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Roundtable - The Banking Industry Outlook for 2004

A Market Perspective on Banks’ 2004 Outlook
Experts focus on an array of factors affecting bank performance in the coming year.
By Sally Kearney, Office of Public Affairs

Bank earnings reached record highs in 2003 and the number of problem banks declined. Will the industry continue to gather strength? In January, the Division of Insurance and Research (DIR) sponsored a symposium on the banking industry’s outlook for this year. Held in New York, the symposium featured a panel of four leading bank industry analysts who shared their perspectives of the key factors influencing banking industry performance in 2004.

DIR Associate Director Rae-Ann Miller, the panel moderator, opened the discussion with an overview of the banking industry in recent years. Banks’ outstanding performance is due to a recovering economy, a favorable interest rate environment and improvements in risk management practices, Miller said. “Bank management has been flexible enough to change the composition of assets over time,” she said.

Moshe Orenbuch, Managing Director, Credit Suisse First Boston, began the session by providing his outlook for mortgage and consumer lenders, including credit card banks.

Looking at the macroeconomy, Orenbuch noted that payrolls and unemployment have been improving and said he anticipates continued gains going forward. The biggest factor constraining consumer loan growth is the debt service burden, and while it remains high, it has been stable for the last few years because of consumer refinancing activity. Orenbuch expects revolving credit growth to increase modestly as consumers take out less money from refinancing their mortgages. During the last three years, consumers have taken out $85-90 billion dollars a year from refinancing, and Orenbuch said that surveys have shown that 30 percent of those dollars were used to pay down non-mortgage debt, the largest piece of which is credit card debt. “We would expect the growth rate of credit card balances to accelerate by a couple of percentage points from six percent in 2003 to eight percent in 2004,” he said.

In 2004, mortgage activity will be cut in half and refinance activity will decrease by 75 to 80 percent, Orenbuch said. Bank profitability is strong and likely to improve. With regard to credit quality, bankruptcies are falling for the first time in three years. “In the last 20 years, bankruptcies have compounded at about eight percent,” he said. “Declines are welcome. We’re looking for a six percent decline in bankruptcy filings in 2004.”

Tom McCandless, Director, Deutsche Bank Securities, Inc., gave his outlook for large financial institutions. He described the sector as mature with a projected long-term growth rate of about seven percent. Large banks have undergone a dramatic change during the past 20 to 30 years; the 1980s and 1990s were a period of geographic diversification and tremendous consolidation activity. In the mid-1990s, the focus shifted to product diversification, and the banking industry, flush with excess capital, began to expand to create a more diverse business model and better revenue growth.

There is much discussion about the consumer-led economic recovery and when the commercial side will begin to participate in that recovery, McCandless said. “Our view is that the transition is occurring now,” he said. “It never happens overnight. It happens over time. But clearly the seeds have been sown for the commercial side to kick in .... In our earnings models, you are basically looking for pretty steady loan growth. We expect margins to continue to be under pressure for the next quarter or so before stabilizing and perhaps even beginning to go up a little bit, although I’m not real optimistic on that front.”

McCandless also looked at deposit and loan growth, which tends to follow cyclical patterns. “There has been a lot of discussion and concern about deposits slowing down dramatically,” he said. “People fear that deposits are going to leave the system and go into the stock market. That’s probably true; some of that will happen.” However, he added, deposit growth will probably pick up as personal income grows.

He also predicted that commercial loan demand will make a comeback in 2004, climbing out of negative territory and perhaps breaking even by the end of the year. In past cycles, increased mergers and acquisition activity, expanding business inventories, and capital expenditures have been key drivers to renewed commercial loan demand. In summarizing his key risks to watch for in 2004, McCandless cited yield curve volatility, the value of the dollar, geopolitical uncertainty and operational risk.

Jason Goldberg, who covers regional banks for Lehman Brothers, noted the growth of the banking industry—and the larger financial services industry—over the past several years. Banking industry growth decelerated in 2003, however, in large part because net interest margins came under pressure due to record-low interest rates as well as a dramatic slowdown in commercial loan demand. Real estate loans and mortgage-backed securities have been fueling banks’ balance sheets while commercial loans have declined.

Businesses flush with cash don’t need to borrow, Goldberg said. The tendency is to tap those funds before seeking outside sources of funding. Also, companies have access to a wider range of funding sources. “Clearly, there has been a shift in preferences, with more sources of financing for commercial borrowers,” Goldberg said. “Commercial loans are down by 18 percent since 2000. Corporate bond liabilities at domestic firms are up 27 percent. Also, there are more uses of commercial mortgage-backed securities. There was $100 billion in issuances in 2003. Corporate debt, commercial paper and mortgages represent more than 70 percent of corporate credit liabilities, up from 60 percent five years ago. I see no reason why that trend won’t continue. I do expect C&I (commercial and industrial) loan growth to pick up.”

Overall, Goldberg predicted improving commercial loan growth, lower credit costs, improved capital and more merger and acquisition activity, along with slowing consumer loan growth.

Gary Townsend, Senior Vice President at Friedman Billings Ramsey, gave an outlook for community banks. “As we look at 2004, I think the principal driver will be the strong extension of the economic recovery,” he said. Townsend foresees continued historically low interest rates, a recovery in manufacturing activity, a need for companies to replenish inventories, a strong recovery in capital expenditures and a falling level of the value of the dollar. “We also expect further improvement in credit quality, but in terms of its impact on 2004 earnings, this is probably the least important of the factors,” Townsend said. “We’ve come through the economic slowdown and the recession that preceded it with extraordinarily great credit quality, generally across the board, and although there are exceptions, for the most part, credit costs have remained relatively low.”

His caveats to the economic outlook include the fact that earnings and asset growth appear constrained, consumer debt levels are high, savings levels are low, and overall commercial lending trends remain adverse. Renewed volatility in interest rates could have a substantial impact on the earnings outlook, especially if long-term rates move upward. Townsend also expects continued steepness in the yield curve.

Luncheon speaker Eugene Ludwig, former Comptroller of the Currency and Managing Partner, Promontory Financial Group, focused on bank profitability. He noted that banks face increasing pressure to show enhanced profitability. “Analysts and institutional investors pressure management for ever greater returns,” he said. “A strong growing bottom line generally translates into a higher stock price and a higher stock price means that the bank is more easily an acquirer and not an acquiree.” Too often there is a disconnect between long-term and short-term profitability, Ludwig said. “As cyclical as this industry is, we don’t really differentiate between a short-term phenomenon and what is long-term profitability,” he said.

Risk management is important when assessing long-term profitability. “Most bankers, even today, view risk management as a necessary evil and a cost center rather than a profit center,” Ludwig said. “I think we’re making a mistake in not looking at risk management as an inherent part of the profitability of financial services entities.”

Banks can improve profitability by focusing on teaching banking staff to sell the bank’s products more effectively, Ludwig said. “Those institutions that have this selling culture are doing vastly better in terms of their own growth and profitability than the institutions that don’t,” he said. “Sales doesn’t just mean people going out like insurance agents, it also means Internet activities and modern techniques that sell the banking product.” Ludwig concluded by saying, “The key differentiator in terms of profitability will not simply be management and risk management, but the development of a truly 21st century sales culture in banking organizations.”

Last Updated 03/08/2004

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