Banks must shift focus to thrive in extraordinary times
The key factors that allowed the best banks to outperform last year included higher fee income, greater efficiency and stronger loan growth than their peers. But suddenly, we are in a very different operating environment than we were just six months ago, and the implications for banks are profound.
Going forward we expect the drivers of top performance will be dramatically different than in the past due to the upheaval from the global coronavirus pandemic.
Here are some of the metrics that forward-thinking executives will have to focus on to thrive amid the uncertainty ahead, based on the annual analysis of bank performance conducted by Capital Performance Group and American Banker. (To see the ranking of publicly traded community banks under $2 billion of assets, click here, and to see the ranking of midtier banks from $2 billion to $10 billion assets, click here.)
■ Credit quality: Credit quality was pristine in 2019, with little difference between top performers and their peers. In fact, credit quality has not been an issue that required any serious discussion in the banking industry for a decade. However, that is about to change in a big way.
Some top-performing banks have enjoyed higher margins from higher-yielding, higher-risk consumer businesses such as credit cards or exposure to business sectors that are especially vulnerable to disruption from the pandemic. But now they’ll see their level of nonperforming loans and leases spike compared to banks that were more conservative in their lending.
Credit quality will likely be the key metric in determining performance in 2020, with high performers diverging from the rest of the industry.
■ Expenses: As was the case for the past few years, top performers in 2019 had both higher revenue growth and higher growth in operating expenses compared to peers. But revenue growth is facing gale-force winds, so the top-performing pendulum is about to swing in favor of those banks that focus primarily on controlling operating expenses.
■ Asset sensitivity: Last year, the top performers were typically more asset sensitive compared to the overall industry. They benefited from that until the Federal Reserve started to reduce rates in July.
Net interest margins contracted in 2019 and yields on earning assets have plummeted further since then. Being asset-sensitive made sense when rates were rising, but now the performance of most asset-sensitive banks will be hurt in the wake of additional interest rate reductions this year.
■ Demand deposits: Top performers last year grew loans at a higher pace than peers and some funded the growth with high-yield savings accounts. But this tactic for gathering deposits no longer makes economic sense for most traditional banks given the decline in earning asset yields.
Instead, top performance in 2020 will be determined largely by a bank’s cost of funds.
So rather than pursue high-yield savings — which can skew core deposit measures — banks should focus on growing their non-interest-bearing demand deposits to at least 25% of total deposits.
■ Loan growth: The pool of qualified borrowers will shrink as unemployment increases and the consequences of the economic contraction reverberate through businesses and households.
Banks have to be more cautious in their underwriting now, and that will make loan growth more challenging. Consequently, top-performing banks in 2020 may be those that most effectively leverage the various government-backed emergency lending programs.
■ Fee income: In 2019, top performers enjoyed higher levels of noninterest income than peers, typically driven by fees from wealth management and account service charges. But in 2020, loan origination fees from the government’s Paycheck Protection Program are likely to be a significant contributor in propelling the banks that rise in the rankings.
In short, this is shaping up to be a topsy-turvy year where the factors driving high performance in the banking industry get reshuffled. What mattered in 2019 isn’t going to be what matters in 2020.
Then again, the same could be said of strategic priorities for many management teams, as their previous focus on outperforming turns instead to navigating the current crisis.