Changing Market Dynamics’ Effect on Banks’ Balance Sheets

By Scott Hildenbrand

While changes in interest rates will always be a major contributing factor to the planning process of bank management teams, recent opportunities in the capital markets and developments in the financial landscape have been increasingly influential in driving key balance sheet decisions for banks. Even banks that have not participated in capital market activities are still feeling the effects, as competitors’ decisions have changed the landscape for all participants. Understanding how constantly evolving market conditions are affecting your business will enable you to implement new strategies to best position your institution.

The first quarter of 2017 saw the highest amount of capital raised since the second quarter of 2014, according to data from S&P Global Market Intelligence. While the credit crisis and the years following saw many defensive capital raises, the level and quality of such transactions has drastically improved in the years since. Subordinated debt and common stock raises have become increasingly common, as many banks have raised capital for a variety of proactive reasons. Organic growth has thus far been the main use of proceeds.

Additional capital has helped banks remain competitive while allowing them to address regulatory issues due to high concentration risk, typically in commercial real estate. As investors and regulators have turned their attention to CRE concentrations, banks are turning to the debt capital markets to support continued growth without having to consider other lending areas outside of their traditional scope and expertise. Furthermore, as bank stocks across the board experienced a “Trump bump” since late 2016, an increase in stock issuance is being used to fund M&A transactions.

Similar to these issuance trends, M&A transactions have moved from defensive to more opportunistic transactions as equity prices have risen following the 2016 election. While the number of annual deals has decreased, the aggregate annual deal value has increased. Thus, economies of scale seem to be the biggest driver of acquisitions. In fact, out of the 39 public and private banks to cross $10 billion since 2010, only 4 have grown organically, according to SNL Financial. Judging by the stock prices of the companies that used M&A to cross the threshold, it seems investors have approved of this strategy.

While capital markets and M&A activity have enabled banks to boost earnings, tailwinds still remain. The spread business suffers from a flat yield curve and cost of funds is under pressure from an increasing fed funds rate. On the asset side, elevated loan-to-deposit ratios and CRE concentrations limit potential loan growth, and the asset mix shift out of bonds and into loans has largely played out. Despite these tailwinds, market expectations have jumped under the Trump presidency, with many people believing tax relief and less regulation could become a reality in the near future. Meeting these lofty expectations may exacerbate the potential increase to cost of funds caused by deposit-starved market participants.

There are various ways in which banks are battling against market forces to stay competitive. In response to a flat curve and fierce competition pressuring yields and terms on the asset side, more banks are using loan hedging programs to meet customer demand and manage interest rate risk on loans. Banks are also evaluating wholesale leverage to enhance earnings, despite seemingly uninspiring spreads.

On the liability side, gone are the days when banks can solely rely on CD specials—customers are looking for their products to keep up with the increase in rates they read about in the papers. CDs are a relic of the past. As such, many banks are considering money market deposit accounts that are specifically indexed to fed funds, allowing banks to deliver a product that customers want and can be hedged in the future.

Ultimately, there will never be a shortage of forces to make bank management teams’ lives a little more challenging. Whether those forces originate in the interest rate realm, or from capital markets, the banks that are first to identify those challenges and address them head-on will likely be more successful and should deliver better returns.

Scott Hildenbrand is a principal and chief balance sheet strategist of Sandler O’Neill and Partners.


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