Asset Based Lending
Chief Investment Officer
Commercial Loan Automation
Twice a year (at minimum) I put my foot in my mouth by making predictions for the coming 6 or 12 months. It is time to do so again. Below are my thoughts for the upcoming year. Thanks in advance for letting me know if you think I'm on the mark!
I believe one significant trend in 2007, which started in 2006, is the secular change in deposit pricing and mix. Our industry has moved from true core deposits to a mix of core and "faux" core (a.k.a. high-yield money market accounts) deposits, which has started as a trend but is here to stay throughout 2007. The implications to the already-hurting margin are significant, as cost-of-funds has experienced a permanent (at least through 2007), not a temporary, rise. Some banks are bucking the trend and refuse to join in the fray. Others are intentionally lowering deposit rates as they can't sustain further margin reductions. I wonder if you share this perspective, and would appreciate your insights.
Wishing you and yours a healthy, joyful, prosperous and delicious Thanksgiving ,
2006 was a year of stability. Our industry did not experience major changes or upheaval. Instead, the flat-to-inverted yield curve continued to take its toll on most banks, credit quality remained best-ever, and retail fee income continued to slowly ebb.
I believe that 2007 will bring us more precipitous changes with deeper implications, both positive and negative, to banks' balance sheets and income statements. Below are the key trends I see after dusting that crystal ball yet again.
Margin management: mixed signals confuse the issue ; plus are we all liability-sensitive yet?
The interminably long inverted yield curve continues to wreak havoc in many banks' net interest margin. Will we experience relief in 2007? I, an eternal optimist, say we will, probably by the end of the second quarter. Despite the Fed's intense efforts, the market has not bought the inflation story, and the yield curve reflects that expectation through its flat to slightly inverted shape. Continued mixed signals make future predictions more difficult than ever, and some are predicting further rate hikes yet in 2006. I dare to expect rates to decline in 2007, and expect rates to start inching their way down, as the economy fully absorbs the impact of 17 rate hikes and slows down beyond initial expectations. The yield curve inversion hasn't corrected but, instead, aggravated (the negative spread between fed funds and the 10 year Treasury has expanded from 10 b.p. to 62 b.p, in the third quarter). This abnormal yield curve has persisted for a historically long record, since the fed funds spread peak in June 2004. In many banks, management has given up forecasting net interest margins, as the impact from competition and the inverted yield curve has become difficult to gauge. Some are abandoning NIM guidance altogether.
In addition to the yield curve woes, deposit gathering continues to be expensive and sluggish, exerting additional pressure on the margin, and loan pricing isn't showing much improvement either.
The implications are many, and vary widely depending on every bank's balance sheet. I expect that most banks will profess to be liability-sensitive as rate start their decline (whenever that might be) , much like they did when rates were climbing and they called for asset-sensitive balance sheets. I applaud in advance those who own up to asset sensitivity as rates start declining, and who are doing something about it as well. Many SuperCommunity Banks are considering the use of derivatives, and some have done so successfully. Their strategy is founded on profit-taking, using derivatives to lock in current profits and insulate the income statement from adverse rate movements. This is a viable and wise strategy, but it does require expertise and more clarity on future rate direction than we have today. Be careful of your friendly investment banker; many are worth their weight in gold, but others are quite dangerous to future earnings.
Last, I expect continued margin pressure due to deposit trends. Deposit pricing is tighter than ever and secular trends might prevent it from rationalizing. Migration trends from low to higher-cost deposits (thanks largely to our own efforts) are the major culprit here, as rate chasing continues nation-wide. In the third quarter, demand deposits have declined by 63 basis points among the top 100 banks on average, a full 30 b.p. more than in the second quarter. Rate sensitivity increases as we awaken rate sleepers and they join the rate chasing game. While SuperCommunity Banks are less susceptible to this trend, they are not immune from it. Even smaller banks such as Western Alliance and Texas Capital, as examples, experienced meaningful drops (over 2%) in their DDAs as a percent of total deposits. This trend will continue to exert pressure on margins even as the yield curve normalizes.
Industry-wide, 44% of the banks in one major investment bank's coverage universe have missed 3Q 2006 earnings. This is a significant number which goes way beyond recent experiences, and might be a harbinger of a tough 2007 to come.
The year of the deposit (continued)
The hunt for deposits continues from 2006, as deposit growth remains sluggish. System-wide deposits have been growing at a reasonable rate (6-8%), and, in high growth markets, many experience double digit deposit growth. The issue is, banks are not capturing their fair share of the market deposit growth, and are currently absorbing only 20%+ of the funding in the market, down from 40%+ in the '60s.
Deposits are growing at 8% annually, but banks are failing to attract them. In their quest for deposit growth, banks have been teaching customers to shift funds from low cost to high cost accounts. The excuse that "if we dont do it, THEY will" is indeed an excuse, since banks that have not compromised their core deposit gathering strategy have not suffered, by and large, relative to their "hot money" brethren. Instead of fighting the good (but difficult) fight, we have created a "faux" core deposit product: the Platinum (a.k.a. Titanium, a.k.a. Plutonium etc.) account. This account marries the worst of both worlds: it has the indefinite maturity of the checking account, with the high rates of the CD. In short, we are taking fixed maturity money and converting it to an in-determinant maturity money while raising our cost of funds and, in a way, transferring wealth from the shareholders to the customers. These "pretend" core accounts are indeed collecting money, much of which is internal cannibalization on lower-cost deposits, but are perceived to be a necessary evil in the world of intense competition for deposits.
Further, traditional bank-owned internet banks are sprouting all over the map in an attempt to capture what ING Direct has left behind. These banks contribute to the trend of raising deposit rates and customer expectations, which, in turn, put even greater pressure on the already-embattled margin.
