Chief Investment Officer
Commercial Loan Automation
It is time to dust off the crystal ball and predict what next year will bring. My track record is solid but not flawless. Uncertainty is intense, especially since this an election year, but I believe some trends are strongly evident.
- The economy
Mixed news continues to plague our economy. Job reports and economic news are inconsistent and often disappointing. The federal debt continues to grow, and some believe it is of no consequence. I'm not among those folks, since, to my simple mind, such assumption defies the basic tenets of economic enterprise and theory.
The Fed will continue to keep rates painfully low and the yield curve flat, as global prospects for economic growth dim further into the future. While this may be good news for home buyers, it is not for banks, whose margins will shrink further in 2013.
The housing market offers some good news, with pricing stabilizing in many (but not all) markets, and in some cases improving. Also, our troubles pale by comparison to the Eurozone... Their issues also artificially inflate the market for our Treasuries, given the flight to (relative) safety, which makes our borrowing appetite less painful in the short run.
In sum, I expect the economy to move sideways for a while, and have little faith in unemployment figures.
- Real estate
Real estate is so local that nationwide predictions are impossible. Overall, apartments are doing better in major markets such as NYC and Washington, DC.
Nearly 10% more existing homes were sold in 5/12 vs. 5/11, and the trend will continue in 2013. Even builders are reviving some plans for single family homes, and most home price indexes are bending up.
Home value affordability returned to the pre-boom years, but qualifying for a mortgage is far more difficult than during the sub-prime era. It's telling that REITs remain among the most shorted sector in the S&!
- The regulators
I expect 2013 to be an even tougher year on our industry from a regulatory perspective. Examinations are shifting focus in many cases from credit, asset quality and safety and soundness to compliance. This is true for non CFPB banks, and the OCC leads the charge.
In general, banks under $10B will be subjected to many of the requirements as their larger brethren, as is already the case for banks under $50B when it comes to stress-testing like the mega-banks.
Regulatory risk will be the #1 risk for banks of all sizes in 2013. This has greater ramifications than in past years since I believe the acquisition market will open up this year, and being in the regulatory penalty box for a compliance matter will preclude some banks from participating in this opportunity.
I highly recommend taking a conservative posture regarding regulatory requirements, and especially compliance-related issues such as Fair Lending and UDAAP. BSA and other "old favorites" are still non-negotiables, but the spotlight is on "disparate impact", whether intentional or unintentional. Discrimination has been freshly interpreted and now includes items such as spousal guarantees.
Further, while legislation will unfold further in 2013 as Dodd-Frank regulations are written, the risk from the supervision and enforcement sides is as serious. Supervisors are, in effect, writing regulations as they require, for example, stress testing scenarios from smaller banks. Note the recent case of Luther Burbank Savings, a $2B institution, which got severe financial and reputation penalties for compliance-related issues that greatly resemble CFPB requirements. Today's regulators impose more rigorous standards on capital, compliance and other aspects of bank operations, both in substance and in process. Documentation is a "must", almost regardless to whether the process is in place de facto or not.
Another regulatory hot button that will gain more traction in 2013 is director qualifications, review of risk management and involvement in compliance oversight. Banks of all sizes are now required to have independent directors that are financial experts and banking experts, and those are harder to come by.
- Financial performance
The industry's fundamentals are consistently improving despite heavy head-winds. Core ROE has recovered 80% to pre-crisis levels despite a 30% increase in equity ratios. However, margin pressures and concerns about organic growth result in bank stocks lagging the market, a trend that will continue in 2013 until regulatory uncertainty and fundamental performance improvement are achieved.
Part of the performance improvement is due to continued credit stabilization; median net charge-offs for the industry continue to fall. At the same time, loan growth is observable as lending is in the early stages of revival. The new "norm" for average performance will range around 10% ROE and 1% ROA.
In 2Q12 over 75% of the banks in the KBW universe beat estimates, and EPS growth continued for the 11th quarter. I believe the performance trend will continue in 2013, but will be due more to expense reductions and belt tightening than to credit improvement. Financial results will be hampered by margin compression, though (roughly 60% of KBW's banks posted margin contraction 2Q12 year over year and quarter over quarter, and there is no relief in sight).
Interestingly, banks with strong capital, core deposits and profitability got rewarded with premium valuations. The valuation matrix is shifting toward performance from pure balance sheet considerations, a trend that will continue in 2013.
One major concern of community banks is the relatively superior performance of the large banks, which, despite far inferior margins, continue to yield better ROEs and ROAs, inversely related to margin performance and underscoring the importance of revenue diversification.
