8 Steps To Profitable Loan Growth Given The Environment

Loan growth is slowing for community banks, and credit spreads are widening. As is typical in economic cycles, recessions present an opportunity for healthy banks to thrive and for weaker banks to be whittled.  Despite the flat and low yield curve, the current banking environment is a perfect recipe for healthy banks to win new, strong credit relationships, and increase loan profitability.  However, healthy banks need to act prudently today in choosing the correct type of credit, appropriate structure, enforceable prepayment provisions, and long-term relationship customers.

Current Environment

Loan Growth: Loan growth at community banks (less than $10Bn in assets) slowed to 0.6% QoQ in Q1’20, versus 0.8% in Q4’19.  For smaller community banks, gross loans declined in the first quarter by 0.4%.  While the numbers are not yet available for Q2’20, outside of PPP loans, gross loans appear to be declining for all community banks during the current quarter.  That decline is not uniform, and we estimate that between 15 and 25% of community banks are de-emphasizing new credits, while 10 to 20% of community banks are ready to take on more market share.  This dichotomy between banks with different capital capacity and various loan credit quality will continue through at least 2020.  Banks with the capacity to add quality loans will have ample opportunity to gain market share.

Margins: The banking industry net interest margin (NIM) declined 9bps in Q1’20 QoQ to the lowest level in three years.  The decline was primarily caused by over 100bps decline in interest rates and a 48% loan beta versus 29% interest-bearing deposit beta.  Smaller banks had a more significant decrease in NIM in Q1’20, of approximately 15bps.  The most significant decline in loan yield in Q1’20 was in CRE and C&I loans.  We believe that we will continue to see NIM pressures, but yields will stabilize and start to increase in 2020.  In fact, we saw an increase in reported A-rated credit quality spread at the end of Q1’20, and our data indicate a 20bps rise in community bank spreads so far in Q2’20.

Community Banks Positioning

Healthy community banks now have an opportunity to add quality credit loans at wider spreads, where margins will expand when interest rates normalize.  Our strategy assumes that interest rates will revert to more normal levels within one to three years, which is well within the timeframe for a loan commitment and within the expected lifetime of a relationship account.  Therefore, bankers should be planning to capture business that will improve profitability at their bank over the next one to 10 years.  Community banks should address the following concepts as they develop strategies to take market share:

Step 1: Identify Relationships vs. Transactions

Winning new business takes the same amount of effort and resources for a transaction as a relationship, but relationships are much more profitable.  Relationships are defined by a greater share of wallet, more cross-sell opportunity, and larger lifetime value.  Banks should avoid doing business today with borrowers that want to bridge their financing until Covid-19 subsides, borrowers that just want a loan without any other banking products or borrowers that have small borrowing needs and low prospects of increasing banking needs.  

Step 2: Avoid Negative Selection Bias

Despite a bank’s best efforts to gain the best credit quality and relationship business, some undesirable and unprofitable prospects will come through the door and become customers.  But any bank can live with that.  What every bank must avoid is negative selection bias – when the economy turns again, and “stupid banks” start lending again, your bank should not lose high credit quality and profitable customers at a disproportionate rate.  When banks poach each others’ customers, they typically target better relationships.  Therefore, banks must structure the right products today to retain customers in one to three years when the economic picture brightens.

Step 3: Measure Lifetime Value

Most community banks do not rely on risk-adjusted return on capital (RAROC) models to measure customer profitability.  These models tend to be highly sophisticated, challenging to calibrate, and, most importantly, difficult to implement with senior managements’ approval.  However, every bank should be able to measure net present value (NPV) of income, which is NIM plus fees earned, minus cost of funds (COF), minus credit charge, minus maintenance cost, and minus upfront acquisition costs.  The calculation is simple, leads to very little disagreement about assumptions, and is very telling about relationship profitability.  It allows banks to compare size, cross-sell, lifetime value, and credit quality across different loan opportunities. The calculation can be done in an excel spreadsheet and can be very revealing for many bankers. 

Step 4: Insist on Prepayment Provision

Now is a perfect opportunity to insist on meaningful prepayment provisions for term loans.  Prepayment provisions help banks avoid transactional customers, decrease loan prepayment speeds, increase the lifetime value of a loan, and assist in cross-selling.  This is especially important if the loan can be booked today at wider credit margins – a bank wants to retain these margins as long as possible into an economic recovery.   

Step 5: Increase Loan Spreads

The opportunity for banks willing to lend today is not just picking up market share, and not just picking up superior credit quality, but doing all of this at above-average credit spreads.  Loan spreads at community banks have widened an average of 20bps, and this trend may continue as the liquidity premium in the lending market transforms into a solvency premium.  Lenders are able to choose bankable deals at substantial premiums to the bank, and it is possible to retain that premium for almost the entire term of the loan commitment, even as the economy improves, and competition forces a decrease in credit spreads in the future.

Step 6: Emphasize Debt Yield

Debt yield is a property’s net operating income (NOI) divided by the property’s debt.  The debt yield right-sizes the loan to measure the cash-on-cash return on the bank’s investment and eliminates the borrower’s benefit of longer amortization periods (that inflate debt service coverage ratios (DSCR)), and it also eliminates the borrower’s benefit of low-interest rates (also inflating DSCR).  Now is the time for banks to right-size the loan to eliminate 1.20X DSCR and 75% loan-to-value (LTV) loans, to gain those 1.50X and 60% LTV credits with 10% debt yield – a sterling credit that may not be getting serviced at another struggling bank.

Step 7: Prioritize Fee Income

In today’s current flat yield, the difference in loan yield between an equivalent credit quality floating rate and a five-year fixed rate is 17.5bps.  It is incumbent on community bankers to figure out how to generate non-interest income to enhance earnings.  Without increased fee income, over a few quarters of this sustained yield curve, community bank profitability will drop substantially.  One of the best ways for community banks to generate substantial fee income is through a loan hedging program.  In our ARC program, community banks recognize an average of 98bps of upfront fee income on booked term loans.   

Step 8: Structure For Risk and Profitability

Again, because of the flat and low yield curve, community banks must design a compelling product offering for customers.  Top-performing banks are offering term loans that are fixed for 10 to 20-year terms.  The advantages of the structure are as follows:

Lower Cost: The incremental cost to the borrower for longer commitment is minimal (the incremental cost from 5 to 10 years is only 26bps). 

Differentiation: The product is differentiated from many competitors, helping banks obtain premium pricing.

Higher Profitability: A meaningful prepayment provision is easy to embed, thereby decreasing prepayment speed, increasing the lifetime value of the loan, and enhancing cross-sell opportunities.

Better Asset Liability Management: The borrower’s business is protected from repricing risk, with interest rates locked at the lowest level in history.  

Conclusion

No banker would choose to operate in this very challenging business environment with so many unknowns.  However, the current business cycle also presents some golden opportunities for banks that have the capital, liquidity, and know-how to win very profitable and long-term accounts.