The period when banks report their first quarter financial performance is about to begin. These performance numbers will likely reinforce the reality that, absent significant changes, many banks simply cannot attain the level of profitability needed to remain viable.
Performance numbers in 2011 were a clear omen, particularly when compared to pre-crisis (2002-06) performance. Last year, asset quality problems receded and fears of a new recession abated, so it was no longer sufficient for an institution to possess above-average asset quality and high levels of equity in order to gain the favor of investors.
Some would argue that performance last year was dampened by lackluster economic growth and abnormally low interest rates, but it is probable that such an environment will continue during the next few years. Therefore, it is wishful thinking to assume performance will be bolstered through a marked improvement in the net interest margin.
To recap some of the salient performance challenges that were manifested during 2011:
- Although most institutions operated in the black, return on equity ratios were anemic: the majority of institutions posted ROEs in the mid-single digits or lower. This is below their cost of capital and it is not sufficient to attract additional capital. Absent marked improvement, investors will move their money to industries offering more attractive risk-adjusted returns.
- A significant portion of the industry remained burdened by high levels of non-performing assets. The ratio of NPAs to total assets was 5% or greater at approximately 107 institutions in the $1-$10 billion asset peer group, which equated to 20% of institutions in this asset tier. It is difficult to envision a realistic scenario where most of these banks survive.
- The majority of banks had efficiency ratios in the mid-sixties. The bottom 25% had efficiency ratios above 75%. By comparison, the median efficiency ratio before the crisis was below 60%. Quite simply, current expense levels cannot be supported by revenue at many banks, yet they have been unable or unwilling to materially reduce operating expenses.
- Equity levels increased dramatically from pre-crisis levels. Among institutions with more than $10 billion in total assets, the median ratio of total equity to average assets increased an eye-popping 209 basis points compared to the level in 2002-06. While equity ratios will decline somewhat with resumption of stock repurchases, increased dividend payouts, and possibly — loan growth, much higher capital levels are a permanent part of the new supervisory approach. Excess capitalization will remain the status quo.
Obviously, last year a number of banks performed at levels more in line with pre-crisis levels and consistent with long-term viability. There was a wide gulf between the performance of these higher performing banks and the rest of the industry. This disparity will carry forward into the performance results for first quarter 2012. Some performance indices, such as asset quality should improve as economic conditions improve. Others, such as capital levels will remain elevated for the foreseeable future.
Regardless, to attract capital banks must demonstrate an ability to organically grow revenue, demonstrate a proper alignment between revenue and operating expenses, as demonstrated by an efficiency ratio of below 60 percent, and generate a return on shareholders’ equity of 12%, which is the minimum return required to attract capital and support growth. For most banks, net income would have to double from that recorded in 2011 to attain ROEs of 12%. This degree of improvement in profitability is implausible at many banks, especially those whose revenue prospects are captive to a geographic market characterized by slow economic growth.
Performance standards today for the industry remain similar to pre-crisis standards. The harsh reality is that many banks will not be able to attain them, and the numbers will bear that out.
It is incumbent upon executives and board members to conduct a clear-eyed appraisal of their institution’s ability to attain the performance standards through aggressive expense reductions, conservative loan growth, and aggressive management of capital levels. If the desired performance cannot be attained as an independent entity, they should seek to merge or sell the institution.
Claude A. Hanley Jr. is a partner at Capital Performance Group.