By: Tom Hannagan
Here’s a further review of results from the Uniform Bank Performance Reports, courtesy of the FDIC, through the third quarter of this year. (See my Dec. 18 post.) The UBPR is based on quarterly call reports that insured banks are required to submit. I wanted to see how the various profit performance components compare to the costs of credit risks discussed in my previous post. The short of it is that banks have a ways to go to be fully pricing for both expected and unexpected risk. (See my Dec. 5 blog dealing with risk definitions.) The FDIC compiles peer averages for various bank size groupings. Here are some findings for the two largest groups, covering 490 reporting banks. Here are the results:
Peer Group 1 consists of 186 institutions with over $3 billion in average total assets for the first nine months.
• Net interest income was 5.34 percent of average total assets for the period. This is down, as we might expect based on this year’s decline in the general level of interest rates, from 6.16 percent in 2007.
• Net interest expense was also down from 2.98 percent in 2007 to 2.16 percent for the nine months to September 30th.
• Net interest margin, the difference between the two metrics, was down slightly from 3.16 percent in 2007 to 3.14 percent so far in 2008, or a loss of 2 basis points.
It should be noted that net interest margins have been in steady decline for at least ten years, with a torturous regular drop of 2 to 5 basis points per annum in recent years. This year’s drop is not that bad, although it does add to the difficulty in generating bottom-line profits.
To find out a bit more about the drop in margins, especially in light of the steady increase in lending over the same past decade, I looked at loans yields.
• Loan yields averaged 6.22 percent for 2008, down (again, expectedly) from 7.32 percent in 2007. This is a drop of 110 basis points or a decline of 15 percent.
• Meanwhile, rates paid on interest-earning deposits dropped from 3.41 percent in 2007 to 2.48 percent so far in 2008. This 93 basis point decline represents a 27 percent lower cost of interest-bearing deposits.
It seems as though margins should have improved somewhat — not declined for these banks.
Digging a bit deeper, I see two possible reasons.
• First, total deposit balances declined from 72 percent of average assets to 70 percent, meaning a larger amount had to be borrowed to fund assets.
• Second, non-interest bearing demand deposits declined from 4.85 percent of average assets to 4.49 percent.
So, fewer deposit balances relative to total asset size, along with a lower proportion of interest-cost-free deposits, appear to have made the difference. Unfortunately, the ”big news” is that margins were only down a bit.
Let’s move on to fee income. Non-interest income, again, as a percent of average total assets, was down to 1.14 percent from 1.23 percent in 2007. For this bank group, fees have also been steadily declining relative to asset size, down from 1.49 percent of assets in 2005. A lot of fee income is deposit based, and largely based on non-interest bearing deposits – and, thus, a source of pressure on fee income.
Operating expenses constituted some good news as they declined from 2.63 percent to 2.61 percent of average assets. That’s 2 basis points to the good. Hey, an improvement is an improvement. Historically this metric has generally moved down, but irregularly from year to year. The number stood at 2.54 percent in 2006, for instance.
As a result of the slight decline in margins and the larger percentage decline in fee income, the Peer Group 1 efficiency ratio lost ground from 57.71 percent in 2007 to only 58.78 percent in 2008. That means the every dollar in gross revenue [net interest income plus fee income] cost them almost 58 cents in administrative expenses so far this year. This metric averaged 55 cents in 2005/2006.
The total impact of margin performance, fee income and operating expenses, if you’ve been tallying along, is a net decline of 0.09 percent on total assets. When we add this to the 2008 increase in provision expense of 57 basis points, we arrive at a total decline in pre-tax operating income of 0.66 percent on total assets. (See my Dec. 18 post.) That is a total decline of 44 percent from the pre-tax performance in 2007 for banks over $3 billion in assets.
It would appear that banks are not pricing enough risk into their loan rates yet – for their own bottom line performance. This would be further confirmed if you compared bank loan rates to the historic risk spreads and absolute rates that the market currently has priced into investment grade and other corporate bonds. They are probably at extremes but still they say more credit risk is present than bank lending rates/yields would indicate.
