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Consumer Wildcard: Loan Growth Ahead?

As banks look to differentiate performance in 2015, a major question is whether consumers are finally ready to pick up the pace of borrowing.

Finally, after a deep recessionary trough and a painfully slow and uneven recovery, the long-awaited economic expansion has begun. After a three percent increase in total loans held by the U.S. banking industry last year, institutions are on track for five percent loan growth in 2014, and we expect to see the pace accelerate slightly in 2015.

Commercial lending continues to lead the way. The category of commercial and industrial (C&I) lending was the quickest to contract during the recession and the first to recover, along with secured asset-based lending. Commercial real estate lending has now returned to a healthy growth rate, and construction and development lending seems to be stabilizing after a lengthy contraction. We expect strong commercial growth in 2015 with expansion rates ratcheting up from 2014 in all categories.

That is good news, and the question now is whether consumers are finally ready to pick up the pace of borrowing as well. Home mortgage and even credit card balances are inching up after a six-year decline. And a trough may be nearing in the long-troubled category of home equity lines of credit, with at least a bit of growth expected next year.

While it is far too early to call a major turn, banks will be keenly watching housing credit going into 2015, alert for any opportunities to rebuild momentum in this former engine of growth and profitability.

Some positive supporting trends continue to progress, including gains in employment and consumer confidence and a recovery of home equity as housing market values rise (Figure 1: Improving Household Trends). But there are braking factors as well, including uneven recovery in regional markets and among income groups, suggesting selective opportunity instead of broad expansion.

Overall, banks still face challenges in restoring pre-recession levels of return on equity and assets. Factors include the slow market for housing-related credit; continuing compression of interest rate margins; and the expenses and complexities of transitioning to a multi-channel marketplace.

Again in 2015, this leaves banking companies to face a revenue-challenged environment where growth is more about market share gains — winning at the expense of competitors. Leaders will be distinguished by higher-than-market loan growth, funded by more stable and lower-cost deposit sources.

Figure 1: Improving Household Trends

Outperforming both with lending and funding will require sharper analytic skills. This includes better segmentation and targeting of customers with the right offers. It also includes smarter loan and deposit pricing to optimize growth while preserving margins and risk-adjusted returns. Elsewhere, analytics will play a key role in rapidly reconfiguring branch and electronic channels to manage down physical cost while improving sales effectiveness.

Household Sector
Auto lending has been the one bright spot on the consumer side, recovering earlier as consumers could not put off car purchases indefinitely. But housing-related loan balances have languished as residential real estate went through a painful correction.

Going forward, we expect to see increasing growth in HELOC originations, but only modest growth in consumer credit card balances. Residential borrowing likely will remain uneven, both geographically and demographically, with outsized portions of growth coming from the local housing markets that are more fully recovered, and from home purchases among higher-income families.

Questions for Mid-size and Community Banks

The specifics of how to improve loan growth while preserving stable funding will vary by bank size, business composition and market position. But some clear questions stand out for mid-sized regionals and community banks largely engaged in local intermediation, or classic deposit-gathering and lending in the local footprint:

  • How to win in local commercial lending without compromising pricing and underwriting?
  • How to keep the distribution franchise relevant and effective?

Mid-size regional and community banks are predominantly local commercial lenders. The traditional differentiator for smaller banks was deep local relationships. But commercial lending spreads have fallen consistently and considerably in recent quarters, forcing many competitors to fall back on price to win business.

Here, smaller banks must develop additional differentiating levers. These include developing superior knowledge of customers and refining local market pricing; smarter negotiating tactics for relationship managers; improved treasury management products; and more consistent relationship building.

With deposit gathering, local banks face both demand- and supply-side issues:

Demand side. Consumer channel preferences are evolving away from the local branch and toward online channels. And the proliferation of remote deposit capture is eliminating the last piece of paper that required customers to come to a local branch.

Supply side. Smaller regionals are surrounded by formidable competitors, including national banks with extensive branch franchises; a new generation of direct banks with powerful brand names; and credit unions with both local appeal and a not-for-profit business model. Here, smaller regionals must find ways to modestly refresh their core local branch networks while still offering adequate e-channels.

