At ProBank Austin, we are always curious at this time of year to find out what’s on the minds of our community bank clients, and in particular, to better understand their plans and goals for the coming year.
As consultants serving clients from around the country, we have a unique window into the thinking of community bankers, as each year we assist our ALCO clients with the preparation of their annual budgets. By confidentially analyzing and comparing these annual financial plans, we are able to provide all community bankers with insight into how their expectations for 2017 compare with that of their peers.
Our clients range in size from under $100 million to $3 billion in total assets. Clients included in our budget review process this year were well distributed across the typical size classes representing the community banking industry, as shown below:
Impact of Election, Stock Market Gains
All of the budgets included in this year’s review were prepared after the presidential election, and during the time period when bank equity values experienced a strong post-election rally. We do not believe that either of these events, or the optimism surrounding them, significantly affected banks’ financial plans for 2017. Even with expectations of lower corporate tax rates, regulatory relief, and improving economic conditions, our bank clients seemingly adopted a “wait and see” strategy and did not significantly revise upward their budget estimates for 2017.
Interest Rate Forecasts
Since this is the first year in recent history with a high probability that interest rates will rise, we were interested to see how our clients were factoring this assumption into their 2017 budgets.
Across banks of all sizes, we found that 21% of banks built into their budgets at least one additional rate increase for 2017. Since these budgets were prepared between November 15, 2016, and January 17, 2017, most banks had adequate time to take into account the Federal Reserve’s rate move in December. As you may recall, the Fed moved rates at their meeting on December 13th, a move that was anticipated by nearly everyone.
Given these expectations, approximately 49% of the banks built into their 2017 budgets two rate increases of 25 basis points each for the year. The remaining 31% of banks prepared their 2017 budgets on the expectation that there would be no further rate increases during the year (after the rate increase in December 2016, which will have some carryover effect into 2017).
Loan Yields and Deposit Cost Changes
Despite the forecasts of managed rates moving up during the year, most banks are not anticipating substantial increases in loan yields. Continued competition and weak loan demand are the two most cited explanations for a muted growth in loan yields. Even though eighteen percent of banks in the sample were forecasting loan growth greater than 10%, the median loan growth rate of the entire sample was only 6.23%, less than the budgeted growth rates of the prior two years, and approximately equal to the actual growth rate between 2016 and 2015.
The impact of this modestly optimistic budget forecast appears to limit banks’ expectations for growing loan yields, which are budgeted to rise by 17 basis points over the ending levels of 2016. For banks estimating two additional interest rate hikes during 2017, in addition to the December, 2016 adjustment, this represents an effective increase of approximately 23% of the actual change in managed interest rates.
On the funding side of the bank, deposit balances are budgeted to increase by a median of 3.40%, as compared to the 6.23% growth in loan balances, indicating that approximately 45% of new loan growth will need to be funded from existing liquidity, brokered deposits, or other borrowings.
Due to this relatively low deposit growth forecast, the distribution of rate increases across the calendar year, and market-based lags in implementing deposit rate increases, deposit rates are budgeted to rise at a modest pace. As the combined result of these factors the median cost of funding is expected to rise by nine basis points during the year. For banks that forecasted an additional 50 basis point upward movement in rates, this represents an adjustment to funding costs equal to only 12% of the full movement of managed rates.
On balance, it is interesting to note that banks are planning for loan yields to rise faster than increases in deposit costs, thereby forecasting an improvement in net interest margins.
Other Income Statement Changes
In addition to our review of the changes to loan and deposit balances and rates as discussed above, we also analyzed clients’ expectations for changes in fee income, provision expense, and operating expenses for 2017.
The ability to raise fee-based income in a variety of areas appears to be meeting with great resistance, as the majority (52%) of clients forecasted their non-interest incomes to decline in 2017. The median change to non-interest income for the group as a whole was a -1.22%. One reason for the decline was that many banks took gains in their investment portfolios in 2016, an opportunity that due to rising interest rates will diminish considerably in 2017. Decreasing non-interest income was far more prevalent among smaller banks, with 62% of banks under $500 million in assets forecasting fee declines in 2017.
Provision for Loan Losses
Credit quality is expected to remain relatively strong on an overall basis, as the expectation for an increase in the provision for loan losses is less than the rate of growth in the loan portfolio. Provision expenses are budgeted to rise by only 4.07%, as loan growth is slated to grow by 6.23%, indicating an expected improvement in overall credit quality.
Operating Expense Inflation
Community banks continue to hold the line on operating expense increases, despite strong pressures from health care, salary and regulatory costs. At a time when the general inflation level has averaged below 2%, banks have budgeted cost increases amounting to just 3.21% of total operating expenses. This is a very positive development, as health care, salary and regulatory cost increases would normally far exceed average inflation levels, and are very difficult for most management teams to control.
Net Income, ROA and ROE
Community bank financial forecasts for 2017 do not appear to reflect the level of optimism commensurate with prospects for an improving economy, lower tax rates and record high stock market indices.
With nearly equal numbers of banks budgeting net income increases for 2017 (52%), as are forecasting net income declines (48%), overall net income is budgeted to rise by 3.89%. Median ROA across our entire sample, (which includes many smaller banks which typically have lower ROA’s), is 0.82%. Median ROE’s are likewise modest, and budgeted to equal 7.91%, for the entire sample.
Banks above $500 million in total assets have an average budgeted ROA of 1.01% for 2017, and an average budgeted ROE of 9.99%. Banks under $500 million in total assets have budgeted ROA’s of 0.46% for 2017, and a budgeted ROE of 4.68%.
Amidst growing optimism related to the economy, interest rates, loan demand and market indices, (especially bank equity values), the short run financial plans of most banks in 2017 are conservatively optimistic, indicating only a measured level of financial improvement. Just as the Federal Reserve has taken a cautiously optimistic forecast for the economy with a strong “wait and see” bent, so too, have community bankers tempered their optimism for earnings improvement in 2017.
If the economy reacts positively to regulatory, tax or fiscal policy changes, (if and when enacted), with strengthening loan demand, actual financial performance could easily outperform most banks’ budgets during 2017. However, very few institutions have based their 2017 budget on this scenario.
Growth in both loan and deposit balances for 2017 are forecasted at achievable levels, with reasonable expectations for loan yield increases. If liquidity is decreased significantly due to greater than expected loan demand or higher than expected inflation or interest rate increases, costs of funding may outpace many banks’ conservative estimates.
Other income statement items, such as low fee increases, modest increases in provision expenses (in the face of higher loan growth), and operating expense increases just slightly higher than the average inflation rate, seem mostly reasonable and should not lead to anything other than minor variances during the year.
As always, maintaining growth of the net interest margin will be challenging unless loan demand strengthens considerably, and accomplishing the planned increase in loan yields while minimizing deposit cost of funding increases will require consistent, sustained pricing discipline.