The State of Banking

Where are we and where have we been? Trends are telling. In 2013, there were 6,812 FDIC-insured financial institutions. At September 30, 2017 there were 5,737, a 16% decline. There were 166 mergers, and four new charters in the first three quarters of 2017. As an industry, the trend is down. Ski slope down.

What about the financial performance and condition of our industry? The Presidential State of the Union address was supposed to report to Congress the Administration's view of the condition and performance of our country. It has turned into a sea of words amounting to nothing more than a wish list and priorities. Because the nation's balance sheet and income statement is not improving.

But what of banking? 

I broke down banking's financial condition, performance, and trading multiples into thirteen charts, seen below. Charts 1-6 are financial condition trends, 7-10 are financial performance, and 11-13 are trading multiples.

The numbers are medians from all publicly traded financial institutions between $1 billion and $10 billion in total assets. That yielded 291 total institutions, broken down by region. 

Financial condition ratios are promising. So I will say to you that the condition of the industry is strong. Assets, Loans, and Deposits continue to grow, although at a more moderate pace. And capital ratios have held steady and strong. In fact, if you listen to some institutional investors, the industry is over-capitalized. Many view an 8% leverage ratio as the "right" number. Although this should depend on an institution's risk profile and growth trajectory. And I have never heard a regulator say the phrase "over capitalized".

Non-performing asset ratios are in a long term downward trend. They have leveled off in the 60-80 basis point range. Some regions are experiencing slightly elevated non-performers from the previous year. A trend to watch.

The challenge with industry balance sheets is that loans have grown faster than deposits over the past few years. And loan/deposit ratios are steadily increasing as liquidity positions steadily decrease. Many bankers are less concerned about this citing their access to wholesale funding to bridge any shortfalls, or that they have been mopping up excess liquidity.

But rates have been rising slowly, and I believe Fed rate increases will accelerate this year, perhaps crossing the rate threshold where depositors now care what you pay them, and dooming those Betas in your ALCO assumptions to irrelevance. My opinion is that one or two more rate increases will trigger more skirmishes on the deposit battlefield. Those that have not positioned their bank to have strong liquidity will have to compete, giving back deposit mix gains they have worked so hard to achieve.

Net interest margins have leveled off from long-term industry declines. Good news! In 2017, NIMs ranged from a high of 3.8% in the West and Southwest, to a low of 3.1% in the Northeast. Are these anomalies due to region, competition, or business models? I would argue a mix of all three. But if I were a Northeast bank, I would ask why other regions achieved between 3.5%-3.8% NIMs and we're at 3.1%. That's a tidy sum to leave on the table.

Efficiency ratio trends look fantastic! And since NIMs are holding steady, it leaves me to think that operating expense control or increased profitability in fee-based businesses are at work. Based on my firm's experience with the profitability of fee lines of business, I am guessing the former. As balance sheets grow, operating expenses grow less, creating greater efficiency. Positive operating leverage!

Both ROAA and ROAE declined 2016-17, although efficiency is better. So what doesn't the Efficiency Ratio measure? Provision, and income taxes. Most of the institutions, if not all of them, probably took a Deferred Tax Asset (DTA) writedown in the income tax line item, impacting these bottom line ratios. But this probably doesn't account for all of the decline. Are assets growing faster than profits, therefore reducing ROAA? Is equity accumulating faster than an institution's ability to deploy it, therefore reducing ROAE? Or, is provision expense up throughout the industry. I believe a combination of the three. But if provision expenses are rising, credits could be moving from pass, to watch, to substandard, and onward. Take note.

Trading mutliple trends are jolting. Banking is not a long-term growth industry. In a past blog post I wrote about the PEG ratio (P/E divided by EPS growth), and to keep an eye out for anything that moves too far from 1. I further deconstructed a bank's p/e ratio because the industry is more capital dependent than most, if not all industries. I estimate that a bank's p/e can be reduced by 5-7 times to calculate PEG due to high capitalization. If I took 7x, and applied it to the Mid Atlantic's 22.1x p/e (the lowest of the six regions), then those banks would have to achieve earnings growth rates of 15% to earn that valuation. Note that p/e measurements for the below charts were done on 12/31, after the new tax law passed, and after most bank's announced their DTA writedowns. But prior to their earnings releases, so the reduced earnings were not yet baked in the cake.

