Bottom-Up Capital Calculations

Ten years ago I wrote What's Your Well-Capitalized on these pages. It was in response to regulators persistently asking bankers the same question. Today, we have not done much about it because we have relied on that lazy space using the regulatory definition of well capitalized. Or at least regulatory expectation of it.

I recently spoke at the American Bankers' Association Conference for Community Bankers regarding risk appetite statements in a presentation called Leave Nothing Unspoken. Drop me your e-mail if you would like me to send the presentation. One slide, however, dealt with this very issue of "what's your well-capitalized." Because developing your risk guardrails for executing strategy, which is what a risk appetite statement should be, is far less effective if you don't build the culture and accountabilities throughout the organization to be consistent with your risk appetite.

Exhibit number 1 is a bank whose main incentive for lenders is volume. This creates the incentive to do deals based on size, regardless of structure, duration or rate. What does it matter if the lender does a thinly priced $4 million, 7-year commercial real estate deal with a 25-year amortization and lite covenants or a fairly priced, 5-year deal with standard covenants? If their goal is $20 million of annual production, they are 20% there regardless. Right? 

In comes risk adjusted return on capital, or RAROC. Most loan pricing tools use an ROE hurdle rate to determine what the rate should be. Aside from proper use of these tools and any manipulating that might go on to get deals done, the goal is a good one. Assign capital to a pending loan deal based on risk to the institution. Like the slide I showed to attendees at the ABA conference.

These capital allocation tables should be done in advance, be simple and understandable, and be transparent to all that use them. I imagine a small risk committee that develops these lookup tables and assigns capital to every balance sheet item. And for many categories, such as loans and investment securities, which carry the most risk to a financial institution, have necessary granularity so a 5-rated, 5-year and 20-year amortizing commercial real estate loan gets a lower capital allocation than a 6-rated, 7-year deal. Now the lender has to seek a better yield to get the same RAROC. And perhaps the ROE for the riskier deal is also higher. Further aligning risk versus reward.

Other major asset categories such as "Cash & Due", "buildings", and "BOLI" can be assigned capital at the balance sheet level, such as "buildings" receive a capital buffer of 1%. Naysayers might argue that a building is a 100% risk-weighted, and therefore needs to carry 10% capital (5% well capitalized under the Leverage Ratio, plus a 5% buffer). But that assumes, as prompt corrective action capital requirements must assume, that liabilities do not have risk.

Ask former Silicon Valley Bank executives if that is true.

For sure there is no 5% Leverage Ratio requirement for liabilities, but buffers should also be assigned to them based on the bank's perceived risk of those liabilities. Deposits and borrowings (i.e. the bank's funding) should create greater granularity based on product and product characteristics and the attendant risk of the instrument, much like loans and investments. 

Some may say that the above model is overly simplistic. I'm a simple man. And there is beauty in simplicity. No matter how complex a model you make, it will be some form of wrong as it stands the test of time. Being simply off is far better than building a highly complex black box to be as off, or even a little less off, than a simple one. Because users of the information will be less motivated to adhere to it if they don't understand how it was made.

This, in my opinion, should be done to identify what is your well capitalized. Because you have evaluated risk by balance sheet category and assigned capital based on risk. You can then determine if you have enough capital to support your current balance sheet and your strategically projected balance sheet. You know what buffer you have to withstand stress events.

If your strategic plan calls for a 15% ROE, now you can create a threshold by loan type for lenders to pursue and fairly price to be consistent with your strategy goal and risk appetite. Plus you would create the cultural discipline to manage risk from your first line of defense, the front line.

As I told attendees to my presentation, all banks should do this.

Do you?

~ Jeff

Online Account Opening

Online account opening remains the wild west for most community banks. In so many strategy sessions, I hear from bankers that it is a bust. They get more fraudsters than customers.

This was the background as I attended Bank Director's Acquire or Be Acquired (AOBA) conference. And naturally I was keenly interested in how to solve this problem, or even diagnose what exactly is the problem, for community banks and online deposit account opening, either retail or business. 

Narmi, a key player in this space, had a presentation titled Leveraging Digital to Drive Core Deposits, and had two partner banks, Berkshire Bank and Community Savings on the stage with them. Berkshire Bank, a $12.3 billion in asset bank based in Pittsfield, Massachusetts, launched Berkshire One for online customers. 

It boasts of account opening in less than two minutes. Otherwise, it has features such as a one-time payment of $200 to open a checking account, and an intriguing APY for opening a money market account. The small print disclosures look pretty much like all such disclosures. Oh, and the Boston Celtics Derrick White is a brand ambassador. We measure product profitability for our clients and the average annualized operating cost per retail interest-bearing checking account was $448 in the third quarter 2024. I suppose it would be more for Berkshire having hired Derrick White.

More impressive than Berkshire's two-minute opening claim was Community Savings of Caldwell, Ohio. As a Notre Dame fan it pains me to type Ohio. And I just did it twice. Community Savings impressed me more for their size and therefore resources to execute on online account opening than the much larger Berkshire. The bank, although established in 1885, was only $270 million in total assets at year-end 2024. And their growth did not come linearly. They were only $68 million in 2021. 

According to the AOBA presentation, Community Savings, once they turned on online account opening using the Narmi solution, acquired $2.5 million in new core deposits in the first month, and $22 million in the first 120 days. Average deposit size per account, according to the presentation, was $57,000. Deposits, which stood at $53 million in 2021 now stand at $198 million. Cost of funds did rise from 78 basis points in 2023 to 3.13% in 2024. So it did come at a cost. Community Savings had a >100% loan-to-deposit ratio. Banks that needed the money tended to pay more for the money. Makes sense.

