Interest rates are going up and a new president will revive the economy, cut bank regulations and lower taxes. All good news, right?
The market certainly thinks so. Analysts lately have even seen banks as growth stocks, which is markedly different from their assessment not that long ago. Investors have heard the recent optimism loud and clear. Since June, more than half the nation’s 144 publicly-traded banks with assets greater than $4 billion saw their stock prices jump at least 40%.
But excuse me for being skeptical. Any economic environment, including one as encouraging as current conditions, has risks. It is unclear whether bankers are sufficiently worried about what lies ahead. There is still plenty about which to be concerned.
What could go wrong? Well, let’s start with interest rates.
Pundits seem to repeat the canard every week that banks make more money when rates rise. But I can find no evidence that this is actually true.
Sure, a few individual banks will capitalize on there being higher rates — those institutions with big demand deposits, lots of floating loans, low loan-to-deposit ratios and limited long-term fixed-rate investments.
But that’s a small number of banks. Based on an analysis of third-quarter balance sheets of 700 publicly-traded banks, the median loan-to-deposit ratio was 89%. That does not bode well for banks funding asset growth. In fact, 157 of the banks had more loans than deposits.
To attract deposits and keep current funds from going out the door, many banks will likely raise their deposit rates — which will lift the market generally for deposit yields — thus raising their cost of funds. If the financial crisis taught bankers anything, it is that deposits are gold. Bankers will protect their gold.
Also, don’t forget that the Federal Reserve raised rates by 25 basis points at the end of 2015. What happened to the industry’s net interest margin in the first quarter? It shrank three basis points.
If you still think rates will drive bigger bank profits, check out the FDIC’s quarterly history of net interest margins dating back to 1984. The net interest margin is calculated by subtracting the industry’s cost of funds from the yield on earning assets. Over 168 quarters the correlation between the yield on earning assets and cost of funds for earnings assets is 98.9%. Near perfect correlation.
That means that as the yield on earning assets goes up, so too does the cost of funds in almost lock step. And vice versa. It is remarkable how stable net interest margins are — at the industry level — over decades. Of course, individual banks can see variation based on any number of factors, especially changes in business model or bad lending or investment practices.
Other historical data casts doubt on the profit power of higher interest rates. In June 2004, the Fed took the first of nine actions over two years to raise rates from 1% to 5.25%. While loan interest rates rose meaningfully, the industry’s net interest margin actually fell during this period, from 3.68% to 3.46%.
Investors and maybe some bankers seem to have forgotten that rising rates are actually not good for borrowers. Perhaps that explains why the Mortgage Bankers Association recently forecasted that 2017 refinancings will fall to a 17-year low.
Let’s turn to the economy.
Bad things happen when the industry tries to grow faster than the economy over any extended period of time. A few banks can pull off this feat, but not the entire industry.
This is a lesson that bankers learn, forget, learn again and forget again … ad infinitum … ad nauseam. Lenders need to be sure this cycle is not about to play out again. As of Sept. 30, annual bank loan growth was four times greater than GDP growth during the same quarter. If you go all the way back to 1984, that ratio was higher only once: in 2007. On average, loan growth is only 1.75 times higher.
Let’s hope we can avoid a violent reversion to the mean.
The good news is that credit quality looks terrific. Just check out another of my favorite ratios: the industry’s quarterly loan-loss provision expense to assets.
FDIC data shows that that ratio was 0.29% on Sept 30, which is historically low. By the way, the ratio was even lower before the crisis, falling to 0.28% at the end of the first quarter 2007, before ramping up to 1.95% in 2009. Historically, the ratio has averaged .60%, albeit with wild volatility.
Banks are a weather vane for the U.S. economy. Loan growth of nearly 7% like we saw through the third quarter of 2016 is unsustainable without an economy capable of growing 3% consistently, and better yet, 4%.
Bankers better hope President-elect Trump delivers the goods on the economy. Or else a day of reckoning for high-growth banks will come sooner than later.
During the next few weeks bank CEOs will hold fourth-quarter earnings calls. I’ll be listening for tone. If not enough CEOs are worried about industry trends, I will be worried.