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.
Mind=blown.
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
