Second quarter results demonstrate continued strong financial performance by community banks. Provided below are some highlights and our perspective on these results and the expectations for the coming quarters. In addition, given the pace of consolidation in the community bank sector, we have provided our initial thoughts on how these KPIs affect the consideration of mergers and acquisitions.
Net loans and leases/assets and loans to deposits
The respective increases in key performance indicators (KPIs) from the first and second quarter of 2018 for net loans and leases to assets (63.60 percent to 64.54 percent) and for loans to deposit (78.92 percent to 80.48 percent) reflect encouraging factors for community banks. The strength of the economy (4.1 percent GDP growth in Q2 2018) has resulted in higher loan demand in all lending categories (i.e., consumer and commercial). Although some sectors of the mortgage market are not as robust due to increasing housing prices, the dollar level of mortgage originations remains high, as does the level of other consumer credit, predominantly due to lower unemployment (3.9 percent at the end of July 2018). Commercial loans, including real estate, remain the driving force of loan growth for many community banks, especially those in more densely populated communities where the shift to urban rental housing continues to be strong.
Another contributing factor is the improvement in the alignment of available liquidity (i.e., core deposits) with loan demand as a result of the continuing consolidation in the community bank sector. Buyers with strong loan origination capacity are actively pursuing core deposits, either through consolidations or branch acquisitions, which are not able to be effectively deployed due to geographic, capital, human resources or other constraints. In some instances, geographic boundaries are being overcome through the active use of digital deposit gathering campaigns and solutions.
Return on equity and yield on earning assets
Community banks continue to show noticeable improvement in their overall earnings capacity. As credit losses remain in check, net interest margins appear to have absorbed the early stages of the Fed’s strategy of increasing interest rates. The earnings ratios also continue their noticeable improvement from Q1 2018 to Q2 2018 in both the return on equity (9.64 percent to 10.42 percent) and the yield on earning assets (4.26 percent to 4.41 percent). The increase in the return on equity is even more impressive in that this improvement was realized on a growing capital base across the community banking sector, in which the Tier 1 capital ratio increased from 12.02 percent at the end of the first quarter of 2018 to 12.11 percent at the end of the second quarter, inclusive of an increasing dividend payout ratio.
Cost of funds
The Fed’s decisions to increase interest rates during the first and second quarters of 2018 is reflected in the increase in the average cost of funds for community banks from 0.56 percent to 0.63 percent. Community banks appear to have been able to effectively pass this increase along to their borrowers, mostly due to the strength of the economy. Although the Fed deferred another rate increase in July 2018, the prediction is for an additional two rate increases between September 2018 and the end of the year. If the interest rate hikes occur, the drive for more efficient alignment of liquidity and loan demand, and improved efficiency ratios, will remain critical for community banks to continue to realize measurable earnings growth.
As noted in the Q1 2018 KPI analysis, community banks continue to demonstrate improvement in their efficiency ratios. Whereas some of this improvement is a function of stronger revenue driven by loan demand, community banks continue to be the beneficiaries of improvements in technology and compliance. FinTech and RegTech solutions continue to emerge and, in many instances, have become more affordable as they become embedded in the technology frameworks of core service organizations and as FinTech and RegTech entities have become more comfortable operating within the traditional community bank environment. Although it is not yet clear how the recent action by the Fed and the Office of the Comptroller of the Currency (OCC) to embrace the concept of a “Fintech charter” will affect the technology solutions in the community banking sector, the expectation is for the cost efficiency related to both technology and compliance to remain a high priority.
Dividend payout ratio
The strong earnings performance noted above resulted in a decline in the dividend payout ratio in between the first and second quarters of 2018 from 41.54 percent to 36.73 percent. This decline is reflective of the sector’s focus on asset growth and capital adequacy. Given the improved current period returns for community banks, resulting from the strong economy and improved operating efficiencies, the most efficient deployment of capital for the majority of banks is to invest in expanding market share, both organically and through acquisitions, and to improve technical capabilities. Because of this, the dividend payout is expected to continue to decline as earnings remain strong through the remainder of 2018 and into 2019.
Insights on mergers and acquisitions
As the pace of consolidating the community banking sector continues, bankers should pay close attention to KPIs that are most likely to drive the decision to buy or sell, as well as the pricing dynamics that can be supported by the anticipated benefits of a transaction. During a period of strong credit performance across the sector, the effective deployment of liquidity into the credit portfolio will generally provide the highest returns. Accordingly, focus on the loan to deposit ratio will provide a sound indicator of what is achievable by aligning healthy, well-established deposit bases with growth-oriented credit markets. Banks should also pay close attention to the pace of decline of their efficiency ratios and the ability to sustain that pace after a merger or acquisition. Knowing where your bank resides on the efficiency ratio curve and what the key drivers are to continued improvement in that ratio will offer significant insights into the ability to recapture the premium paid by the acquiring organization.
For more information on this topic, or to learn how Baker Tilly’s Value Architects™ can help, contact our team.