Community banks are facing one of the most challenging treasury management environments in recent history. The combination of the continued period of low interest rates (both long-term and short-term), excess liquidity and limited credit demand is severely limiting the opportunity for banks to generate expected level of net interest income.
Fortunately, it appears the government stimulus efforts, including the Paycheck Protection Program (PPP) and extended unemployment benefits, have resulted in continued favorable credit portfolio performance. Additionally, banking institutions that have been able to establish sustainable non-interest income channels – such as trust or wealth management – are experiencing some benefits as assets under management grew modestly during the quarter. As noted in the previous quarter, the level of mergers and acquisitions (M&A) remained notably subdued compared with the preceding three to four years.
Return on average equity (ROAE)
On average, community banks saw a decline in ROAE from 9.54% in the second quarter to 9.14% in the most recent quarter. Downward pressure on net interest margins, arising from excess liquidity during the low-rate environment and limited credit demand, has minimized the ability of community banks to achieve traditional core earnings levels. This downward pressure on net interest margins has been offset for some banks by higher levels of non-interest income, which grew as a percentage of total income to 12.53%, in comparison to 11.16% in the preceding quarter. Current expectations are for non-interest income to continue to grow as a percentage of total income well into 2021.
After declining measurably between the first and second quarters of this year, the collective efficiency ratio of community banks increased from 62.54% in the second quarter to 64.17% in the third quarter, reflecting the aforementioned downward pressure on net interest income and a relatively unchanged cost of operations. Community banks have not yet been able to fully adjust their cost frameworks, which are generally dominated by compensation and technology related costs. In response to the expectations of prolonged downward pressures core earnings, banks have begun to focus on challenging their existing branch structures and maximizing the benefits of recent investments in technology, including the expansion of collaboration with financial technology companies (fintechs).
Loan to deposits ratio
This key indicator of the earnings capacity of a community bank continued to move downward during the current quarter. The decline during the quarter from 79.73% to 78.81% reflects deposit growth of 5.55% and loan growth of 2.41%, a relationship that is great than 2:1. This dynamic arises from the notable shift in depositor behavior to maintain funds in low-risk accounts and the reluctance of most small and mid-sized companies to actively increase their borrowings beyond what was obtained through the PPP. Given the continued uncertainties as to the form and extent of any additional government stimulus as well as the duration of the COVID-19 pandemic, these deposit and borrowing behaviors are expected to continue at least through the second quarter of 2021.
Both of the credit quality KPIs – i.e., allowance for loan and lease losses (ALLL) to total loans and leases, and non-performing assets (NPAs) and 90 days past due/assets – reflect continued stability in the credit portfolios of community banks. Although the tempered demand for credit growth, as noted above, has contributed to the decline in community bank returns on equity, the favorable portfolio performance has enabled banks to avoid additional provisions for credit losses while sustaining consistent levels of allowance coverage in comparison with previous quarters. To some degree, this credit performance has been supported by the PPP and loan payment deferrals, both key parts of the government stimulus efforts. It is not yet evident as to the extent of any negative credit performance arising upon the completion of these stimulus efforts, although it is encouraging in that the extent of deferral programs was less than 5% across the industry, and except for the larger PPP borrowers, it appears forgiveness will be broadly achieved.
Until 2020, the community banking industry had experienced well over 200 deals in each of the preceding five years. Clearly, this has not been the case in 2020. As community banks anticipate likely policy changes arising from the 2020 election and the toward ending the COVID-19 pandemic, we expect the M&A dialogue to re-emerge. With the anticipation of continued low interest rates and the rapid advancement of technology solutions in the financial services industry, it will become more critical for many community banking organizations to explore their path to long-term sustainability in light of dramatically changing performance expectations.
For more information on this topic, or to learn how Baker Tilly’s Value Architects™ can help, contact our team.