In early July, The Economist featured a story on U.S banks titled “Tighter Times Ahead.” Similarly, last Thursday’s Wall Street Journal published an article, “Bank Stocks May Face Rough Ride.” Both articles raise caution flags about future bank performance, based on the view that some of the fundamental factors that have propelled bank earnings appear to be slowing down or even ending.
We think these writers have correctly focused on the proverbial “elephant in the room” that not enough executives are facing up to. Many banks will find themselves unable to grow, and their shareholders may see value erosion, as growth by internal means become inadequate and acquirers grow more circumspect in evaluating targets.

A Positive Environment for Banks

In recent years, many banks have benefited from an extraordinarily favorable business climate. Banks have been able to exploit a strong mortgage refi market, the carry trade (benefiting from the wide gap between short and long term rates), and the sale of bonds whose value has increased due to a low interest rate environment. In addition, many banks have executed cost reduction programs that have eliminated much of the low hanging expense fruit. At some banks, the majority of annual earnings growth can be traced to these factors.
Unfortunately, for many of these same banks, currently rising rates and the expectation that they will rise further over the next year will lower mortgage volume, reduce the carry trade opportunity, and decrease potential gains from bond sales. While banks can always reduce their expenses further in various areas, many are at the point where they need to spend money to build their marketing and sales capabilities.

A Good Time to Sell …

Some smart bankers have looked at the challenges ahead of them…and decided to sell. We knew top executives at two of the banks that recently sold. One of them was looking for  “the next big thing” to continue to propel his bank’s growth (we don’t think such an item exists) while the other bank, at least in our conversations with them, evidenced little sales focus, strategic leadership, or sense of urgency. In fact, the executives of these banks may have made exactly the right decision for their shareholders by letting someone else deal with the issue of how to generate growth.

…But Not a Good Time to Buy

Increasingly, we find that while some bank executives are acting quickly and decisively to implement the changes necessary to respond to a changed operating environment, many others either fail to understand that their world is changing or lack the ability to respond.
Furthermore, while smaller banks like to view themselves as faster moving and more flexible than larger players, our experience as independent observers suggests the opposite may be true. For example, several of our largest bank clients are actively and aggressively working through organizational roadblocks and challenging historic approaches to various markets. They know that doing so opens up significant cross-sell opportunities and better meets their customers’ needs.
Too often, however, smaller banks (particularly those with a long history) act tentatively and cling to the past. We see little correlation between small size and flexibility or small size and speed in decision-making. One danger for the community and super-community banks is that they risk becoming irrelevant to their more demanding customers; another is that they lose their attractiveness to supposedly eager suitors.
We think that by 2005, if not sooner, those banks with a true growth franchise will become evident and will show numbers that contrast sharply with those that focused more attention on managing interest rates rather than fundamental growth. Many banks, perhaps in the hundreds or more, have pulled all the growth levers mentioned above and may have simply run out of steam, thereby becoming much easier prey for banks that we expect to become significantly pickier buyers.

Shop…and Wait

For acquirers, now may be a time to continue to evaluate targets, bid very selectively, and focus on tracking target names over the next three-four quarters. Banks expecting reduced earnings or slow growth from core businesses (as opposed to financial engineering) should quickly consider whether to start shopping themselves. Alternatively, they can light a fire under their sales effort and reenergize their emphasis on internal growth. The second path is certainly the more difficult of the two, but it also better addresses the needs of the customer and the shareholder as well as the expectations of the investment community.