Personal touch and service will remain at the forefront of differentiation, and these attributes must translate into effective in-branch sales, coupled with new ways to reach local customers. This will be no mean feat for smaller regional banks, but essential if they wish to avoid ending up with higher deposit rates as the sole lever in the competitive hunt for funding.

— Lee Kyriacou


Next year’s outlook for consumer and residential borrowing is heavily influenced by aftershocks from the crash of five years ago, and it is helpful to review some of the chronology to see these influences at work. Chief among them is housing equity, which affects more than three fourths of all consumer borrowing.

On paper, the rapid run-up in housing prices of a decade ago provided what seemed to be an ever-growing cushion of home equity, or market value in excess of outstanding loan balances. Peaking at roughly 60% of the total value of the average home in 1995, this cushion encouraged rampant borrowing with results that are well known.

When the real estate bubble burst, the collective home-equity-to-value (HETV, or the inverse of bank loan-to-value (LTV)) plummeted to less than 40% and stayed there for three long years. Consumers halted unnecessary spending (e.g., reducing credit card purchase, holding cars another year) and paid down debt wherever possible — not just in HELOCs and mortgages, but across the board. The lone exception was student lending, a category that is now served largely by direct federal lending.

Looking to next year, the good news is that recovering home values have buoyed home equity significantly. From the trough of 37% in first quarter of 2009, collective HETV climbed to 54% by the second quarter of 2014. This trend should help contribute to rising growth in all consumer loan categories.
Also there are helpful trends in employment and consumer confidence. From a nearly 10% peak in late 2009, the U.S. unemployment rate had fallen to 6.1% at midyear 2014, according to the U.S. Bureau of Labor Statistics. Meanwhile the running survey of consumer sentiment sponsored by Thomson Reuters and the University of Michigan saw the midyear reading on its index climb from 56.4 to 82.5 between 2008 and 2014.

But now for the post-recession braking factors:

  • First, the recovery is uneven, with income growth and housing appreciation skewed to higher income brackets and more expensive homes.
    Second, while unemployment is down, there is significant “under-employment” and wages have not picked up.
  • Third, while consumer confidence is approaching pre-crisis levels, a good deal of residual borrowing caution is to be expected from individuals and households that felt the full brunt of the Great Recession. Though not as profound as the Great Depression of 1929–1939, the hangover effect is real and will last for quite some time.
  • Finally, much of the housing recovery is related to the historic low interest rates engineered by the Federal Reserve. When rates eventually rise, further home value appreciation will encounter major headwinds.

All in all, this paints a more modest picture for consumer loan growth. Opportunity will go to the banks best able to pick through the market and find it; others risk losing more market share and will feel the greatest pressure to further reduce costs.

Industry Fundamentals for 2015
Deposits have been growing far faster than loans for quite some time, leaving the industry with a record low loan-to-deposit ratio and starved for earning assets. But the situation is easing as healthier loan growth begins to outpace deposit expansion.

Precision Performance

For all banks — particularly the larger banks with multi-regional footprints and some national business lines — there are growing skill requirements that fall under the heading of precision management. These skills revolve around using data-informed analytic approaches to improve decisions, investments and pricing.

Differentiation, segmentation and targeting. Better identification of target customer segments is a foundational component in superior lending and deposit-gathering. On the commercial side, this applies to lead generation and cross-sell prioritization, both hinging on an understanding of potential customer wallet for banking services. On the consumer side, the emphasis is on aligning comprehensive product sets with key customer segments, as well as smarter direct-to-consumer marketing.

Smarter loan and deposit pricing. Just as knowing which customers should or should not be offered credit provides advantage, so too does knowing which customers do or do not require better pricing. On the commercial side, price sensitivity analysis provides the relationship manager with the best information and guidance to negotiate commercial loan products and relationships. On the consumer side, it optimizes rack-rate and lifetime relationship pricing for deposits and loans. In all cases, precision pricing is the key to expanding both sides of the balance sheet without overpaying.

