SAWING THROUGH NIM

In yesterday's edition, we discussed the risk of focusing solely on NIM to drive loan pricing decisions. Our commentary equated NIM to a hammer in order to prove a point. While a hammer is certainly a fine tool for many tasks, an expanded tool selection will be needed for different projects at different times. Today we begin by reviewing recent and historical FDIC data. In it, we find that large banks (defined as those with assets above $10B) have a NIM that is roughly 100bp lower (3.35% vs. 4.29%) than independent banks (defined as banks with assets between $100mm and $1B). Yet, these same large banks are able to generate an ROE that is about 100bp higher than the independent bank group (14.14% vs. 13.05%). To fully understand why this is happening requires a closer look at the blueprints. We find that while there are many potential reasons for this striking difference between the groups, some are more obvious than others. [1] The efficiency ratio is much higher (about 11%) at an independent bank than it is at a larger bank (61.9% vs. 55.7%). Evidence suggests that large banks operate more like a manufactured housing builder, while independent banks could be compared to custom builders. The result is that independent banks are also more willing to originate creative and structured loans to service their customers, while large banks are focused on assembly line, but precision based origination. [2] Next, we find that large banks are significantly better than independent banks at leveraging their capital. While independent banks are content to hold an average of 9.72% leverage, large banks run closer to 7.35%. The result in this 33% more aggressive posture from the large bank is that in the end, sheer volume produces greater profitability for this group. In short, independent bank capital is underleveraged when compared to large bank competitors. [3] Independent banks are more willing to allow clients to prepay at any time and in most cases, without penalty. The larger the proportion of floating rate loans, the more rollover and prepayment risk that book of business inherently carries. Higher prepayments translate to higher acquisition costs for the portfolio, resulting in a lower ROE. [4] Independent banks are more willing to originate smaller (and usually more complex) loans on average than larger banks. This results in a higher cost per loan, expanded documentation requirements and reduced overall profitability. While diversification is a good thing, studies suggest there is very little difference in risk between a loan portfolio of 100 credits and one with 30 credits. The mere fact that independent banks originate nearly all loans within a 50-mile radius overwhelms the value received (and reduced risk) from originating smaller credits for diversification reasons. [5] Finally, large banks enjoy just over a 2 to 1 ratio to independent banks of non-interest income to earning assets (3.17% to 1.38%). While many independent banks will feel there is little they can do on this front, a periodic review of deposit account service charges, expanding into insurance and boosting loan servicing activities are all real possibilities. NIM cannot be the only focus, as it is about overall bank profitability. Coupon measurements alone simply do not capture the whole picture. The fact is that the larger and more stable the loan, the more room a bank can saw off the NIM and still boost profitability. There is absolutely no reason to be afraid of a 3.00% NIM if it increases profit, reduces risk and boosts return.