Earnings & Results Roundtable: How banks have outperformed during the COVID-19 pandemic

On May 19, 2021, community bankers from across the country met virtually at Gather 2021: Illuminating insights in community banking to discuss current trends in community banking, the important role that community banks play in serving and supporting their communities. This blog summarizes the general session on “Earnings & Results”.

Nathan Stovall, Principal Analyst at S&P Global Market Intelligence, moderated the session that included two participants: (1) Gary Svec, Managing Director at Performance Trust Capital Partners, and (2) Jonah Marcus, Portfolio Manager at Endeavour Capital Advisors.

The roundtable focused on:

Traits of banks that have outperformed, the current credit situation, a view on deposits, how liquidity should be deployed, how excess capital and liquidity are being used, the threat of fintech companies, and the role of bank Boards.

A few highlights:

• Banks need to structure the balance sheet to protect themselves in this environment. There’s a lot of sensitivity to down rates, not only for margin compression, but also for economic softness.
• It’s an advantage to have a niche where you can generate better-than-average risk-adjusted results. In addition, it’s important to become more branch-light and efficient.
• One view is that we're not out of the woods yet when it comes to credit. When margins get compressed, people start to stretch, and that's when you can see losses.
• Paycheck Protection Program (PPP) loans are a great potential if banks can take that market share and pivot it to long-term clients.
• It’s a good time to attract deposits when competition is light, and if they need to be deployed, there are securities portfolios that can generate high risk-adjusted spreads outside of lending.
• Banks shouldn’t get into new products and businesses that they're not comfortable managing. Alternatively, expense savings, capital management, or M&A could generate operating leverage.
• Bank Boards need to be shaken up a bit and have greater diversity of thought on multiple levels.
• Banks need to become a lot sharper if they want to be successful given fintech companies.

Questions to the Panelists:

When we think about earnings and results, what have you seen in banks that have outperformed?

Gary Svec: As we look at the last 1.5 years, there are some obvious performers. Asset generators have certainly done well in this tough environment, as have those in mortgages, given where rates are now. Less obvious are niche businesses with something that fintech can’t commoditize. Lastly, those who understood their balance sheets in 2018/2019 when everybody thought rates were going up, but they looked at rates going down.

Banks need to structure the balance sheet to have something to protect them in this environment. There are many institutions that have done a really good job at that and are not experiencing the asset repricing that many institutions face.

I've heard for years that you're not supposed to make big rate bets. Is that the takeaway? Don't bet one side or the other because many were very asset-sensitive saying that rates just had to keep going higher.

Gary Svec: Most banks are asset sensitive, and the average duration of loan portfolios is less than two years. We keep the rest of our balance sheet short because we're trained not to have anything that's going to be a loss when rates are up, which means you can’t have anything that's going to be a gain when rates are down. That's a big problem since banks have a lot of sensitivity to down rates, not only for margin compression, but also for economic softness and potential loan losses.

You really need to look at how the balance is sheet performing. When rates are up, we have cheap deposits that don't reprice as fast as the market. Also, it tends to mean strong economic conditions, so we have growth and fewer loan losses. We can’t make a one-directional interest rate bet because it’s very rare that rates go up a lot. As an industry, we need to prepare for all rate scenarios.

Jonah, what have you seen in terms of banks that have outperformed?

Jonah Marcus: For me, it comes down to two things. First and foremost, it's about who can grow pre-tax, pre-provision dollars and ROA, for example, for mortgages or PPP loans. That's achieved in a couple of ways:

(1) We can generate asset growth. So, if you have a niche where you can generate better-than-average risk-adjusted results, that's an advantage.

(2) We can look at expenses. It’s important to become more branch-light and more efficient in both the delivery system and back of the house operations by automating manual processes.

The last piece is how you manage capital. You can drive performance if you can get dollars going in the right direction on revenue, then manage the expense side and bolster that over a shrinking denominator (meaning buybacks). There has been a bifurcation in size. The larger banks, even those outside of the KRE ETF, have significantly outperformed the real micro-caps. The market is saying that to invest in technology, to have the size and scale to attract investment dollars, there's probably a lot of demarcation that's somewhere north of $500 million in market cap. In addition there are PPP winners who can use this to drive future growth.

That's a really interesting point that PPP is perhaps not a one-time thing, but a proxy for who really can adjust to the new world. Is that a fair way to put it?

