American Banker's
Transcription:
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Jim Dobbs (00:15):
Good day everyone. Thank you for joining. My name is Jim Dobbs. I'm an American Banker reporter and editor. Joining me today from Capital Performance Group are Claude Hanley and Emma Metzler. Claude is a founder and partner of the firm, while Emma is a consultant and project manager. Capital Performance Group is a consulting firm that specializes in strategy, marketing, distribution planning, and financial risk management for a variety of financial services companies, including banks. CPG also compiles a series of top performing bank ratings that are published annually in American Banker, and that's where we'll begin today. With that, I'd like to turn this over to CPG, to the CPG experts for a look at the ratings and the latest rankings. So thanks. Over to you, Claude.
Claude Hanley (01:03):
Thank you, Jim. So in today's session, we're going to talk about 2023 and what stood out amongst the top performers, some of the strategies that they pursued in order to achieve above peer performance in what was a very challenging environment. We're going to cover quite a bit of information in quite a short period of time. So we hope if you have questions, you can post them in the board for us and we'll get back to them at the end of the session. So we will cover the external environment that predominated in 2023 and what that meant for the performance of the industry and the top performers. And I think there'll be some surprises as we get through that. We certainly were surprised at some of the findings. I'll turn it over to Emma after talking about the external environment and she'll talk about some of the specific performance metrics of the top performers, trends in those metrics and call out some specific case studies of top performers in the asset tiers. And then at the very end of the session, we'll do a little crystal ball gazing and talk about how 2024 and beyond might be different than what we saw last year or possibly similar.
(02:40):
So just a point of orientation, we're going to review top performance in three asset tiers. Public banks under $2 billion in assets, all banks, both public and closely held between $2 billion and $10 billion in total assets. And again, all banks between $10 billion and $50 billion in assets. And you can see the definition of top performance under each of those three tiers, as well as the total number of institutions that were in each of those tiers last year. One note that I'd like to make is in the public banks under $2 billion in 2023. So last year we made a change in the definition for what constitutes top performance. We defined it as the top 100 banks in that group. Basically, there had been a significant consolidation over the years amongst that tier of banks; it dropped by 50%. So we in turn reduced the definition of top performance from 200 to 100. That has some implications for some of the performance metrics. And Emma will point that out as she goes through the results of the analysis.
(04:05):
So just briefly, the external environment last year, it was quite challenging for financial institutions. Mainly we had the Fed's rapid rate increases. They're basically 11, starting I think in June of 2022 and going all the way through March of 2023. So it continued into the first quarter of last year. We obviously had significant readjustments for banks in the wake of that. We saw bank failure concerns around safety and soundness resurrected for the first time in decades on bank deposits. We continued to see high inflation. There were recession concerns, constant speculation. Are we going to go into a recession? The housing market went into a deep freeze due to the high rate environment. Consumer spending did remain strong, but the labor market remained tight. And a lot of institutions, like most other industries, a lot of banking institutions had to compete and pay up for talent.
(05:21):
In terms of the regulatory focus, on top of the ongoing focus on fair lending and overdraft fees and third party risk management, we had liquidity and interest rate risk concerns and concerns of the regulators around CRE exposure and the fact that many bond portfolios had gone underwater. So what does that mean for the overall banking industry? In 2023, they had significant balance sheet stress, underwater bond portfolios and loan portfolios due to the rapid rate rate increase, significant deposit outflows and rotation from low cost of DDA deposits into higher yielding deposit product types like high yield savings and CDs. We saw a reduction in loan growth from prior years for two reasons. Many financial institutions began to tighten their underwriting standards due to concerns around borrowers' ability to repay or a potential impending recession, as well as the fact that many borrowers are simply delaying projects due to the high rate environment. The end result is there is significant margin contraction, which translated into overall reduction in profitability from the industry across all asset tiers. And the combination of these factors basically put a damper on M&A activity. So with those sort of external challenges in mind, I'm going to turn it over to Emma and she's going to sort of walk through how top performers managed to navigate this. Emma?