Banks might earn that valuation depending on how they take advantage of the new tax law. Do they take the one-time earnings injection, or make strategic investments for longer term earnings growth. If the former, I do not believe the p/e's will last long term. And therefore I believe, as an industry, bank stocks are likely at peak valuations.

Or as industry stock analysts put it: Neutral.


What are your thoughts on the state of banking?


~ Jeff


Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.


Source for all charts: S&P Global Market Intelligence

For Banks, What Is Top Quartile Performance?

What is top quartile financial performance? I am often asked this question, and top quartile performance appears as stretch goals in many strategic plans. And I say bravo! Nobody wants to be average.

Usually top quartile performance is compared to a bank's or thrift's pre-selected peer group. Executive compensation is often tied to it.

I won't belabor the point. A key benefit of being a blogger is that I can use research I perform for my own knowledge to benefit my readers. 

The below statistics are from all FDIC insured financial institutions either for the year-to-date ended or period ended September 30, 2017. This period end was largely driven by the significant number of financial institutions taking deferred tax asset write downs in the fourth quarter, which would have skewed ROAA/ROAE for the year ended 2017. I used Call Report data, so the calendar year is the fiscal year.

I also excluded extraneous performers by category, as noted in the footnotes of each table. For profitability numbers (ROAA, ROAE), I excluded Subchapter S financial institutions. Quite a large cohort at over 1,900. Sub S bankers can gross up those numbers to come up with their equivalents.

See where your financial institution ranks!

Banking's Total Return Top 5: 2016 Edition

For the past five years I searched for the Top 5 financial institutions in five-year total return to shareholders because I grew weary of the persistent "get big or get out" mentality of many bankers and industry pundits. If their platitudes about scale and all that goes with it are correct, then the largest FIs should logically demonstrate better shareholder returns. Right?

Not so over the five years I have been keeping track.

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 than those that make those investments.

Total return includes two components: capital appreciation and dividends. However, to exclude trading inefficiencies associated with illiquidity, I filtered for those FIs that trade over 1,000 shares per day. This, naturally, eliminated many of the smaller, illiquid FIs. I also filtered for anomalies that result from recent mutual-to-stock conversions and penny stocks. 

Before we begin and for comparison purposes, here are last year's top five, as measured in December 2015:

#1.  Independent Bank Corporation (Nasdaq: IBCP)
#2.  Fentura Financial, Inc. (OTCQX: FETM)
#3.  BNCCORP, Inc. (OTCQX: BNCC)
#4.  Carolina Bank Holdings, Inc. (Nasdaq: CLBH)
#5.  Coastal Banking Company, Inc. (OTCQX: CBCO)

Here is this year's list:

Independent Bank Corporation celebrates its second straight Top 5 recognition, and BNCCORP celebrates its third straight year on this august list. Congratulations to them. A summary of the banks, their stories, and links to their website are below. 

#1. Independent Bank Corporation (Nasdaq: IBCP)

Independent Bank dates back to 1864 as the First National Bank of Iona. Its size today, at $2.5 billion in assets, is smaller than it was a decade ago. It is a turnaround story because the bank was hammered with credit problems between 2008-11, when it lost over $200 million. In 2011, at the height of its problems, non-performing assets/assets was nine percent. Today that number is 3.6%. Exclude performing restructured loans, and that number plummets to 0.62%. The result: those investors that jumped onboard at the end of 2011 were well rewarded. Their total return was greater than 1,500%. You read it right.


#2. Waterstone Financial, Inc. (Nasdaq: WSBF)

Waterstone is a single-bank holding company headquartered in Wauwatosa, Wisconsin. It has $1.8 billion of assets and operates eleven branches in the metropolitan Milwaukee market, a loan production office (LPO) in Minneapolis, Minnesota, and 45 mortgage banking offices in 21 states. The mortgage bank has more than 3x the employees of the bank. Year-to-date, the company has generated more fee income, at $95.2 million, than it has in operating expense, at $95.0 million. I don't know any other bank that accomplished this. I'm sure there are some. But I haven't heard the tale. This tale is true. That means their year-to-date $31.8 million net interest income after provision... is gravy. And that is a key reason why their five-year total return exceeded 1,000%!