Online deposit account opening is more prominent today than it was yesterday and will be even more so tomorrow as today. First Internet Bank in Indiana was opened in 1998. It now has $5.7 billion in total assets. Grasshopper Bank, a Narmi customer, opens hundreds of business checking accounts per month online. You read that right. Hundreds. Per month. Business accounts. Grasshopper has 96 full-time equivalent (FTE) employees. Community Savings launched its online account opening tool in 49 days. They have 59 FTEs. 

According to Susan Bui Bergen, CEO of Infinite Potentiality and 30+ year bank marketer for banks $1 billion - $30 billion in total assets, "The shift to online account opening represents a significant opportunity for community banks to enhance their reach and operational effectiveness."

Totally agree. Because many banks are struggling today with their funding. Funding strategies should be perpetual and strategic. If your bank is flush with liquidity you should encourage your relationship officers and marketing personnel to keep it rolling. Turning the spigot on and off is an ineffective funding strategy, in my opinion, except for wholesale approaches to fill gaps. When is a good time to deepen depositor relationships and grow core deposits? Always.

I don't believe branching is dead. Neither does Jamie Dimon, so I'm in good company. But I do believe that each location, be it physical or virtual, should deliver profit to the bank. And banks have struggled with their virtual branch. 

According to Mantl, a Narmi competitor, low-performing banks in online account opening experience a 30% submission rate, meaning if 100 people start an online checking application only 30 complete it. And then experience a 30% approval rate of the 30 that completed the application. Meaning, out of 100 people who started an online deposit account application, only 10 get opened and funded. 

High-performing banks in online account opening had a 55% submission rate and a 65% approval rate. Meaning out of our hypothetical 100 people, 36 get opened and funded. I'm not sure "initial funding" is a good stat because it would make sense that new customers would seed a new account with maybe $100 until they moved everything over. Online account balances are notoriously lower than in-branch opened accounts, but becoming less so. 

According to Bergen, "To succeed, it's vital to meet customer expectations by making the process straightforward, intuitive, and secure. By focusing on user-friendly interfaces and strong fraud prevention, banks can achieve continuous improvement and truly benefit from digital advancements. Those who excel will set themselves apart and flourish in the competitive landscape."

The challenge remains core deposit growth at a reasonable cost. Many banks, like Berkshire and Community Savings, tend to offer higher online rates to encourage people to move. The branch or a relationship with a banker likely does not exist, although I wouldn't discount that customers who are in towns where you have branches will open accounts online. So a branch could play a factor although the prospect does not have to enter it.

Here is the profit performance of retail interest-checking for all banks that we measure this for on an outsourced basis.

Let's say that an online account experiences half the average balance of a traditional account. In this case, $7,255. Total income is 4.14% in the 3Q24. So revenue for our hypothetical online account is ($7,255 x 4.14%) just over $300. Not enough to cover the annualized cost per account (for acquisition and maintenance) of $448. Adding to the challenge is that the traditional account represented above is only paying 35 bps interest expense. So if you must juice that number to incentivize that person sitting at home to open an account, the total income of 4.14% will go down. 

Online account opening solutions providers would likely argue that acquisition and maintenance costs are lower for the online account opener. Perhaps true. Then, as your online branch grows and becomes a greater proportion of all accounts opened, that annualized cost per account should also go down. Banks should build this discipline into their accountabilities.

Flipping on the online account opening switch does not end the project. It has only just begun! There must be marketing, internal education, and continuous improvement to make sure you are not blocking legitimate prospects out by having overly conservative triggers in your account opening solution. This happens when a bank's risk appetite for fraud is zero. They tighten the screws so tight that their local minister can't get an account. And the bank becomes low performing as described above based on Mantl's numbers.

Online account opening is here to stay. The tools have evolved to surpass ease of use of our in-branch account opening tools. In fact, I don't know why Fiserv users still use BPM to open accounts. Use the online account opening tool. According to Berkshire Bank, it takes two minutes!

But as you make progress in your online account opening journey, measure the profitability of those products and that virtual branch. Just like you should do with your physical branch. How else would you know if it is successful?

~ Jeff

Bonds Gone Bad

Bank earnings remained below par for 2024 due to continued net interest margin pressures. As a result, many financial institutions amplified their misery by turning unrealized losses in their relatively low-yielding bond portfolios into actual losses by selling their underperforming bonds.

In my book, Squared Away-How Bankers Can Succeed as Economic First Responders, I referred to the phenomenon of further impairing already impaired earnings by making strategic investments in your bank as "pulling into the pits." The difference between what I recommended in the book versus what has transpired is that I was referring to strategic investments in technology, products, lines of business and people to build a financial institution that is relevant, even important to its constituencies. If macroeconomic factors, such as the interest rate environment, led to a suboptimal ROA, why not make it an even less optimal ROA by investing in the bank's future?

Overcoming bad balance sheet decisions in a zero-rate environment was not exactly what I had in mind unless, and I hope my conjecture is correct, some of the increased interest income generated by higher-yielding bonds leads to strategic investments needed to build an enduring financial institution. I suspect, however, it's just to have better earnings in 2025. Not better capital, mind you, but the promise of better earnings. 

Some may take exception to me calling bond-buying decisions made during the pandemic era as bad. And I will admit, I do not sell bonds nor consider myself a bond expert. I leave that to your fixed-income advisors. With a particular shout-out to those who did not advise clients to "go long" in a zero-rate environment or at least hedge if they went long. Special mention to those who admitted to making a bad call if they advised clients to go long.

