The Fed Effect

Bank Director’s 2019 Bank Performance Scorecard

Click below to see this year’s rankings.

The Federal Reserve was in a giving mood in 2018, while many banks were not.

Four interest rate increases by the central bank last year-which upped the federal funds rate by a combined 100 basis points-was a double-edged sword for the banking industry. Higher rates generally led to higher deposit costs as retail customers shopped around for better deals, but also enabled asset-sensitive banks to reprice many of their existing variable-rate commercial and residential mortgage loans.

In many instances, banks were able to increase the pricing of their loans faster than their deposits as rates went up.

The three top finishers in Bank Director’s 2019 Bank Performance Scorecard-a ranking of the 300 largest publicly traded U.S. banks across three size categories-were uniquely positioned to benefit from rising rates, with an inordinate share of their assets allocated to variable-rate loans. For the second year in a row, Dallas-based Comerica placed first in the $50 billion and above asset category. Western Alliance Bancorp., which is headquartered in Phoenix, took top honors in the $5 billion to $50 billion asset category. And Southfield, Michigan-based Sterling Bancorp, which is primarily a residential mortgage lender, was the top ranked bank in the $1 billion to $5 billion category.

“What you really wanted was a bank that … had loans that were tied to LIBOR or [the] prime [rate], and were funded with core deposits,” says Tom Brown, chief executive officer of the hedge fund Second Curve Capital, referring to the the London Interbank Offered Rate. “So you lagged your core deposit rates when rates went up, and you got the immediate benefit on the asset side.”

The 300 largest public banks are also ranked against each other as a single group. The top ranked bank was Sterling, followed by FS Bancorp in Mountlake Terrace, Washington, and Louisville, Kentucky-based Stockyards Bancorp. Western Alliance placed seventh in this separate ranking, and Comerica twentieth.

The Bank Performance Scorecard uses five metrics that measure performance across a range of attributes that are commonly associated with strong banks. Return on average assets (ROAA) and return on average equity (ROAE) are used to measure profitability. Capitalization is captured through the ratio of tangible common equity (TCE) to total assets, while asset quality is measured through the ratios of nonperforming assets (NPA) to total assets, and net charge-offs (NCO) to average loans. The banks receive a numerical score for each of the metrics, which are then added across to arrive at an overall score. The lower the overall score, the higher the ranking. For scoring purposes, ROAA, ROAE and the TCE ratio are given full weighting, while the two asset quality metrics are each given a half weighting. As such, the Scorecard rewards well balanced banks across the five metrics, with a slight bias toward profitability.

The Scorecard ranking was compiled by the investment bank Sandler O’Neill + Partners using data from S&P Global Market Intelligence.

The banking industry as a whole posted record profits in 2018. Net income for the industry was $237 billion compared to $183 billion in 2017, according to the Federal Deposit Insurance Corp. Those results were heavily influenced by the Tax Cuts and Jobs Act of 2017’s reduction in the federal corporate tax rate from 35 percent to 21 percent. Without the lower rate, the industry’s net income would have been $208 billion, according to the FDIC.

There was also significant improvement last year in the industry’s net interest margin, which rose to 3.40 percent from 3.25 percent in 2017. A 28-basis-point increase in funding costs was more than offset by a 43-basis-point rise in average asset yields as most banks were able to reprice their loans faster than their deposits, according to the FDIC.

As a group, the Scorecard’s 300 banks turned in a strong performance in 2018. The ROAAs and ROAEs in each size category were higher last year than in 2017. For example, in the $50 billion and above category, the median ROAA and ROAE were 1.29 and 11.35, respectively, compared to 1.04 and 9.24 in 2017. The other size categories saw similar increases year over year. “Those are as good a set of numbers as I can remember in the 25-plus years that I have been doing this,” says Mark Fitzgibbon, director of research at Sandler O’Neill.

Another trend that was evident in the Scorecard’s universe of 300 banks was a plateauing of loan quality metrics at many institutions-a reversal of the previous three years when loan quality metrics showed significant improvements in year-over-year comparisons. NPA and NCO levels for the group did improve in 2018, but by a lesser magnitude than in previous years.

