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A gloomy forecast with few bright spots

Many smaller banks face a rough 2012, with only a few alternatives

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By George Darling, Darling Consulting Group

The past four years have been very difficult for the banking industry. Credit losses, increased loan loss provisions, real estate foreclosures, increased regulatory burdens, political demonization, and unfavorable media coverage have all combined to put substantial strains on bank earnings, capital levels, and reputations.

Although levels of non-performing assets (NPAs) have stabilized for many banks, NPAs will still create a drag on earnings into the future. Moreover, the industry is facing additional challenges that could make 2012 another stressful year; the two most significant being declining levels of net interest income (NII) and controlling operating expenses.

For many, it will be another tough year. Let’s review the outlook in more detail, and then I’ll address a few strategic wrinkles.
Declining Net Interest Income (NII)

NII for a bank is analogous to the Gross Profit Margin for a manufacturing company. NII is the difference between what a bank receives for income on its assets (loans and investments) and what it pays for the liabilities (deposits, borrowings, and capital) it needs to fund those assets. NII has been under downward pressure for most of 2011 and will continue to be stressed in 2012 as a result of:
• Weak loan demand: The weak economy, political uncertainty in Washington, an anti-business regulatory environment, and the escalating costs of hiring and health care are keeping many businesses from expanding in this country. Very often successful businesses and individuals are paying down debt as the country continues to deleverage from the excesses of the past 30 years. Since the primary earning asset of a bank is its loan portfolio, the lack of loan demand is very detrimental to a bank’s income.
• Intense competition/irrational pricing: The dearth of lending opportunities has created an intense competitive environment and, in many markets, irrational pricing with little or no compensation for risk. Banks that are able to grow their loan portfolios have usually done so by stealing customers from other banks based upon price. As a result, loan yields are under intense downward pressure as loans either renew or re-price in the current environment.
• Counterproductive Federal Reserve interventions: The Federal Reserve has been very aggressive in its efforts to keep longer-term borrowing rates low. Quantitative Easing (QE1 and QE2) and the current Operation Twist have flattened the yield curve and driven longer-term rates to historically depressed levels. One consequence of these actions is to make investments very expensive and the resulting yields extremely unattractive. With weak loan demand, banks find it necessary to put excess cash to work at yields that neither compensate for interest rate risk nor enable them to earn enough of a margin to cover overhead.
• No ability to lower funding costs: Most banks have aggressively lowered the rates paid on their deposits to offset the declining revenues on assets. Many banks are approaching a funding cost of zero while they will still need to pay assessments for FDIC insurance. For many bankers, it will be very difficult, if not impossible, to offset continued asset revenue declines with further reductions of funding costs.

The decline in NII will be a serious challenge for the banking industry in 2012 unless loan demand suddenly increases and/or the yield curve steepens considerably (e.g. the Federal Reserve exits the market). A sampling of 197 banks modeled by the Darling Consulting Group for balance sheets as of 9/30/2011, showed a projected average 12-month decline of NII (month 1 year 1 versus month 1 year 2) of 4.34% for 62% of the banks modeled.

When looking out a little further, comparing the first quarter of year 1 with the last quarter of year 2, the results were even more dramatic. The percent of banks showing declines of NII increased to 65% and the average projected decrease increased to 5.15%.

And these results did not factor in significant levels of loan prepayments, nor modifications that also may be demanded by the strongest commercial borrowers as a result of the intensified competitive environment.
Controlling operating expenses

The combination of decreasing NII and the inability to invest excess cash at reasonable profit margins raises the concern about a bank’s ability to cover operating expenses if the current environment persists over a multi-year time period. When comparing non-interest expenses for the nine months ending 9/30/2011 to the nine months ending 9/30/2010, excluding the loan loss provision, these expenses increased 8.85% for all banks in the U.S. For banks with assets over $10 billion, the increase was 10.1%. For banks with assets less than $10 billion, the increase was 4.3%.

For banks to survive this current environment it will be necessary to better control, and preferably reduce, non-interest expenses. This will be especially critical for banks with under $10 billion in assets as it seems that opportunities to increase non-interest income are limited as compared with larger institutions. (For the same 9-month period banks over $10 billion in assets increased non-interest income by 2.9% versus only 0.04% for banks under $10 billion in assets).

This need to control/reduce operating expenses comes at a time when expenses are under significant upward pressure as a result of increased costs to comply with new regulations and consumer legislation, and mandated improvements in risk management processes. For many banks, this will result in branch closings, personnel layoffs, and reduced or more expensive service offerings. For smaller institutions, the result may be the sale to, or merger with, another bank.
Strategic implications

Unfortunately, there are no simple solutions to the challenges banks are facing in the current environment. Each bank must continue to manage to its strengths and strive to overcome its weaknesses. Strategic planning and focused asset/liability management have never been more critical, albeit the planning horizon may be much shorter than the usual three to five years.

Bankers must focus on the balance sheet to find ways to either maintain or slow the rate of decline in NII. Some balance sheet strategies may require the bank to portfolio loans it might ordinarily sell (i.e., 15-year mortgages) or to be more aggressive with loan pricing for the most desirable assets with the best credit quality. Strategies may require accepting more interest rate risk than the bank would usually take or more aggressive lowering of deposit rates, even at the risk of customer defections. Whatever the strategy, it will not be business as usual!

Finally, each bank must confront itself with the key questions regarding its own viability:

• “Why do we exist and how will we compete successfully in the future?”

• “What will differentiate us from the other banks?” 

These are two difficult questions that every bank must be able to answer as part of their planning process. Never have the answers to these questions been more important!
About the author
George Darling is CEO of Darling Consulting Group, Newburyport, Mass. Darling and the consultants of his asset-liability management firm write the "ALCO Beat" column. Darling’s professional experience includes: thirty years with his own company, two years as a senior executive with a $2 billion financial institution, two years with a Big Five Accounting firm, and ten years with IBM. He is a nationally-recognized resource for assisting financial institutions in the areas of interest rate risk management, liquidity management, and capital planning.

ALCO Beat articles featured exclusively on are written by the asset-liability management experts at Darling Consulting Group. Individual authors' credentials appear with their articles. DCG's consultants have served the banking industry for more than 30 years. You can read more about the firm's history here.

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