May 6, 2019
The Road to Higher Profits
By Alec Hollis, Director, ALM Strategy Group, ALM First Financial Advisors, LLC

Banks want to achieve above-average profitability. Profitable growth is a critical element to success as an organization. Long-run commercial viability occurs when an organization delivers value to its constituents in a profitable and sustainable manner. But how do banks get that way? Are there distinguishing characteristics of high-profit banks?

The year 2018 was a blockbuster one for the banking industry, thanks in large part to the Tax Cuts and Jobs Act (TCJA). The industry earned $236.7 billion in 2018, a whopping 44.1% improvement over the $164.3 billion in 2017, and return on assets (ROA) was 1.35% – its highest point in over seven years. According to the FDIC’s Quarterly Banking Profile, the 44.1% increase in full-year net income would have only been an estimated 13.5% given a normalized tax rate.

Drawing conclusions from the FDIC’s published data, it’s clear that asset size is a factor to profitability. Medium and larger banks have a much higher profit advantage over smaller banks. For example, banks under $100 million in assets have a ROA disadvantage of 33 basis points (bps) to the industry’s 1.35%, much of which can be attributed to scale that results in greater efficiency. However, the discussion of size and performance recalls the chicken-and-egg conundrum; or as statisticians would put it, correlation does not imply causation.

The effectiveness of an institution’s management team shapes its performance, and hence its size. Growth for the sake of growth is no substitute for profits. The wrong incentives related to growth could lead to uncontrolled increases in operating expenses and a loss of a competitive advantage. Rather, management teams should focus on delivering value in a profitable manner. Growth then becomes a natural byproduct, which can bring scale and further improvements in efficiency.

To view performance outside of the traditional confines of asset size, we created a bank screener to profile high-profit banks. To start, we filtered out the largest of banks, removing banks above $20 billion in assets and other unrepresentative specialty banks.

From there, our high-profit benchmark (HPB) contains banks with the following criteria:
- ROA and ROE higher than the industry in four out of the past five years
- A higher ROA today than five years ago
- Non-performing assets not greater than 1.20% of assets (double the industry’s aggregated figure)

Of the 5,406 institutions reporting according to the FDIC, 575 banks were included in the HPB, representing about 11% of the total number of banks. These are institutions without excessive credit losses and a strong track record of performance over the past five years. The asset size distribution is very similar to the broader industry, indicating high-profit banks across all asset sizes are represented. However, the skew is more towards the larger side, as the average asset size is $873 million in the HPB compared to $670 million on average for banks less than $20 billion in assets. In our findings, the factors these high-profit banks share are expense control, leverage and balance sheet structure.

How High-Profit Banks Do It
Expense control is one factor that leads to higher profits, and arguably the most important one. Operating overhead stands out as the most statistically significant factor in profitability, as HPBs posted 2.57% of average assets in non-interest costs and a 50.38% efficiency ratio – both significantly lower than the numbers of their similarly-sized peers. HPBs also have lower interest costs and higher net interest margins (NIMs). On the other hand, non-interest income and fee income don’t seem to be key factors; HPBs seem to earn less in these diversified sources of income relative to larger banks. Overall, HPBs outpaced the broad industry by a wide margin last year, generating a 1.81% ROA and 16.03% ROE.

Leverage also stands out, but more so when comparing to banks on the smaller side. Larger banks tend to make better use of economically cheaper debt relative to high-cost owners’ capital. Interestingly, HPBs have higher capital ratios than the broader industry – including the largest banks – but risk-based capital ratios are about the same. This indicates HPBs are more likely to utilize risk-based capital, which leads us to the next point.

Balance sheet structure influences performance, at least for the time being when credit performance is strong. Loan-to-deposit and loan-to-asset ratios are significantly higher than the broader industry. HPBs also have higher deposit-to-asset ratios, perhaps giving them a cost of funds advantage.

Ultimately, profitability is a result of many factors. Market forces are certainly a big part of this discussion – once again, think back to 2018’s tax tailwind. A bank’s financial statement performance, however, suffers from the drawback that it is not risk-adjusted. That is the purpose of asset-liability management (ALM) – to increase profits by reducing risks that may adversely impact profitability. Should market forces move unfavorably, efficient, well-run banks will be the best positioned to survive.

Figure 1: The Index of High-Profit Banks Compared to the FDIC's Compiled Data

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

As a Director for the ALM Strategy Group at ALM First Financial Advisors, Alec Hollis performs asset liability management strategy research for financial institutions, implements firm-wide ALM modeling procedures and assists in the execution of client balance sheet hedging programs.