INDUSTRY INSIGHTS | SUMMER 2010 EFFECT

Recession Lessons: Back to Basics Banking

by Dean Rohne

Financial institutions have been one of the hardest hit industries during this recession. The number of failing entities will continue to be higher than historic averages for the near future. However, this comes after a long period of prosperity and growth for banks and credit unions.

Thriving times

With years of success and the growth of electronic services, such as Internet banking, ATM and debit cards, and the Automated Clearing House (ACH) electronic payment network, the financial institution industry experienced increased efficiency and profitability. This led to an expansion of branches, new charters, and new products and services during the last decade.

Consumer spending increased and many people tapped into any unused home equity as the value of real estate increased. Businesses also expanded and leveraged their assets during this time. With such a long period of prosperity, many financial institutions forgot certain fundamental principles of banking. Trends over the last 15 years are listed in the following table, indicating how banks and credit unions started to show financial struggles:

All Banks As a Percent of Assets 1994 1999 2004 2009 Net Interest Margin 3.65 3.40 3.08 2.98 Non-Interest Income 1.70 2.36 2.13 1.96 Provision for Loan Losses 0.28 0.36 0.30 1.86 Operating Expenses 3.46 3.48 3.09 2.89 Return on Average Assets 1.05 1.26 1.28 0.09

All Credit Unions As a Percent of Assets 1994 1999 2004 2009 Net Interest Margin 3.91 3.72 3.32 3.23 Non-Interest Income 0.63 0.89 1.16 1.62 Provision for Loan Losses 0.24 0.35 0.36 1.11 Operating Expenses 3.09 3.34 3.21 3.18 Return on Average Assets 1.21 0.93 0.91 0.18

Sources: Federal Deposit Insurance Corporation and National Credit Union Administration 

The forgotten fundamentals

The impact of the recession has clearly indicated financial institutions strayed away from certain keys to profitability. To ensure future success, they need to revert to “back to basics” banking.

Increasing net interest margins

Over the 15-year period above, we saw declining interest margins. Both banks and credit unions had a decrease in net interest margin of approximately 70 basis points. Even with the increased loan provision experienced in 2009, the decline was seen directly in the drop in return on average assets.

The net interest margin must increase by at least the 70 basis points lost over the last 15 years. I believe the targeted margin should be between 3.75 and 4 percent. This can be accomplished by keeping deposit rates low when interest rates start to rise.

Strong loan underwriting practices

The impact of the decline in real estate values and increasing unemployment is specifically seen in the increase in the provision for loan losses. Unfortunately these lending decisions will continue to burden financial institutions into the future.

Many organizations placed reliance for repayment on the collateral of the borrower instead of the borrower’s ability to repay. They were not willing to say no, fearing the customer would leave for another lender. You must ensure borrowers can repay the loan in addition to adequate collateral and be willing to say no if the loan does not meet their underwriting criteria or loan policy.

Responding to declines in non-interest income

To make up for the declining interest margin in recent years, financial institutions generated additional revenue from fees and service charges. But regulation and limitation surrounding these fees is increasing. Both consumers and merchants are turning to Congress to control things such as overdraft charges for deposit products and income generated from processing credit cards. This will decrease the amount of revenue financial institutions will generate.

Ultimately, you should rely less on fees and service charges to meet a targeted return on average assets. An increase in net interest margin will recover the drop in both.

Managing operating expenses

Banks and credit unions have managed operating expenses over the last 15 years with efficiency gains by increasing electronic transaction processing and managing employee costs. But you’ll need to continue efforts to decrease these costs to meet targeted operating expense ratios.

The next couple years are projected to be challenging for the financial institution industry. With a back to basics approach, you can position your organizations for long-term financial stability.