Emma Metzler (07:25):
Yes, thank you, Claude. Yep. So digging into the performance of the different asset tiers, we can see that profitability was down across the asset tiers last year, including that of our top performers. And if you look closely, the one exception to this that, our data shows, is the top performers under $2 billion tier, which you can find on the left of the chart, which had an ROAE of 15.8% in 2023. But it's important to note that to some degree this is due to the fact that our definition of the top performers for this tier was reduced the top two hundred and twenty two in years prior down to the top one hundred and twenty three to reflect the fact that there had been so much consolidation over the last couple of years, as Claude previously highlighted. And if we kept that definition as the top 200, the top performers for the public under $2 billion would've actually also seen a decline in 2023, a 0.2% decrease in their ROAE.
(08:26):
So all in all, profitability was definitely a challenge in 2023; however, profitability declined less among our top performers, which are those gold horizontal bars. You see here, it's worth calling out some of the strategies that contributed to the top 100 banks' success for the public banks under $2 billion. So FFB Bancorp in Fresno, California, they were our number one in the rankings for this tier in 2023 and number four in the prior year 2022. So a consistent top performer, they recorded a 31.3% ROAE, up two basis points from 2022, and their success was driven largely by their net revenue produced by their merchant services business. They process card payments for merchants and that constituted about $12.9 million in net revenue. Not to mention they also operate under a single branch model. So this of course helps immensely to keep expenses down. So overall, their digital forward strategy has really benefited them in this way. And we'll talk more about other strategies that banks are pursuing throughout the remainder of this session. But FFB is a great one to call out here in the public under $2 billion tier I.
(09:52):
And we also saw some uptick in non-performing assets in certain tiers last year, such as the top performers $2 to $10 billion, as well as the $10 to $50 billion tiers, both their top performers and the overall peer group. That being said, generally speaking, credit quality has remained pretty benign in terms of factors that drove top performance and most groups have been able to maintain decent credit quality over the years, and 2023 top performance we interestingly saw was not predicated on size in two of the three asset tiers. The top performers were actually smaller than their peer group. Looking at median total assets, the highest performing banks in terms of profitability sat in the mid-size tier that $2 to $10 billion and top performers of this tier were $2.9 billion, which was $240 million less than their peer group. Similarly, top performers in the $10 billion to $50 billion tier were $17.9 billion, and that was $63 million less than their peer group. So something interesting to just call out here is that size did not necessarily imply better performance and ability to scale. And actually in the case of the $2 to $10 billion tier, this trend of top performers being slightly smaller than their peer group is consistently true. Looking back to 2015, so interesting to note there.
(11:25):
And so we know that profitability was down across asset tiers last year, yet the top performers still managed to improve their margins last year; when rates were going up so sharply that was really difficult to do. Top performers in the $2 to $10 billion asset tier experienced a 71 basis point jump in their median NIM. As we can see here in the chart, that was the largest increase amongst the asset tiers. They had a median margin of 4.57% in 2023. So taking a look at our top performers, State Bank of Texas, they ranked number one in the mid-size asset tier. They had a margin of 6.5%, and so they were positively gapped and looking at their one year gap to assets, which is one of the underlying factors that really drove their margin. And many of the top performers, as we saw looking at the data were positively gapped as well. So that helped them in a time of rising rates.
(12:33):
And just to go a little deeper here on how the top performers managed to increase their margin, looking at the individual tiers for the public banks under $2 billion group top performers generated a higher increase in yield on average earning assets while also managing a smaller increase in their cost of funds for the all banks. The $2 to $10 group top performers also generated a higher increase in yield on average earning assets, which more than offset their slightly higher cost of funds compared to all banks. A good example of this in the $2 to $10 billion tier was capital bank based in Rockville, Maryland. They're a consistent top performer. They ranked number nine in 2023. They had a 6.6% margin, increasing it about 32 basis points year over year due to their strong yield on average earning assets, about 8.57%, despite also having an increase in their cost of funds. So they cited increases in average rates like money market accounts and time deposits as a contributor. And then finally, for all banks, $10 to $50 billion top performers remained more liquid than their peer group, meaning that they had a higher one year gap, about 25.7% for top performers versus 12.4 for the peer group, thus benefiting their net interest margin from the rising rate environment as more assets were repricing.
