Balance-Sheet Bind: Banks Chase Max Profits and Minimal Rate Risk

Proper balance sheet management is an often underappreciated, but critical, differentiator among regional banks trying to maintain strong efficiency ratios.

When discussing efficiency, executives regularly focus on cost-cutting. But increasing revenue is just as important, and it often requires loans and securities with durations and interest rates that can handle market fluctuations. Finding that optimal asset sensitivity has proven tricky for banks during this prolonged period of low interest rates, and it has taken a toll on some efficiency ratios.

"Your balance-sheet position is something you can control," said Marty Mosby, an analyst at Vining Sparks. "Executives want to blame it on the [Federal Reserve] since the Fed isn't raising rates. But in the end it comes back to your decision about how asset-sensitive you are."

Before the financial crisis, investors could expect efficiency ratios at many large regional banks to range from 56% to 58%, Mosby said. Now, low rates and higher compliance costs have moved those numbers, on average, north of 60%. (Efficiency ratios compare noninterest expenses with revenue, often measuring how much a bank must spend to make a dollar. The lower the figure, the better.)

Regionals originally "were content to wait out the years of slow economic growth without announcing big operating-expense-reduction plans because they could always produce profitability improvement through reserve release … and increased fee income from mortgage refinance activity," said Tony Plath, a finance professor at the University of North Carolina at Charlotte.

Loan-loss reserve releases and refi activity have largely run their course, forcing bankers to focus more on expenses. To be sure, regionals have room to reduce headcount and close branches, said Brad Milsaps, an analyst at Sandler O'Neill, though doing so can also only take a bank so far.

"You've got to grow your revenue to grow your earnings," Milsaps said. "At some point you can only cut so many things, particularly as regulatory costs continue to rise."

That's why it is critical to strike the right level of asset sensitivity. Doing so can help improve revenue, and thus lower the efficiency ratio by boosting its denominator. Since the financial crisis, management teams at large regionals have taken a wide range of approaches to managing their balance sheets.

That is partly because low rates have lasted longer than expected, said Terry McEvoy, an analyst at Stephens. Most banks are still drowning in deposits, and executives want to be prepared for a possible outflow when rates eventually rise, he added.

"It's a trade-off," McEvoy said. "You can make more revenue today, or you can say, 'We know at some point rates will go higher and that environment would be prudent to invest in.' But if you have a meaningful percent of your assets earning next to nothing, it will have an implication for efficiency."

M&T Bank in Buffalo, N.Y., and Huntington Bancshares in Columbus, Ohio, while asset sensitive, have historically managed their balance sheets by making more fixed-rate oans — commercial real estate at M&T and auto loans at Huntington — and by buying mortgage-backed securities with longer durations, Mosby said.

Their efficiency ratios partially reflect this strategy. M&T's 60.6% efficiency ratio, though up from its precrisis level, it is still on the lower end of similarly sized banks. Huntington's 59.2% ratio is actually lower than the 62.3% mark it had in 2007.

"How they position their balance sheet is a benefit," Mosby added. "They're not incurring these hidden costs of being too short on their asset side, and this allows them to not be waiting for interest rates to go higher."

Still, fears exist that rates will move up while banks are locked into longer-duration bonds, said Jeff Davis, managing director of the financial institutions group at Mercer Capital. Some large regionals have resisted buying longer mortgage-backed securities and are sitting on more cash so they can be more nimble when rates rise. But the trade-off is the loss of revenue in the short run, which works against near-term efficiency.

Overall, the nation's 20 biggest banks are losing more than $2 billion a quarter by being overly asset sensitive, Mosby said.

Zions Bancorp. in Salt Lake City and PNC Financial Services Group in Pittsburgh are among the banks experiencing such opportunity costs, industry experts said. PNC's efficiency ratio rose from roughly 61% in 2007 to 65.4% at Dec. 31; Zions' ratio jumped from about 54% to 71.1% over the same period.

"We've been very public in regard to our asset sensitivity and in regard to our investment portfolio, the conservative nature in terms of keeping our powder dry to be deployed more aggressively in a higher rate environment," Robert Reilly, chief financial officer at the $340.2 billion-asset PNC, said during a recent presentation at an investor's conference. "We're getting closer to that higher-rate environment so we'll be ready to go."

The $57.6 billion-asset Zions announced plans earlier this month to reduce its efficiency ratio to below 65% by 2017 by cutting costs through branch closures and reducing headcount. Boosting revenue "is the wild card" to that goal, Milsaps said.

To help lift earnings, management said it would deploy cash into short-term mortgage-backed securities in addition to growing fee income.

The "problem with every ratio is its two data points trying to describe an issue," Harris Simmons, Zions' chairman and chief executive, said during a recent investor presentation. "The efficiency ratio is a little like that, and we are focused on it as an expense measure, but fundamentally revenue is a big part of it."

Of course, buying mortgage-backed securities also carries a degree of risk, especially as the Fed seems poised to raise rates. But this strategy, even without a rise in rates, can help Zions catch up with its peers, Mosby said.

"It's a tough call," Davis said. "It's easy to look back and say, 'You would have been better to extend duration.' "