How Consolidation Changed Banking in Five Charts

Over the past 35 years, few secular trends have reshaped the U.S. banking industry more than consolidation. From over 18,000 banks in the mid-1980s, 5,300 remain today.

Consolidation has created some very large U.S. banks, including four that top $1 trillion in assets. The country’s largest bank, JPMorgan Chase & Co., has $2.7 trillion in assets.

Historically, very large banks have been less profitable on performance metrics like return on average assets (ROAA) and return on average tangible common equity (ROTCE) than smaller banks. The standard theory is that banks benefit from economies of scale as they grow until they reach a certain size, at which point diseconomies of scale begin to drag down their performance.

This might be changing, according to interesting data offered Keefe, Bruyette & Woods CEO Thomas Michaud in the opening presentation at Bank Director’s 2020 Acquire or Be Acquired conference. The rising profitability of large publicly traded banks and one of the underlying factors can be seen in five charts from Michaud’s presentation.

Profitability is High

Banking has been highly profitable since the early 1990s — except, of course, for that big dip starting in 2006 when earnings nosedived during the financial crisis. The industry’s profitability reached a post-crisis high in the third quarter of 2018 when its ROAA hit 1.41%. Keep in mind, however, this chart looks at the entire industry and averages all 5,300 banks.

Banking 2016

Sweet Spot of Profitability
Banking is also highly differentiated by asset size: many very small institutions at the bottom of the stack,  four behemoths at the top. Michaud’s “sweet spot” in banking refers to a specific asset category that allows banks to maximize their profitability relative to other size categories. They have enough scale to be efficient but are still manageable enterprises. In 2016, this sweet spot was in the $5 billion to $10 billion asset category, where the banks’ pre-tax, pre-provision income was 2.32% of risk weighted assets.

Banking 2019

Sweet Spot Shifts
It’s a different story three years later. In 2019, the category of banks with $50 billion in assets and above captured the profitability sweet spot, with pre-tax, pre-provision income of 2.43% of risk weighted assets. What’s especially interesting about this shift is that, by my count, there are just 31 U.S. domiciled banks in this size category. (I excluded the U.S. subsidiaries of foreign banks, but included The Goldman Sachs Group and Morgan Stanley.) Of course, these 31 banks control an overwhelming percentage of the industry’s assets and deposits, so they wield disproportionate power to their actual numbers. But what I find most interesting is that as a group, the biggest banks are now the most profitable.

Big Banks

Big Bank Profitability
Even the behemoths have stepped up their game. You can see from the chart that KBW expects five of the six big banks — Bank of America Corp., JPMorgan, Wells Fargo & Co., Morgan Stanley and Goldman Sachs — to post ROTCEs of 12% or better for 2019. And some, like JPMorgan and Bank of America, are expected to perform significantly better. KBW expects this trend to continue through 2021, for the most part. What’s behind this improved performance? Buying back stock is one explanation. For example, between 2017 and 2021, KBW expects Bank of America to have repurchased 27.6% of its outstanding stock at 2017 levels. But there is more to the story than that.

bank share

Taking Market Share
The 20 largest U.S. banks have aggressively grown their national deposit market share – a trend that seems to be accelerating. Beginning during the financial crisis in 2008, the top 20 began gaining market share at a faster rate than the rest of the industry. The differential continues to widen through at least the third quarter of last year. But the financial crisis ended over a decade ago, so a flight to safety can no longer explain this trend. Something else is clearly going on.

Consumers across the board are increasingly doing their banking through digital channels. Digital banking requires a significant investment in technology, and this is where the biggest banks have a clear advantage. Digital has essentially aggregated local deposit markets into a single national deposit market, and the largest banks’ ability to tap this market through technology gives them a significant competitive advantage that is beginning to drive their profitability.

Having too much scale was once a disadvantage in terms of performance — that may no longer be the case. Banking increasingly is becoming a technology-driven business and the ability to fund ambitious innovation programs is quickly becoming table stakes.

Is there a Sweet Spot for Bank Stock Pricing?

stock-valuation-7-8-15.pngWhat drives bank stock valuations? Is it asset size, growth, profitability—or a combination of factors acting in concert? Keefe Bruyette & Woods Managing Director Jeffrey Wishner presented an extensive study recently at the Crowe Horwath Bank Growth & Profitability Conference in San Diego in which he examined how a variety of factors influenced the stock prices of 381 publicly held banks traded on the Nasdaq or NYSE exchanges during the first quarter of 2015.

For starters, size would seem to have a positive impact on valuations—although it is by no means a linear relationship. Wishner divided the universe of public banks into seven asset size categories, beginning with institutions having $500 million in assets or less, and ending with $50 billion in assets and above. Banks in the $5 billion to $10 billion category traded on average 1.8 times their tangible book value (TBV) in the first quarter of this year, which was the highest of any of the asset groupings. Interestingly, banks in the $10 billion to $50 billion and $50 billion and above categories had lower price-to-TBV (P/TBV) ratios—1.69x and 1.56x on average, respectively—an indication that the benefits of size dissipate as banks grow larger.

Wishner also looked at the impact that profitability had on stock prices.  Banks that had a return on average assets (ROAA) of 1 percent or better traded on average 1.59 times TBV in the first quarter. Those that had lower ROAAs had correspondingly lower P/TBV ratios. The same relationship was observed with return on tangible common equity (ROTCE): Banks that had a ROTCE of 10 percent or better traded at 1.6 times TBV while those institutions below that mark all had lower valuations.

As one might expect, banks that had solid loan growth also tended to have higher stock prices. Those that grew loans by at least 10 percent also had P/TBV ratios on average of 1.55x, while those that had lower loan growth also had lower P/TBV ratios. Loan growth became even more powerful when combined with higher efficiency, which only makes sense since more of the economic benefits are falling to the bottom line. Banks whose five-year loan compound annual growth rate (CAGR) was 10 percent or better, and also had an efficiency ratio of 60 percent or lower, traded on average 1.9 times their TBV.

Strong loan growth combined with a high ROAA produced the highest returns of all. Banks that had a five-year loan CAGR of 10 percent or higher, and a ROAA of at least 1 percent, had a median P/TBV ratio of 2.09x.

Wishner’s study uncovered some other interesting findings as well. Commercial real estate has accounted for a significant percentage of commercial loan growth in recent years, but too much of a good thing can depress valuations. Banks that had between 25 percent and 50 percent of their loans in commercial real estate traded at 1.61 times TBV, but banks that had higher concentrations also had significantly lower P/TBV ratios. Capital is another factor where having too much can negatively impact a bank’s stock price. Institutions whose ratio of tangible common equity (TCE) to tangible assets ranged between 6 and 8 percent had a P/TBV of 1.58x. Bump the TCE ratio up to a range of 8 to 10 percent and the P/TBV ratio drops to 1.4x. Increase it to 10 percent or greater and the P/TBV ratio plummets to 1.2x. Why? The higher the TCE ratio, the less leverage the bank has—which in turn drives down return on equity.

Although the banking industry tends to be obsessed with growth, it’s not what investors value the most. “The market values efficiency and profitability a little more than growth,” says Wishner.

It would be possible from Wishner’s study to construct the ideal bank from a valuation perspective. That would be a bank with assets of $5 billion to $10 billion, with strong loan growth, high efficiency, enough commercial real estate exposure to help drive profitability but not so much that it distorts the bank’s risk profile, and a TCE ratio of between 6 percent and 8 percent. Any bank that has these characteristics occupies a sweet spot in the bank stock market and should enjoy a higher valuation than many of its peers.