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2010 Industry Outlook

POV 03.26.2010

2010 Outlook

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by Curtis Carpenter, Managing Director, Sheshunof & Co. Investment Banking

Looking ahead, 2010 portends to be an inflection point for community banks. With asset quality problems appearing to be at or near the point of cresting, this year may bring the long-awaited first signs of a recovery.

INDUSTRY REVIEW

Bank profitability has been plummeting on a quarterly basis since the beginning of this financial crisis in the first quarter of 2008. Finally, in the fourth quarter of 2009, the percent of banks reporting losses on a last-twelve-month (LTM) basis declined slightly to 29% from 30% in third quarter. (Exhibit 1) This isn’t yet a trend and profitability for 54% of the banks remains at a subpar level (50 basis points or less). At these performance levels, the industry cannot generate enough capital to support robust economic growth.

Asset write-downs have been the primary cause for poor profitability. Goodwill and other impairments of $19.7 billion were dwarfed by the $246.5 billion of provision expense. (Pre-provision earnings for the industry were $290.3 billion in 2009.) Provision expense for the industry by quarter exhibits no discernible trend. In fact, the highest level of provision expense was recorded in the fourth quarter of 2009.

The number of banks reporting total non-performing assets (including loans 90 days past due) greater than 4% of total assets increased each quarter during 2009 as shown in Exhibit 2. The median level of Total NPAs/ Total Assets rose from 1.02% in the fourth quarter of 2008 to 1.54% in the fourth quarter of 2009. However, the number of banks reporting a lower level of Total NPAs/ Total Assets increased each quarter during 2009, with 3,660 or 45% of all banks reporting an improvement for the fourth quarter. This suggests that asset quality for many banks is improving but that asset quality for some is getting much worse.

Exhibit 3 shows the quarterly trend of banks with the highest levels of nonperforming assets. When viewed in conjunction with the quarterly trend in the Texas Ratio (Exhibit 4), it appears the number of problem banks may be cresting. If so, this is good news for the industry but there remains a ponderous number of problem banks to resolve over the next few years. While there will certainly be several hundred additional failures, there will need to be even more mergers of weak banks into stronger ones.

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The FDIC recently announced it will begin “clustering” failing banks in certain geographies. This will speed the clean-up process for the industry as multiple failed banks can be sold as a package to a large buyer. However, this process will unfortunately shut out small banks in these markets from bidding on individual failed bank opportunities.

CAPITAL

Perhaps the most problematic subject in community banking today is capital. The regulatory agencies are pressing hard for higher capital standards at precisely the wrong time. The industry needs capital forbearance not higher requirements. The uncertainty created by an uneven regulatory response to the issue of capital is having a paralyzing effect. Thousands of banks with the requisite capital and management to help clean up the current mess by acquiring problem banks are unwilling to move forward with a merger until they are certain they will have capital sufficient to meet any new standards following the merger. In addition, private equity firms and others with capital are poised to pour billions of new capital into the industry once it can be determined what the new standards will be.

It is important to note that the problem at failing community banks during this cycle was not a lack of adequate capital. The problems had more to do with lax regulatory oversight of lending (loan concentrations, out-sized bets on home prices and out-of-market loans) and of excessive reliance on wholesale funding magnified by a prolonged period of unrealistically low interest rates. The median bank that failed in 2009 had positive equity the quarter prior to failure. More banks in 2009 were closed due to liquidity and funding concerns than an absence of capital. One of the most expensive failures in 2009, Guaranty Financial, a thrift with branches in Texas and California, was allowed to stay open for months while operating with a negative capital ratio in excess of 5% of assets while the OTS shopped for a buyer.

Raising capital requirements for community banks is the wrong response to this crisis. In the last banking crisis (over 20 years ago), banks with good management were given forbearance and were required to submit a “capital plan” that would demonstrate how they could return to required levels of capital through earnings retention and management of growth. Cease and Desist orders were given only to those banks with owners and management that refused to cooperate with regulators as a form of punishment for bad behavior. In the current cycle, “prompt corrective action” is the charge, and C&Ds are given based upon a formula without the exercise of any professional judgment on behalf of the regulators.

One of the “new standards” gaining favor is a 9% Tier 1 Leverage Ratio, a dramatic increase given that the current standard is 5% for well-capitalized institutions. Adoption of this new standard would require community banks (defined as those with less than $20 billion in assets) to raise an estimated $43 billion of new capital just to support current asset levels, not to mention a cushion for growth. This is five times the amount of common equity raised by this group of banks during 2009.

Additional Capital Required
Assuming 9% Tier 1 Leverage Ratio
  < 5% 5 - 7% 7 - 9% > 9%
Number of institutions 200 392 2,426 3,816
Total assets $140,790 $448,064 $1,384,897 $1,387,113
Estimated additional capital  4.50%   3.50%   1.50%   
Additional capital needed $6,336 $15,682 $20,773  
Cumulative capital needed $6,336 $22,018 $42,791  
Number of banks (cumulative) 200 592 3,018 6,834
Excludes: Banks over $20B, investment banks, insurance companies, foreign banks
Well Capitalized Standards      
Tier 1 Leverage 5.0%      
Tier 1 Risk-Based 6.0%      
Total Risk-Based 10.0%      

Presently, clear, consistent regulatory guidance is lacking, causing banks to control balance sheet growth and risk, which has the effect of reducing profitability and returns on capital. This restricts capital growth in two ways: (a) it reduces internally-generated capital and (b) it drives external capital to industries with better risk/reward profiles. It would seem that a part of the capital solution would be to allow banks with good management time to work through asset quality issues or to acquire problem banks under current capital standards. Until this issue is resolved, community banks cannot assume their usual role as the wellspring of economic growth.

CONCLUSION

Although the banking industry continues to labor under the weight of billions in nonperforming assets and the list of problem banks reached a new high as of year-end, we are beginning to spot some early signs of recovery. While we anticipate over 200 bank failures in 2010, it is encouraging to note that 45% of banks showed improved asset quality in the fourth quarter. Capital raises are becoming more common, and we are seeing renewed aggressiveness from buyers looking for bargains. With well over 1,000 banks in serious trouble, the table is set for an increase in merger activity as strong banks acquire weaker ones outside of the FDIC auction process. If the FDIC is successful in auctioning off “clusters” of failed banks, we could see the number of problem banks actually begin to decrease in the second half of 2010.

Overly zealous regulators and lack of clarity surrounding capital levels and other aspects of regulatory reform are providing strong headwinds for merger activity. Nonetheless, the compelling opportunities of acquiring banking franchises at historically low prices will likely spur an increase in the number of mergers. ■