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By: Tom Hannagan Here’s a further review of results from the Uniform Bank Performance Reports, courtesy of the FDIC, through the third quarter of this year. (See my Dec. 18 post.) The UBPR is based on quarterly call reports that insured banks are required to submit. I wanted to see how the various profit performance components compare to the costs of credit risks discussed in my previous post. The short of it is that banks have a ways to go to be fully pricing for both expected and unexpected risk. (See my Dec. 5 blog dealing with risk definitions.) The FDIC compiles peer averages for various bank size groupings. Here are some findings for the two largest groups, covering 490 reporting banks. Here are the results: Peer Group 1 consists of 186 institutions with over $3 billion in average total assets for the first nine months. • Net interest income was 5.34 percent of average total assets for the period. This is down, as we might expect based on this year’s decline in the general level of interest rates, from 6.16 percent in 2007. • Net interest expense was also down from 2.98 percent in 2007 to 2.16 percent for the nine months to September 30th. • Net interest margin, the difference between the two metrics, was down slightly from 3.16 percent in 2007 to 3.14 percent so far in 2008, or a loss of 2 basis points. It should be noted that net interest margins have been in steady decline for at least ten years, with a torturous regular drop of 2 to 5 basis points per annum in recent years. This year’s drop is not that bad, although it does add to the difficulty in generating bottom-line profits. To find out a bit more about the drop in margins, especially in light of the steady increase in lending over the same past decade, I looked at loans yields. • Loan yields averaged 6.22 percent for 2008, down (again, expectedly) from 7.32 percent in 2007. This is a drop of 110 basis points or a decline of 15 percent. • Meanwhile, rates paid on interest-earning deposits dropped from 3.41 percent in 2007 to 2.48 percent so far in 2008. This 93 basis point decline represents a 27 percent lower cost of interest-bearing deposits.   It seems as though margins should have improved somewhat — not declined for these banks.   Digging a bit deeper, I see two possible reasons. • First, total deposit balances declined from 72 percent of average assets to 70 percent, meaning a larger amount had to be borrowed to fund assets. • Second, non-interest bearing demand deposits declined from 4.85 percent of average assets to 4.49 percent.   So, fewer deposit balances relative to total asset size, along with a lower proportion of interest-cost-free deposits, appear to have made the difference. Unfortunately, the ”big news” is that margins were only down a bit. Let’s move on to fee income. Non-interest income, again, as a percent of average total assets, was down to 1.14 percent from 1.23 percent in 2007. For this bank group, fees have also been steadily declining relative to asset size, down from 1.49 percent of assets in 2005. A lot of fee income is deposit based, and largely based on non-interest bearing deposits – and, thus, a source of pressure on fee income. Operating expenses constituted some good news as they declined from 2.63 percent to 2.61 percent of average assets. That’s 2 basis points to the good. Hey, an improvement is an improvement. Historically this metric has generally moved down, but irregularly from year to year. The number stood at 2.54 percent in 2006, for instance. As a result of the slight decline in margins and the larger percentage decline in fee income, the Peer Group 1 efficiency ratio lost ground from 57.71 percent in 2007 to only 58.78 percent in 2008. That means the every dollar in gross revenue [net interest income plus fee income] cost them almost 58 cents in administrative expenses so far this year. This metric averaged 55 cents in 2005/2006. The total impact of margin performance, fee income and operating expenses, if you’ve been tallying along, is a net decline of 0.09 percent on total assets. When we add this to the 2008 increase in provision expense of 57 basis points, we arrive at a total decline in pre-tax operating income of 0.66 percent on total assets. (See my Dec. 18 post.) That is a total decline of 44 percent from the pre-tax performance in 2007 for banks over $3 billion in assets. It would appear that banks are not pricing enough risk into their loan rates yet – for their own bottom line performance. This would be further confirmed if you compared bank loan rates to the historic risk spreads and absolute rates that the market currently has priced into investment grade and other corporate bonds. They are probably at extremes but still they say more credit risk is present than bank lending rates/yields would indicate.   