Why is this trend important? Improvements in loan quality did not appear to drive the industry’s profitability in 2018 as much as in the 2015 to 2017 time periods-and may not in 2019, either. “I don’t think you’ll see a decline again this year in the level of problem assets,” says Fitzgibbon. “The economy is still strong, but I think we’re certainly done with nonperforming asset levels going south.”

Although asset quality generally remained high across the industry last year, and any decline will most likely be modest at best unless the economy takes a sudden turn for the worse, it is unlikely that loan recoveries and reserve releases will drive earnings in 2019 to the degree they did in previous years. “In the first quarter, we saw some reserve building at some of the banks in my [coverage] universe,” says Allen Tischler, who follows several large institutions for Moody’s Investors Service. “Reserve releases are not going to be a driver of earnings improvement going forward as [they were] in the past.”

Comerica, the top-ranked bank in the $50 billion and above category, may be the poster child for asset-sensitive banks that benefited from last year’s rising rate environment. Comerica’s net income rose 32 percent last year, to $1.24 billion, while its noninterest expense actually declined 3.6 percent, reflecting the culmination of a multi-year program to cut costs.

“Comerica is about the most asset sensitive of the large banks out there,” says Scott Siefers, an analyst who covers the company for Sandler O’Neill. “The Fed was in a pretty consistent interest raising posture, and no one was as well positioned to capture the benefits of that kind of environment as Comerica.” Much of that benefit came through the repricing of variable-rate commercial loans the bank already had in its portfolio. Comerica also made the strategic decision to not hedge its interest rate exposure in 2018, according to Siefers, “which allowed them to see more of the benefits drop to the bottom line.” The bank’s net interest margin jumped from 3.11 percent in 2017 to 3.58 percent last year.

That Comerica was able to reduce its year-over-year noninterest expenses while also generating higher revenue had the effect of turbocharging its earnings. “Not only was the revenue environment very favorable for them last year, they also had cut costs really aggressively,” says Siefers. “That really expanded their positive operating leverage as a result.”

Comerica also announced in April that its president, Curtis Farmer, had been promoted to chief executive officer, succeeding Ralph Babb Jr., who assumed the role of executive chairman. Farmer has been with the company since 2008. Comerica did not respond to several requests to interview Farmer.

The No. 1 bank in the $5 billion to $50 billion category, Western Alliance, also benefited from the shift in monetary policy last year. Forty-three percent of its loan portfolio consists of commercial and industrial or construction and land development loans, which typically have variable rate structures that reprice as rates go up. This, along with an extensive niche lending operation that focuses on industries where it can earn a high rate of return, contributed to a robust net interest margin last year of 4.68 percent. The bank reported net income for the year of $436 million, a 25 percent increase over 2017.

With $23 billion in assets, Western Alliance is essentially a pure commercial bank with a small retail banking business. Most of its deposits come from its commercial customers, and it is a formidable competitor for the larger banks in its market. “In Nevada, Arizona and to a degree in Southern California, they are the only midsized community bank in town going up against the big guys, so they really have an advantage being the local alternative to Bank of America, Wells Fargo, U.S. Bank and others,” says Sandler O’Neill analyst Brad Milsaps.

“We have very few competitors, which allows us to have either pricing stability or price at a premium to the existing market,” agrees Western Alliance President and Chief Executive Officer Ken Vecchione. “We have great operating leverage … and great asset quality. All that combined together gives us above trend earnings growth.” (To read more about Western Alliance, see page 12.)

Sterling Bancorp-the top-ranked bank overall as well as the No. 1 bank in the $1 billion to $5 billion category-also fit the conventional template for high performance last year. Sterling is primarily a residential mortgage lender (it also does smaller amounts of construction and commercial real estate loans), but the majority of its home loans have adjustable rates that are indexed to the one-year LIBOR. Sterling keeps most of these loans on its balance sheet, which enabled it to benefit from rising rates last year.

