Asset growth and low rates inhibit earnings capacity
As we reported for most of the past year, the COVID-19 pandemic and the resulting changes in fiscal policy and economic behavior has measurably inhibited earnings capacity for a large majority of the community banking industry. Bank balance sheets have grown principally due to government stimulus payments, limited capital investment by small and mid-sized businesses, and – notwithstanding strong equity markets – a general flight to quality by most consumers as it relates to discretionary funds.
The fourth quarter of 2020, in comparison to previous quarters in 2020 as well as the fourth quarter of 2019, reflected continued strong capital levels but challenges in achieving earnings growth, principally due to historically low net interest margins. With expectations for the pandemic to persist well into 2021, the assurance of expanded government assistance, and low interest rates continuing for the foreseeable future, the results of this equation are not likely to change in the coming months.
Return on average equity
Community bank profitability of 8.90% in relation to average equity remained relatively stable in comparison to each of the previous three quarters in 2020 as well as the fourth quarter of 2019, for which the average was 8.97%. For most banks in this segment, profitability was restricted in the fourth quarter by continued low interest rates, excess liquidity and limited loan demand. In addition, it appears that cost reduction opportunities arising from technology investments and staff reductions have stabilized. Lastly, as discussed below, loan loss provisions continued to be relatively low as credit quality remained favorable in part due to the benefits of government stimulus programs.
Noninterest income to net income
Noninterest income as a percentage of total income increased to 13.17% during the fourth quarter of 2020 compared to the quarterly average of 11.60% for the trailing four quarters. This reflects the combination of continued downward pressure on net interest margin, which remained constant at 3.35% in comparison to the most recent quarter, and emerging efforts across the sector to expand fee-based income such as higher fee levels on deposit accounts and other services. Given the Federal Reserve’s stated intent to keep interest rates low for the foreseeable future, and the likelihood of continued tempered loan demand from consumers and small to mid-sized business, it is expected that this trend will continue throughout 2021.
Credit and credit quality
As previously noted, credit demand for community banks continued to decline throughout the fourth quarter of 2020. Keeping in mind that that the second round of the Payment Protection Program (PPP2) was not launched until January of this year (i.e., 2021), community banks saw the loan to deposit ratio decline to 74.15% as of the end of 2020. This compares to 82.09% as of the end of 2019, and an average of 79.4% for the full year 2020. This decline is somewhat muted by the first round of PPP (PPP1) loans issued by community banks; however, as was widely publicized, the majority of PPP1 loans were issued by large banks.
Credit quality remains favorable, principally due to the benefits of government stimulus and limited loan demand, as reflected by nonperforming loans being just 0.53% of total loans. Accordingly, average loan loss allowance levels have been held steady at 1.30% of total loans as of the end of 2020. In some instances, banks recaptured provisions for loan losses recognized during the first half of 2020. We anticipate a more normalized loan loss provision curve in 2020, certainly subject to the duration of the pandemic, the effectiveness of government stimulus and fiscal policy.
Cost management in relation to declining revenues continues to be an increasing challenge. Most notably, the benefits of technology investments have either been fully realized or limited due to the absence of loan demand. In addition, the operating inefficiency of branch networks in a more virtually dependent environment have been the largest contributors to the increase in the segment-wide efficiency ratio from an average of 63.35% for the previous two quarters to 66.82% for the current quarter. As community banks continue to reassess the shift to digital banking solutions and the continued emergence of nonbank alternatives for many financial service needs, we expect more changes to branch networks and investments in technology in an effort to gain higher levels of operating efficiency.
Merger and acquisition (M&A) insights
Certainly, 2020 represented the quietest year in recent history as to the number and size of community bank acquisitions. For the most part, both buyers and sellers took a pause to assess the strategic and economic value of mergers and acquisitions, as well as to focus on the operational demands arising from the pandemic and uncertainties associated with both the pandemic and the political/regulatory landscape.
Based on the results of the recent elections and the promise of an economic recovery fueled by continued government stimulus, and a moderately successful distribution of vaccines, we believe 2021 will represent the restart of the rapid consolidation of the community bank sector. Upon stabilization of the economy and broader “re-opening” of small and mid-sized businesses, we believe more appealing pricing dynamics for both buyers and sellers will emerge. Lastly, the evolution of fintech organizations and the broader acceptance of these solutions by consumers, businesses and regulators will likely motivate many community bankers to engage in targeted and strategic transactions.
For more information on this topic, or to learn how Baker Tilly’s Value Architects™ can help, contact our team.