The slow recovery will force banks to deal with branch overcapacity and changing business models — and hunt more aggressively and intelligently for revenue growth.
2012 marked a significant earnings recovery for U.S. banks, driven largely by continuing improvement of credit quality, but also by putting un-lent deposits to work in securities portfolios; recovering loan growth in some non-real estate categories; and cost cuts. Amazingly, considering the travails of the recession, the industry booked $141 billion of profits in 2012, approaching the record level achieved in the roaring economy of 2006 (including all FDIC-insured depositories).
Yet despite this performance, stock valuations are depressed from historical levels, with most of the large commercial banks trading near book value or even less. Investors are not satisfied with returns on equity and assets, which remain below pre-recession norms (Figure 1). And as the cushion from falling loan-loss provisions dwindles, issues with sustainable revenue growth are more visible and acute. The situation spells continued performance pressure for 2013. In their quest to improve market valuations, banking leaders will be dealing with three fundamental issues, including: 1) continuing low interest rates and margins; 2) weak loan demand; and 3) structural overcapacity in retail banking.
While the depressed rate environment probably will extend through all of 2013, there is still hope for a further modest pickup of loan demand. Winning banks will outcompete to win share of market and superior loan growth. Meanwhile, all banks will face pressure to rapidly redesign their retail banking franchises, both to reduce cost and to realign resources around new distribution models.
This is a different kind of economic recovery and it continues to defy tactics and expectations based on previous cycles. Some banking industry profit drivers are extraordinarily slow in rebounding and others will never return to pre-recession levels. Meanwhile there is a growing need for reinvention as multi-channel customers shift more activity away from their local branches.
Rates. The ongoing low interest rate environment — now in its fifth year — is taking a toll on bank net interest margins. Initially falling rates were a plus for banks as funding costs fell more rapidly than asset yields. Further along in the cycle, however, deposit rates can go no lower and yields from loans and securities investment have continued to drift down in a slack market, slowly eroding margins for banks.
While Fed macroeconomic policy has ballooned bank deposits, the lack of loan demand or other higher-yielding investments has slashed balance sheet efficiency in generating spread income. As a coping tactic, banks have expanded their securities portfolios, wringing only modest income from a higher volume of low-yielding assets.
One temptation in the current rate climate is to book higher-yielding, longer-term assets (both securities and mortgages) to squeeze out more margin. But this introduces more interest rate risk, given the potential for short-term funding to re-price more rapidly in an eventual recovering rate environment. To the extent that banks cannot adequately hedge against this risk, it becomes another braking factor on portfolio strategy.
Consumer Loan Demand. While low rates and tepid loan demand are typical at the onset of a cyclical recovery, there is also a structural issue for loans and debt issuance. The housing bubble encouraged homeowners to borrow excessively, in line with perceived home appreciation, fueling an expansion in mortgage debt as well as debt securitization. While mortgage debt previously hovered at roughly 35% to 40% of home value for the average family, that figure soared above 60% when the market collapsed.
In turn we have entered a long period of consumer deleveraging and lower loan demand, with further impact on home equity lending as well (Figure 2). One bright spot is that mortgage origination volume has rebounded, largely from low-rate refinancing which has just about run its course, but also from home purchases as the housing market begins to revive in many areas of the country. However, overall consumer mortgage balances likely will remain flat to falling as hangover debt is worked down.
On the capital markets side, the go-go years of securitizing anything and everything are gone for good. This has created substantial fixed income overcapacity — even before any impact from regulation on proprietary trading.
Overcapacity. If low rates were the sole affliction for retail branch banking, then managers might have been right to simply wait for the economy to restore deposit spreads. But the retail business model also took massive hits to its two other primary revenue sources — overdraft fees and debit interchange — following new regulation. The combined effect has been to depress equity returns on deposit-taking to single digits or break-even, and to force a rethinking of the “free checking” consumer business model.
On top of this, there is a fundamental customer behavioral shift to deal with. Mirroring trends in other retail chains such as bookstores and electronics stores, technology and changing preferences are rapidly shifting consumers out of the branch and into electronic channels. We see this in the rapidly growing segment of “virtually domiciled” (vs. branch domiciled) customers who rely on web/mobile banking and seldom visit the branch.
Combined with the lowered returns of the retail banking model and unwieldy fixed costs in the branch channel, this has fostered a state of significant over-capacity in branchbased businesses. The situation will not heal on its own, and there is much restructuring to be done in 2013 and beyond.
Bank executives must focus on achieving superior loan and revenue growth while at the same time redesigning and streamlining their retail banking franchises.
Growth. Loan demand is stronger from the business sector, a good sign of economic optimism — but tempered by the fact that companies are cash-rich and will spend down some of those balances first. Banks with a heavier commercial banking mix will have an easier time with top-line growth. There are also competitive opportunities for banks that can serve the most promising industry sectors more effectively; judiciously refine pricing and underwriting; and win the right pieces of relationship business. Banks with ancillary fee businesses — asset management, standalone card and mortgage units, capital markets, insurance — will also have stronger prospects for above-average growth.
In consumer lending, there are opportunities for banks that can create new unsecured and payments-related credit products and pitch them to the right customers. Winners will also get the most out of their loan businesses with more precise credit/pricing models, and smarter targeting and offers.
