Strip out the effects of mergers and acquisitions, and it is clear that banks trying to decide between the goals of growth and profitability have tilted dramatically in the direction of the latter for the past year.
Whether because of challenges on the funding side or the active deleveraging of balance sheets, observers at a recent American Banker roundtable said the trend is playing out broadly across the industry.
"I think it's a period of rationalization," Christopher Whalen, managing director of Lord, Whalen LLC's Institutional Risk Analytics, said during the roundtable. "Assets that might have looked attractive a couple of years ago, or seemed attractive, are now under close scrutiny. … I think that the industry is having to look very hard at what it does keep on balance sheet, and this has to affect securitization as well as origination activities."
Many bankers have slimmed down by selling securities and paying down debt, mainly to offset the damage of an unfavorable yield curve. But a liquid loan syndication also has been a factor in the slimming - commercial lending has picked up, but at a time when the secondary market has a seemingly limitless capacity to provide credit.
Analysts said that once hedge funds and other market players are done grabbing their share, attractive assets to hold on the balance sheet can be hard to find.
"The very, very large institutions can grow or not grow as they see fit, because … the nature of their product lends itself to distribution, and they can pretty much turn that faucet on and off," said Sharon Haas, a managing director of Fitch Inc. "When you start looking at more regionally operated institutions, that's where the nature of their assets is different. They're really either portfolio lenders, or they're selling into some sort of conduit structure. And most of them would love to keep the good assets on the balance sheet. There just aren't a lot of good assets out there."
The panelists agreed that balance-sheet growth may remain a function of dealmaking for at least a while. But Ms. Haas said the trend should not be viewed as a negative.
Growth has been viewed as "a means to the end, and we may be at that point where it's not an end of itself," she said. "When was the last time you heard Goldman Sachs or Morgan Stanley talk about how big they are? If you're JPMorgan Chase or Citigroup or Bank of America or even Wachovia, you're competing day in and day out with Morgan Stanley and Goldman Sachs. And the endgame may not just be how big you are … but it's really and truly a function of how profitable you are."
All the participants in the roundtable - Ms. Haas, Mr. Whalen, Gerard Cassidy, an analyst with Royal Bank of Canada's RBC Capital Markets, and A. Scott Baret, a partner with Deloitte & Touche LLP - said the secondary market for commercial loans shows little sign of drying up, so banks can go on making loans, despite rising deposit costs and tight spreads.
"Every day we see more and more of these big buyouts. The math is very attractive for the players, and the banks are very eager to finance them," Mr. Cassidy said. "I think that's where the growth is coming [from], rather than the traditional financing of receivables or inventory."
For large banking companies, the debate over what to keep and what to sell for the sake of profitability and risk has gotten a new dimension, because of the strong appetite of private-equity investors and hedge funds.
"Banks are very anxious to finance these transactions. They're not necessarily anxious to hold these assets on their balance sheets afterward," Ms. Haas said.
"There's an awful lot of liquidity in the marketplace that's looking for some place to park. And I think that's the wild card that we've seen over the last couple of years in terms of the market dynamics. Who is bidding up for these assets? Why are they drifting off of bank balance sheets? Why is the market able to finance so much? We hear all sorts of stories about no loan covenants or light-covenant, light-type structures - obviously, very thin spreads."
Knowing where the risk really resides may not be possible until a crunch occurs, the panelists said.
"The syndicated lending market for the leveraged loans is enormous. As we know, that is driving C&I loan growth today," Mr. Cassidy said. "The annual leveraged loan volumes … [are] off the charts, and somebody's holding this paper. When a recession comes, the problems are going to be in these portfolios. … Somebody will be caught holding the bag when the downturn comes."
Much of the risk - and much of the loan growth - is coming from loans related to real estate, he said, and that has had an impact on the list companies able to generate balance-sheet growth organically. "What's so interesting, if you look at the top 50 banks in this country," Citigroup, JPMorgan Chase, and Bank of New York Co. Inc. are among the lowest in risk exposure in construction lending. "These banks were destroyed in 1990 and are not anywhere near the top. The banks that didn't have any problems in the early '90s are all the big construction lenders today, in my view."
In general, the top banks' risk appetites do not seem to have increased much in recent quarters.
"Looking at the top five," value at risk "really hasn't moved that dramatically as compared with the size change in their balance sheets from 2000 to 2006," Mr. Baret said. "They're making more prudent decisions with regard to actual structure of their balance sheets."
Funding challenges were also cited as a reason balance sheets are not growing.
"I think part of the problem with the balance sheet is actually on the deposit side," Mr. Cassidy said. "The yield curve does not give many companies today the opportunity to fund short and go out long. Therefore, the carry trade does not work in this environment. There is no need to do it, as there was when the yield curve was very steep. This trend has had a negative impact on the industry's balance sheet."
The growth-profitability analysis for bank managements typically comes down to balancing investors' preferences against the risks of a misstep in an aggressive strategy. However, Mr. Whalen said, it would be a mistake to think conservative necessarily equals safe.
"If you grow and you stumble and you take a really serious earnings hit, you get bought," Mr. Whalen said. "If, on the other hand, you're conservative and you muddle along, you may have the same issue, because you're not showing the growth, and that's what the Street wants."
Mr. Cassidy said price-earnings multiples suggest the market is "rewarding the companies that are growing faster and sacrificing margin than the guys that are not growing fast and protecting themselves."