In hindsight, buying long-term bonds in a historically low interest rate environment doesn't sound like a great strategy though what were the alternatives given such excessive liquidity? One alternative would have been to stay on the shorter end of the curve as short-term yields moved in tandem with rising rates. But according to the below tables and charts, it looks like we didn't do that. The below charts, courtesy of S&P Capital IQ are from all banks between $1B-$10B in total assets where the information is available. I went through the list and eliminated some specialty banks like Charles Schwab Bank, etc. It yielded 600 banks and savings banks. In the table, one column is when rates were zero (pandemic era), and the second column is when the Fed tightened.

During the period when rates plummeted to zero as a result of the pandemic, and liquidity rushed into financial institutions as a result of government stimulus and a flight to safety and liquidity for consumers and businesses, bank securities portfolios grew 83%.

What did they do with the money? Bought long-term bonds, as each maturity/repricing bucket grew more in the over one year and beyond bucket than the 0-12 months buckets. The greatest growth was in the 3-5 year bucket. Over five years grew 192%. This bond buying might result from "present bias", which Gemini AI defined as the tendency to overvalue present rewards without considering future consequences. Such as, I don't know, selling a lot of those bonds at a loss that will take three years to earn back and, in many cases, raising capital causing shareholder dilution. It requires an assumption that current conditions, good or bad, will continue indefinitely.  Present bias is the only rationale I could conjure for Silicon Valley Bank's unhedged bond portfolio. 

In the rate runup from 2Q22 to 3Q23, securities portfolios declined 7.8%. One reason is we thought customers would stick with us through thick and thin. Maybe through thin, but not through thick. FDIC-insured financial institutions hemorrhaged $1 trillion in deposits while money market mutual fund assets grew by the same amount. Now we needed the securities portfolio for liquidity. This time also included the high-profile failures of three banks. One had the signatory of the Dodd-Frank Act on its board. 

That fact is irrelevant to this article but I like to bring it up whenever the opportunity presents itself.

Although the overall securities portfolio declined, bonds with maturities or reprices in less than three years grew. Long-term bonds declined to help us meet liquidity needs. We ran off long-term bonds and bought short-term ones. This makes sense to me because the interest rate environment was so unpredictable. We had an inverted yield curve during this time. It would have been nice, however, if we bought long-term bonds at peak interest rates, not trough. But this is Monday morning quarterbacking.  

My point is that if we are elevating rates over liquidity in our bond portfolio, remember Covid! If we thought we had loyal customers that don't demand competitive deposit rates, remember post-Covid Fed tightening!

In terms of making hypothetical losses into actual losses and prioritizing rate over liquidity in our bond portfolios, this chart visualizes consequences.

In a couple of weeks I will be heading off to Bank Director's Acquire or Be Acquired conference. There will be plenty of presenters with snappy looking charts describing how loss-sales make sense. And in some cases these transactions may make sense. I had a BOLI person extoll the virtues of taking an exit fee hit to trade for higher paying BOLI. I got off the call thinking "let's sell off some BOLI!" Note: I don't have BOLI. Sometimes critical thinking skills take a back seat to the compulsion to act, thinking if everyone else is doing it perhaps we should too.

If we are selling off assets at a loss, we must perform a post-mortem to create long-term institutional knowledge as to what happened to lead to it and how can we learn from it to apply to future situations. Let's not waste an "ahh crap" moment. Let's make us smarter, and our bank better.

~ Jeff

Financial Metrics of Credit Unions vs. Banks

I often hear that credit unions (or mutual banks) don't have to maximize profits because they don't have shareholders.

This is technically correct. Shareholders demand a return in the form of capital appreciation on the stock and the dividends paid per share, also known as total shareholder return (TSR). Credit Unions, however, do have owners that they call members. Members may pay little attention to the increase or decrease in the value of what they own because they are comfortable under the umbrella of NCUA insurance (much like depositors with FDIC insurance). This comfort might not make them salivate in anticipation of their CUs next quarterly Call Report. Members rarely hold CU executives accountable for financial performance.

But financial performance has meaning. Credit Unions primary source of capital is retained earnings. And if they have sub-optimal profits because of a lack of expense or pricing discipline, there is less retained earnings and therefore less capital to support growth or serve as a buffer for hard times. 

In addition, if CUs are inefficient and squander resources deep in the bowels of their infrastructure, there is less for members/depositors, employees, or their communities, i.e., their stakeholders. In this sense, TSR has a different meaning: total stakeholder returns. For example, some credit unions pay special dividends to depositors if they have good earnings and sufficient capital.

This month Robins Financial Credit Union, a $4.6 billion in asset CU in Georgia, paid a $20 million member rebate, representing about $74 per member and 45 basis points of its ROA. The reason they did it: their YTD ROA was 1.31% and their net worth/assets was 16.12%. Combine that with a clean balance sheet (0.41% delinquent loans/total loans) and there were ample resources to return that solid performance to their members. It's their money, right?

But the CUs that don't deliver that performance or have that capital position and strong balance sheet, management teams and trustees are reticent to return that money to members. Or other stakeholders for that matter.

Below is a series of charts that compares and contrasts the financial performance of banks + thrifts and credit unions with between $1 billion and $10 billion in total assets. Banks were controlled for those with less than 20% of their loan portfolio in commercial real estate loans to mitigate the differences in bank vs credit union balance sheets. This yielded only 118 banks because of the commercial loan restriction, versus 319 credit unions. I used medians so a few outsized banks or CUs didn't skew an average. The median-sized bank was $2.1 billion in total assets and the median CU was $2.2 billion. 

