Driving Market Value in 2005

By Jack Milligan

Analysts say continued economic expansion and a return of commercial loan demand should yield another strong year. Expect heightened competition for deposits, and earnings to be impacted by the need to boost loan-loss reserve levels.

How will banks in 2005 follow their recent run? Life has been good since 2001, with the industry setting new earnings records each succeeding year. Through September 2004, the industry's net income totaled $95.5 billion — setting the stage for yet another record year.

Loan quality also is outstanding, with non-current loans at just 0.85% of total loans in the third quarter of 2004. At press time in mid-December, publicly traded bank stocks were close to beating the S&P 500 for a fifth straight year in terms of value appreciation.

Low interest rates explain a significant part of the performance picture of the last few years. But leading bank analysts are positive on banks, even in this rising rate environment. Most economists expect the Federal Reserve Board to continue its recent policy of gradually raising interest rates, which could lead to a flattening of the yield curve later this year and narrowing net interest margins for many institutions. Some analysts, however, think margins could actually improve if banks are able to re-price their loans faster than their deposits. The actual outcome is likely to depend on how well individual institutions have positioned their balance sheets.

The analysts' outlook assumes continued expansion of the economy, albeit at a more modest pace than in 2004. Even as consumer banking remains robust, commercial lending is expected to pick up after a long dry spell as U.S. companies gradually exhaust their excess cash and start to borrow again.

Increased lending activity will come at a price. The industry's loan-loss reserve levels are at their lowest in several years and will have to be rebuilt through higher provisions as commercial loan demand grows. In part, the industry's declining reserve levels merely reflect the decline in actual loan losses in recent years. But some analysts believe banks will have to reverse that situation in 2005, possibly at the expense of earnings.

Such are some of the issues likely to be faced by bank management. Wall Street's response is less predictable. As of early December, the bank group's valuation relative to the broader market was at its highest point in four years. Banks historically trade at a discount to the broad market. But in early December, the average P/E for all the banks in the SNL Bank Index was only 22.5% lower than the average P/E for all the companies in the S&P 500 — while in December 2001, the comparable ratio was 54.6% lower.

Given the changes that lie ahead, there may be nowhere for prices to go but down, although no one's jumping ship just yet. Lehman Brothers' Jason Goldberg notes that if the bank group succeeds in outperforming the S&P 500 for the fifth year in a row, it will be the first time that has happened in 80 years.

Thomas D. McCandless
Covers large-cap bank stocks
Director and senior commercial bank analyst, Deutsche Bank Securities Inc., New York

Banking Strategies: Why has the bank group performed so well over the past four years compared to the S&P 500?

McCandless: Low interest rates have helped the stocks a lot. While they didn't help margins, lower rates helped improve credit, and lower loan-loss provision expense has driven earnings in recent years. In our view, that trend has ended for this business cycle, and I think investors could be negatively surprised at how much provisions could potentially re-accelerate in 2005 if loan growth continues to improve.

There is a lot of pressure on reserves. And it's somewhat a function of the Securities and Exchange Commission leaning on bank auditors to release more reserves into earnings on the notion that you shouldn't save for a rainy day anymore. That's viewed as managing earnings.

We now find ourselves in a situation where we've had a lot of years of solid consumer loan growth. As that business begins to season and throw off losses, you'll see a gradual up-tick in both business and commercial real estate lending, for which banks have to set aside reserves. So it's possible to think about a scenario in 2005 where provisions must go up more than people expect, not so much because of losses but because reserves have to be rebuilt from a low base. By our measures, the reserve-to-loan ratio is at a 20-year low.

That's sort of the dark side of the story. The bright side is that with the assistance of derivatives and more sophisticated capital market activities, the margin pressure may self-correct sooner than people expect, leading to a re-acceleration of net interest income in 2005. However, the amount of that re-acceleration of spread income falling to the bottom line is open to debate.

Banking Strategies: Why would the improvement in net interest margins not all fall to the bottom line?

McCandless: Because of the likelihood of loan-loss provisions going up.

And there's still some question as to how much margin improvement we're going to get because of the unanswered questions about deposit growth. Competition for deposits is growing. And a lot of the deposit growth that has occurred in the past year or two really came from corporations, not from consumers. As companies begin to build and hire, that will drive down their excess cash levels — which are in bank deposits — and they'll begin to borrow.

