Looming Problems Portend Hard Times Ahead for Community Banks

Unsettling trends that may not be obvious now – but are vivid when quantified with the right analytics – indicate more trouble ahead for community banks. Survival, from a shareholder value perspective, will require a radical new approach to M&A. 

By Kamal Mustafa, Invictus Consulting Group Chairman

Community bankers have reinvented themselves in the last eight post-recession years. Between the capital losses of 2008 and 2009, increased regulatory constraints, an extended slow recovery and the artificial interest rate environment, senior executives have faced and overcome challenges of an unprecedented nature and magnitude. They have accomplished this – in most cases – without analytical systems that can quantify, analyze and project the impact of the aforementioned changes.

Due to the limitations of legacy analytical and reporting systems, all their actions have been defensive and reactive, rather than offensive and proactive. Unfortunately, there are serious community banking issues that have been bubbling below the surface that are due to see the light of day in the upcoming years. These issues will affect practically every community bank, no matter its profitability.

Traditional analytics and financial reporting show that practically all community banks are facing some level of earnings compression. Most of these systems indicate a fairly slow but steady decline in gross yield on assets, with this decline historically offset by steady or marginally improving net interest margins. (See chart). Traditional extrapolation of these results would indicate a shallow but slightly declining trend in community bank earnings. The response to this dollar earnings compression has been – and continues to be – an increased emphasis on organic growth.

Unfortunately, these historical financial statements and existing pro forma models are repeating the errors of the post-recession world. The assumption that historical trends can be simply extrapolated based on recent history is wrong. Even worse, it is masking the underlying turbulence that is about to strike the community banking market. It is only when you break down and quantify the components and patterns that affect gross loan yield and the different timing patterns affecting the cost of funds (deposits) that one can measure the magnitude of the problems bubbling just below the surface.

To best illustrate and quantify these potential problems, it’s important to first review the community bank market’s post-recession performance, using appropriate analytics that take into account the considerable impact of monetary policy.

As illustrated in this next chart, which shows the prime rate since 1990, interest rate troughs are not a new phenomenon. However the present trough, created by the post-recession monetary policy, is unprecedented in not only its depth but more importantly by its extended duration. It has lasted long enough to influence more than 80 percent of existing loan portfolios.

The following chart shows the distribution of loans for every community bank in the country by gross loan yield based on loan vintage, for the past four years. One can clearly see the increased “poisoning” of the balance sheet as higher yielding loans continue to run off the banks’ books and are replaced by lower yielding “trough” loans. As is evident from the graphs, there has been a steady decline in gross loan yields across the community banking system. Ongoing organic growth will continue to make this situation worse.

So what does this mean? Here comes the insidious part. In spite of this increasing poisoning of loan portfolios (declining gross yields), the actual net interest margins and profitability declines have not displayed a corresponding deterioration.

Traditional analytical tools and accounting systems indicate increased pressure on NIM spreads and net profits, but they do not even approximate the magnitude and rate of decline in gross yields. As mentioned earlier, extrapolation of these trends using legacy tools would merely show a shallow slope to this deterioration that could be easily mitigated by an eventual uptick in interest rates.

All the while, analysts and shareholders are pressuring bank management to increase dollar earnings. Their answer: increased asset growth. And that is part of the problem. Bankers are flying blind by relying on these outdated analytics.

Let’s analyze the impact of gross yields in asset portfolios. The trend will become easier to see if we superimpose the cost of funds on the prior chart.

As can be seen from this chart, the decline in gross loan yields has been effectively offset with a corresponding decline in the cost of deposits, resulting in a net, relatively minor, degradation in bank net interest margins. If banks are using traditional analytical processes and accounting methods, they would assume that increasing asset volume is a partial but seemingly effective solution to the degradation in dollar earnings. This approach is dangerous. It is actually driving the community bank ship directly into the reefs.

Appropriate analytics provide far greater clarity. Consider the following two critical facts:

As pre-recession and pre-Bernanke-era loans (with their higher yields) run off the bank’s books, they are replaced by post-Bernanke-era low yielding loans. All incremental growth is also booked at these low rates. Each year the percentage of pre-recession and pre-Bernanke-era loans (with their higher yields) decreases at a fairly rapid rate, while new and replacement loans (with low gross yields) continue to grow as a percentage of the total portfolio.

Historically, the post-Bernanke deposits continued to follow the same pattern, with rates declining across the deposit base. However, the near matching decline in deposits has year-to-date positively affected the funding of the entire asset portfolio (pre-and post-Bernanke). As a net result, the net spreads of the declining, but still present, on the books (pre-Bernanke) higher yielding portfolios has widened, largely compensating for the new and replacement loans written at the post-Bernanke depressed rates. This is extremely important.

Unfortunately, the stage is now set for this process to reverse itself, a reversal that is far from evident if one were to rely on traditional financial statements and legacy forecasting systems.

Deposit rates have now plateaued close to their lowest possible level. As a result, the compensating increasing spreads across total loan porfolios have come to a grinding halt.

The higher rate pre-Bernanke loans will continue to amortize fairly rapidly, continually being replaced by low gross yielding market loans. The net effect of this ongoing reduction in total portfolio gross yields and plateaued cost of funds will have a massive and cumulative impact on bank profitability and returns in the next few years.

This impact will be dramatically different than trends extrapolated using legacy analytics and bank financial accounting statements. Banks that do not recognize these key trends and take appropriate action immediately will be left in fairly dire straits.

A rising interest rate environment will make the situation even worse. The cost of all deposits will increase very rapidly, while loan portfolios will turn over at a far slower rate, further compressing spreads. It goes without saying that recent and near-term organic growth substantially increases the amplitude and duration of these previously undiscovered negative trends.

There are some very practical solutions to this scenario, which will be explored in a future issue of Bank Insights, but the problem must first be recognized and quantified.