Here are the results (courtesy of S&P Capital IQ):

 

Banks had a 41 basis points year-to-date advantage (1.00% vs .59%) in ROAA although banks pay federal taxes. Apply that to the median CU size of our sample ($2.2B in total assets) and that equates to $9 million. Perhaps that disadvantage is precisely because the measured CUs pay a special dividend to members, although banks' cost of interest-bearing liabilities was 1.21% more than CUs. Perhaps the salary and benefits per FTE is greater at CUs than banks, or their community support costs more. This we can't tell from the above charts. 

CUs will have to reflect on if that is true. 

Is it true that the 82 basis points disadvantage to banks in year-to-date non-interest expense to average assets, which equates to $18 million, is because CUs pay their people more, or provide that much more in community support?

Whether you have shareholders or not, running your business for the benefit of stakeholders should be your guiding star. You are doing stakeholders no favors by running it sub-optimally and wasting resources on inefficiencies deep in the bowels of your organization. Wouldn't it be great to have a full end-of-year bonus pool where you reward your most productive and loyal employees, have the pricing discipline to deliver a special dividend to your most loyal core depositors, or be able to meet some social needs in your community?

Profit performance matters, no matter which stakeholder(s) you favor.

Happy New Year to my readers!

~ Jeff

Note: My firm does two things to help create the culture for more optimal profit performance for financial institutions: 1) Profitability Measurement-we measure the profitability of lines of business and products on an outsourced basis so management teams can measure and maintain accountabilities for profit trends at much more granular levels than their Call Report; and 2) Process Improvement- we dispatch a team to analyze processes, resource and technology utilization and make recommendations for greater efficiencies. This is sometimes tough to do internally due to resource constraints and experiences outside of the organization. Follow the links to learn more or reach out to me. 

Guest Post: Financial Markets and Economic Update-Fourth Quarter 2024

 Drones

On the night of December 12^th, I saw reports from friends that they were personally seeing (and some videoing) the drones that have been filling the skies of New Jersey and Pennsylvania.  Their reports came from Doylestown, Willow Grove, Perkasie, Phoenixville, and Conshohocken.  Countless reports were coming in from the Lehigh Valley and the Poconos of large drones flying in formation and hovering in place.  Our government has no answers about the drones that were first reported flying in New Jersey on November 18^th.  They are dismissing the reports, saying people are seeing planes (even though they are hovering). and saying there is no risk.  We can bring the drones down (safely with technology that they use in Europe to bring down drones at soccer games) and see what they are and what’s on board.  Very strange indeed.  Because we are not bringing them down, it makes me think that they are government assets, potentially scanning for radiation, according to one corporate executive who manufactures drones and identifies what he thinks is the exact make and model of drone.  Are they scanning for radiation, spying for the Iranians or Chinese, or just crazy operators who like to fly drones at night?  We don’t know because our government won’t tell us.  Stay tuned!

Instead of speculating, I decided to wait and see what the Federal Reserve did with rates December 18th.  They lowered the Fed Funds rate by .25% to a range of 4.25% to 4.50%. as expected, and I believe they made up their minds long ago.  By the Chairman’s admission, they are still restrictive in policy.  I think they don’t want to weaken employment or the economy before our new President takes control in January.  By the way, the Trump team is concerned that inflation is not falling and are not calling for rate cuts.  The team’s arrival cannot come soon enough.  The Fed also released their quarterly projections, showing they think GDP will decline from 2.5% in 2024 to 2.1% in 2025 and they show an unemployment rate that rises to 4.3% and stays there.  The surprise is that they show PCE inflation not dropping fully to the 2.00% target until 2026.  We are so close, but why are we waiting two years?  Why?  Stock markets reacted very badly after the news of the rate cut and Powell’s press conference.  The Dow was down over 1,000 points to close in negative territory for the tenth consecutive day.  Ugh, another overreaction.

Inflation

The decline in the year-over-year inflation rates has stalled in the past few months.  The biggest declines came during the period when the Fed was allowing the M2 money supply to outright contract on a y-o-y basis.  That stopped this past April and M2 has been slowly growing ever since.  Does that mean that the Fed should not lower rates?  No, the Fed was overly restrictive when Fed Funds was at 5.50% and they are still restrictive at 4.50%.  Inflation was a critical issue this election cycle.  People are feeling the effects of cumulative inflation, up 20% since early 2021, and high prices and they need strong wage growth (on a real basis above inflation) to catch up.

It is still driving me crazy! People still refer to the CPI and say it is not at the Fed’s target of 2.0%.  It will not be!  The Fed targets PCE (and headline PCE at that) and monitors core PCE in setting their targets; the PCE and CPI indices are constructed differently with different weightings of components.  PCE covers urban and rural areas and changes weightings monthly to account for consumers substituting different goods when prices change.  The CPI covers only urban areas and weightings are adjusted once a year.  The Fed favors headline PCE and that is their target.  We can certainly use CPI but it must be adjusted to compare to PCE.

In research from November, 2017, Noah Johnson of the BLS showed analysis of the two indices.  He showed that CPI has exceeded PCE by 100 basis points over the past 50 years.  I read a research report by Bloomberg (some time ago) that showed the spread to be lower at lower rate levels and they adjusted the spread to 50 basis points for the past 10 to 15 years.  So, if the Fed target for PCE is 2.0%, CPI can be 2.5% and they still meet their target.  We are getting so close but frustratingly far away on some measures: PCE in October was 2.3% (September 2.1%), core PCE in October was 2.8% (September 2.7%), CPI in November was 2.7% (October 2.6%) and core CPI in November was 3.3% (October 3.3%).  GDP’s PCE for 3Q24 was 3.7% compared to 2.8% in 2Q24, sharing a 3 handle with core CPI, so that is worrying people.  The other PCE measures are trending so slowly to 2.0%.  People worried that CPI rose in November, but one of the main causes was a large increase in egg prices due to Avian bird flu.  Should the Fed change rates based on egg prices?

