My firm is 15 years old. And approximately every five years, we performed an analysis to determine how the stock market rewards financial institutions for different strategies. In particular, does the market reward banks that drive net interest margin through a high yield on earning assets, or a low cost of funds?
The first two times we did this, the low cost of funds banks won, hands down. So I assumed that this is the way it was, and therefore is the way it will be. But we recently revisited the analysis for an "asset-driven" client... i.e. one that focuses on loan production, and backfills with funding as they figure out how to pay for the loan pipeline. This strategy typically leads to a higher cost of funds as the bank turns to higher rate deposits, brokered deposits, or FHLB borrowings because it's quicker than winning deposit relationships.
The following charts show the results. Sorry for column overrun but wanted to make them bigger and I have no idea how to do that other than blowing them up. I digress. Fortunately, I have two daughters and am very familiar with being told I'm wrong. If not for my two angels, the below charts might have broken my confidence.
The charts show the price/tangible book and price/earnings multiples of two sets of banks. As the Criteria states, we took banks with between $800MM and $3.0B in total assets with healthy net interest margins and profitability. The size range is consistent with our bank client. We then divided the result into the top 10 yield on earning assets banks, and the top 10 (lowest) cost of funds banks. And then charted their trading multiple trends. Yes, there were two cross-over banks that made both charts. Quite an accomplishment, in my opinion.
The low cost of funds banks are no longer the clear winner, as the yield on earning assets banks sport a greater price/tangible book multiples.
What caused the shift that improved asset driven banks trading multiples to be comparable to core funded banks? I have my opinions. Note the next chart.
Yeah, I know. Charts again from Marsico. Hey, I'm a strategy-finance wonk.
My firm measures the profitability of products for dozens of community financial institutions. As part of that service, we roll up bank specific products to common products so we can compare each client's product profitability to that of a peer group. Think home equity and commercial real estate loans, business checking and personal money market accounts, etc.
As a result, we can determine the spreads (using actual yields for assets and costs for funding offset by a funds transfer price) of all products on the asset and liability sides of the balance sheet. The trend of those spreads are in the chart. Notice in 2006, when the Fed Funds rate stood at 5.25%, and the yield curve was inverted, liability spreads exceeded asset spreads.
Then the Fed started dropping short term rates (quickly to 0-25 bps) and the yield curve went positively sloped. Loan spreads quickly exceeded deposit spreads. And loan profitability followed in quick succession.
So for an extended period of time that includes present day, loan spreads exceed deposit spreads, and loan profitability has mostly exceeded deposit profitability.
Therefore, asset driven banks were rewarded with greater overall profitability than core funded banks, and trading multiples moved to greater parity.
But it won't always be so.
I thought you would like to know.
Jeff – Thanks for sharing. I have been monitoring and observing the same thing. Since 2006-07, it has been death by deposits (or life by lending). A couple of additional items for you.ReplyDelete
1. It would be interesting in seeing the P/E ratios for banks that are good at assets and liabilities simultaneously. You could look at the loan to asset and non-time deposit to asset ratios as criteria.
2. As you noted, in 2006-07, it really did not matter if you did not have the skills to lend. You could be liability driven and be successful. Since that time, those who don’t have the skills to lend have been exposed.
3. The ramp-up in the mortgage market ending in 2006-07 was an economic policy outlier, in my opinion. It was effectively an unregulated period of expansion that was not sustainable. As a result, liability sensitive banks benefited -- to a degree that was not sustainable either.
4. Given the choice between being an asset driven bank versus a liability driven bank, I would take the asset drive one. Liability driven banks have their destiny determined by an outside factor -- the yield curve. I’d rather determine my own fate. The ability to extend and administer credit is a strategic asset; it’s also the sign of a well-functioning sales culture. In addition, you can always lay-off loans into the secondary market or participate out to those who can’t lend. At the end of the day, I’ll take the athlete with skills every time.
Thanks for another good post.
Thank you Mike!ReplyDelete
Skills to lend can take two meanings. 1) The ability to generate volume, and 2) the ability to underwrite and administer loans well. As one lender once told me: "Anyone can make a loan. Collecting on the loan is more difficult."
I would choose differently, the deposit driven strategy. Although the stock market appears to be slightly favoring the asset-driven approach today, I think long-term that core funded bank valuations will increase, especially since asset-driven banks shop for funding in the M&A market (i.e. high core funded, lower loan/deposit ratios).
Also, core funding is harder to replicate, in my opinion, than an asset driven bank.
But your point that building an asset driven bank designed to remain higher than average profitability during a recession is also difficult to replicate.
Thank you for the comment!
Points well taken. Indeed, there is more than one way to be successful. I tend to take your point of view on competing with oneself (posted long ago) rather than against everyone else. Capital constrains how much market share one can gobble up; it's how efficiently the capital is deployed that matters. Demonstration of that plays out in the numbers.ReplyDelete
Your the beestReplyDelete