Channel and sales reconfiguration. The franchise realignments of the larger regional and national banks are more complex. Clearly there are consolidations within markets, but there are also considerations with branch redesigns; hub-and-spoke branch options; and small business service models — as well as market-by-market optimization of automated teller machine networks, advertising and brand presence. There is also work to be done in analyzing and redesigning sales efforts, both in-branch and direct, to recover lost productivity and improve returns.

Fee and consumer lending revenue. Larger banks must expand their sources of fee revenue as well as their access to consumer lending markets. Much of this diversification will come from standalone ancillary businesses — mortgage, indirect auto, capital markets, wealth/brokerage and insurance. But banks also must be bold enough to innovate with unsecured lending options for their core relationship customers.

Branding savvy. With online browsing becoming the preferred channel to research financial products, the bank brand is more important than ever before. A comprehensive and adaptive branding strategy that covers markets, segments and products — both physical and online — is now a requirement for better multi-regional and multi-channel performance.

— Lee Kyriacou


Looking forward, we do not expect to see Fed policy affect overall deposit balance growth through the end of 2015, though the onset of rising rates toward midyear will start having modest impacts on which sector holds deposits, and at which banks. As loan growth continues, the primary balance sheet impact will be the substitution of loans for securities, as opposed to major changes on the funding side.

Net interest income will improve primarily on the strength of loan expansion, with no help from net interest margin in the near future. As for non-interest revenue, there are significant headwinds from further regulation and the end of the mortgage refinance boom. Those banks with ancillary fee businesses — capital markets, advanced treasury management, brokerage/wealth management and insurance — will enjoy fee growth, but classic intermediation banks will not.

The industry has been working to push down operating expenses, but next year’s improvements in the efficiency ratio likely will come from revenue growth rather than a further round of cost cuts. One offset is that part of the added revenue will be diverted to loss reserves, necessary to cover expanding loan portfolios.

While these expansionary benefits will increase industry profitability, investor returns will still fall short of pre-crisis levels. Even with increasing stock buy-backs, the industry is carrying a boatload of capital that is difficult to fully leverage in the current environment, leaving muted returns on equity that typically will not exceed 11%.

Catching Up and Differentiating
With economic trends progressing (even without a significant acceleration of consumer lending), banking executives can take a quick breath and try to deal with some deferred issues — clean up or catch up. While the particulars will vary by individual bank, there are some common industry challenges:

  • First, there are the remaining non-performing home mortgages — whether currently carried on bank balance sheets or being put back to originators.
  • Second is fully implementing new compliance requirements, including more robust modeling for the Fed’s Comprehensive Capital Analysis and Review (CCAR).
  • Third is tending to deferred investments in systems.
  • And last but not least, there are the write-offs associated with reconfiguring the increasingly underutilized branch system.

Investors have already set expectations for certain improvements and will be demanding new levels of differentiated performance from the best banks. As credit concerns continue to abate, stock market valuation for banks will more purely center on superior growth and profitability.

For those banks where ROE and ROA are visibly below the industry norm, further near-term cost reduction may be the first order of business. But for most banks, aspirations for improved performance will center on outgrowing the market, helping to leverage a stable expense base. Obviously there will be winners and losers.

In particular, we believe the differentiators of bank performance will be twofold:

Superior loan growth. Beating the market pace of growth will be the clearest way to gain higher valuations from investors. That growth may come from either better positioning in higher-growth loan categories (C&I, CRE, auto, HELOC) or from taking share, and from either new customer acquisition or deepening current relationships — but not at the expense of spreads and credit quality.

Stable low-cost funding. To preserve net interest margins as loans grow, banks must manage their funding sources. This includes garnering deposits without overpaying, especially as interest rates begin to rise, and looking for ways to attract and retain more of the stable core deposits that are now heavily emphasized under Basel III.

Lee Kyriacou is a Managing Director at Novantas Inc., a management consultancy based in New York City. He can be reached at

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