Based on a Fed Funds rate of 4.50% and inflation measures, is the Fed tight/restrictive?  Yes, certainly they are based on a spread to PCE of 2.2%, core PCE of 1.7%, CPI of 1.8%, and core CPI of 1.2%.  Comparing Fed Funds to nominal GDP in 3Q24 of 5.0%, the spread is -.5% and not tight.  Granted, when the Fed eased yesterday, nominal GDP was 4.7% prior to today’s final revision.

GDP, and Should We Look at GDI Too?

Anyone who knows me knows that I am a fan of Dr. Lacy Hunt’s writings on the Fed, rates, and the economy.  His continued research has convinced me to look at the average of two economic production measures: GDP- tracks expenditures on final goods and services produced, and GDI- sum of the income received by all those who produce the goods and services, and not just focus on GDP.   Both are contained in the quarterly GDP reports.

Real GDP in 3Q24 was +3.0%, 2Q24 was+3.0%, and 1Q24 was +1.6%.  Real GDI for 3Q24 was +2.1%, 2Q24 was +2.0%, and 1Q24 was +3.0%.  It’s a mixed picture, right?  Shouldn’t they equal?  The short answer is yes and attempts are made during annual benchmark revisions.  But the average of GDP and GDI is more consistent: for 3Q24, it was +2.6%, in 2Q24 was +2.5%, and in 1Q24 was +2.3%.  It gives a smoother picture of the growth trend, which is clearly lower than headlines for GDP would indicate.

I think the lower trend of the average of GDP and GDI is why the Fed started to ease.  The nominal average of GDP and GDI for 3Q24 was +4.5% (equal to FF), for 2Q24 was +5.1% (was .4% under FF) and 1Q24 was +5.4% (.1% under FF).  The Fed generally eases policy when Fed Funds exceeds nominal GDP, or better yet, the nominal average of GDP and GDI.

November, 2024

What a month it was!   For me personally, I went to Disney World with family and reconnected with Florida cousins.  We toasted my one-year retirement anniversary at lunch on November 8^th.  But the election dominated the news, with Donald Trump regaining the White House for a second term.  He swept all of the swing states by connecting with everyday people.  His promises on immigration, securing the border and deportations, lower taxes for consumers, seniors on social security, and businesses, improving trade with tariff strategies, lower inflation by ramping up production dramatically for oil and natural gas, cutting costs of government using DOGE, and putting an end to endless wars resonated with voters.  He has surrounded himself with businessmen and some surprising picks to run the government agencies, with a promise to cut regulations that are strangling banks and corporations.  It’s music to Jamie Dimon’s ears, although I’m a little sad that he is not part of the new administration.  He’ll continue in the role of consultant to Trump, as has been the case for many months.

Stocks rallied wildly during November at the promise of lower taxes and an improved business environment.  Bitcoin’s price exploded from 66,000 in October to 106,000 the other day, or +61% due to the Trump effect of supporting Bitcoin.  The DJIA has struggled this month, with the December 18^th  selloff the 10^th consecutive day of declines (but up 14% y-t-d), the S&P 500 and Nasdaq achieved new handles of 6,000 on the S&P (up 25% y-t-d), and Nasdaq of 20,000 (up 34% y-t-d).  Trump had the honor of ringing the opening bell on the NYSE on December 12^th.

The markets perceive improved GDP growth with less government cash flooding the economy and crowding out business, although the Fed’s projections from yesterday show a decline in GDP from 2.5% this year to 2.1% next year.  A lower budget deficit would be a welcome relief for the bond market roller coaster, where yields plunged in September upon the first Fed rate cut of .50%, only to have long-term yields rise by 70 to 80 basis points, while the short-term rates fell 100 basis points so far.  The yield curve has gone from inverted (10 yr to 2 yr and 10 yr to 3 month), to flat, to steepening very quickly.  The budget deficit for 2024 was -$1.8 trillion, or 6.1% of GDP, and was -$1.7 trillion in 2023.  The Trump goals include reducing the deficit to GDP to 3% or less.  Debt is at $36.2 trillion and interest to service that debt was $950 billion in 2024.  Debt-to-GDP is at 120.7% in 3Q24; long periods above 90% will reduce GDP potential by one-third.

And speaking of government, on December 18^th, Congressional and Senate leaders tried to jam a 1,547 page “continuing resolution” down the throats of Congress and the American people.  It was loaded with incredible spending and unrelated “perks,” such as giving a gigantic pay raise to Congress while many American people can’t make ends meet, sheltering Congress members from subpoenas (wow!), giving state and local workers an extra social security payment, allowing Congress members to opt out of Obamacare when all of us cannot, providing money to upgrade the NFL Washington Commanders’ stadium (why?), paying for the destroyed bridge in Baltimore that should be paid for by private insurance, paying $10 billion to keep a government agency in the business of censorship of conservatives for another year, and a restrictive debt ceiling.  The list goes on and on.  Elon Musk, Donald Trump, and JD Vance put an end to this outrage and back room dealing.  This bill is now thankfully off the table.  The deadline for a spending bill is December 20^th  at midnight or else the government shuts down.  Stay tuned but the American people did not vote for this…

What About Other Indicators?