The solution to the funding issue lies in several factors including
"out-of-the-box" thinking; more effective sales process execution on the retail side; form deposit gathering expectations on the commercial side;
better small business segment execution;
innovative segmentation (have you considered funeral parlors, non-profits, etc.);
more effective "happy meals" (product packages and relationship-based pricing);
a simplified deposit product offering; and
improved use of technology (such as remote deposit capture).
More can be said on each of the bullets above, but the overall message is clear: the competition for deposits will remain fierce throughout 2007.
Credit will get worse
The last few years have given banks an unexpected bonanza in the form of outstanding credit performance, with low double digit or even single digit losses. The cycle will turn in 2007, and credit performance will worsen, as liberalized terms, covenants and razor-thin pricing will come home to roost. Smart banks will incorporate the price of this anticipated credit deterioration in their 2007 budgets, at least in the second half of the year. There are no signs of deterioration at this point, but it is likely to come within the year.
Loan growth continues to be robust across the board, with C&I lending back on the map. At the same time, CRE growth has outstripped C&I lending throughout 2006, and will not take a second seat to C&I lending possibly throughout 2007. The cooling real estate market might facilitate improved C&I performance, as well as intensified regulatory concerns regarding CRE portfolios and the careful application of policies and procedures to their originations.
Shared National Credits are also on the rise, and their credit quality is improving. However, continued easing of underwriting standards in syndicated lending in general, particularly in the non-investment grade sector, is causing the regulators some concern and will impact NPLs in the second half of 2007.
Incenting lenders on C&I lending and deposit generation can mitigate future credit and funding concerns and can be quite productive, especially when coupled with effective sales management. I find that most banks do not differentiate in their incentive plans between CRE loan dollars and C&I loan dollars; between CD deposits and DDA deposits; or between transaction sales (one-off deals) vs. relationship loans (loans, deposits, cash management etc. to one customer). So long as incentives are not aligned with banks' strategic intent, execution will suffer.
The acquisition business - back in business?
The acquisition market is heating up at all levels, and sellers' expectations continue to be unreasonable yet fully rewarded by the marketplace. Record prices are being paid for banks of all sizes, especially in high-growth markets, and even more so for deposit-rich franchises. Deposit premiums have recently broken 30% and will continue to do so in 2007. We have too many assets chasing too few liabilities on banks' balance sheets, and too many buyers willing to pay the price.
2007 will be a big year for acquisitions, as large bank P/Es will get them back in the hunt, and SuperCommunity Bank P/Es relative to the S&P at an all time high. Competition will intensify as de novos are falling out of favor for many, which supports record-high prices in 2007 for coveted deposit-rich or high growth market properties.
What's on the regulators' mind?
BSA continues to be the never ending story, with unprecedented regulatory scrutiny and a huge bonanza for accounting firms and consultants who make a living scrubbing your files to ensure BSA/AML compliance.
Commercial real estate and credit scrutiny are the new "hot buttons" for 2007, but BSA will continue to rule as the greatest regulatory concerns for the year. Business continuity and margin management through ALM are distance seconds on the list.
There is not much to be said on this topic, except that accepting the harshness of some regulatory examinations is, generally, the only way to go. It might not be pleasant, but arguing with the regulators is a no-win path.
News on the payments front
Debit cards are THE product for 2007. Debit card transaction volume is exploding and will continue to grow exponentially in 2007 and beyond, as transaction size continues to shrink. Just go to Starbucks and try paying in cash; you'll see what I mean. The average debit card yields almost $40 of fee income per year, and is the next major fee income generator in retail banking, especially since there is only so much tinkering that can be done with the overdraft privilege matrixes
Another huge development which will come fully to bear in 2007 is Remote Deposit Capture (RDC). The demand for the product is so high that manufacturers of the RDC tool (often a computer) are running behind on orders, as many of the mega-banks are gobbling up the equipment. The growth trajectory for this service is very steep, and the "stickiness" ramifications profound, as are the implications to future branch staffing. I believe that the impact of RDC and the debit card revolution (to be closely followed by the "wave-and-go" payment technology) will be the new fee income vehicles for the business, and will quickly take root among both commercial and retail customers. Those who capture the position in the customer's mind early will win relationships and balances, as well as longer-term fee income.
Credit cards are also making a comeback, especially in the small business sector, as banks are returning to their roots in marketing the product. Banks have long considered credit cards to be a transaction product, which is true for the consumer segment, but not so for the small business customer. Credit card opportunities might be less attractive than the two products described above, but they should not be neglected, especially for small businesses, as they lead to additional sales and deeper relationships with such customers, and to fee income all around for the bank.
Industry trends and the "Street"
Overall, the industry continues to be profitable with double digit revenue and balance sheet growth. In the third quarter, EPS expanded 9.4% (!), a high number for an industry under stress. Many banks are beating street estimates, but also more banks than ever are experiencing profitability hiccups as margin surprises abound. The picture will turn uglier in 2007 with more expected and unexpected margin contraction and credit woes in some banks, further separating strong and weak performers in our industry.
Mid- and small-cap stocks are at an all time high based on relative P/Es vs. the S&P 500; this means that issues such as anticipated credit deterioration and "risk layering" in mortgage products have not impacted bank stock prices, which continue to match or beat the market.
High organic-growth bank stocks are doing the best, regardless to their P/E levels. One might conclude that investors are finally differentiating among banks based upon business models, balance sheet and execution...
In sum, 2007 will be a challenging year for the industry as a whole, but it will see many winners as well. "Business as usual" won't suffice in 2007 for many banks, and quick adoption of new technologies (e.g. RDC), new approaches to marketing and sales (especially deposits and C&I lending) and clever acquisition targeting could separate the winners from the losers this coming year.