For Peer Group 2, consisting of 304 reporting banks between $1 billion and $3 billion in assets: • Net interest income was 5.87 percent of average total assets for the period. This is also down, as expected, from 6.73 percent in 2007. • Net interest expense was also down from 3.07 percent in 2007 to 2.39 percent for the nine months to September 30th. • Net interest margin, was down from 3.66 percent in 2007 to 3.48 percent so far in 2008, or a loss of 18 basis points. These margins are at somewhat higher levels than found in Peer Group 1, but the drop of .18 percent was much larger than the decline in Peer Group 1.   As with all banks, net interest margins have been in steady chronic decline, but the drops for Peer Group 2 have been coming in larger chunks the last two years, down 18 points this year so far, after dropping 16 points from 2006 to 2007. Behind the drop in margins, loans yields are 6.69 percent for 2008, down from 7.82 percent in 2007. This is a drop of 113 basis points or a decline of 14 percent. Meanwhile rates paid on interest-earning deposits dropped from 3.70 percent in 2007 to 2.85 percent so far in 2008. This 85 basis point decline represents a 23 percent lower cost of interest-bearing deposits. Again, with a steeper decline in interest costs, you’d think margins should have improved somewhat. That didn’t happen. I notice the same two culprits. • Total deposit balances declined from 78 percent of average assets to 76 percent, meaning, again, a larger amount had to be borrowed to fund assets. • Also, non-interest bearing demand deposits continued an already steady decline from 5.58 percent of average assets in 2007 to 5.08 percent.   Fewer deposit balances relative to total asset size…along with a lower proportion of interest-cost-free deposits…and we know the result. Now, about fee income for these banks… Non-interest income, again as a percent of average total assets, was down to 0.92 percent from 0.95 percent in 2007. For this bank group, fees have also been steadily declining relative to asset size, down from 1.04 percent of assets in 2005. A smaller non-interest bearing deposit base, without other new and offsetting sources of fee income, will mean pressure on this metric. Operating expenses constituted some good news here as well. They declined from 2.79 percent to 2.75 percent of average assets. That’s 4 basis points to the good. Historically this metric has been flatter for this size bank, moving up or down a bit from year to year. As a result of the not-so-slight decline in margins and the continued decline in fee income, the Peer Group 2 efficiency ratio lost ground from 59.52 percent in 2007 to only 61.86 percent in 2008. That means the every dollar in gross revenue cost these banks almost 62 cents in administrative expenses so far this year. This metric averaged 56 cents in 2005/2006. The total impact of margin performance, fee income and operating expenses is a net decline of 0.17 percent on total assets. When we add this to the 2008 increase in provision expense of 36 basis points, we arrive at a total decline in pre-tax operating income of 0.53 percent on total assets. (See my Dec. 18 post.) That is a total decline of 34 percent from the pre-tax performance in 2007. As I concluded above, more credit risk is present than bank lending rates/yields would indicate. Although all 490 banks are declining in efficiency, the larger banks have a scale edge in this regard. The somewhat smaller banks seem to have an edge in pricing loans, but not regarding deposits. Although up dramatically in 2007 and even more this year for both groups, the Peer Group 2 banks seem to be suffering fewer credit losses relative to their asset size than their larger brethren. Both groups have resulting huge profit declines, but the largest banks are under the most pressure through this period. It’s interesting to note that, with higher loan yields and fewer apparent losses, Peer Group 2 banks are somewhat better at risk-adjusted loan pricing than the largest bank group. Results are results. The fourth quarter numbers aren’t expected to show a lot of improvement as the general economy continues to slow and credit issues continue. I’ll comment on entire year’s results in posts early next year.     Next year, too, look for my comments on risk management solutions especially relevant to enterprise risk management.