Jonah Marcus: Yes. It's great potential for the winners because 55% of PPP loans were done by banks under $10 billion in assets. To the extent that they can take that market share and pivot it to long-term clients is a great opportunity.

Gary, credit quality has been so strong, especially in the face of a pretty severe recession. Do you think it's too early to say things are behind us?

Gary Svec: I get nervous when we say we really haven't had a credit event. The government threw trillions of dollars at the credit event to put a Band-Aid on it. There has been a massive change in work from home and many companies have realized that they don't have to rent expensive office space any more. That will have a big impact going forward, along with ancillary businesses that rely on foot traffic. Also, people are moving to communities that have good schools and open space, which will affect residential real estate. In addition, there’s the long-term impact of COVID on travel and hotels, plus the impact on big box companies leaving strip malls. So, I don't think we're out of the woods when it comes to credit. When margins get compressed, people start to stretch, and that's when you start to see losses. So, I would say be cautious.

Jonah, how do you think about credit right now?

Jonah Marcus: I think credit is officially in the rear view. When I think about reserve levels today, what the trends have been, and that markets have reopened, I think that picture is positive for credit. We don't know what rot is under the economy because of the government stimulus, but we do know that the government will probably remain supportive, and cash flows seem to be generally good.

Jonah, I want to shift to liquidity and deposits. What do you think about deposits now?

Jonah Marcus: It's not possible to have too many good deposits. I think this is the time to attract them when competition is light. If you need to deploy them, there are securities portfolios that can generate high risk-adjusted spreads outside of lending.

Gary, how do you think banks should deploy liquidity at this point?

Gary Svec: I know banks that have 10% to 25% of their balance sheet in cash waiting for rates to rise, and that's expensive. We need to be smarter about what we do on our balance sheets and think about what it looks like in a rates up and a rates down scenario, and how that impacts liquidity. I think it will lead to very different decision-making and it'll give us an advantage as we deal with fintech.

I have heard a lot of people say they don’t want to take on too much duration risk now, so they're being hesitant.

Gary Svec: For every duration risk, there should be duration reward, and we never talk about the institutions that are sitting on massive gains right now because they realized their rates down exposure and did something about it. I think there are things that can be done in this environment.

Jonah, do you have to find a way to grow loans at this point in the cycle, even though the growth is pretty hard to come by?

Jonah Marcus: If the loan growth and revenue growth doesn't exist, we don't want banks to push into new products and businesses that they're not comfortable managing. You've got to think about other ways to generate positive operating leverage, whether it's through expense savings, capital management, or M&A.

How do you feel about people moving into a new product line, new asset classes?

Jonah Marcus: You need to look at the business lines and ask if you have the skill set and risk tolerance. There may be opportunities that aren't right for your bank that could work for another, and vice versa.

How would you bring Boards up to speed about what needs to happen going forward?

Gary Svec: Literally, have education sessions with the Board and talk about things that can be done. So, helping them understand their institution and thinking about strategies going forward to offset the risks.

Jonah Marcus: I believe that bank Boards need to be shaken up, and they need greater diversity of thought. Boards need to be proactive and be willing to be change agents. If there was no regulatory environment, fintech companies would demolish the banking industry today. Banks need to become a lot sharper if they want to be successful.

Gary Svec: I agree. We have to shake up our Boards and bring on different expertise. We need people who are going to bring ideas to the table and are going to be open to change.

Gary, what are firms doing with dry powder? Are they looking to do deals? Are they waiting for more clarity?

Gary Svec: You have to be proactive as it relates to capital. If other banks have gone up a lot in value and my bank hasn’t, I need to think about repurchasing my shares. When I can do it at the levels that are out there from a subordinated debt perspective, it’s a really interesting opportunity. Maybe the best acquisition you can do is acquiring a piece of yourself.

Jonah, how do community banks make sure that they attract investment dollars. Do they need to be a particular size, a certain profitability profile, a certain loan composition?

Jonah Marcus: When you get into that sub-$500 million market cap, it’s hard to attract the attention of the investment community. To get the attention of the investment community you have to be able to invest in technology and have enough liquidity. The micro-cap banking industry has become a game of speculation on who's going to sell. M&A today should be done with an eye towards linking yourself to a faster moving train with a higher enhancement over what people can do by investing in the KRE. If you can issue capital that's cheap and have the optionality on growth, M&A, share repurchase, downside protection, those are things that you can control and create wins for shareholders.