We can’t forget my other favorite indicators; watch them and you know what’s fundamentally happening and what will eventually happen.

-           M2 growth y-o-y- From the Fed H.6 report, y-o-y growth in M2 money supply for October was +3.1%, September was +2.6%, August was +2.0%, and July was +1.3%.  Y-o-y growth turned positive in April, 2024 after 16 months of y-o-y declines, which hadn’t happened since 1931-1933.  Milton Friedman said M2 growth should equate to nominal GDP growth, so the Fed is still restrictive.  Dr. Hunt indicates that the rate cuts by the Fed are needed to reverse the negative and low trend growth of M2.  And don’t forget, they are still doing QT, or reducing their bond portfolio, which also drains money from the system.

-          The dollar was volatile all year.  Standing at 106.84 on December 12^th, with a low of 100.16 on September 27^th, but it is now up +5.4% from the level at December 31, 2023 of 101.33.  This is good news for fighting inflation as import prices will be lower on a relative basis and this will help to keep inflation down; however, it may not be the best news for exports.  China is experiencing deflation for the last six quarters and factory prices there have declined y-o-y for 26 months in a row, according to the WSJ and that is good news.

-          Leading economic indicators- Surprise!  In today’s release, the LEI rose +.3% for November (the Trump effect), after declining for 30 of 31 months since April, 2022 with only a small increase in February, 2024.  The index fell below 100 (100=2016) in September and November equaled that level at 99.7.  Go figure.

-      Housing- Y-o-y home prices are still increasing with Case Shiller at +4.6% in September and FHFA at +4.4%.  Average mortgage rates for new 30-year loans are 6.72% while the average mortgage rate currently on homes in the US is 3.78%.  No wonder there is no inventory on the market.  New construction continues to be slow.  Zillow showed how unaffordable housing really is- today, a salary of $106,500 is needed to buy a house at the average sale price; in 2020, that same salary was $59,000.

-   Employment- The unemployment rate in November was 4.2%, up from 3.7% one year ago.  In November, payrolls rose by 227,000 after two grim months, but household employment fell by -355,000.  Unemployed persons now total 7.14 million and the pool of available workers is 12.63 million.  Over the past year, full-time jobs have fallen by -1.34 million to 133.39 million while part-time jobs have grown by 106,000 to 37 million, with likely few benefits for the latter.  This is hardly a robust employment market.  Remember the August announcement that at least 818,000 “jobs” will be pulled out of totals for 2024 as they simply did not exist.  Perhaps that was due to the Philadelphia Fed monitoring job growth and showing that there were job losses that began in 2Q24.  This could explain the Fed rate cuts.

-     Productivity- In 3Q24, it ran at +2.2% following 2Q24’s rate of +2.5%.  Wages can rise greater than inflation targets if productivity runs close to its long-term average of +1.5%.  Currently, in November, the wage growth was +4.0% y-o-y, which is okay if productivity stays above 2.0%.

-    Crude Oil- The latest price is just below $70 per barrel, equal to where we started 2024.  If we can increase production dramatically (the goal may be an increase of 3 million barrels per day), a decline in oil prices can lead inflation lower.

 

Finally. 2024 has been a great ride.  There’s more time to travel, to write, to be with family and friends.  People ask me if I miss working.  The answer will always be yes, I do.  I especially miss my colleagues.  They probably have missed me saying throughout the year that “Christmas will be here before you know it.”   Christmas is less than a week away and I pray that all of you find time to relax and enjoy life.  I wish you all a very Merry Christmas and a Happy 2025!!!

I appreciate all of your support!  Thanks for reading!  DLJ 12/19/24

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy recently retired from Penn Community Bank where she worked since 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

Disclaimer: This publication is provided to you solely for educational and entertainment purposes.  The information contained herein is based on sources believed to be reliable but is not represented to be complete and its accuracy is not guaranteed.  The expressed opinions, views, and estimates are those of the author as of this date and are subject to change without notice.  The author cannot provide investment advice but welcomes all of your comments.

Banking's Top 5 Total Return to Shareholders: 2024 Edition

There have been some humbling moments in Top 5 recognitions, with some award recipients failing and one voluntarily liquidating. Although we seek long-term performance in our 5-year lookback to mitigate the risk of banks that stoke performance with risky bets, we are reminded that banking is a long game. Business models built to endure do so over different economic cycles. And in today's world, economic cycles tend to last more than five years. Having said that, I am here to count numbers with minimal subjectivity (although there is some), and if they have the best five-year total return to shareholders within the criteria mentioned below, they are most likely on the list.

For the past thirteen years, I searched for the Top 5 financial institutions in five-year total return to shareholders because I support long-term strategic decision-making that may not benefit next quarter's or even next year's earnings. And I am weary of the persistent "get big or get out" mentality of many industry pundits. If their platitudes about scale are correct, then the largest FIs should logically demonstrate better shareholder returns, right?

Not so over the thirteen years I have been keeping track. The first bank to crack the Top 5 over $50 billion did so in 2020. As a reference, the best SIFI bank in five-year total return this year was JPMorgan Chase at 46th overall. Although one might argue that First Citizens BancShares of Raleigh is a SIFI as it had $220 billion of total assets, roughly the size of Silicon Valley Bank when it failed. The  FDIC designated SVB as systemically important.

My method was to search for the best banks based on total return to shareholders over the past five years. I chose five years because banks that focus on year-over-year returns tend to cut strategic investments come budget time, which hurts their market position, earnings power, and future relevance more than those that make those investments. I call this "pulling into the pits" in my book: Squared Away-How Can Bankers Succeed as Economic First Responders. Short-term focus is a common trait of banks that focus on shareholder primacy over stakeholder primacy.