(14:08):
And deposit growth was a huge challenge and focus for most institutions last year, and of course still is in 2024. We hear that a lot in our conversations with clients. So in 2023, top performers experienced a smaller outflow of core deposits than their peers though, and the $10 to $$50 billion tier actually managed to increase deposits year over year. This deposit growth in turn helped top performers of the larger tier to minimize deposit costs increases because of higher rates. So digging into that comment a little further, the $10 to $50 billion tier saw the change in median cost of funds from 2022 to 2023 increase for both the top performers and the overall peer group. However, the top performers experienced a lower increase in cost of funds at 1.42% compared to their peer group at 1.46%.
(15:10):
So it's important to note that the top performers that saw core deposit growth in the $10 to $50 billion tier were doing it primarily through offering interest bearing deposit accounts as the industry was experiencing that rotation of deposit accounts out of checking and into higher yield savings and CDs. This was true for banks like Service First Bank shares based in Birmingham. They ranked number four in 2023 and number three in 2022. So consistent top performer, they saw increases in core deposits of 13.4%, and that was due to their increases in their interest bearing deposits or in Pennsylvania was our number one for the asset tier, the $10 to $50 billion group. So on the other hand, they grew their core deposits in 2023, mainly through increasing their non-interest bearing deposits. But so the strategies differed slightly, but all in all, the primary strategy that we saw that was a driver in increased deposit growth was that mix shift into those interest bearing deposit accounts.
(16:30):
Okay? Industry was mostly positive in 2023, as we can see here, and even higher amongst our top performers. In the case of the $2 to $10 billion tier loan growth was about 1.8% higher for top performers compared to their peers. And in the public under $2 billion group, it was roughly 1.1% higher for top performers versus their peers. So loan growth strategies, they also varied against amongst the top performers. So focusing on the two smallest tiers since they had the higher loan growth of the three groups we're analyzing, starting with banks $2 to $10 billion. Sentier Bank, which is a subsidiary of First Bank shares in Indiana. They ranked number 12 in this tier and increased their loan growth by 32.27%. And they did that with a more traditional loan strategy based in CRE loan growth. But then taking a look at our public banks under $2 billion, looking at FinWise Bancorp in Utah, they ranked number two for the asset tier and their loan growth increase was 64%; large increase in commercial loans as well as a large increase in their SBA 7(a) loans that was about $95 million increase from 22 to 23, and they're continuing to pursue that in 2024.
(18:00):
It's a strategy that's really working from them on the loan growth side.
(18:09):
And then finally, looking back to 2015, when we began this analysis with the American Banker to more recent years, we've seen non-interest expense to average assets decline among top performers in all tiers. Looking at that line graph on the left, as they found ways to continuously reduce expenses and become more efficient, that's fairly true for that $10 to $50 billion tier. As we can see from the horizontal bar chart on the right, they actually increased on non-interest expense to average assets by about 33 basis points. They operated a higher non-interest expense base than their peers... and grew it well beyond in 2023. So is interesting though, because they have a higher performance ROAE like we discussed at the beginning. So how did they offset that higher expense base? Well, as we've discussed through our review of key metrics, their margin improved while their peers was weakening... And now I will pass it back to Claude to give us a look ahead into his crystal ball on what the industry can expect over the next year or so.
Claude Hanley (19:40):
Thank you, Emma. So obviously there's a high degree of speculation in this slide, but we expect an improvement in the overall operating environment of banks as the Fed begins to reduce rates and loan growth begins to rebound a bit. So as a consequence, we would expect profitability to improve in the second half of this year. In fact, listening to some of the second quarter earnings earnings calls of publicly traded institutions, most were expecting, most felt like the trough and the non-interest income category had been reached and their margins would start to expand. So we think that'll have an effect on overall profitability improvement. We expect there be continued focus on core deposit growth. Many institutions are still constrained in terms of their ability to lend because of their lack of core deposit funding. So we expect that that will continue to be a focus for institutions and the top performers specifically. Loan growth, as I mentioned before, should come back from the lowest single digits that we saw in the first half of this year as far has become more confident about the economic environments.
(21:27):
M&A activity we also anticipate will rebound from the doldrums in 2023 in the first part of this year as acquirers become more comfortable with the asset quality of potential sellers and the need really, quite honestly, to find core deposit growth. I think that'll drive a lot of acquisition activity. But the caveat on all of these speculative points is what will happen with the overall economy and therefore how will asset quality hold up if we go into recession, high unemployment, we're going to have loan problems and therefore it's going to be more defensive than. So with that, I guess we'll look to you, Jim, or see if there's other questions we can ask answer.