The whole area of relationship expansion and cross-sell remains fertile ground for banks that can drive initiatives to full fruition with customers in the branch, online and in the contact center. This remains a prime opportunity to build market share.
Retail Restructuring. On the retail side, banks face a much tougher road to address substantial overcapacity. In the quest to revive network profitability, most players have already harvested the “low hanging fruit,” including select fee increases, higher balance or activity requirements, staff cuts and closing the worst of the zombie branches. Yet these measures are not nearly sufficient to plug the retail profitability gap.
Going forward, we believe that all retail branch banking companies will be caught up in the industry’s long and painful restructuring challenge. Issues include reducing the number and/or size of branches; reconfiguring branch staff to better focus on sales; investing in online and mobile to improve acquisition, cross-sell and retention with multi-channel customers; appropriately encouraging customers to transfer more transaction activity from physical to e-channels; and redefining the retail business model.
The difficulty of the retail restructuring task cannot be underestimated. Closing too many branches or the wrong branches will damage valuable customer relationships and revenues in local markets. Under-investing in e-channels will undercut customer acquisition and sales in the emerging digital marketplace. Pushing customers too hard into lower-cost channels might well push them out of the bank. Raising the wrong fees will actually reduce revenue.
Yet retail restructuring must be done relatively quickly. Several high-performing banks already have gained an advantaged revenue and cost position, and they are further restructuring to gain additional advantage. Meanwhile, alternative banking models — from card lenders, wealth managers and direct online players — all threaten to siphon away customers as traditional ties with the branch continue to erode.
Hence while we believe dramatic transformation is essential and timely, that transformation must also be smart and well planned. In a very real sense, executive leadership will be a swing factor as banks broach a variety of critical transitions this year.
Outlook for 2013
Here are some details on the banking industry outlook for this year, based on industry results, macroeconomic trends and our own industry forecasting:
Loan Growth. The pace of loan growth will pick up further — up from 2%–3% to a more respectable but still sub-par 4%–5%. Commercial lending will continue to lead, though probably not quite at the 14%–15% clip of the past two years. Consumers will continue to de-leverage until real estate values re-inflate somewhat. Mortgage refinancing will cool, offsetting rising origination volume. While overall consumer mortgage balances will come down, we expect banks to hold more mortgages (versus selling them into the secondary market) and therefore to see balance sheet growth.
Deposit Growth. The deposit base will continue to expand, though possibly slower than the current 6%–7% pace. While we do not expect a change in Fed monetary policy, we do think that investors and businesses will reduce cash stockpiles. Loan growth may well outpace deposit growth by yearend. The recent expiration of the Transaction Account Guarantee Program (TAG), a market-calming measure that insured $1.5 trillion in jumbo balances in the depths of the recession, will not cause a significant industry deposit run-off, or even much change between large and small banks.
Margins and Spread Income. Net interest margins apparently will not climb anytime soon, at least not while rates remain this low. Indeed, the downward creep of industry NIM may well continue deep into 2013, though the nadir may be reached by yearend if the yield curve tilts upward. By virtue of further balance sheet expansion, however, banks stand to generate modest low-single digit growth in net interest income.
Fee Revenues. On the retail side, deposit fees and card interchange fees have resumed growth, albeit from a sharply lowered base following new regulations. Mortgage origination fees will likely slow as the refinancing boom peaks. Trading revenues for the largest banks will get a sizable haircut from the forthcoming finalization of new regulations. Also a few large banks face the prospect of having to repurchase additional troubled mortgages that were originated prior to the market crash, depressing results in their mortgage divisions. All told, fee revenue likely will remain flat for the industry this year — though this will vary substantially by bank.
Credit Quality. Although credit quality continues to improve overall, loan-loss provisions and charge-offs likely will rise in 2013, reflecting further portfolio cleanup efforts following the recession and a bounce in reserve-building to support new loan growth. The major mortgage banks have been carrying a large concentration of troubled credits for quite some time, and a significant portion of these non-performing first mortgages likely will be written off this year.
Expenses. Cost cutting is in full swing at banks of all sizes, but one tempering factor is the need to restart a variety of deferred projects, including technology upgrades for the distribution network and critical enhancements of remote banking capabilities. Some renovations can be funded by new revenue growth. Traditional efficiency metrics, based on current operating expenses as a percent of net revenues, should improve. But while the industry efficiency ratio could drop below 60%, banks still have some distance to go in regaining the 53%– 57% levels that were considered “normal” prior to the recession, particularly in retail banking.
Earnings. Given the above, earnings should continue to improve for the U.S. banking industry in 2013. Net income should set a record in dollar amount, yet investors will not yet see a return to pre-crash profitability levels. Equity returns will probably edge above 10% for the industry as a whole, with the return on tangible common equity topping 13%. Meanwhile the industry should see a roughly 1.15% return on average total assets. While that is quite a comeback, this resurgence nevertheless falls short of pre-crisis industry norms, which saw equity returns of 12% to 14% and ROAs in the 1.3% range.
Lee Kyriacou is a Managing Director at Novantas, Inc., a management consultancy based in New York City.