For Low-Performing Banks, It's Fold or Be Sold

Capitalists often say that the ultimate purpose of a business is to create an adequate return of capital for shareholders. It is on this measure that U.S. banks are vulnerable. And that is why accelerated mergers and acquisitions will transform the banking industry over the next decade.

Banks that fail to deliver double-digit returns to shareholders may lose control of their destinies as investors seek better returns from top-performing banks and industries such as public utilities, which pay out reliable 4% dividends. Given that banks averaged a 7.95% return on equity during the first quarter of 2014, the majority of them are at risk.

A number of factors have conspired to limit banks' options as to how to push their ROE to a more acceptable 10%.

Higher capital requirements are lowering banks' return on equity. Although newspaper headlines blast declarations about how big banks need to improve their capital ratios, banks of all sizes carry more capital now than at any other time in recent memory. Federal Deposit Insurance Corp. reports show that even the 2,000 U.S. banks with assets below $100 million have 12% more Tier 1 risk-based capital today than they have had on average since 1984. (Big banks have 39% more.) While banks are simply following regulatory instructions by holding more equity, this will not earn them a free pass from investors hungry for higher returns.

Banks will also have trouble boosting ROE because economic growth, which dictates the long-term growth rate of the banking industry, remains sluggish. Over the past 30 years, gross domestic product in the U.S. has declined from a 4% run-rate to the current 2%. Unless the banking industry decides to take on more risk by booking the "cheap" revenue of marginal quality loans, banks cannot expect industry-wide revenue to grow faster than 2-3%.

Another factor putting the squeeze on banks is increased competition for loans. Alternative lenders like Lending Club, Biz2credit, Intuit’s Quicken and Blackstone offer stiff competition across all loan categories. Because these firms are not funded by FDIC-protected deposits, they are less encumbered by regulatory pressures and more nimble in providing loans across a wide range of borrower needs.

U.S. Bank's aggressive tactics in the battle for creditworthy borrowers has further upped the competition. Taking a book from the pages of Walmart, U.S. Bank is using its lower cost-of-fund advantage to go after high-quality loans. The bank's chief executive, Richard K. Davis, unabashedly acknowledged this month on a quarterly earnings analyst call that his bank competes on price when it wants a good loan. It's no surprise that U.S. Bank is therefore gaining market share in segments of the loan market that historically post the best risk-adjusted returns, notably commercial and industrial loans. As borrowers will readily report, there is nothing wrong with the bank's strategy.

Banks can't count on further improvement in credit performance to boost their ROE either. Loan portfolios across the country are already squeaky-clean, which is certainly related to the fact that the industry has fewer loans on the books than it did six years ago. As a result, the industry’s average loan-loss provision across four consecutive quarters has reached its lowest point in the 30 years tracked by the FDIC.

If GDP growth is anemic, competition intense, and credit quality as good as it gets, bankers are left with just one sure lever to improve profitability: Cut expenses.

As a simple rule-of-thumb, banks need to reduce non-interest expenses by 5% to make a 1% improvement in ROE. Of course, capital leverage ratios as well as expense run rates vary significantly by bank, so this rule of thumb does not apply universally to all banks. For example, banks with higher capital ratios will require greater expense cuts.

But in general, a bank that earns an 8% ROE today would need to cut noninterest expenses by 10% in order to boost returns to the double-digits. Cuts of that size are difficult to accomplish, since traditional commercial banks are burdened by a fairly fixed cost structure.

Banks are locked into costs associated with property, utilities and supplier contracts, which constitute approximately 50% of a typical lender's noninterest expenses, for at least a year or two. The other 50% of noninterest expenses are personnel — arguably the only truly variable expense for banks.

This means that banks are forced to slash jobs in order to drive the bulk of the expense cuts necessary for a 10% ROE. A bank with a current ROE of 8% must reduce personnel expenses by 20% to hit the higher earnings target.

Cutting personnel expenses is a double-edged sword. Earnings may improve in the short term, but few companies have proven capable of slicing and dicing their way to prosperity in the long run. Periodic bursts of layoffs are often evidence of a company in a death spiral.

Given these dynamics, it's probable that investors over the next decade will turn to bank mergers to address the industry's excess capacity, intensifying competition, overwhelming regulatory burden and inadequate profitability. A slew of mergers and acquisitions are inevitable because consolidation is the most efficient means of addressing the antiquated cost structure plaguing banks. The free hand of market forces will eventually prevail.

Bankers and directors who produce ROEs consistently at or above 10%, along with a reliable 3-5% dividend yield, will be rewarded with more capital and opportunities to expand. Those who prove unable to do so will fold or be sold to those who can.

Richard J. Parsons is the author of Broke: America’s Banking System: Common Sense Ideas to Fix Banking in America, published in 2013 by the Risk Management Association. After a 31-year career at Bank of America, he now speaks about banking.