In a recent project, I was comparing the performance of banks based on their asset size, and one giant trend jumped out that I thought was worth sharing.
Community and regional banks have developed a dangerous reliance on commercial real estate (CRE) lending that is not sustainable. This CRE dependency has become like a dangerous, fast-moving treadmill, and banks must now decide how to safely get off it.
First, two bits of quick housekeeping:
- No. 1: All the analysis below is based on FDIC call report data for U.S. banks over $1 billion in assets. (It’s not that I don’t love the smaller community banks; I happened to cut my teeth in a very small bank in my hometown. But, for this particular project, I was analyzing the performance of a larger bank, and didn’t need to include the smallest group for comparisons.) And, I used the usual regulatory cutoffs for my grouping of the banks:
- No. 2: I originally conducted this analysis in early 2018 and relied on Q3 2017 numbers for my research. Though we're now nearly midway through 2018, the economic climate has largely remained the same. Thus, the data in these charts remains relevant.
Now, back to the analysis.
The most obvious difference for banks by size is the makeup of their earnings. It sticks out in net interest margins:
And it sticks out in what I’ll call Net Overhead, which is Non-Interest Expense less Non-Interest Income:
Neither of these trends are new, but combining those two charts tells a very important story about the industry.
The largest banks, those with over $250 billion in assets, have a huge advantage from their scale. That scale affords them much lower net expenses relative to assets. It also means that they have entire lines of business that the smaller banks do not, and are able to offer their customers a more complete product set (more on this later). The result is that the larger banks have to generate much less net interest margin to cover their net overhead; they are able to aggressively price loans and deposits to win the business of customers that will generate meaningful fee income through non-credit products. Community and regional banks have no choice but to book high margin business to keep the lights on.
This need for margin manifests into a very different loan mix for these banks. The next chart compares the loan mix based on asset size. I have highlighted all the real estate categories:
Community and regional banks both have more than 50% of their loans in real estate, with the share for community banks at more than 70%. And while the reliance on real estate is jarring, it isn’t based on holding 1-4 family real estate. Instead, it is an out-sized exposure to CRE and construction loans. Despite holding less than 14% of total industry loan balances, community banks hold the highest balances of loans in both the commercial real estate and construction & development categories.
Why does this matter? After all, real estate is the ultimate local asset, and community and regional banks pride themselves on being active investors in their local markets.
For obvious reasons, regulators are leery of any bank that builds a concentration in CRE. Those banks experienced some of the worst losses in the financial crisis, and were far more prone to failure, so regulators and investors should be both be conscious of the potential risks. But in this case, the risks are deeper than fighting the battles of the last cycle.
This time around, banks seem to have been more prudent in which deals to turn away. But, the smaller banks have been completely dependent on the rebound in CRE to drive their growth. This chart compares the growing reliance on CRE to a national index for CRE prices (CPPI from Green Street Advisors):
As prices have risen over the last two decades, so too has the share of CRE in smaller bank portfolios. Those banks are now nearing the highs from before the crisis. This is worrisome because of the latest trends in Green Street’s CPPI. During 2017, the price change went from a negative second derivative (a slowing growth rate) to year-over-year declines.
If these data points become more than a temporary slump, where will community and regional banks turn for their growth? This question might be the most important that these banks are currently wrestling with.
Diversifying loan portfolios has proven impossible for these smaller banks in recent years. Shifting the focus to commercial & industrial lending (C&I) means running up against well-established competitors that have a few structural advantages:
These competitors are much larger, and thus benefit from the scale discussed above. The larger banks don’t see C&I lending as lucrative, high margin business. Instead they see it as a way to win relationships that will give them access to cross selling fee business that is lucrative and high margin. The smaller banks don’t have these platforms and product offerings, or if they do, they are not core competencies. Without the cross selling, the stand-alone loan doesn’t make sense.
Besides the wider product offerings, the national banks are also able to bank much larger and more established businesses. Through a combination of higher lending limits and the ability to syndicate, the national banks are the only game in town for the best, grade A borrowers. Smaller banks are left to deal with the smaller, less mature borrowers that are more volatile and susceptible to downturns.
And finally, the largest banks have more than just a scale and product advantage. They also have an advantage in staff experience. Their RMs have long term relationships with the best borrowers, the credit group knows how to underwrite them (without requiring real estate as collateral), and the management group is familiar with the risk profiles, strategies, and typical profitability of these loans.
Consumer lending and small business lending both create similar challenges, as it takes meaningful investments in platforms and huge scale to make these profitable products.
Now the big question…what are the community and regional banks to do about this reality? There are three approaches in play:
Sell the Bank
Many banks simply don’t see a clear path forward, and feel that their best outcome is to jump aboard a larger bank and benefit from their scale.
Continue Business as Usual
Many of the banks I talk to really don’t see this exposure as an issue. They feel that they are a real estate bank, and that they are well equipped to manage and mitigate the associated risks. I hope they’re right.
Invest Now to be Competitive
While this option sounds daunting to some, others are embracing it with open arms. They view the current environment as a once-in-a-career opportunity to reshape their bank. Earnings are good, balance sheets are strong, and spending has been neglected long enough that there is an appetite for change within the organization. If not now, then when? This means that they are investing in new products, new talent, and new technology in order to better compete for business outside of commercial real estate.
Some management teams will bet wrong, or will not be able to execute, and will get left behind. But this category is also where the winners will come from.
No matter which category you fall into, the most important thing is own that decision. Too many banks are landing in the “business as usual” bucket by default. They are paralyzed by all of the potential technology investments, and aren’t sure where to spend, so they sit back and wait to see what works for their peers. But, the status quo is a choice, too, and making that choice comes with its own risk that you will be left behind.
Are you still willing to try to be a fast follower given how fast today’s markets and technologies move? Are you happy staying on the CRE treadmill for the foreseeable future?
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