By: Tom Hannagan I reviewed the Uniform Bank Performance Reports (UBPR: (http://www2.fdic.gov/ubpr/ReportTypes.asp ) for selected clients through the third quarter of this year. The UBPR is a compilation of the FDIC, based on the call reports submitted by insured banks. The FDIC reports peer averages for various bank size groupings.   Here are a few findings for the two largest groups, covering 490 banks. Peer Group 1 consists of 186 institutions over $3 billion in average total assets for the first nine months. Net loans accounted for 67.59 percent of average total assets, up from 65.79 percent in 2007. Loans, as a percent of assets, have increased steadily since at least 2005. The loan-to-deposit ratio for the largest banks was also up to 97 percent, from 91 percent in 2007 and 88 percent in both 2006 and 2005. So, it appears these banks are lending more, at least through the September quarter, as an allocation of their asset base and relative to their deposit source of funding. In fact, net loans grew at a rate of 11.51 percent for the group through September, which is down from the average growth rate of 15.07 percent for the years 2005 through 2007.  But, it is still growth. For Peer Group 2, consisting of 304 reporting banks between $1billion and $3 billion in assets, net loans accounted for 72.57 percent of average total assets, up from 71.75 percent in 2007. Again, the loans as a percent of assets have increased steadily since at least 2005. The loan-to-deposit ratio for these banks was up to 95 percent, from 92 percent in 2007 and an average of 90 percent for 2006 and 2005. So, these banks are also lending more, at least through the September quarter, as a portion of their asset base and relative to their deposit source of funding. In fact, net loans grew at a rate of 12.57 percent for the group through September, which is up from 11.94 percent growth in 2007 and down from an average growth of 15.04 percent for 2006 and 2005.  Combined, for these 490 largest institutions, loans were still growing through September. More loans probably mean more credit risk. Credit costs were up. The Peer Group 1 banks reported net loan losses of 0.67 percent of total loans, up from 0.28 percent in 2007, which was up from an average of 18 basis points on the portfolio in 2006/2005.  The Group 2 banks reported net loan losses of 0.54 percent, also up substantially from 24 basis points in 2007, and an average of 15 basis points in 2006/2005. Both groups also ramped up their reserve for future expected losses substantially. The September 30th allowance for loan and lease losses (ALLL) as a percent of total loans stood at 1.52 percent for the largest banks, up from 1.20 percent in 2007 and an average of 1.11 percent in 2006/2005. Peer Group 2 banks saw their allocation for losses up to 1.40 percent from 1.22 percent in 2007 and 1.16 percent in 2006. So, lending is up even in the face of increased write-offs, increased expected losses and the burden of higher expenses for these increased loss reserves. Obviously, we would expect this to negatively impact earnings. It did, greatly. Peer Group 1 banks saw a decline in return on assets to 0.42 percent, from 0.96 percent in 2007 and an average of 1.26 percent in 2006/2005. That is a decline in return on assets (ROA) of 56 percent from 2007 and a decline of 68 percent from the 2006/2005 era. Return on equity declined even more. ROE was at 5.21 percent through September for the large bank group, down from 11.97 percent in 2007. ROE stood at 14.36 percent in 2005. For the $1 billion to $3 billion banks, ROA stood at 0.66 percent for the nine months, down from 1.08 percent in 2007, 1.30 percent in 2006 and 1.33 percent in 2005. The decline in 2008 was 39 percent from 2007. Return on equity (ROE) for the group was also down at 7.71 percent from 12.37 percent in 2007. The drops in profitability were not entirely the result of credit losses, but this was by far the largest impact from 2007 and earlier. The beefed-up ALLL accounts would seem to indicate that, as a group, the banks expect further loan losses in the remainder of 2008 and into 2009.  All of these numbers pre-dated the launch of the TARP program, but it is clear that banks had not contracted lending through the first three quarter of 2008, even in the face of mounting credit issues, cost of credit, challenges regarding loan pricing and profitability, net interest margins,  and the generally declining economic picture. It will be interesting to see how things unfold in the next several quarter [See my December 5th post about ROE versus ROA.] Disclosure: No positions.

We continue to receive inquiries from our clients, and the market in general, around whether they are required to comply with the Red Flag Rule or not. That final decision can be found with the legal and compliance teams within your organization. I am finding, however, that there generally seems to be too literal and narrow an interpretation of the terms ‘creditor’ or ‘financial institution’ as described in the guidelines.  I often hear an organization state that they don’t believe they’re covered because they are not one of those types of entities. Ultimately, as I said, that’s up to your internal team(s) to establish. I would recommend, however, that you ensure that opinion and ultimate determination is well researched. It may sound simple, but reach out to your examining agencies or the Federal Trade Commission (FTC) and discuss any ambiguities you feel exist related to covered accounts.  There is some great clarifying language out there beyond the initial Red Flag Rule. For example, the FTC provided a very useful article (www.ftc.gov/bcp/edu/pubs/articles/art11.shtm) that described how even health care providers can be covered under the Red Flag Rule.  At first glance, they may not seem to fall under the umbrella of a ‘creditor or financial institution.’ As stated in the article, the extension of credit “means an arrangement by which you defer payment of debts or accept deferred payments for the purchase of property or services. In other words, payment is made after the product was sold or the service was rendered. Even if you’re a non-profit or government agency, you still may be a creditor if you accept deferred payments for goods or services.” Maybe it’s just me, but that description is arguably much broader-reaching than one might initially think. Long story short: do your research, and don’t assume you or your accounts are not covered under the guidelines. Better to find out now instead of after your first examination….for obvious reasons.