Should Bankers Pursue an Asset Driven or Core Funded Strategy?

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

Bankers: Think about what gets measured.

"What gets measured, gets managed." Why did we need Peter Drucker to point this out? Educators are forever carping about standardized tests because they are spending a lot of time on teaching kids to improve their test scores.

Baseball players are measured on batting average, on base and slugging percentages. So they are spending significant energy to improve them. Why is this a bad thing?

Because in banking, what we measure is not always consistent with where we want our institution to go... i.e. with our strategy. We measure branches by number of accounts opened. And we're surprised that Wells Fargo gets accused of opening accounts without customers' knowledge. We measure lenders by size of portfolio, and we're surprised that we drop rate, points, and covenants to get deals done.

I recently did a podcast for PrecisionLender regarding this subject for lenders entitled: Using Bank Data to Get Better Results. That's right, I did a podcast. I only learned a few months ago what a podcast was.

But if you didn't invest the twenty minutes to listen to the interview, I'll exemplify my comments about another way to measure lender performance. The age-old measure by portfolio has led to what we have today... lenders willing to make any concession to get a deal done. A done deal is the best deal.

But what if your strategy revolves around superior service to a certain commercial customer segment? How would you measure it. Most likely the size of the lenders portfolio plays a part. But should the lender be the best price if he/she provides the best advice? That runs the risk of providing Four Seasons service at Motel 6 prices.

So I suggested using different measurements, such as coterminous spread, coterminous spread less provision, pre-tax portfolio profit, and ROE. See my suggestion exemplified in the table below.

Now this lender's portfolio may be considered small, at $30.3 million in the current period. But it has been growing, while maintaining its spread. When considering the provision expense, which brings credit quality into the picture, spread has grown from 1.95% to 2.01%, all while growing the average balance of the portfolio.

You can see this portfolio took a credit hit in CP-1, as the provision spiked a bit, possibly due to a loan downgrade and the resulting provision increase. 

But overall this lender's trend is good, as represented by the ROE increase from 15.89% to 17.34%. Which brings us to a second report I suggest for lender accountability, the Schmidlap National Bank Lender Ranking Report.

It is clear from this report that Jeff's portfolio is relatively small, ranking him 8th of 12 lenders. This contributes to the bottom half ranking in Net Asset Spread on a dollar basis, Net Asset Spread Less Provision on a dollar basis and ROE.

But the portfolio is growing, ranking him 3rd, and the Net Asset Spread percentage has him 2nd, even when considering the provision. So there are some positives in Jeff's performance. Which is good because I wouldn't want to be let go from my fictitious lending job at a fictitious bank. 

Imagine the behavior that would ensue if you held your lenders similarly accountable? The performance review would go like this: "Jeff you are doing an excellent job maintaining pricing while growing your portfolio with strong credits. Your biggest challenge is continuing to grow the portfolio. For this upcoming period, Schmidlap will do x, x, and x to help you accomplish this while staying in the top quartile for spread. Let's do this!"

I know Jeff pretty well, and being ranked in the bottom half of his peers won't sit well. Let me get back to some fictitious work!

How do you measure lender performance?

~ Jeff

Why Are Bank Net Interest Margins Under Pressure?

Industry analysts are beating the drum of net interest margin (NIM) decline. Irrational pricing by competitors is often cited in strategy sessions.

But in picking through the numbers, there appears to be something else at work. Factually, NIMs were actually greater in 2013 than in 2007 for Bank and Thrifts, according to the financial institutions included in SNL Financial's Bank & Thrift Index (2.91% in 2007 versus 2.94% in 2013). But NIM has been on the decline since 2010 when it stood at 3.31%.

Is it irrational pricing by the competition? I think all bankers will attest that at the forefront of the financial crisis, credit spreads worked their way back into pricing decisions. Banks were not only more cautious about the quality of the credit, but the yield on the loan too. And this partially explains why the NIM rose from 2007-2010. But has irrational loan pricing driven the NIM south since that time? The below chart shows differently.

                        Source: The Kafafian Group, Inc.

The largest loan categories on bank balance sheets actually showed spread gains during this period, until they finally began to wane in 2013.  This analysis measures loan spreads by taking the actual yield of the loan portfolios, and charging a transfer price for funding the loans using a market instrument with the same repricing characteristics. In plain English, it removes interest rate risk from the spread, often called co-terminous spread. 

How do we explain rising loan spreads, combined with decreasing NIMs? Well one reason can be the reduced benefit of deposit repricing. Financial institutions have benefited by the significantly reduced funding costs brought about by the historically low Fed Funds rate. But that benefit has been mostly exhausted. Leaving re-pricing of loans to be offset by, well, nothing.

The second culprit behind NIM decline since 2010 is the continued decline in loan to deposit ratios (see chart). Perhaps you hear talk of this in your FIs senior management meetings over the last couple of years. "We don't need more deposits because we have no place to put them." "We have tons of cash to lend." Etc.

But loan pipelines are getting fuller as the tortoise-like economic recovery grows deeper roots. With many FIs still mopping up excess liquidity, competition remains strong for those "good" credits, whatever that means. Presumably it means borrowers who will pay you back. This will continue to put pressure on NIMs. Once rates rise, there will likely be additional pressures as the least liquid FIs start pricing up their deposits to keep funding their pipeline. 

Will deposit rates rise faster than the loans those deposits will fund? Time will tell. 

Do you think NIMs will continue to decline, even when rates rise?

~ Jeff