The cessation of corporate deposit growth is commonly viewed as a precursor to improving commercial loan demand and we're getting some of that now. So the question is, how do you get much margin improvement if you end up having lower-than-expected deposits?

Banking Strategies: In your view, what will be the major drivers of bank stock valuations in 2005?

McCandless: If the trend of declining loan-loss provisions has bottomed out, then by definition, revenue growth takes over as the key driver.

Banking Strategies: And what drives revenue growth for the industry this year?

McCandless: Revenues are driven by two broad factors: spread income and fee income.

In terms of the former, commercial and real estate lending is improving and consumer loan growth is still likely to stay positive, while growing at a slower pace than it is right now, which is pretty rapid. In recent years, we've had declining overall loan volumes because of the rapid deceleration on the commercial side, but that has clearly bottomed out and is beginning to grow again.

So banks are going to have positive overall loan growth. And as they take money out of bonds and use it to make loans, we should see an acceleration in the turnover of assets as well as expanding margins — assuming they can fund the growth in loans cheaply.

We do think the possibility of the industry's net interest income re-accelerating modestly is not out of the question. That probably captures 40% to 45% of the industry's revenues.

On the fee income side, the earnings drivers are likely to be somewhat improved year-over-year comparisons on activities that are tied to the capital markets via trust, brokerage, investment banking and venture capital activities.

Gerard Cassidy
Covers large-cap and mid-cap bank stocks
Managing director and bank analyst, RBC Capital Markets, Portland, Maine

Banking Strategies: What will drive bank earnings in 2005?

Cassidy: We expect it will come down to two main issues: interest rates and credit quality.

Bank stocks did very well over the last three years due to a very favorable interest rate environment. In 2005, we expect the Federal Reserve to continue raising short-term interest rates, which will flatten the yield curve. The yield curve, which is the difference between the yield on 10-year government securities and the Fed Funds rate, was extremely steep for the last couple of years; it's now starting to flatten out. We think that positive benefit from rising short-term rates will start to diminish in 2005 as the yield curve flattens out in the second half of the year.

Banking Strategies: Until now, at least, haven't banks been able to raise their pricing on assets sooner than they've been required to raise their pricing on liabilities?

Cassidy: That is absolutely correct. But the lag in liability costs will eventually catch up to the increases in asset yield. For example, after the first 100-basis-point increase in the Fed Funds rate, the prime rate and other short-term lending rates increased a full 100 basis points. However, the cost of bank deposits has not, on average, increased by 100 basis points, but rather closer to 30 or 40 basis points. Eventually, those deposit costs will rise equally with the rise in yield on assets so that the benefit of rising short-term interest rates will be diminished as quarters go by because of the rise in the deposit costs.

Banking Strategies: Banks have been successful at raising deposits, despite paying historically low rates. Will that change this year?

Cassidy: Yes. Until recently, the rate that money-market mutual funds paid for their deposits has been below what bank money-market deposit accounts were paying. This was quite unusual because, for the last 25 years, money-market mutual fund yields had always exceeded bank money-market deposit account yields.

So the competitive advantage the banks had by offering customers a higher yielding product is no longer there. Rates will continue to rise because the money-market mutual fund yields are tied explicitly to the short-term wholesale interest rate market, which is driven by Fed Funds. So we expect banks to start raising their deposit rates. If they don't, they risk losing deposits.

We're coming up to that inflection point and we think we're going to hit it in 2005, where the banks have to raise their deposit rates to remain competitive.

Banking Strategies: What about credit quality, which you identified as the other big driver of 2005 earnings?

Cassidy: We've had a steady decline in credit costs coinciding with an improved asset quality picture from 1993 until today, if you exclude from the statistics for a moment the asset quality for the top 15 U.S. banks in 2000 and 2001. So the industry has seen a wonderful decline in non-performing assets and their associated costs. The 2000-2001 blip was almost entirely due to the exposure of the top 15 banks to the syndicated loan market and problems that telecom and other industries experienced during the last recession.

The improvement in credit quality has been so material that many banks — particularly the larger institutions — have been able to bring down their loan-loss provisions, which of course represent the major credit cost on an income statement. Those provisions are now at unsustainably low levels.