Jim Dobbs (22:29):
Sure, yeah. Just sort of picking up on what you were saying about asset quality, it seems that that has held up quite well through the first half of the year. Of course there's been pockets of stress within commercial real estate and office properties in particular, but overall, by historical standards, credit losses are quite low. But even if you did see some tick up on the asset quality side of things in terms of losses, there's a fair amount of room to move up and still be relatively strong. Is that a fair way to look at it and how are you thinking about just where things stand in midyear here?
Claude Hanley (23:06):
Yeah, I mean I think that's a fair characterization. It's also worth keeping in mind where we're coming from. I mean, really the last 18 months institutions were really kind of preparing for the worst. We were expecting to go under a recession. We had expectations that unemployment would go north of 5% or higher. Many institutions were reserving based on those assumptions. And so I think the industry is pretty well reserved to weather an uptick in a reasonable uptick in non-performing loans and not really missing people.
Jim Dobbs (23:54):
And then you also mentioned MA&. There has been, at this point in 2024, more deals announced than last year. Probably more importantly, there've been more larger deals, which would suggest that at least some buyers are comfortable with asset quality as they look ahead through this year. And also the readings they're seeing after the second quarter. What you've seen so far on the M&A front, I would imagine supports what you were talking about before, but are you already seeing the beginnings of an uptick on the M&A front or do you expect that to?
Claude Hanley (24:29):
I think MA& is now sort of a core growth strategy for a lot of institutions, quite honestly. So a lot of institutions nowadays think in terms of not just their organic growth path, but how are we going to grow through MA&. Obviously there's elements that they don't control in that particular strategy, but they're being a lot more thoughtful and deliberate about thinking about how they're going to be capitalizing on MA& activity that makes me believe... That's one of the reasons I believe we'll see an even greater uptick in activity. And incidentally, we've just seen such an awful lot of consolidation within the under $2 billion public tier. I would expect that that will continue as institutions like to get more efficient and get scale. So I think those factors will drive the activity higher. Again, assuming buyers can get comfortable with asset quality.
Jim Dobbs (25:37):
Right. Okay. And so from a listener here, we have a question. What is the current norm for deposit beta and your projection for the trend in the beta over the next six to 12 months?
Claude Hanley (25:50):
I can't answer that. I don't really have a deposit beta calculation. I'm sorry. Okay.
Jim Dobbs (25:59):
Maybe just a little bit more general way of addressing the same topic. You've got the expectation of a Fed rate cut as soon as this month. Today's CPI figure showing inflation slowing to a 2.5% annual rate, which really does affirm the expectation for a Fed rate cut in September and more to follow. Any concerns on deposit costs coming down slower than loan rates, and that causing some near term NIM pressure?
Claude Hanley (26:34):
Well, I think it's going to vary depending on the balance sheet mix of the individual institutions. So yes, the institutions that were primarily very liquid in a rising rate environment are going to see the margin compression on the earning asset yield side quicker than others. In terms of, I don't think you're going to see an immediate sharp reduction in the cost of deposits simply because of liquidity issues. Banks still need the liquidity to fund loans, still need the deposits. So I think it's going to take a while before you really start see, to take us several more rate cuts before you really see significant reductions in the cost of deposits. So we'll have a bit of a mixed bag, I guess.
Jim Dobbs (27:36):
One more question before our time's up here, then another one from the listener. What is your viewpoint on current fee income levels and expectations for fee income through 2025?
Claude Hanley (27:47):
Current fee incomes are for most community institutions are inadequate. There's a lot of pressure on the sources of fee income, the regulatory focus now on junk fees, potential limits on credit card fees, et cetera. So I think there's going to be continued downward pressure. The only relief I can really see, significant relief, is for a lot of institutions is if we get a rebound in the mortgage banking market, we should get a rebound in some of the mortgage banking related fees. And we're talking just in terms of material contributions in the short term. But yeah, right now there's a lot of headwinds facing backs on the fee income site.
Jim Dobbs (28:41):
Absolutely. Well, we're approaching our time here in just a few seconds, so I just wanted to pause things here and thank you both for a really interesting discussion, and I wanted to thank everyone who listened in and sent in questions. So thanks everyone for participating.
