Banks Should Take a Cue from Online Lenders' Pricing

Jamie Dimon of JPMorgan Chase and Richard Evans of Cullen/Frost Bankers are among the very few bank chief executives who have aggressively bought their own bank stocks in the open market during the 2016 stock price swoon. 

Much more common are the CEOs who have unloaded large holdings over the past two years and remain on the sidelines in 2016. Is there any wonder why the majority of bank stocks now sell for prices lower than 2004 when even highly informed CEOs are sellers, not buyers?

At the heart of the crisis in bank stock prices is a failure of the industry to create returns sufficient to cover a cost of capital that is today somewhere between 9% and 10% for most banks.

The earnings problem is so profound that it’s time the banking community think differently about its principal source of revenue: loan rates.

When was the last time you read about a bank raising the interest rates it charges for loans because of a fear that a weakening economy could cause a spike in loan losses?

That’s exactly what online lenders Prosper and Lending Club recently announced. In Prosper’s case, the lender jacked up rates by 140 basis points because of “the current turbulent market environment that we have witnessed since the beginning of 2016.” Lending Club’s CEO said in December that the marketplace lender raised rates “to provide investors with more loss coverage in case losses start to increase if the economy starts slowing down.” 

There are three reasons bank CEOs and directors need to think differently about how banks price the industry’s main product.

First, the fintech lenders are exactly right about the risk of deteriorating credit metrics. Since 1984, the banking industry has averaged an annualized loan-loss provision expense of 0.60% of assets. In 2015, this same ratio is 0.20%. Never in 31 years since the Federal Deposit Insurance Corp. started tracking this data has the ratio been lower. A reversion to the mean is inevitable. 

A 20-basis-point increase in provision expense will cost the industry $32 billion in pretax earnings. When this happens, the industry’s ROE will drop to less than 8% from today’s 9% ROE. This won’t help bank stock prices.

Second, banks are far more capitalized today than any time in decades. But the problem is that capital is not free. 

If regulators want more capital in banks, the industry must turn around and pass this cost on to borrowers. Otherwise, the burden of greater capital is borne entirely by investors, which is exactly the situation today. Is there any wonder why bank stock prices remain depressed?

Third, bankers have to stop waiting for Godot; in other words, bankers who are waiting for higher Federal Reserve interest rates to help boost loan-related revenue may end up waiting quite a long time. More generally, the notion that rising Fed rates always improves bank net interest margins is faulty. Dating to 1983, there is a 98.9% correlation between the industry’s quarterly cost of funds and quarterly yield. In other words, yield and cost of funds move in tandem over time. The industry does not enjoy greater yields without seeing commensurate increase in cost of funds. 

Just to be clear, rising Fed rates will help some banks and hurt others. Silicon Valley Bank in Santa Clara, Calif. and Columbia State Bank in Tacoma, Wash., are among the few clear-cut winners if and when rates rise. But in the aggregate, rate movement is a wash to the industry.

Even when Fed rates rose dramatically in the past, there was no evidence that upward trending rates fueled an expansion in the industry’s net interest margin. The Federal Open Market Committee raised the federal funds rate 10 times from the first quarter of 2004 through the second quarter of 2006. But the industry’s average NIM shrunk as short-term rates increased. Industry NIM fell to 3.43% as of June 30, 2006, from 3.68% in early 2004. Longer-term rates failed to move up in parallel with the increase in short-term rates. The same phenomenon is happening since the FOMC ratcheted up rates in December 2015. 

What needs to happen?

It is time that bank CEOs stop pricing loans at rates guaranteed to produce returns below the cost of capital. Just as Prosper and Lending Club announced their intentions to charge more for their loans, the nation’s leading banks need to make a similar proclamation.

It is high time that the industry got paid appropriately for taking risk and holding investor capital.

Richard J. Parsons is the author of "Broke: America's Banking System." The analysis for this post is from his new book, "Investing in Banks: Strategies and Statistics for Bankers, Directors, and Investors," to be published by the Risk Management Association in April.