The next five years in banking aren't apt to be as benign as the past five.According to government data, FDIC-insured banks, in aggregate, have generated average annual earnings growth of 10% over the past five years. For an industry that’s as large and mature as banking, it’s been an outstandingly strong performance. That’s the good news. The less-than-good news, unfortunately, is that over the next five years, banks’ earnings will almost certainly grow at a rate much lower than 10% annually. At many banks, earnings growth will be minimal, or even negative. There are eight reasons why:Falling interest rates and a flattening yield curve will squash margins. All things being equal, banks make more money when rates are higher rather than lower. Reason: noninterest-bearing deposits and equity fund more than 20% of earning assets at a typical bank. So the more rates go up, the wider the spread. But the cycle of tightening that’s under way now isn’t typical. This time, long-term rates have actually come down as short-term rates have risen. That spells narrowing margins: As banks’ longer-dated assets mature, the proceeds are being invested at lower yields. Margin compression will be especially acute at banks that have outsized securities portfolios funded from wholesale sources. Deposit growth is slowing. The banking business has seen huge growth in deposits since 2000, for a number of reasons. The stock market crackup, for one thing, has made bank’s deposits seem highly attractive for investors and savers. Plus, the mortgage-lending boom has caused escrow balances to balloon. And corporations have been husbanding cash since the economic slowdown of 2000. Unfortunately, all those forces have begun to reverse. That means the torrent of new money flowing into banks will likely turn into a trickle. Some banks might even have trouble holding on to the deposits they already have. Slowing deposit growth will inevitably lead to slowing growth in net interest income.Deposits are about to become more expensive. Not only have deposits grown at an unsustainably high rate for the last few years, the mix of that growth was unsustainably favorable to the banks. Many went into shorter-maturity, lower-cost accounts rather than fixed-term (and higher-cost) CDs. Now that short-term rates are rising, though, those short-term deposits are about to cost banks a lot more than they used to.Loan loss provisions are going to go up. Commercial loan losses have declined to cyclically low levels in recent quarters; as a result, reserve drawdowns have been mandated. Almost every bank in the industry, especially the largest ones, have lately recorded below-normal loan loss provisions. Provisions simply can’t fall much further. There’s no “loan problem” on the horizon; even so, loss provisions will have to rise, as a result of the increasingly formulaic calculation of reserve levels now being required by auditors and regulators.The cost to compete in retail banking is rising faster than revenues are. Many banks have embarked on aggressive expansions of their branch networks and are refurbishing their older branches. In addition, they’re increasing the number of hours their branches are open and are trying to upgrade the service levels. All this costs money. Unfortunately, too many banks are expanding at the same time. Even if retail banking revenues weren’t about to slow, there won’t be nearly enough new business to justify all this new spending.Deposit fee income is slowing. The banking industry’s “free checking” craze has about run its course. Consumers have shown they like the “free” part of the deal—free online banking, say, and free iPods—and won’t likely give that stuff up without resistance. What consumers don’t like, though, are all those bounced-check (NSF) charges, which are the basis for free checking’s economics. Indeed, many consumers have begun changing their behavior so that they pay fewer NSFs. The result: NSFs are headed permanently down, while the consumer has become inured to paying fewer fixed fees. It is not a profitable combination of circumstances.Specialists are taking over the asset-generation side of the business. The retail banking business is being split right down the balance sheet. On the liability side, small local banks have consistently gained share in deposit-gathering at the expense of the large, national players and will continue to do so. But on the asset-generation side, it’s a different story. There, the national, specialized players are beating the locals. Back in 1997, for instance, the 10 largest credit card lenders accounted for 62% of all card receivables; by 2003, that number had risen to 93%. In mortgage originations, similarly, the top 10’s share has risen to 61% from 31%. The story is the same in home equity and auto. The rise of the big specialists in asset generation has put pressure on yields at most banks, and has perhaps contributed to irrational, pricing of commercial loans.Regulatory costs are rising. It’s no secret that Sarbanes-Oxley is a huge new costly burden. Costs related to the Bank Secrecy Act and the Patriot Act are rising, too. The increased regulatory burden doesn’t just add to a banks costs, it’s made the entire organization less efficient, as well. In all, the industry’s operating environment for banks has become noticeably tougher in 2005. Unhappily, I don’t see the related pressures easing any time soon. Which banks will perform best in this environment? The ones that start with a realistic assessment of it, in my view. |BD|