Fast-Rising Costs Emerge as Latest Worry for Banks

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Higher-than-expected expenses in the fourth quarter could be a signal that banks’ cost-cutting initiatives are losing steam.

Banks have benefited from efficiency improvements in recent years, but those efforts noticeably stalled in the recently ended quarter. Noninterest expenses, on average, rose nearly 3% in the quarter compared to a year earlier, to $35.4 million, based on an American Banker analysis of 275 banks that have reported results. The average is the highest figure in more than two years for those banks.

The results disappointed analysts. More than 85% of banks reported higher expenses than consensus estimates, according to a Monday research note by the research team at Sterne, Agee & Leach. The analysts called the expense uptick “one of the biggest stories coming out of this earnings season.”

Rising expenses show that cost-cutting “has been getting harder each year,” said Terry McEvoy, an analyst at Sterne Agee. McEvoy said he plans to update his firm’s earnings model to increase expense estimates for this year and 2016.

“Banks have focused on cutting costs for the past several years, and generally they have been successful,” McEvoy said. “Unfortunately, now there are new areas that need investment.”

The good news is that revenue has outpaced rising costs. Average revenue at the banks analyzed by American Banker rose nearly 11% from a year earlier, to $54.5 million, because of an 11% rise in net interest income and a 10% increase in fee income.

Despite stronger revenue, higher costs caused the average efficiency ratio to decline by 1 basis point from a year earlier, at 64.8%. The ratio had been declining since the fourth quarter of 2013.

It is easy to make too much of the quarter’s increase in costs, and hard to determine the causes. There is a seasonal component to the high fourth-quarter expenses, as banks tend to book one-off costs at the end of the year.

Still, analysts and some bankers pointed to systematically higher compliance and technology costs that are likely to continue at least throughout this year.

“I think we’re going to have heavy lifting for many years to come” in terms of expenses, Joseph DePaolo, president and chief executive of Signature Bank, said during the New York company’s Jan. 22 conference call. He told analysts to expect year-over-year expense growth in the “mid-teens” in 2015, compared to typical increases of 10% to 12%.

“We’re anticipating a fair level of regulatory spend for the foreseeable future,” DePaolo warned.

Much of the investment is in areas like compliance and risk-management that don’t provide offsetting revenue, McEvoy said.

“During the financial crisis, upgrading accounting systems and operating platforms wasn’t a top priority,” McEvoy said. “We’re seeing some catch-up institutions that are in a more stable position and are thinking about internal investing.”

Incremental expense pressure will make increasing revenue more crucial this year, analysts said. Expecting earnings growth through expenses cuts, rather than higher revenue, may no longer be a viable strategy.

“For 2015, it’s going to be tough to show positive operating leverage without better revenue growth,” said Peter Winter, an analyst at BMO Capital Markets.

Based on fourth-quarter results, BMO raised its expense estimates for the banks it covers from flat to 2% growth over 2015.

“The regulatory environment has really changed, and this is the new paradigm that we’re in for banks,” Winter said. “The bottom line is that it’s getting more challenging to cut expenses, and that’s combined with increased regulatory compliance and the need to invest for future growth in a challenging environment.”

Not all industry observers see this as the end of cost-cutting leverage. Frank Schiraldi, a Sandler O’Neill analyst who covers super-community banks in the mid-Atlantic, said noninterest expenses came in about 1% higher than his group expected, mostly due to regulatory costs. But he sees it more as a blip than a trend, and his firm did not raise expense forecasts for 2015.

“Banks continue to talk a good game in terms of their cost-save initiatives for 2015, centered around technology updates and thinning of branch costs,” Schiraldi said. These efforts should help banks at least “run in place” while drumming up new revenue.

Schiraldi cited Fulton Financial as a bank that impressed on expenses in spite of regulatory pressures. Despite dealing with Bank Secrecy Act issues, the $17 billion-asset company’s noninterest expenses rose less than 1% from a year earlier, to $117.7 million, which was lower Schiraldi had forecast. He called Fulton’s forecast of low-single-digit expense growth in 2015 “a big positive.”

For most banks, however, the cost guidance for the rest of the year suggests that the expense bump is not a one-quarter anomaly, McEvoy said. Banks will have to “dig deep” with expense cuts to balance rising baseline costs, he said.

“There will continue to be the need to add to regulatory and compliance and improve systems and technology,” McEvoy said. “Banks will be challenged to offset that.”


Paul Davis contributed to this report.

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