BID® Daily Newsletter
Jun 21, 2012

BID® Daily Newsletter

Jun 21, 2012

FOMC AND BANK STRATEGY


Yesterday's FOMC meeting resulted in few surprises except for one nagging question - are banks prepared for 7+ years of low interest rates? While short-term rates were left unchanged, Operation Twist was extended until the end of the year (longer than the 3 months expected) and the policy was slightly more dovish than the past. The real change came after the meeting, with a sharp downward revision of economic forecasts. This shifted the central tendency of FOMC voting members of the first rate increases in this cycle out to mid- 2015 from late-2014. Most important in yesterday's Fed news was the downward revision in employment and GDP, combined with the policy acknowledgement that growth in household spending is slowing. The pessimistic outlook, coupled with a strengthening of the language regarding further Fed action, is reminiscent of the FOMC statement and actions back in Sept. 2010. That leaves us wondering whether the Fed is laying the groundwork for a full- fledged QE3 as early as the next meeting on August 1. The biggest takeaways for bankers are for policy and strategy and the two overlap. On the policy side, in our opinion, Operation Twist and the jawboning of the market will have little impact on the economy from here. Real rates are already negative and we understand that the Fed is constrained in what it can do, but the only positive outcome from yesterday is the support helps incrementally with equity markets. That preserves the wealth effect as people spend more when stocks are up. However, this impact could be short lived and the greater issue is the dysfunction of policy and regulation on the economy. To improve the economy, D.C. should shift the focus away from rates and over to credit and liquidity. Credit supply and demand both need to shift up to have a positive long term effect. That means a better balance is needed between bank regulation and policy. Banks all want to lend right now, but higher capital requirements from Basel III and reserve expectations (combined with compliance uncertainties), has many on the sidelines. Meanwhile, the Volker Rule and other Dodd Frank provisions have significantly curtailed securitizations and corporate debt issuance for the largest companies, preventing refinancing, increasing transaction costs and hurting liquidity. Finally, the looming Fiscal Cliff and the threat of higher taxes have hurt small and mid-sized business sentiment, keeping credit demand low.From a bank strategy standpoint, after 3 successive downward revisions in the economic forecast, banks should ask themselves what happens if rates are low and flat for 7 to 10Ys. How does your current bank business model adapt? At a high level, if this occurs, margins will continue to compress and competition for loans will drive spreads tighter. Lower leverage and tighter credit margins mean banks will produce below their cost of capital (around 11%). Consider that large public companies have produced almost an 8% return on an YTD basis. Common bank equity, with much lower liquidity, needs to return above that. This target ROE will be very difficult to hit, thereby causing problems for banks that need to raise capital to meet growth, replace fatigued shareholders or substitute TARP/SBLF. To combat this, banks need to manage growth to make sure it is profitable. Maintain leverage at risk tolerances, continue to trim costs, relook at the delivery structure and take a hard look at product profitability. Going forward, it will be hard to justify strategies that increase core deposit balances, but result in a net cost to the bank. The same goes for the loan side. Banks making loans below $400k are also going to find it difficult to produce superior returns. Here, a complete restructuring of loan processes is needed to lower costs. Finally, more resources need to be devoted to development of fee income lines that truly add value to the customer - such as cash management and support services. The years ahead remain difficult for banks, but the smart, hard working and lucky ones will succeed. The good news is that lower rates will continue to support credit quality on a forward looking basis and allocation decisions will be less important because abundant capital will result in many sectors moving together (thus diversification is less meaningful). Community banking will survive just fine, as long as you are prepared for a period of long term lower rates.
Subscribe to the BID Daily Newsletter to have it delivered by email daily.