For Peer Group 2, consisting of 304 reporting banks between $1 billion and $3 billion in assets:
• Net interest income was 5.87 percent of average total assets for the period. This is also down, as expected, from 6.73 percent in 2007.
• Net interest expense was also down from 3.07 percent in 2007 to 2.39 percent for the nine months to September 30th.
• Net interest margin, was down from 3.66 percent in 2007 to 3.48 percent so far in 2008, or a loss of 18 basis points. These margins are at somewhat higher levels than found in Peer Group 1, but the drop of .18 percent was much larger than the decline in Peer Group 1.
As with all banks, net interest margins have been in steady chronic decline, but the drops for Peer Group 2 have been coming in larger chunks the last two years, down 18 points this year so far, after dropping 16 points from 2006 to 2007.
Behind the drop in margins, loans yields are 6.69 percent for 2008, down from 7.82 percent in 2007. This is a drop of 113 basis points or a decline of 14 percent. Meanwhile rates paid on interest-earning deposits dropped from 3.70 percent in 2007 to 2.85 percent so far in 2008. This 85 basis point decline represents a 23 percent lower cost of interest-bearing deposits. Again, with a steeper decline in interest costs, you’d think margins should have improved somewhat. That didn’t happen.
I notice the same two culprits.
• Total deposit balances declined from 78 percent of average assets to 76 percent, meaning, again, a larger amount had to be borrowed to fund assets.
• Also, non-interest bearing demand deposits continued an already steady decline from 5.58 percent of average assets in 2007 to 5.08 percent.
Fewer deposit balances relative to total asset size…along with a lower proportion of interest-cost-free deposits…and we know the result.
Now, about fee income for these banks… Non-interest income, again as a percent of average total assets, was down to 0.92 percent from 0.95 percent in 2007. For this bank group, fees have also been steadily declining relative to asset size, down from 1.04 percent of assets in 2005. A smaller non-interest bearing deposit base, without other new and offsetting sources of fee income, will mean pressure on this metric.
Operating expenses constituted some good news here as well. They declined from 2.79 percent to 2.75 percent of average assets. That’s 4 basis points to the good. Historically this metric has been flatter for this size bank, moving up or down a bit from year to year.
As a result of the not-so-slight decline in margins and the continued decline in fee income, the Peer Group 2 efficiency ratio lost ground from 59.52 percent in 2007 to only 61.86 percent in 2008. That means the every dollar in gross revenue cost these banks almost 62 cents in administrative expenses so far this year. This metric averaged 56 cents in 2005/2006.
The total impact of margin performance, fee income and operating expenses is a net decline of 0.17 percent on total assets. When we add this to the 2008 increase in provision expense of 36 basis points, we arrive at a total decline in pre-tax operating income of 0.53 percent on total assets. (See my Dec. 18 post.) That is a total decline of 34 percent from the pre-tax performance in 2007.
As I concluded above, more credit risk is present than bank lending rates/yields would indicate.
Although all 490 banks are declining in efficiency, the larger banks have a scale edge in this regard. The somewhat smaller banks seem to have an edge in pricing loans, but not regarding deposits. Although up dramatically in 2007 and even more this year for both groups, the Peer Group 2 banks seem to be suffering fewer credit losses relative to their asset size than their larger brethren.
Both groups have resulting huge profit declines, but the largest banks are under the most pressure through this period. It’s interesting to note that, with higher loan yields and fewer apparent losses, Peer Group 2 banks are somewhat better at risk-adjusted loan pricing than the largest bank group.
Results are results. The fourth quarter numbers aren’t expected to show a lot of improvement as the general economy continues to slow and credit issues continue. I’ll comment on entire year’s results in posts early next year.
Next year, too, look for my comments on risk management solutions especially relevant to enterprise risk management.