We don't necessarily believe that credit will deteriorate in 2005, but we do think the incremental improvement in earnings that was caused by the significant decline in credit costs in 2004 versus 2003 will not be present in 2005. Therefore, banks will need to generate stronger revenue growth to offset the impact of not having credit costs decline any further.

If, by chance, credit costs start to rise, banks will have to generate even faster revenue growth to offset that drag on earnings.

Banking Strategies: What are you looking for in terms of commercial loan activity?

Cassidy: That's expected to improve in 2005, having bottomed in April or May of 2004. The growth has been steady, but volatile, since the spring of 2004. Since we expect the U.S. economy to continue to expand this year, driven by a strengthening export market, we anticipate that commercial loan growth will continue to move forward.

The key battle for bank profitability in 2005 will be the tug-of-war between higher revenue from commercial loan growth, combined with a stable to slightly improving net interest margin, versus the potentially higher cost of credit, which of course would be a drag on that earnings growth.

Banking Strategies: Would not rising loan activity in itself require higher provisions if your reserving methodology includes some basic percentage calculation?

Cassidy: I agree with you wholeheartedly. Stronger commercial loan demand dictates that you need to set aside higher levels of loan-loss provisions. So in almost any circumstance in 2005, the banking industry is going to be confronted with higher credit costs.

Denis Laplante
Covers large-cap banks
Head of bank research, Keefe Bruyette & Woods Inc., New York

Banking Strategies: What's your outlook for bank earnings in 2005?

Laplante: The biggest factor for the typical regional bank is what's going to happen with net interest margins. We're expecting margins to widen. Higher short-term interest rates will help with that, provided the yield curve does not flatten too much. It depends on the company, but in the large-cap category, we're looking at margins improving, say, in a range of 10 to 20 basis points between the end of the third quarter of 2004 and the fourth quarter of 2005.

Banking Strategies: What's happening that will lead to margin improvement?

Laplante: Most banks are positioned to benefit from higher interest rates. If you think about it, most banks have 20% to 30% of their total funding coming out of non-interest bearing deposits and capital. If short rates go up, spreads on that funding automatically widen, and that's very beneficial. In addition, as interest rates increase, we will probably see deposit rates lag a little in the marketplace. That will be good for core-funded institutions.

Banking Strategies: What other positive factors do you expect to see this year?

Laplante: There are probably two things worth highlighting. First, commercial credit trends have been outstanding. We're not sure there will be a lot of improvement from here, but we could see losses and problem loans bounce along the bottom for awhile.

Second, we think we will see an improving trend in commercial loan growth. Right now, we're expecting to see mid-single digit growth in commercial loans this year, which would be a good performance.

To the extent that investors are looking for double-digit loan growth, they may be disappointed. You have to keep in mind that commercial outstandings only account for 20% to 25% of total loan portfolios today. It's not going to be a big swing factor, but certainly a positive one. And it's better than loan volume we saw through a good part of the first half of 2004.

Banking Strategies: What's going on in the economy that would lead toward stronger commercial lending?

Laplante: Banks are seeing growth in loan commitments and reporting improvement in their loan pipelines. Customers seem to be talking about borrowing more today than they did this time last year. So we think Commercial & Industrial (C&I) lending will be a positive contributor to earnings growth in 2005, but not something that will be a major swing factor in the outlook.

Jason Goldberg
Covers large-cap and mid-cap banks. In October 2004, was named the top mid-cap bank analyst in Institutional Investors' annual All American Research Team ranking of equity analysts, and named runner up in the large-cap bank sector.
Senior vice president and bank analyst, Lehman Brothers, New York

Banking Strategies: What will drive bank earnings in 2005?

Goldberg: I think the keys will be the pace of commercial loan demand, the shape of the yield curve and the pace of mergers and acquisitions.

With respect to commercial loan demand, we expect continued improvement, which would give us the best growth in C&I loans since 2000 as the economic recovery continues to take hold.

As for the yield curve, we've seen tremendous flattening since June and obviously that tends to hamper banks' performance. We expect some of that negative impact to be mitigated by the fact that a lot of banks have moved into asset-sensitive positions. While the prime rate continues to tick higher as the Federal Reserve raises rates, banks do not necessarily have to follow lock-step in terms of raising deposit pricing. So they'll get some benefit there.

Overall, we expect high single-digit/low double-digit earnings growth.