Tom Lopp, the company’s president and chief operations officer, says Sterling’s interest-earning assets rose 12 basis points in 2018, and 75 percent of that increase was due to repricing. Sterling earned $63 million in 2018, a 67 percent increase over the prior year. The bank did see a 43-basis-point increase in the cost of its interest-bearing deposits, which contributed to a decline in its net interest margin from 4.13 percent in 2017 to 3.94 percent last year. But strong growth and a lean cost structure enabled it to post a 2.06 ROAA and 20.79 ROAE-tops in its asset size category.

Sterling’s 35.4 percent efficiency ratio last year was driven in part by its unusual organizational structure. The bank was founded in 1984, in Michigan, by real estate developer and builder Scott Seligman, and for the first 10 years focused on its local market. But Seligman later expanded Sterling’s banking operations to San Francisco, after moving there to live, because he thought it was a better banking market than Michigan. Sterling eventually sold its Michigan branches to KeyCorp in 2004, and the bank now has 20 branches in San Francisco, with smaller, more recent de novo branch operations in Los Angeles, Seattle and New York. What makes Sterling unique-and contributes to its low efficiency ratio-is that it has kept its corporate headquarters in Southfield, Michigan. Lopp says the bank can operate more cheaply from Michigan than in any of its four banking markets, which helps keep its costs down. Sterling also has a lean management structure, which further lowers its overhead.

“We’re very flat-we pride ourselves on that,” Lopp says. “We have an excellent efficiency ratio, and that’s part of the reason. There are no ivory towers here, and you either embrace that or you don’t. Those of us who have been here a long time certainly embrace it. We think it is a tremendous benefit, because it allows us to make decisions quickly and to react quickly.”

Sterling also benefited from superb asset quality in 2018. It reported nonperforming loans of just 3.5 basis points, and loan recoveries of $168,000. Part of the reason is that the residential mortgage market continues to perform well, but Sterling also has a conservative underwriting philosophy. Lopp says the bank requires a loan-to-value ratio as low as 65 percent on its mortgage loans. “That does two things,” says Sandler O’Neill analyst Aaron Deer. “One, it gives the bank protection, but two, it puts more more skin in the game for borrowers. They don’t want to lose the equity that they’ve put in there, so they’re going to make sure those payments are good.”

One of the most unique banks among the Scorecard’s top performers is Santa Clara, California-based SVB Financial Group, which placed second in the $50 billion and above asset category. SVB focuses primarily on the venture capital and private equity sectors through its Silicon Valley Bank subsidiary, and lends both to the funds themselves and to the startup companies the funds invest in. The company’s net income in 2018 nearly doubled, to $974 million, in a year-over-year comparison.

An important element of SVB’s business model is how it has tapped into the money flows characteristic of startup companies that have received funding from venture capital or private equity firms. These companies tend to be highly liquid and provide the bank with low-cost commercial deposits. SVB’s average noninterest-bearing deposits grew 12.5 percent in 2018-and at approximately $40 billion, accounted for 82 percent of its average total deposits. That these are commercial deposits, raised without the expense of a high-cost branch system, contributed to the bank’s 45 percent efficiency ratio last year.

As with the Scorecard’s other strong performers, SVB benefited from last year’s rising rate environment. “They’re arguably one of the most asset-sensitive banks in the country, so they got a nice lift in their net interest margin as a result of rate hikes that occurred in 2018,” says Deer. “Their margin in 2018 was 357 [basis points], and that compared to 305 in 2017.” The bank’s loans grew 23 percent last year to $28.4 billion.

At a more fundamental level, one of SVB’s advantages is that it’s the dominant lender in Silicon Valley. “This is the niche we’ve been in for 35 years,” says President and CEO Greg Becker. Because of its specialty focus, SVB has a deep understanding of the investor community, the companies they invest in, and the private equity and venture capital industries generally. “We can support them personally, we can support their companies, we can support their investors, and we do it on a global basis,” Becker says. “And so, all those things fit together incredibly well, and I would say [that] has been a key part of our long-term success.”