Asset Based Lending
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, although in general, things are looking up. Job reports and economic news are inconsistent and often dramatically revised, but the trend is positive. 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 stock market has reached new heights and manh exoect the trend to continue.
The Fed, recognizing this improvement and weary of inflation, will start tapering off its liquidity programs. I expect the shift to be extremely gradual with a steepening impact on the yield curve. The dollar continues to strengthen as global prospects for economic growth dim further into the future. This may not last, but we should enjoy it while it's here.
The housing market offers some good news as well, with pricing stabilizing in many (but not all) markets, and in many cases showing double digit growth. 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.
A Greenwich Associates survey of small business owners and midsized companies shows that the vast majority of both are expecting to make some capital investments this coming year, and are looking to borrow to fund these investments. This, in turn, bodes well not only for banks but for the economy as a whole, as it indicates confidence in future prospects that didn't exist for quite some time.
In sum, I expect the economy to move slowly upward in 2014 for a while, and have little faith in unemployment figures.
Real estate - Real estate is so local that nationwide predictions are impossible. Overall, things are looking up across the country in most sectors, including sales of existing homes and apartment building
Sales are picking up, and new construction is sprouting in many markets, including some that have been depressed since 2008. Has anyone noticed the myriad of cranes dotting the Miami skyline these days?
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&P!
The regulators - I expect 2014 to be an even tougher year on our industry from a regulatory perspective. Examinations are shifting focus in many cases from credit and asset quality, safety, and soundness to compliance, operational risk (which also includes many compliance elements), and information security.
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, enterprise risk management, and BSA programs like the mega-banks.
The implications of this risk are profound. First, as the M&A market heats up, banks which have compliance issues, particularly BSA and Fair Lending, will be forced to sit it out as their competitors snag coveted banks in their market. Second, the compliance risk embedded in acquisitions themselves is rising, such that, if a bank acquires another bank which carries with it a compliance issue, it will become a problem for the acquiring bank at some point in the future. This changes the due diligence process by adding an important and difficult dimension to the mix.
Regulators have also made it clear that they will take more enforcement actions in 2014.
I highly recommend taking a conservative and proactive posture regarding regulatory requirements, including compliance-related issues such as Fair Lending and UDAAP. BSA, Enterprise Risk Management and other "old favorites" are still non-negotiables, and the bar for compliance continues to be raised. It's a moving target.
Further, while legislation will unfold in 2014 as Dodd-Frank regulations are written, and with the advent of the final Volcker Rule, the risk from the supervision and enforcement sides is as serious as the risk from legislation. Supervisors are, in effect, writing regulations as they require, things like stress testing scenarios from smaller banks. Documentation continues to be 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 2014 is board management, including director qualifications. Expectations from the board continue to rise, including board involvement in risk management and 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. 2013 proved to be a solid year for the industry, and profitability has improved meaningfully, as reflected by rising stock prices. However, margin pressures and concerns about organic growth cast a pall over 2014 and 2015 expectations, a trend that will continue until regulatory pressures 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 continues to improve, despite pricing and structure pressures. The new "norm" for average performance will range around 10% ROE and 1% ROA.
During 2013 we have seen a shift in market attention from tangible book value to organic income growth and EPS. This trend will intensify further in 2014 and beyond, and will impact bank valuations meaningfully.
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. This trend has moderated in 2013, as midsize banks were handsomely rewarded for revenue growth and revenue diversification. I expect the trend to continue in 2014.
Capital - 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. Loan demand is picking up and commercial line utilization is improving 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. Some are entering new (or old) lines such as indirect auto lending, Asset Based Lending, credit cards, and other specialty businesses to improve their loan growth numbers and reduce investment portfolios.
Banks, especially large ones, have increased hold limits and reduced participation amounts in the quest for higher yielding assets. Others are now buying participations to improve loan-to-deposit ratios, including small banks that can't generate sufficient loans themselves. The market for Shared National Credits and other participations will continue to grow in 2014. SNICs performed well during the recession and offer great origination cost efficiencies; however, 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.
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 2014 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. Bankers are taking today's record-low loss levels into consideration as they assess ALLL in 2014 and beyond, with expectations for higher losses as newly originated loans mature.
Margin - Net interest margin is hurting in the current rate environment. The pressure might ease in 2014 as the Fed moderates its bond-buying program, 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 part of the solution.
This is an excellent time to bring the entire bank to bear on your customers through effective cross- and team selling , especially on the business and commercial sides.
Expense management - With pressures on revenue growth, expense management is the obvious answer. Today's technology, and the steep adoption curve that will steepen even further in 2014 and beyond, 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.
Banks will become more creative and courageous in trimming and adjusting their branch networks. No one wants to be on the bleeding edge, but we will see many more innovative branch models in 2014, with extensive self-service options and modular approaches that allow the self-service segment to be available 24x7.
Acquisitions - The market for banks $250mm-$1B opened up in 2013 as regulatory burdens, capital requirements, and a weak economy took their toll. I expect the trend to continue in 2014. Even midsize banks such as First Horizon found value in acquiring banks under $1B in assets with immediate EPS accretion and excellent market-fill opportunities. Participating in the M&A market, 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.
This trend has already started in 2014 with several deals, most notably Old National's purchase of a small Michigan franchise.
Another development which I expect to continue started with the ground-breaking deals of First Market and Union Bank in Virginia, Provident and Sterling in New York, First Federal and SCBT in South Carolina and other MOEs. These transactions are creating institutions with franchise value where the whole is truly greater than the sum of the parts. I hope and anticipate more deals like this in 2014 and beyond, where CEOs leave their egos behind and do what's right for shareholders.
In sum, 2014 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 signs of life, and strong banks can refocus externally on garnering market share and offering more complete solutions to the customers.