Bank Earnings Trends

The Federal Reserve’s actions in response to the U.S. economy’s sluggish growth and high unemployment rate have virtually ensured depressed bank earnings for the foreseeable future.

The Federal Open Market Committee (FOMC) recently proclaimed that it will “keep the target range for the federal funds rate at zero to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” In addition to keeping interest rates “exceptionally low,” the Fed is embarking on another round of quantitative easing (QE3)—this time with no end date in sight. Indeed, the spigot is now open.

The obvious impact to bank earnings of Fed Chairman Ben Bernanke’s monetary policies is that net interest margins will continue to contract as we have seen virtually every quarter since 2010. Deposit costs are as low as possible, and loan yields will continue to decline as higher rate loans are replaced with lower yielding assets. Interestingly, as the chart [below] depicts, banks with assets less than $1 billion have been able to sustain higher net interest margins than their larger brethren, who have brought down the industry’s margins in lock-step. Banks less than $1 billion maintain a net interest margin of 3.75 percent, while those greater than $1 billion average a net interest margin of 3.42 percent through Q2 2012.  Nevertheless, the majority of banks of all sizes are seeing NIM contraction.

When margins contract, banks are forced to pull other levers in order to maintain consistent net income streams:

• As asset quality has improved across the industry, banks have been able to release reserves back into income, although at some point this strategy will end as banks are unable to continue depleting their reserves.
• Declining interest rates have meant increases in the value of securities portfolios for many banks which, in turn, increased income from realized gains on sale; however, securities yields will continue to decline during the low interest rate environment and future gains on sales will decline.
• Noninterest income is notoriously difficult to generate—especially for community banks—and lawmakers have cracked down on fees such as overdraft, rendering this strategy more or less futile.
• Banks can streamline operations and become more efficient, although at some point this strategy faces diminishing returns.

All the strategies above can help maintain earnings for the short term, but eventually they will leave bankers grasping at air without any more levers to pull. Absent an increase in net interest margins, returns on assets will continue to decline; this is inevitable. At that point, banks will face a choice: increase credit risk and loan volume to generate yield, increase interest rate risk by stretching for yield, or accept diminished returns. Certainly, one unintended consequence of Chairman Bernanke’s policies is that banks will begin to take on more credit and interest rate risk, threatening the industry’s renewed strength once again.

However, another strategy exists to increase shareholder value: exploring an acquisition or merger is one of the only ways to increase returns in today’s environment. Both buyers and sellers can benefit greatly from this strategy if the right deal is struck. A buyer can increase its net interest income by combining with a partner that has higher yielding assets or a lower cost of funds. Furthermore, cost savings can result in a more efficient operation. Likewise, sellers tired of fighting for returns—particularly those small, community banks—can achieve a liquidity event and cash out or ride the buyer’s stock, resulting in returns that could take years to achieve on a standalone basis.

Banks can expect at least another three years of difficult returns. Thankfully, the industry’s balance sheets are healthier, and it is likely industry consolidation will pick up precipitously as a consequence.