#3. Summit Financial Group, Inc. (Nasdaq: SMMF)

Summit Financial Group, Inc. is a $1.7 billion in asset company headquartered in West Virginia, providing community banking services primarily in the Eastern Panhandle and South Central regions of the state, and the Northern and Shenandoah Valley regions of Virginia. Summit also operates an insurance subsidiary. In 2011, the company had net income of $4.1 million on assets of $1.5 billion. Today, the company has annualized net income of $16.8 million. A reversal of fortune from a 0.28% ROA to a 1.09%. How did they do it, from my perspective? 1: Margin expansion, and 2: Expense discipline. Annual operating expenses were $36.6 million in 2011, and are $33.2 million today. And that includes some of the expenses associated with an acquisition that is set to close shortly. So they grew. And spent less to do it. A bank that viewed its operating expenditures as investments. Amazing!


#4. MBT Financial Corp. (Nasdaq: MBTF)

In 1858, while Lincoln and Douglas debated for a US Senate seat, Benjamin Dansard started Dansard State Bank to operate from the back of Dansard General Store. Ultimately renamed Monroe Bank and Trust, this bank pre-dates the Civil War! Similar to IBCP above, MBT is a turnaround story. In 2011, non-performing assets/assets was at 7.7%. Today they are at 1.8%, and below 1% if you exclude restructured yet performing loans. The asset quality issues led to a $3.8 million loss in 2011. Since that time, nothing but black ink, leading to a year-to-date ROA of 1.10%, and ROE of 10.13%. How did they get there? A dramatic improvement in asset quality, a process and efficiency initiative that led to reduced costs and improved processes, and motivation. Insiders own over 22% of the company. That's motivation! Well done!  

#5. BNCCORP, Inc. (OTCQX: BNCC)

BNCCORP, Inc., through its subsidiary BNC National Bank, offers community banking and wealth management services in Arizona, Minnesota, and North Dakota from 16 locations. It also conducts mortgage banking from 12 offices in Illinois, Kansas, Nebraska, Missouri, Minnesota, Arizona, and North Dakota. BNC suffered significant credit woes during 2008-09 which led to material losses in '09-10, and the decline in their tangible book value to $5.09/share at the end of 2010. Growth, supported by the oil boom in North Dakota's Bakken formation, and a robust mortgage banking business, is challenged due to  the decrease in oil and ag commodity prices. But earnings continue to increase in spite of the challenges. This has resulted in a tangible book value per share at September 30th of $22.51... a significant recovery and turnaround story that landed BNC in our top 5 for the third straight year. Your investment five years ago would have resulted in over an 800% total return!

Here's how total return looks for you chart geeks, with the lower green, and flat line being the S&P 500 Bank Index.

There you have it! The JFB all stars in top 5, five-year total return. The largest of the lot is $2.5 billion in total assets. No SIFI banks on the list. Ask your investment banker why this is so.

Congratulations to all of the above that developed a specific strategy and is clearly executing well. Your shareholders have been rewarded!

Are you noticing themes that led to these banks' performance?

~ Jeff

Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.

A Financial Institution Investment Banker Had Questions. Here Are My Answers.

My colleagues and I are frequent speakers at industry events. At one such event, a financial institution investment banker approached my colleague and handed him a list of questions he would like answered during his speech. My colleague gave it to me the next day, and I provided my answers thinking he wanted them. Not really. Just thought I would be interested in the questions. So I think: Blog Post!

The list of questions read like the script used to convince banks they can't go it alone. But I'm a cynic. And should give the investment banker the benefit of the doubt. Here we go...

1. What should a financial institution's target levels be in the following?

Return on Tangible Equity (ROTE): ROTE is a crap ratio. Not my term, but one told to me by a bank stock analyst, and I agree with him. If you don't want intangibles, don't do premium deals. If it was such a good deal, then measure ROE. ROTE is just an investment banker talking buyers into doing expensive deals and to not be accountable for the intangible.  

But to answer the ROE question, the long-term average should be >10%. Why? Because an investor in an equity security should expect a 10+% total return. So it serves as a proxy, of sorts. It is different, for each bank however. What if a bank trades at 125% of book? Then a slightly greater than 10% ROE would be required to deliver a 10% total return. It's math.

