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2005 in the Rear View Mirror
Happy holidays from all of us at BAI Banking Strategies and BAI Banking Strategies Retail Delivery Insights. We’re devoting this issue of the newsletter to a recap of 2005. Our next issue, Jan. 4, 2006, will provide a forecast of what to expect in retail financial services in the year ahead.
Continuing superb asset quality, robust loan growth and an expansion of fee income combined to produce a profitable year for the industry, despite narrow interest rate margins derived from the Federal Reserve’s tight monetary policy. Through the first nine months of the year, banks reported net income of $87.2 billion, up 12% from $78 billion in 2004, according to the Federal Deposit Insurance Corp. (FDIC). Analysts expect these trends to continue through the fourth quarter. “The key thing that happened in 2005 is that banks were able to earn their way through a difficult interest rate environment,” says John E. McDonald, a bank analyst at Banc of America Securities in New York.
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Margin Squeeze
That difficulty impacted the industry’s net interest margin, which was 3.59% through the first three quarters of this year, identical to the same period in 2004, according to the FDIC. This margin measures the difference between what banks are able to charge for loans on one hand and must pay to attract consumer deposits or borrow money in the debt market on the other. When the industry’s funding costs rise faster than the yield on its loans, the net interest margin shrinks.
Banks maintained the 3.59% margin despite interest rate increases totaling 175 basis points (following a 125 bp rise in 2004), which brought the federal funds rate to 4.25%. But the margin has declined in seven of the last 10 quarters, according to the FDIC. Lehman Brothers analyst Jason M. Goldberg says the margin pressure, which continued into the fourth quarter, is part of a long-term trend. He calculates the industry’s net interest margin fell in 11 of the past 12 years through 2004.
Deposit Growth Declines
Banks did earn a much higher yield on their assets (5.65% versus 4.93% in 2004) because rising interest rates enabled them to charge more for their loans. But the industry’s cost of funds was up significantly because banks had to pay more for their consumer deposits, according to FDIC data. By the third quarter, the industry’s cost of funds, expressed as a percentage of earning assets, had risen to 2.06%, compared to 1.35% last year. (This means that for every $100 in earning assets the industry spent $2.06 to fund it.)
Midway through the fourth quarter, according to Banc of America Securities, the industry’s total deposits had risen 8% compared to 9% in 2004. Core deposits – comprised of low-cost checking and savings accounts – grew an average of just 5.33% in the first three quarters of 2005, while non-core deposits – including higher-cost certificates of deposit – increased an average of 18%. The disparity was even starker midway through the fourth quarter, with non-core deposits outpacing core deposits 22% to just 2%.
Asset Quality Strong
The industry’s margin pressure was offset by a variety of factors, beginning with the continuation of its pristine credit quality. Lehman Brothers says the industry’s net charge-off ratio in the third quarter was just 0.50%, less than half of its most recent peak of 1.11% in 2002. “Just when you think it can’t get any better, it continues to be exceptionally strong,” says Goldberg. He credits a growing economy and low unemployment, more emphasis on secured lending and tighter terms and conditions in the syndicated loan market for the industry’s credit quality.
While rates have been climbing the past two years, they are still low by historical standards. This has eased the debt repayment burden for many corporate borrowers. And low rates induced consumers to refinance their home mortgages. “It has helped cash flow across the board,” says Gary Townsend, an analyst with Friedman Billings Ramsey Group Inc. in Arlington, Va.
Growth
Most banks also saw strong loan growth this year. According to McDonald at Banc of America Securities, total loans were up an average of 8.33% through the first three quarters of this year – a growth trajectory that seemed to be holding more or less steady midway through the fourth quarter. Consumer loans – including home equity lines of credit and mortgage loans – grew 10% through the first nine months. However, home equity loan production cooled as the year progressed, dropping from a 39% growth rate in the first quarter to 29% in the second quarter and 19% in the third.
Commercial loans, including commercial real estate, grew an average of 7.33% through Sept. 30. The C&I sector was the big story here, with volume growing sharply as the year progressed, from just 3% in the first quarter to 9% in the third. The growth in business loans reflected the fact that a significant number of U.S. companies started borrowing again after the economy’s mild recession in 2002. “A lot of corporate borrowers have been playing catch up,” says McDonald.
Another positive: strong growth in fee income, which Goldberg says rose 15% in the third quarter in a year-to-year comparison. Fee income gains were posted across the board, including consumer service charges, credit cards and trust, asset management, securities brokerage and mortgage underwriting activities. Fees now account for about 42% of the industry’s total revenue – compared to about 20% in the late 1970s. Goldberg says this also helped mitigate the effects of a declining net interest margin.
Bumpy Ride for Bank Stocks
Despite the industry’s excellent asset quality and strong growth in loans and fees, investors were concerned enough about margin compression that many of them avoided bank stocks for much of the year. Through mid-December, the SNL Bank and Thrift Index – provided by SNL Financial, a Charlottesville, Va.-based research firm – was down 0.70% for the year, compared to a 4.27% gain for the S&P 500. The index includes all publicly traded U.S. banks and thrifts. A second SNL index comprised of all public banks with $10 billion in assets or greater was down 0.83% for the year.
A strong rally in early October nearly brought the group back to the break-even point for the year. Mark Fitzgibbon, director of research at New York-based Sandler O’Neill & Partners, attributes this to anticipation by institutional investors that the Fed might begin easing its rate-hiking policy. Steady interest rates would enable funding costs to stabilize, relieving pressure on the industry’s net interest margin. “A lot of growth-oriented managers had been underweighted in financial stocks, but now they want a market weighting or even a slight over-weighting,” Fitzgibbon says.
M&A Activity Off Sharply
The banking sector’s lackluster stock performance restrained mergers and acquisitions. Through mid-December, there were just 230 deals for a combined value of $26.7 billion, according to SNL Financial. This compares to 270 deals totaling $72.4 billion for all of 2004.
An important factor was the mismatch between large- and mid-cap bank stock valuations, according to Goldberg. Large caps traded at a discount to mid-caps for much of the year, which made it prohibitively expensive for large banks to acquire smaller ones. But prices of large- and mid-cap stocks were closer through mid-December. This, according to Goldberg, should make it easier for larger banks to do deals next year.
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