolidation over time has been approximately 3.41 percent.

In 2014 and so far in 2015, the consolidation rate has been above 4.5 percent, which is another indication of how strong the bank M&A market is.

Credit Drives M&A Volume
So where is all of the consolidation coming from, and what are the drivers of the strong M&A volume?

Credit has been a significant driver, and last year saw credit improve enough at target banks to spur an increase in deal volume. The other drivers have been the size of the banks sold and an improvement in pricing.

Over the past five and a half years, deals have been dominated by smaller community banks (those with less than $250 million in assets), as shown below.

The median size of sellers has not fluctuated significantly over this time frame. What has changed are the levels of nonperforming assets and the profitability of the sellers. In 2010-2011 these deals were affected by high levels of nonperforming assets, which drove losses at many of the sellers. Nonperforming asset levels currently are down, and profits are up. As a result, the price/tangible book value realized increased from the lower levels of five-plus years ago and is spurring deal flow.

While deal pricing has improved, it’s interesting to look at the stratification of the number of deals in each band of price/tangible book value. Even with improved pricing, no clear pattern of where pricing is being clustered is emerging. Several bands at both the low and high ends of the pricing spectrum indicate that the deals are varied and include banks that still suffer from credit and earnings issues as well as banks in desirable markets with strong credit quality and strong earnings prospects.

All Regions Show Improvement
As shown below, all regions in the U.S. have fared well during the 18 months ending June 30, 2015. Compared to two years ago, the improvement is marked.

The highest deal volume occurred in the Midwest region, which is consistent with the fact that the Midwest has the most bank charters. However, the median size of the seller is the lowest, and this translated into the lowest price/tangible book value ratios of any region. After the initial impact of plummeting oil prices on deal volume and values, the Southwest rebounded to have the most robust pricing. The other two compelling regions are the Southeast and the West. Both regions were hit hard by declines in land values during the credit crisis and now, having weathered that storm, are experiencing strong activity and rising prices. New England continues to be strong, although the deal volume there is the lowest of any region.

Future for Bank M&A Is Consistent
2015 should shape up to be another strong year in bank M&A. The buyers are smaller in asset size than in the pre-crisis years, but they are active and looking to increase their franchise footprint. Many of the buyers are facing challenges to earnings growth, whether from a lack of organic growth in loans and deposits or because of the Federal Reserve’s prolonged low interest rates negatively affecting bank net interest margins. At the same time, many sellers have expressed concerns over the cost of regulatory burdens on their income statement, and some sellers are finding it difficult to replace retiring board members and upper management, leading them to look for a partner for the future. Whatever the impetus, the data clearly shows that bank M&A should remain consistent for some time into the future.

Report from Audit Conference: Banking Still Faces Headwinds


asset-quality-6-11-15.pngSure, banks have seen asset quality improve. Profitability is higher than it was during the recession. The SNL U.S. Bank and Thrift Index of publicly traded banks has risen 88 percent since the start of 2012. But all is not happy-go-lucky in bank land.

Speakers at Bank Director’s Bank Audit and Risk Committees Conference discussed the slow economic recovery and the headwinds banks are facing as a result. The banking industry’s compound annual loan growth rate during the last few years of 3 percent is down from the average of 7 percent from 1993 to 2007, said Steve Hovde, president and CEO of the Chicago-based investment bank Hovde Group. Net interest margins are 50 basis points lower than they were at the start of the decade. Combined with low interest rates, weak loan demand is hurting growth and profitability. Banks are stretching for loans and pricing competition is difficult. The median return on average assets (ROAA) was .93 percent in the first quarter of 2015, even though half of the banking industry made an ROAA of 1 percent or better pre-recession, Hovde said.

“In this environment, net interest margins are the lowest point they’ve been in 25 years,’’ Hovde said. “Clearly, if we had a more vibrant economy, banks could go back to making more money.”

With the Federal Reserve keeping rates low for the foreseeable future, and all the pricing competition, bubbles could be forming in some sectors, Hovde said. He specifically mentioned multi-family housing and junk bonds as possibilities.

Even stock prices aren’t that great from a historical perspective. The SNL U.S. Bank and Thrift Index has only climbed 4.2 percent since the start of 2000, compared to 40.7 percent for the S&P 500 during that time.

And what about the economic forecast for housing, a significant economic driver and source of revenue for many banks? 

Doug Duncan, the chief economist for Fannie Mae, said the housing market is in no way back to pre-recession levels. Although he expects an increase in mortgage originations in 2015 and 2016, refinancing volume is down. 

Households are still deleveraging in the aftermath from the Great Recession, but that has stabilized somewhat. Consumer spending in this economic recovery has been “incredibly weak,’’ Duncan said. Only recently have consumers in surveys reported an expectation for future income gains. 

Household growth, or the rate at which people are forming new households, has been depressed, as young adults have not been leaving the nest and getting their own apartments or buying homes in large numbers. Large numbers of adult children live at home. Millennials, burdened by college debt and the aftermath of the recession, are forming households at a slower pace than previous generations, and their real incomes are lower than the same generation a decade ago. It’s not that they don’t want to own houses, Duncan said. He said 76 percent of them think owning a house is a good idea financially. It’s just that they can’t afford it. 

But household formation is expected to rebound in 2015 to 2020, as the economy continues to improve and employment grows, he said. 

Is Banking’s Business Model Broken?


5-28-13_Hovde.pngThe 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.