Based upon conversations with clients, prospects, and industry observers, including analysts and reporters, 2007 is shaping up as a very tough year for the U.S. banking industry. Many banks will find it increasingly difficult to generate growth numbers that exceed 2006 results, while others will struggle to avoid sliding back below 2006 performance.
This week’s newsletter reviews some of the factors limiting growth opportunities while our next newsletter will offer some recommended approaches for banks to consider in light of this tougher environment.
The Easy Growth is Over
At least seven factors will slow growth:
- Flat yield curve
- Customer demand for higher rates
- Loan pricing squeeze due to more intense bank and non-bank competition
- Improved execution by the largest banks
- Reduced commercial real estate lending opportunities
- Increases in provisions
- Continued disintermediation by the capital markets
Flat/inverted yield curve. There is no news here for bankers managing through an environment in which funding profits are increasingly limited. The carry trade (borrowing short/investing long) provided a great opportunistic profit event for many banks. That opportunity has largely disappeared unless one is willing to speculate in currencies such as the New Zealand dollar or Icelandic currencies (not a good idea for most banks). Some analysts view the yield curve challenge lasting until next year.
Customer demand for higher rates. During 2006, the customer reached the tipping point concerning sensitivity to interest rates. When rates were at one-to-two percent, many consumers and small and mid-sized companies did not bother to reinvest funds into higher rate vehicles; increasingly, they are aware of the upside move in rates and want to capture the benefit. Those banks that avoid actively moving good customers to higher rate deposits risk alienating them and losing the customer when more aggressive banks come to call or when the customer wakes up. Banks not actively approaching current customers with investment alternatives are relying on the customer being preoccupied, lazy, or stupid; not a good strategy for relationship building.
Loan pricing squeeze due to more intense bank and non-bank competition. At the same time as deposit rates are heading up, loan margins appear to be heading down. Why? More competition fighting over a non-growing borrower base provides the core reason. Some geographies, such as areas of the Mid West see little new business growth; they need to steal share to grow and stealing share is expensive. In addition, more regional and national players are entering or establishing stronger footholds in various geographies. For example, Chase is number two in branch holdings in Michigan; Wachovia is entering California; various regional players continue to expand beyond their home states to other attractive or more attractive geographies. Until the inevitable shakeout occurs, competitive dynamics will only intensify. Microbusiness loans and loans to the upper end of the middle market have already largely become commodity pricing markets. This point and the two above it all result in reduced net margin income.
Improved execution by the largest banks. Many regional and community banks long viewed big banks as “the gift that kept on giving.” Smaller competitors viewed players such as Bank One and Fleet, among others, as internally focused on acquisition integration activities and related cost reduction events, resulting in a steady stream of unhappy customers ready to switch to a local provider. That “gift” has now been taken away, replaced by what is often a hard-charging sales and marketing emphasis that out-muscles and out-focuses many smaller players.
We expect the consolidation that has come to many product areas to spread to small business and commercial banking: five banks control 60 percent of credit card loans; the top ten banks hold 40 percent of all mortgages and more than 50 percent of all assets; 12 banks and brokers generate 75 percent of all online stock and securities trading. Up to now, small business and the middle market have functioned largely as the private preserves of community and regional banks. No longer.
Reduced commercial real estate lending opportunities. Almost uniformly, the analysts I spoke with recently view the asset growth in banks with less than $10 billion in assets as having been largely fueled by commercial real estate lending. In many geographies, these lending opportunities have already begun to slow down; in any case, that “one trick pony” cannot be counted on to sustain growth indefinitely.
Increases in provisions. In recent years, most every lender and credit person has been a credit genius. The quality of portfolios has to be “as good as it gets.” However, even in 2006, more conservative banks are increasing their reserves in preparation for rockier times ahead. Certainly, the increase in recoveries has reached an end for most players. As seems to always be the case in this stage of the cycle, some banks are stretching their risk parameters to make their loan growth numbers. The end results are inevitable.
Continued disintermediation in commercial banking. Disintermediation has not yet had a dramatic impact on small business and the middle market, but it will as non-bank lenders, including private equity firms and hedge funds, look for investment areas. The inroads made by these and other groups into traditional bank areas are already significant. One example: non-bank lenders (including hedge funds, brokerage firms, mutual funds, and insurance companies) now hold almost 15 percent of syndicated loan commitments versus two percent ten years ago.
Concluding Thought
The challenges are clear and, for some banks, fairly stark. Articulating the problem situation is relatively easy; providing practical solutions for addressing them, less so. But, banks cannot view themselves as passive victims of circumstance. Their range of available options and the commitment and skills required to carry them off vary significantly. That is next week’s topic.