Monday, November 14, 2011
Banking Industry's Third Wave
The American banking industry through the 1970’s operated within a patchwork of state and federal regulations that were largely rooted in legislation from the great depression of the 1930’s. Within that framework banks were limited to operating within a single state and in some states to a single location. Beginning around 1980 state regulations began to give way to demands to modernize the industry through deregulation.
The 1980’s became what I would characterize as the first wave of deregulation, or perhaps more correctly, reduced operating restrictions. During this wave banks found success through consolidation both internally and externally, both for the purpose of gaining operational efficiency. Merged banks consolidated branches and back office units. Operations and lending functions were centralized with smaller branch staffs focused on sales. Although it seemed quite challenging at the time, in retrospect it seems more like we were just “harvesting the low hanging fruit”.
The consolidation of the industry continued into the 1990’s when it combined with a re-energized economy to produce growing bank profits. After catching its breath with the internet bubble induced recession of 2000, the economy took off again, this time driven by increasing real estate values. During the 1990’s and well into the next decade, banks large and small continued to grow their profits. In addition to the benefits from consolidation, profits were driven by growing loan portfolios and fee income. If you look below the numbers just a bit, you could see that loan growth was largely driven by real estate across all categories. The real estate bubble that developed in the last decade was made possible by consumers’ willingness to go deeper and deeper into debt. For many community and regional banks their loan growth was concentrated in construction lending and commercial real estate in general. In terms of fee income, if you looked below the top number you could not help but note that much of the growth was coming from overdraft charges. As I summed it up at the time, banks were feasting on commercial real estate and overdraft fees. One of my favorite expressions is from a fictional economist who said, “Things that can’t go on forever, tend not to”. Indeed they did not. The real estate bubble burst and consumers finally reached their breaking point on debt and their tolerance of bank fees. Today banks are dealing with the aftermath of a collapsed real estate market and a reduction in fee income from overdrafts and debit card transactions.
This brings us to what I would call today’s “third wave” of the post-depression era banking industry. Most banks today are well into the process of recovering from the elevated loan loss provisions that they somewhat grudgingly began in the fourth quarter of 2008. Nearly every bank will be able to look to their loan loss provision for a lift in earnings in 2012. But, the lift will not be enough to restore earnings to prerecession levels. Even with the benefit of historically low funds cost, tepid loan demand will limit growth in net interest income. Fee income as we all know is now limited by both regulation and consumer backlash. This operating environment, in my view, will continue well beyond 2012. In fact, it could very well get worse. In a future article I plan to write about what may be the future for bank branches.
In this new “revenue challenged” environment the winners that will emerge will have two distinguishing characteristics. They will be exceptionally skilled credit grantors and exceptionally skilled at improving operating efficiency. A banker reading this sentence will likely respond by saying, “hey, we are already good in both areas”. No you are not! Not in the manner that will be required going forward. With the pressure building to find new loans, a bank will need to be able to land the good credits and leave the marginal ones to competitors. And, having tough credit approvers who are willing to just say no (maybe too willingly as if they enjoy it), will not be enough. Anyone can find a reason to say no to a credit, it takes skill to understand when and under what conditions to say yes. In a sense, this will be something of a back to the future process. The winning banks will be those that put forth skilled bankers that can discern credit and at the same time convince those good borrowers to do business with their bank instead of the competition. In terms of gaining operating efficiencies, let’s just say the industry is ripe for disruption. In yet another article I plan to write about a growing amount of money being invested by some very smart people with an eye to being very disruptive.