Note that I said long-term ROE because it should be better in a strong, expanding economy and worse in recessions AND periods of strategic investment. Dropping ROE to 8% to make strategic investments so the financial institution can elevate it to 11% makes total sense to the CEO and Board that manages for long-term performance. Not so much to the CEO and Board worried about his/her next analysts' call.

Tangible Equity/Assets: This depends on the financial institution's risk profile. They should calculate their unique "well-capitalized" by estimating the risk on their balance sheet per balance sheet item, now and as projected. I like the Basel III approach of setting a base level that they don't want to go below (4.5% in Basel III's case) with a 2.5% buffer in place in good times so when times are not so good, the buffer serves its purpose. But the risk buffer should be set by each institution based on the risk on their balance sheet and projected to be on their balance sheet. My guess is that if every bank did this, their target capital range (base + buffer) would be between 7%-9%.

ROA: Greater than 1% should be achievable by most financial institutions, as so many are currently doing it. For institutions with meaningful fee-based businesses, the number should be greater because a profitable fee-based business will deliver "return", without adding "assets".

Efficiency Ratio: This is totally dependent on the business model and growth trajectory. Not many investors complained about the old Commerce Bank (NJ) efficiency ratio of 70+% when they were delivering 20+% profit growth.

Organic Growth Rates: If they exceed their markets, then they are above average, right? So it depends, in large part on their markets. Earnings growth should exceed balance sheet growth. That's positive operating leverage that so many financial institutions struggle with. Earnings growth plus dividend yield should be close to or exceed 10%, in my opinion. If markets can't support it, expand, take it from the competition, or acquire!

2. What is the total non-interest expense to have full internal staffing? 

I have no idea how to answer this one Mr. Investment Banker.

3. What is a financial institution's cost of equity? 

I bet he was looking for a CAPM calculation, as I see this often in investment bankers' presentations. But no. I'm a simple man.

For slower growth, conservatively run banks I would estimate ~10%. For fast growth and/or banks pursuing a higher risk strategy, I would estimate 13%+ for common equity, as investors should demand more for that business model. For convertible preferred, I would estimate the coupon until the conversion date, then the cost of common equity. If it is not mandatorily convertible, then it's the coupon plus the cost of common equity mentioned above. Convertible preferreds are ridiculously expensive because they dilute common returns while sitting back clipping coupons, in my opinion.

4. What asset size is critical mass? 

You know when there is a rule, and someone throws up an exception to the rule that might represent 1% of the total universe subject to that rule? Banking has plenty of exceptions to the critical mass asset size estimates bandied about by bankers, consultants, and investment bankers. My firm's first podcast highlighted the average size of all Sub S banks in the US as $273 million. Small. Yet their average ROA was 1.36%. Sub S banks represent ~ 1/3 of all financial institutions in the US. 

So there are myriads of exceptions to the economies of scale conventional wisdom. I would say, however, that banks with <$500MM in total assets have unique challenges relating to technology investments, stock liquidity, and management succession that will make things difficult. They also suffer significant stock trading discounts to larger banks, even though they may perform better. The change in community bank shareholders from retail to institutional also works against smaller banks, as institutional shareholders typically have float requirements (i.e. so many shares must trade per day). That's where the small banks challenges lie, in my opinion. Not in their ability to deliver superior financial performance. Because they are doing it.

5. Should banks form a bank holding company (BHC)?

I've already taken up enough of my readers' time than to answer this boring investment banker question.

What are your opinions of the above questions?

~ Jeff

Ever test the theory that acquiring banks is good? I did.

Every strategic planning retreat has its own flavor. This one particular retreat included a parade of investment bankers conveying the virtues of deal making while the audience of senior bank executives and board members nodded their heads in unison and solidarity.

One question that was unasked was whether it is better to seek acquisitions or go it alone. The conventional wisdom being that doing deals is better than not doing deals. I didn't know the answer, and figured asking an investment banker the question would be like asking a Beverly Hills plastic surgeon if it was better to do a little nip-and-tuck or let nature have its way. (Disclosure: I am also an investment banker, but don't like to admit it at cocktail parties. I am not a plastic surgeon.)

So I went to the spreadsheets. It always comes down to the spreadsheets. The operative question was does doing deals result in better financial performance and total return than not doing deals?