Total return includes two components: capital appreciation and dividends. However, to exclude trading inefficiencies associated with illiquidity, I filtered out those FIs that trade less than 1,000 shares per day. I changed this from 2,000 shares as it was pruning too many fine institutions. But the 1,000 shares/day minimum naturally eliminates many of the smaller, illiquid FIs. I also filtered for anomalies such as recent merger announcements as a seller, turnaround situations (losses suffered from 2018 forward), mutual-to-stock conversions, large ECIP recipients, and penny stocks. 

As a point of reference, the S&P US BMI Bank Total Return Index for the five years ended December 6, 2024 was 34.55%.

Before we begin and for comparison purposes, here are last year's top five, as measured in December 2023:

#1.  M&F Bancorp, Inc. (OTCPK: MFBP)

#2.  The Bancorp, Inc. (Nasdaq: TBBK)

#3.  Citizens Bancorp Corporation (OTCPK: CZBS)

#4.  First Citizens BancShares, Inc. (Nasdaq.GS: FCNC.A)

#5.  FFB Bancorp (OTCQX: FFBB)

Here is this year's list:

#1. The Bancorp, Inc. (Nasdaq: TBBK)

Founded in 2000, this $8.1 billion financial institution remains one of the few banks in the U.S. that specializes in providing private-label banking and technology solutions for non-bank companies ranging from entrepreneurial start-ups to those in the Fortune 500.  They provide white-label payments and depository services (think Paypal, Chime) and deploy that funding into specialized lending programs such as lending to wealth management firms, commercial fleet leasing, and real estate bridge lending. Note their asset size, because their value as the BaaS bank for Chime is that they are under $10 billion in total assets and not subject to the Durbin Amendment portion of the Dodd-Frank Act that fixes interchange income pricing. It has not been all sunshine and rainbows for TBBK. They were under an FDIC consent order from 2014 through 2020 relating to their BSA and OFAC compliance and their relationship with third parties seeking access to the banking system. So in 2019, when our 5-year measurement period began, they were under that cloud. Bankers considering becoming a BaaS provider to such third parties should read their order. Having said that, they posted a 2.75% ROA and 26.56% ROE year-to-date and that surpassed their aspirational goal (which they disclosed) of having a >2% ROA and >20% ROE. They put it out there and got it done! And have delivered a 397% five-year total return to their shareholders and third straight Top 5 accolade and topping our list this year! 

#2 Northeast Bank (NasdaqGM: NBN)

Northeast Bank is a full-service bank headquartered in Portland, Maine that had $3.9 billion in total assets and seven branches at September 30, 2024. It offers personal and business services to the Maine market, and sports a national lending platform which purchases and originates commercial loans, mostly secured by real estate, and SBA loans, on a nationwide basis. It has a nationwide digital bank, ableBanking, that offers online savings products to consumers nationwide to assist in funding its nationwide lending program. The Bank is currently offering shares for sale at-the-market to support future growth. Its national lending program represents all but a small percentage of its entire loan portfolio. Two thirds of its deposits are time deposits, resulting in an LTM (their fiscal year ends September 30th) cost of funds of 4.16%. By way of comparison, we do a quarterly flip book for Massachusetts that shows all MA banks cost of funds was 2.48%. New England financial institutions generally have higher cost of funds. But not that much higher. This is because there are a lot of loans to fund! And the bank's yield on loans was 9.30%. I know what you're thinking, but so far their NPLs/Loans was 1.31% at September 30th. With a net interest margin of 5.06%, having relatively higher NPLs than those with NIMs with a 2-handle makes sense.  This resulted in a 1.97% LTM ROA and 17.09% ROE and a 370% 5-year total return to shareholders. Well done!

#3. Coastal Financial Corporation (Nasdaq: CCB)

Since 1997, Coastal Community Bank, the wholly owned bank subsidiary of Coastal Financial Corporation, has delivered a full range of banking services to small and medium-sized businesses, professionals, and individuals throughout the greater Puget Sound (Washington) area through a traditional community bank branch network in its three-county market. The bank consists of two segments: 1) the traditional community bank, and 2) CCBX, which is its Banking as a Service (BaaS) division started in 2018. Prior to starting CCBX and for the year ended 2017, the Company had $806 million in total assets and $5.4 million in net income for an ROA of 0.73%. As of or for the latest twelve months ended September 30, 2024, the Company had $4.1 billion of total assets, $40.9 million net income and a 1.10% ROA. Their CCBX segment continues to evolve, particularly with enhanced regulatory scrutiny of BaaS banks. CCBX is focused on expanding products with existing partners rather than partner growth. What has this bifurcated business model delivered? A 351% five-year total return and place on the JFB Top 5 in two of the last three years! Well done!

#4 First Citizens BancShares, Inc. (NasdaqGS: FCNC.A)

First Citizens Bank was founded in North Carolina in 1898 as the Bank of Smithfield. In 1935, R.P. Holding was elected Chairman and President of First-Citizens Bank & Trust, a family legacy of leadership that lasts to this day.   First Citizens includes a network of more than 500 branches and offices in 30 states spanning coast to coast, and a nationwide direct banking business. In January 2022, First Citizens did a tangible book value accretive merger of equals with CIT Group. And followed that savvy deal with another tangible book accretive deal by completing the failed Silicon Valley Bridge Bank acquisition in the first quarter 2023. Concern about maintaining SVB accounts has dissipated as the bank has more loans and more deposits now than in the first quarter 2023. For the LTM ended September 30, 2024, net interest margin was 3.68%, ROA was 1.19%, and ROE was 12.74%. Its efficiency ratio pre-SVB was 61% and now it is 55%. Economies of scale were realized. All this accretive deal making and prudent management has resulted in a brass ring for shareholders in the form of a 327% five-year total return. Congratulations!

