In case you didn’t notice, banks are lending money. Lots of it.
My review of second-quarter earnings reports and analyst calls for 80 banks shows that just over half are reporting double-digit loan growth for either their entire loan portfolio or key loan categories.
Here are a few examples:
- At SunTrust, consumer loans are up 15.5%.
- Commercial real estate loans are up 14.6% at Associated Bank in Green Bay, Wis.
- Commercial and industrial loan originations grew 109% in the quarter compared to a year earlier at Banc of California in Irvine.
- At JPMorgan Chase, “core” loans are up 23% in the “consumer and community banking” business.
Across the country banks of all sizes are booking impressive loan growth. How can so many banks book so many loans in an economy that grew by 1.2% in the second quarter and by only 0.8% in the first quarter?
There appear to be three possible explanations. The answer likely is some combination of all three.
First, some banks are taking on more risk.
Not unlike investors hungry for yield in a low interest rate environment, some banks are expanding their risk appetite. On the surface this move makes sense as low-yielding cash and bonds give way to higher-yielding loans. Absent higher- yielding assets, banks today are hard-pressed to generate returns sufficient to meet analyst expectations and 2016 profit plans.
What might go wrong with this move?
The big concern is that banks are increasing their risk profile at the wrong time in the banking cycle. History shows that too many banks lower their risk standards when credit quality metrics look most healthy. The industry’s loan-loss provision rate is running at historically low levels for the past two years. Consequently, the industry’s loan loss reserve is at a 30-year low except for the 2005-2007 period.
Encouraged by clear-cut signs that credit quality is stable, lenders tend to take on more risk at this stage in the cycle. Eventually, the industry’s willingness to take on more risk is punished. Provisions revert to historic levels and earnings suffer.
The second possible reason for the loan growth is that some banks have lowered their return expectations. Hungry for higher-earning assets, some lenders are willing to book loans that fail to generate a return sufficient to cover a 9-10% cost of capital common to most banks. In the short term, earnings per share do indeed improve, yet long-term return on equity declines.
There are two potential problems with this strategy. The most obvious is that lower ROE results over time in declining shareholder value. Perhaps evidence that banks are accepting lower ROEs is the growing trend of publicly-traded banks reporting Return on Tangible Common Equity. This relatively new metric allows banks to show puffier returns than plain ROEs. There are a lot of drawbacks to the ROTCE metric, but that’s the subject of another discussion.
The second problem can be even more problematic long term and this gets back to the banking cycle. Banks that underprice loans today do so when credit quality is as good as it gets. When credit metrics revert to historic averages — which will happen — banks that underpriced credit will face more severe earnings challenges than lenders that remained disciplined in loan pricing through the cycle.
A third possible explanation for the enormous disparity between bank loan growth in the U.S. and sluggish GDP growth may be because highly qualified borrowers are eager to jump on the opportunity to lock down loans when interest rates are at historic lows.
Enticed by cheap credit, borrowers borrow even when they don’t really need the money. Assuming banks price credit appropriately and successfully avoid interest rate risk, then it is quite possible that this type of lending is reasonably safe. This phenomenon may be the best explanation for the explosive growth in credit across the industry.
Bankers know firsthand that there is such a thing as too much debt and too little capital. Increased debt may not be a concern when examined borrower by borrower. In aggregate, however, leverage can become a systemic risk. No bank is an island.
Two final thoughts. Both are related to comments made by bank CEOs during their second-quarter analyst calls.
The first comes from BB&T’s CEO, Kelly King, who for the second time in three quarters reminded analysts on the call that his bank cannot significantly outgrow GDP. Apparently not all bank CEOs agree.
The second comes from Melanie Dressel of Columbia Bank in Tacoma, Wash. On her call, she cited data from a second-quarter survey of business customers. Most interesting was her report that less than one quarter of the business owners plan capital expenditures in the next three to six months. Concerned about government regulations, taxes and political uncertainty, the majority of businesses apparently are being cautious.
Perhaps banks would be wise to follow their lead.