Banking Strategies: In regard to acquisitions, the last major deal was Wachovia Corp.'s $14 billion purchase of SouthTrust Corp., in June 2004. What lies ahead?

Goldberg: With 7,700 banks remaining in the United States we clearly expect consolidation to continue. We do, however, think pricing will come down, in part because some of the potential buyers are integrating earlier transactions. At the same time, large-cap banks are trading at an 8% multiple discount to the mid-cap banks, compared to an 8% premium historically. That lack of a currency advantage could constrain pricing.

The wild card involves foreign buyers. Clearly we've seen some foreign activity already, from Royal Bank of Scotland, Toronto-Dominion Bank and BNP Paribus. To the extent some of the foreign players take an interest, they could influence pricing.

Michael McMahon
Covers small-cap California banks and thrifts.
In May 2004, was named the top stock picker in the bank and thrift group by the Wall Street Journal in its annual "Best on the Street" survey of equity analysts.
Managing director and bank analyst, Sandler O'Neill & Partners, San Francisco

Banking Strategies: Mike, you mostly cover community banks. What will be the primary factors driving valuations for those institutions in 2005?

McMahon: Earnings growth is always the primary driver. And earnings will be driven primarily by a combination of loan growth and margin expansion. I'm mainly talking about the smaller community banks that tend to be more commercial as opposed to consumer- or retail-focused.

Asset quality, which from time to time is a driver, is not an issue at this point in the credit cycle. We've come through a downturn in the economy with balance sheets holding up extremely well.

With regard to banks with less than $5 billion in assets, I'm looking for loan growth in the neighborhood of 10% to 15% this year. And keep in mind, this is off a relatively low base. So loan growth for the whole banking industry might be single-digit, but could be up to 15% for the smaller community banks. I would expect to see that loan growth mainly in commercial real estate-related lending. Traditionally, commercial real estate has constituted a disproportionately large percentage of community bank portfolio lending. And the commercial real estate market in the West continues to be very, very strong.

To a lesser extent, some of the community banks that have a modest retail presence are also seeing very strong home equity lending. That always increases when interest rates start moving up because people stop refinancing their homes in a higher interest rate environment and instead take out second mortgages, whether they be home equity lines of credit — which is the product of choice now — or fixed-rate second mortgages.

Home equity loans always become much more popular in a rising rate environment. And right now, those are driving a lot of the consumer lending portfolios.

Banking Strategies: What are you expecting in term of margin expansion?

McMahon: We expect the Fed to increase rates to perhaps 3% or 4% by the end of 2005. Community banks should benefit from that — just as they were victims when rates were going down. Community banks, especially the more business-focused ones, tend to have a higher proportion of non-interest bearing DDA deposits funding their balance sheets. And so, as rates start moving up, their earning asset yields should be moving up while their cost of funds lags behind.

I would expect, in general, that for every 25 basis point increase in the Fed Funds rate, banks will pick up on average about 10 to 12 basis points in margin. It depends on the institution's earning asset mix. Those that have left the composition of their balance sheet pretty much intact from where it was in, say, 2001 — specifically with regards to the low securities component — will benefit the most. Those that leveraged up with securities in the interim as a means to augment net interest income may not get as much margin expansion.

Thrifts are different. They generally benefited from the declining interest rate environment over the past couple of years because they typically have more expensive funding sources and their cost of funds went down faster than their earning asset yields. So they had margin expansion at the same time banks had margin compression. Those forces are reversing. As bank margins expand, thrift margins are compressing.

Companies that have a high percentage of core deposits will be the winners in this rising interest rate environment.

Banking Strategies: How much M&A activity do you expect to see next year in the community bank sector, particularly for the Western banks that you cover? And what impact will that have on stock valuations?

McMahon: I expect that activity will continue to be strong because the cost of doing business is increasing, especially with regulatory burdens like the Sarbanes-Oxley Act. In some cases, for the smaller banks, the compliance costs can exceed the profitability of the company. So it's becoming harder and harder for some of the smaller players to remain independent.

On the other hand, valuations are very, very high for community banks and exceed those of their natural acquirers, the regional banks. Until that reverses itself, the deals are going to be harder to do.

Questions or comments about this article? Post them at the Banking Strategies blog.

Mr. Milligan is a freelance writer based in Charlottesville, Va.

Copyright © 2005 by Banking Strategies, published by BAI.

back to top