#5 GBank Financial Holdings, Inc. (OTCQX: GBFH)

New to the JFB Top 5 is Las Vegas based GBank Financial Holdings, Inc. Like most things Vegas, this is a unique financial institution. Founded in 2007, GBank operates two full-service commercial branches in Las Vegas. It conducts business nationally through its SBA lending business that is a top 10 national 7(a) lender by volume. Through its partnership with BankCard Services (BCS), it has established relationships with gaming companies, skills gaming companies, and payments and wallet provider companies. This likely explains why the CEO of MGM and general counsel of Great Canadian Gaming Corporation are on the company's board. It has also struck an agreement with MasterCard to provide pre-paid card services. At and for the LTM ended September 30, 2024 it had a mere $1.0 billion in total assets but had net income of $13.4 million leading to an ROA of 1.82% and ROE of 16.54%. This is the smallest bank in our Top 5, yet it enjoys an average daily trading volume of over 15,000 shares. Only in Vegas! Congratulations for your Top 5 recognition and huzzah to your shareholders who enjoyed a 294% 5-year total return! 

There they are. Interesting there is no bank that I would deem a traditional community bank. Be it BaaS, nationwide lending, focus on a niche such as v/c and p/e ecosystems, or gaming. All 5 have a unique path to delivering to their shareholders. And 4 of 5 are less than $10 billion in total assets. GBank is 1/10th that size.   

The evolution of this august list tells me that having something other than "plain vanilla" is driving performance and shareholder returns. 

~ Jeff

Note: I make no investment recommendations in this article or this blog.

2024 Ranking Banking by Bank Director-Jeff For Banks Version

Bank Director Magazine recently came out with its Ranking Banking report for 2024. The analysis was performed by Piper Sandler using the following criteria:

"The report uses year-end 2023 data from S&P Global Market Intelligence. It uses four metrics to gauge the performance of public commercial and savings banks as defined by S&P. The metrics are core return on average assets and core return on average equity, tangible common equity to tangible assets, and nonperforming assets to loans and other real estate owned. Each bank is ranked on each metric, and the sum of the rankings produces a final score. Total shareholder return was excluded because some over-the-counter banks are thinly traded, making the metric unfair as a comparison."

I concurred with a Bank Director writer about the challenge with total shareholder return, as I rank top five banks every year on total shareholder return and had to use a minimum average daily trading volume to reduce the incidence of thinly traded banks topping the list because someone traded 300 shares immediately prior to my lookback. 

Here is the reports top 25 banks. Note that lower total score is better because if you are ranked 1st in a category, only 1 is added to the score whereas if ranked 25th, then a 25 is added.

Click on image to see it larger.

It's a good list with fine institutions that have obviously outperformed. I wanted to take another cut at it though. One is I wanted to push it forward to second quarter 2024 (the list was year ended 2023). Another critical addition is to determine if each bank was trending favorably in each metric. One thing I have learned being in the banking industry is momentum is critical to success. Particularly in an industry whose revenues are driven from their balance sheet. Meaning that tomorrow's sales doesn't equate to this quarter's profits. This quarter's profits were driven by sales two to four quarters ago. Net interest income is typically greater than 80% of community bank revenues. And the commercial real estate loan you booked today will contribute to profits next quarter, not necessarily this one. And the same for that business checking account.

So trend is critical to a bank's success. So I added trend to each category and awarded five points for every negative trend, and no points for positive ones, in sticking with the lower is better score used by Bank Director. 

I should note some differences in categories. One is I used five quarter averages, meaning I looked back to the second quarter 2023 through the second quarter 2024. And I used NPAs/Assets as the asset quality metric. Here are the results.

Click on image to see it larger.

The top 2, Westamerica and Farmers & Merchants (California) are the same, meaning they not only outperformed the group in the Bank Director cut using 2023 numbers, but the above metrics and trends as well.

Big differences, however, happened from the Bank Director list. Cashmere Valley Bank, for example, dropped from number 7 on the Bank Director list to number 15 here. It wasn't because of their trends. They recorded positive trends from 2Q23 to 2Q24 in ROAA, ROAE and tangible equity/assets. In the Bank Director report, they were compared to 300 financial institutions. In the above table, they are only compared to the top 25 identified by Bank Director. Cashmere was high average in most categories when compared to 300. Ranking them a solid seventh because of their consistency. They received no such love when compared only to the top 25. 

Moving significantly up in rankings were International Bancshares, from 24th to 5th, and 1st Source, also from tied for 24th to 8th. It was asset quality that dropped International in the Bank Director list, landing them 275th of 300 because the other metrics had them ranked well (number 1 in ROAA in the Bank Director report). Because asset quality in the above table only penalized them with a 22nd out of 25, they rose on the list. And shouldn't banks compare risk to reward? International Bancshares five quarter NPAs/Assets average was 57 bps. Not exactly a three-alarm fire.

1st Source, however, got their bump from positive trends in all four metrics measured, even though they were only 12th in ROAA and 18th in ROAE. Things are moving in the right direction. And as I mentioned, trend is important because revenues are mostly from balance sheets. And balance sheets move more like aircraft carriers than speed boats. 

I would vote for including trend information in Bank Director's next Ranking Banking report. Because it is so critical in telling the story of who is performing well and who will continue to perform well.

~ Jeff