Margin Pressure Could Get Worse, Analysts Warn

Bankers who are poised to report third-quarter earnings in coming weeks will likely face tough questions about how they will grow in an environment where net interest margins are sinking to unprecedented lows.

Many banking companies have seemingly tapped every method of bolstering earnings — from releasing loan-loss reserves and slashing deposit rates to booking securities gains and cutting expenses, industry observers say.

There is no relief in sight from the artificially low interest rates and tepid loan demand that has battered margins for more than a year. For some directors and management teams, the third quarter could be a determining factor when deciding whether to keep fighting or start trying to find a buyer.

"There's not much incremental reserve release to come for the industry," says Brett Rabatin, an analyst at Sterne Agee & Leach. "They've dug the quarters out of the car, and it's getting harder to find extra pennies."

The bank research team at KBW's Keefe, Bruyette & Woods predicted last week that more than 80% of the banks it covers will report narrowing net interest margins in the third quarter.

Of those companies, City National in Los Angeles, Cullen/Frost Bankers in San Antonio and Susquehanna Bancshares in Lititz, Pa., could report 10 basis points or more of margin compression compared to a quarter earlier, analysts say.

Next year will be more unfriendly still to banks' margins, which could prompt antsy shareholders — particularly institutional investors — to push management teams for more consolidation, they add.

"The more pronounced margin pressure may [take place] in 2013 when some of the offsetting items" are gone, says Kevin Fitzsimmons, an analyst at Sandler O'Neill & Partners. "Investors will ask, 'You have offsets today but how are you going to do it next year?'"

"Flattish" is how Sandler O'Neill banking analysts in an Oct. 1 note to clients described their expectiations for quarter-over-quarter earnings per share. While the analysts project 11% growth from a year earlier, that would pale in comparison to the 20% year-over-year growth that took place in the second quarter.

Analysts have long projected that stagnant earnings would eventually usher in a wave of bank consolidation. There are a number of bankers who are starting to feel the same way.

"Everything we're looking at now is in the yields that you can achieve," says Roy Dowdy Jr., the president and chief executive of Citizens Bank in Geneva, Ala. "We don't have enough quality loan demand in our area to satisfy our earnings requirements."

Those concerns led Citizens Bank's parent, Genala Banc, to agree to sell to Bank of the Ozarks in Little Rock, Ark., in a deal announced last week. The $170 million-asset bank was profitable and well-capitalized, but Dowdy says it lacked resources to expand outside Alabama. Such expansion would have been necessary to offset low interest rates and higher operating costs.

On a larger scale, the well-capitalized Alliance Financial in Syracuse, N.Y. agreed on Monday to sell to NBT Bancorp in Norwich, N.Y., for $233 million. Alexander Twerdahl, a Sandler O'Neill analyst, wrote in a note to clients that an inability to increase loans and margin pressure could have contributed to Alliance's decision to sell.

"Banks are fed up with showing mediocre results so if there's a way to put money to work, they will," says Christopher Marinac, a managing principal and the director of research at FIG Partners in Atlanta. "Banks are running hard to stay in place."

To be sure, banks are getting more aggressive when it comes to booking loans because of the lackluster returns from parking funds into securities investments, industry observers say.

"We're starting to see more banks that will offer a [loan] rate below 4% for longer durations as an alternative for lower-yielding securities," says Derek Hewett, an analyst at Keefe Bruyette & Woods.

Booking loans with longer durations could create balance sheet risk whenever interest rates begin to rise. Still, some analysts say they would prefer to see bankers attempt to put up a fight, adding that it could be several years before interest rates creep up meaningfully.

"We want to know who's in the game and who's fighting," says Marinac of FIG Partners. "The quarterback has to make plays and fight for the ball."