One more factoid: no new banks were chartered in 2012...
Banks can still obtain capital and long-term debt, but prices and availability vary widely depending upon the balance sheet strength of the issuer and overall asset size. Micro-cap issuers have difficulty accessing capital due to illiquid stock and expectations of sub-par financial performance due to heavy regulatory and compliance costs.
- Loan growth
The pressure for loan growth is intense as investment yields are extremely low. At the same time, loan demand is still sluggish and commercial line utilization well below 50% at most banks. The competition for credit-worthy borrowers is extreme, resulting in price-cutting and covenant and term compromises. Many banks have lengthened their asset maturity to pick up yield, a risky tactic in such a low-rate environment.
Banks, especially large ones, have increased hold limits and reduced participation amounts in the quest for higher yielding assets. Others are considering buying participations to improve loan-to-deposit ratios. The market for Shared National Credits and other participations is heating up and will continue to do so in 2013. SNICs grew 11% in 2Q12 ($2.8T) and show good asset quality currently. I advise extreme caution if you're a novice in this business. Re-underwriting the credit as if it's your own isn't the answer. This is a highly specialized business that requires specific expertise in participation contract and term negotiations as well as in-depth knowledge of various participating agents, down to the individual level. Entering this business without the requisite expertise is bound to cost you meaningful dollars in the long run.
Similarly, banks are looking for specialty businesses, such as factoring and asset-based lending (ABL). Again, those require unique expertise and infrastructure, and very specific policy restrictions to ensure the assets you originate are consistent with your risk appetite (a prime example is the prohibition on buying assets from brokers).
- Credit quality
Credit quality is improving by and large on all fronts, which is also evidenced by the improving market for buying delinquent assets as perception of stability spreads. Laggards in recognizing and dealing with problem portfolios will be penalized in 2013 as they stand out among their improved-quality peers.
A side-effect of this improvement is handling the allowance for loan losses (ALLL ). Now that asset quality is improving, what's the right look-back period for allowance assessment? In 2007 it was typically 16 quarters, and during the crisis it was significantly reduced. Should we return to the longer look-back period in 2013 to over-weight non-performing assets? Some regulators say "yes", others, including the accountants, say no.
Another dynamic is the impact of the pressure for loan growth on future asset quality. Suffice it to say, "Proceed with caution". And remember that, throughout this cycle, construction and land loans suffered the most, while C&I loans fared the best.
Net interest margin is hurting in the current rate environment. The pressure will intensify in 2013, and one should be careful to balance short-term tactics to meet income needs with their long-term implications. There is never a good time to mortgage your future.
- Fee income
The collective impact of the environment as described above will be the quest for more fee income. While this is a worthy goal, getting there by nickeling-and-diming the consumer is no longer a viable option. Creative solutions through account restructuring and improved fee collection across the board, especially on the commercial and wealth management sides, are parts of the solution.
This is an excellent time to bring the entire bank to bear on your customers through effective cross- and team selling. My article about Treasury Management opportunities discussed other fee income possibilities. Wealth Management is another pure fee business, but managing its bottom line impact can be challenging.
- Expense management
In the absence of revenue growth, expense management is the obvious answer. Today's technology, and the steep adoption curve that will steepen even further in 2013, offer excellent opportunities for smart cost reductions, particularly in distribution. Banking is shifting toward becoming a business of communication of information and solutions to customers where, when and how they wish. We should focus more intently on value-added activities and communications, and reduce investment in other, less valuable activities we perform.
The market for banks $250mm-$1B is heating up as regulatory burdens, capital requirements and weak economy take its toll. Participating in this opportunity, whether as an acquirer or as a market force to be reckoned with during the inevitable dislocation that occurs during acquisitions, is an opportunity open to all banks, small and large alike.
Size has not correlated to performance historically. This might not be the case as the requirements for compliance infrastructure intensify. While I don't agree with some investment bankers that $5B is the necessary critical mass, I can see their point with far smaller banks. Sellers' expectations still need to rationalize, but the impetus for a wave of transactions is there.
In sum, 2013 isn't going to be a fun year. There will be much slogging through process review and documentation, working hard for every loan dollar in face of seemingly irrational competitors and continued challenges on the reputation side as banks are reviled in Washington and elsewhere. At the same time, asset quality is improving, the real estate market is showing some signs of life, and strong banks can refocus externally on garnering market share and offering more complete solutions to the customers.