First I had to create some criteria to control for some variables that impact total return and financial performance greatly, such as bank size and asset quality. So I chose publicly traded financial institutions between $1 billion and $20 billion in total assets, with non-performing assets to assets of less than 2%.

I then divided the group into two, deal makers and non deal makers. Deal makers did two or more merger deals for whole institutions since 2010. Non deal makers did one or no deals. There were 46 deal makers and 173 non deal makers. A decent sample, in my opinion.

Their Return on Average Assets and Average Equity performance, at the average, were as follows from 2011 to present.

Deal makers had a better ROA year-to-date: 0.96% versus 0.90% for the non deal makers. But non deal makers had a better ROE: 8.57% versus 8.47% for the deal makers. This may be why you hear so many deal makers talk about return on tangible equity (ROTE) in their earnings conference calls. Better to ignore that goodwill they keep building on their balance sheets as a result of paying premiums for selling financial institutions. Because for ROE, it looks like non deal makers take the brass ring.

And what about three-year total return? Deal makers delivered 73.97% to their shareholders. Non deal makers did better... 75.56% on average.

Does your FI pursue acquisitions? If so, have you tested the conventional wisdom that doing deals is better than going it alone?

~ Jeff

In Pursuit of Return on Equity

When performing ratio analysis to determine a company's profitability we should remember that a ratio has at least two data points: a numerator and a denominator. It doesn't matter if it is banking, retailing, or widget making.

In banking, the standard profitability ratio has long been return on equity (ROE). That is... until the financial crisis of 2007-08. It was in the aftermath that capital, the denominator in the return on equity calculation, resumed its place as king.

Where has the pursuit of ROE led us? Yes, it made us focus on profitability, the numerator in the equation. But it also resulted in us looking at bank equity. The smaller the E, the better the ROE, right?

Bond salesman loved the concept. They encouraged their bank clients to borrow from their respective Federal Home Loan Banks (FHLB) or chase high cost deposits to fund the bonds they sold for minuscule spreads. The logic: blow up the balance sheet, eek out incremental profits, and reduce the E. Genius! And equity analysts, who coincidentally worked for the same firms as the bond salesman, loved it too.

During the period 2002-07, when loan growth outpaced the ability to fund it, FIs took on more FHLB borrowings and high cost deposits. This was a higher spread concept, because loans typically had greater yields than bonds. Loans also typically had greater credit risk. FIs did provision for such losses, but accounting rules and how the SEC enforced them did not allow FIs to "over-reserve", whatever that means. This was determined by the high profile case the SEC brought against SunTrust in the Fall of 1998 for managing earnings through the loan loss provision. Read a summary of it from the Atlanta Fed here. The Fed research piece on the subject, written in 2000, is almost comical to read given what has happened.

So, in pursuit of ROE, banks leveraged up their balance sheet. They thinned their capital leaving them more susceptible to distress during economic hard times. This distress was clearly evident when I recently performed some "where are they now" research on the highest performing ROE FIs in 2006, the last normal year prior to the crisis (see table).

A note on the data. I searched all publicly traded banks and thrifts that existed in 2006 and sorted them by the highest ROE. But I also ensured that their prior year ROE was similarly high, in order to weed out one-time gainers. In other words, I wanted consistent, high ROE FIs.

The results are telling. Of the top 10 ROE FIs of 2006, only three are currently profitable. Two are under a regulatory agreement. The remaining five failed. Yes, failed.

How does an FI, sitting atop the ROE chain, fall so far so fast?  As mostly always the case, it was bad loans. But many if not most FIs have had loan troubles. What made so many in this group take the perp walk to the FDIC? I already mentioned their inability to put extra away for a rainy day via the loan loss provision. But the pursuit of ROE encouraged levering up the balance sheet to leave little in excess equity to absorb the losses. Inadequate loan loss allowance, relatively low equity. The recipe for disaster in bad times.

I think ROE will re-emerge as ONE important indicator of profitability. But I don't think we will make the same mistake twice. Having the past three years as history in our loan loss allowance calculations, our regulators and the SEC will probably permit us to be more aggressive in provisioning. Needing the federal government to chip in capital because we did not have enough to withstand the storm is resulting in higher capital requirements, and lower ROE expectations. Analysts take note.

What do you think should be the primary measure of FI profitability?

~ Jeff