Earnings are up in the Banking industry! That’s great news. What’s behind it is not so reassuring.
The 2011 first quarter consolidated report from the FDIC showed positive bottom line results. This is good news. Loan losses are down, and this has been a key indicator for not only the health of the banking industry, but for the housing market and of the overall economy. Is it a sign of good things to come?
Here are some notable highlights from the latest FDIC report:
“This is only the second time in the 27 years for which data are available that the industry has reported a year-over-year decline in quarterly net operating revenue.” FDIC Quarterly 1 2011, Volume 5, No. 2
“This is the fifth-largest quarterly percent¬age decline in loan balances in the 28 years for which data are available” FDIC Quarterly 1 2011, Volume 5, No. 2
Improvement in earnings is certainly a good sign for the banking industry and a relief to many. The reduction in charge-offs and provisions was significant enough to drive overall earning up and is a key sign that the industry is well on its way towards solving credit related issues. To get back to net-income levels of 2006, which were nearly double of those from 2010, charge-offs certainly need to be reduced further. The latest quarter reduction was a significant improvement, however charge-offs for the quarter were still higher than in all of 2006.
After the reduction of charge-offs and provisions, the results do not go very far to show signs of improved performance in the business of banking. Revenue was down and expenses are up year-on-year, while loan volume has shrunk. In the short term, as the industry continues to work through credit related issues and reduce the amount of losses stemming from the financial crisis, long term results are not likely to show improvement unless other issues are addressed. Whether or not the progress continues will depend on the ability to improve on the underlying business.
Deposits are up and have been increasing steadily for years. Normally, this should result in an increase in service charges and provide a boost in earnings. Unfortunately, the relationship between deposits and service charges has not held up. Total service charges fell by 15% in the last year while deposits rose by 4.2%. Comparing the latest four quarters to 2006, deposits have grown by 50% while service charges shrank by 5.2%.
As deposits grew, interest expense has steadily declined. In fact, while total deposits grew 4.4% from Q1 2010, interest expense shrank 10% as interest rates on deposits have shrunk to negligible levels.
Normally a huge benefit, banks have not been able to utilize those deposits towards income producing assets, a situation that is likely to persist. The tight credit market makes the reduction in net interest income understandable. The unknown is how long it could take to get to a period of sustainable loan growth. The regulatory environment has provided much uncertainty in this regard. No one is relying on an immediate swing back to 2006 levels, but moderate growth would be welcomed. Banks have been fighting to grow profits or get back to profitability and the number of profitable banks has risen. There are many strategies being employed to improve profits and it is clear that larding on the assets to become bigger is not the solution. With interest rates at near all-time lows, relief won’t come from rate adjustments. In fact, rates can only increase over time.
Non-interest income declined 4% from Q1 2010. Offset by gains in interest rate exposure, net servicing fees and fees on deposit accounts shrank considerably. In fact, excluding the gains from interest rate exposures would result in a 12% decline in non-interest income. Since interest rate exposures are largely dependent on external factors and tend to be erratic from quarter to quarter, steady income in this category is not typical. As interest rates rise from current (relative) lows, reliance on gains from interest rate exposures will be a challenge.
Excluding amortization and goodwill impairment, Non-interest expense rose 8% from Q1 2010. Salaries and Benefits and Other Non-Interest expense rose by 8.6%. Premises and Equipment expense rose slightly and amortization and goodwill impairment decreased. Surely certain institutions are focused on expense reduction, but the industry as a whole is spending more and seeing little in return.
In the five years leading up to and including 2006, the average efficiency ratio amongst US banks was 59%. Since 2006, the average is 63%. Of course this varies (sometimes drastically) from bank to bank, and typically larger institutions tend to have lower ratios, however this indicator demonstrates the need to return the industry to more steady and profitable results.
It is becoming increasingly clear that reduced loan losses are not going to be enough for sustained improvement. The regulatory environment is making it hard to increase or even maintain fee revenue. Reliance on fee income from payment products is not what it used to be. Loan growth will also be a challenge as the market leans towards more conservative risk models (and rightfully so). Simply outlasting the cycle and waiting for the good old days to return will not work.
Banks that are expending a significant amount of resource to counteract their credit issues will have the ability to reduce expense or repurpose their resources towards more productive activities as the problem subsides. Bringing the industry back to more normalized credit losses may still take years, so the reduction of associated expense will likely be a slow burn-off. The underlying business must achieve increased revenues in net interest and non-interest categories with attention to expense reduction and efficiency at the same time.
The credit crisis is a monstrous problem and requires significant attention, however the focus should be on customer needs, not on problematic customers. The leaders in the market will focus their staff on the customer experience, revenue enhancement and expense reduction programs in the short term in order that they exit the cycle of credit losses with a long term competitive advantage. These latest results show much needed progress and shows that many are executing strategies towards profitability. At the same time, more is needed and the underlying business of banking needs attention.
Carl LoBue, Jr. CLOBUEJR@LOBUE.COM (702)241-3565 Acknowledgements: FDIC Quarterly, Volume 5, No. 2. ; Bankrate.com