Bank boards and top executives have been preoccupied with shoring up their bank's balance sheet and capital structure, but they now need to focus on the income statement for three key reasons:
- The income statement — and especially the expense structure — is something they can more immediately influence.
- The value of banks is driven by underlying earnings power. For banks in decent shape, earnings performance will be the largest influence on stock price, as always.
- Banks' ability to attract investors to replenish their capital on reasonable terms will depend crucially on earnings prospects. Single-digit ROEs will drive substantial discounts to book.
At the same time, banks face seismic shifts in revenues that may persist for several years, arising from regulation, deleveraging, shrinking loan portfolios, "normalization" of short-term interest rates, as well as lower prices of real estate and other assets against which loans are secured. Banks cannot rely on revenues to improve their profitability.
Our analysis suggests that banks may face revenue declines of 15- 25%. Without a corresponding adjustment in expenses, unit costs and profits are likely to deteriorate sharply.
Noninterest income will face strong headwinds, especially in credit card fees and capital gains through trading and investment banking. Community banks will be less affected, but even they will see gains-on-sale of mortgages decline as the most recent refinancing wave comes to a close. We forecast NII declines of 10bp to 30bp.
Net interest margin is likely to trend back down from its recent resurgence. Banks have recently benefited from the sharp downward move in short-term interest rates, while interest income has adjusted more slowly. Futures markets forecast a 60bp increase in short-term money within 18-24 months. Meanwhile, yields on loan portfolios are not likely to increase anytime soon, and may drift lower as some loans are refinanced.
The high-earning portion of the balance sheet will plateau or may even shrink. Over the last three years 5% of banks' assets have shifted from loans (typically yielding around 500bp) to cash and securities (yielding 20-50bp). While at first this shift seems rather modest (and perhaps even prudent), it is responsible for a decline in banks' ROA of over 20bp. In the face of modest loan demand and banks' continuing desire to manage risk, we expect that this trend is likely to continue.
Collectively, these three drivers could cut revenues 70bp to 110bp (approximately 15% to 25% of typical banks' revenues), by our estimates.
At the same time, there is likely to be upward pressure on costs to address recently introduced regulations, high FDIC fees are likely to persist and the costs of managing foreclosed assets and delinquent loans will not likely decline soon; banks may well be facing upward pressure on expenses even as revenues are declining.
The prudent bank will take preventive measures and develop contingency plans across a wider-than-normal range of scenarios. Many of the factors cited above are likely to persist for several years. Banks that choose to accept lower profits for the next few years will find it very difficult to attract capital on terms short of outright sale, or extensive dilution of current shareholders.
We advise taking control of one of the last remaining performance levers available: managing expenses.
Many banks are reluctant to pursue aggressive expense reduction. Some have gone through a cost-cutting exercise in recent years and feel there is not much left to cut. Others are concerned that cutting costs will damage their long-term prospects.
Still others feel that their expense structure is already in good shape and does not need to be reduced. Given the paucity of good levers to pull, and the possibility that these arguments are not really "data-driven," it is wise to re-look at expenses with a clinical and dispassionate eye.
Expense reductions are often done poorly — doing it "right" is harder than it seems. The typical response to revenue downturns consists of freezing discretionary spending, bonuses and capital investment, and handing out head-count reduction targets to senior executives, often resulting in disproportionate cuts among junior staff in customer-facing roles. This approach has detrimental effects on sales, service levels and productivity, not to mention retention of talented staff.
Prudent expense reductions should focus on overhead, excess management layers, restructured and renegotiated external contracts, rationalized IT expenditures, streamlined (but effective) ways to address regulatory requirements as well as re-engineering of critical customer-facing processes to improve service metrics. The bank should review special projects and new distribution channels. Consider exiting or selling underperforming businesses and reinvesting in higher-margin businesses.