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.