Pure and Simple: It's All About Loan Growth

January 17, 2013 at 11:14 AM

It has been stated often that banks are caught in a vise of rising compliance costs and declining revenue. An examination of trends in key financial ratios brings the problem into sharper focus.

As shown in Table A below, operating expense levels relative to average assets have remained essentially flat compared to pre-crisis levels. While there was some variation (i.e., modest increases or decreases) among the asset tiers, there was no significant reduction in the level of expenses relative to average assets. Consequently, the differential of operating expenses among the banks by asset size has not changed. The expense base of smaller banks remains between 12-25 basis points higher than that of larger banks.

While operating expense levels have remained unchanged, operating revenue, defined as the sum of net interest income and total noninterest income, has plunged from pre-crisis levels. Table B. shows that operating revenue as a percentage of average assets dropped industry-wide by 35 basis points. The decline was steepest among institutions with less than $1.0 billion in assets.

Not surprisingly, the culprit behind the drop in operating revenue has been a significant reduction in the percentage of average assets invested in loans. As Table C shows, it has declined industry-wide by more than 1,000 basis points.

The trends in these key metrics paint a simple and compelling picture. Expense levels among banks, especially community banks, are unsupportable given the reduction in revenue and the shrinking of the loan portfolio. However, no amount of expense cutting can offset the negative effect of shrinking loan portfolios. An expense base of approximately 300 basis points is not required to manage a securities portfolio. The traditional financial intermediation model cannot survive unless there is a resumption of loan growth.

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