Welcome Byproduct of Lower Bank Revenue: Lower Selling Costs

There is one redeeming aspect to falling revenue: certain expenses fall, too.

Weak sales of home mortgages and business loans mean big banks are paying fewer bonuses and commissions, and that helped reduce stubbornly high expenses across the industry in the first quarter.

Median expenses fell 2% quarter to quarter among 23 large and midsize banks tracked by Barclays Capital. Median employee expenses, meanwhile, fell 3%.

That was striking because employee costs tend to rise during the first quarter, because that is when banks cover payroll taxes and settle retirement stock awards.

And many observers had feared overall expenses were poised to rise. A broad increase in noninterest costs like outside services, equipment and occupancy charges had driven expenses higher at the nation's largest banks during the fourth quarter, catching investors and analysts off guard. Expenses at the median bank in the Barclays group rose 5% that quarter.

Observers began to worry that rising expenses from investments in new people and business initiatives would squeeze potential profitability and revenue gains. The first quarter's unexpectedly sharp expense decline has eased that concern. It also has raised hopes that the industry is entering an extended period of belt-tightening that will last until loan demand and interest rates rise.

"The revenue environment remains challenging and companies have to manage their costs more tightly," said Jason Goldberg, an analyst with Barclays. "Profitability metrics are under pressure from a host of areas, and you have more control over expenses than you do over revenue and capital."

Expenses began to rise late last year as bankers began to feel "a little bit better about the world" as the economy began to rebound, loan losses fell and some businesses started borrowing again, he said. That optimism seems to have fizzled, he said, noting that "it was interesting" that two of the biggest banks — Wells Fargo & Co. and Bank of America Corp. — recently said they will be developing cost-control programs.

That's a sign that the first quarter's falling expenses may not be a fluke, Goldberg said. Current expenses are unwieldy, he and other experts said. Before the recession, large banks were spending about 50 to 60 cents for every dollar of revenue. At least eight big banks as of last quarter were spending more than 65 cents per dollar: Bank of America, First Horizon National Corp., Zions Bancorp., Regions Financial Corp., Comerica Inc., KeyCorp, SunTrust Banks Inc. and Synovus Financial Corp.

In contrast, U.S. Bancorp, perhaps the most efficient large bank, spent about 51 cents on every dollar of revenue in the first quarter. PNC Financial Services Group Inc. spent 57 cents. The fewer expenses that go to revenue, the more efficient and profitable the institution and the more flexibility it has to invest in new business.

Expenses came down quarter to quarter at all of these institutions, mostly because of environmental factors rather than aggressive cost-cutting. There are exceptions: U.S. Bancorp and PNC are saving money by integrating banks they bought, reducing fixed costs. Synovus and Regions have been laying people off as they continue to streamline. The thing all these companies have in common is that they are spending less money to deal with bad loans. Mortgage litigation expenses are easing. Banks are paying fewer people to reclaim debt from delinquent business and manage foreclosed assets.

That was not altogether surprising. What was: the correlation between falling revenue and falling expenses.

The slowdown in home lending and lack of demand for other banking services during the first three months that reduced banks' top-line numbers led to lower overhead costs.

Wells Fargo, of San Francisco, let go of more than 4,500 people in its mortgage-dependent retail bank. Another 2,000 will be terminated this quarter. "It's a meaningful number," John G. Stumpf, Wells Fargo's chief executive, said in a call with analysts last month.

At Regions, employee costs declined for the first time in three quarters. Though part of that was related to layoffs, the Birmingham, Ala., company also handed out fewer incentive payments to the investment bankers and brokers in its capital markets division because of a slowdown in business.

Fifth Third's head count did not change, but salaries and wages were down $33 million quarter to quarter because the Cincinnati company paid fewer bonuses and commissions to its home lenders.

"We do see some lower levels of incentive compensation and so forth, particularly with respect to the mortgage business," Daniel Poston, Fifth Third's chief financial officer, said in a call with analyst last month.

PNC's employee costs fell for the first time in at least a year, by $43 million, primarily "due to lower incentive compensation," the Pittsburgh company said in a slide presentation to investors last month.

Marty Mosby, an analyst with Guggenheim Securities LLC who covers large banks, said "efficiency started to eke down the right path" in the first quarter, despite the seasonal payroll issues.

"So the efficiency improvements were actually better" than they appeared and should be even higher next quarter because "those things are going to go away," he said.

Banks are in a lull right now between crisis and rebound, Mosby said. Loan losses are easing, but revenue is not increasing because people and businesses are reluctant to borrow or spend money. That is not going to change until employment picks up. And banks' revenue prospects will not improve until interest rates rise. Both of those things probably will not change until 2012, he said, which means banks must focus on reducing expenses over the next year.

They "gotta be more efficient," he said.