Authored by Timothy M. Kosiek
Based on the key performance indicators (KPIs) tracked by Baker Tilly, 2017 was a strong year for community banks. All twelve of the KPIs in our analysis trended in the positive direction in comparison to the year ended Dec. 31, 2016. These results reflect the overall increased confidence and forward momentum in the community banking industry. Community banks appear to be participating fully in the continued economic growth, while at the same time building capital and improving profitability and operating efficiency.
Most notably, the KPIs reflect the following:
Tier 1 capital
This primary measure of the strength of a bank’s financial condition increased to 12.22 percent at the end of 2017 from 11.88 percent at the end of 2016. The primary contributors to the overall strengthening of community bank balance sheets were stable and sustainable earnings and a heightened level of receptivity of the capital markets for bank equities. Community banks, on average, have reduced their dividend payout ratios, indicating a desire to retain higher capital levels to accommodate growth expectations or, although as noted below there do not appear to be any impending negative trends (see credit environment), to more effectively prepare for unexpected interruptions to the current growth in earnings.
Return on average equity
Notwithstanding higher capital levels, community banks have continued to experience reasonably strong growth in earnings in relation to capital, evidenced by the increase of the group’s return on average equity in 2017 of 9.59 percent from 8.61 percent realized in 2016. The largest contributor to this improvement was the continued strong credit performance throughout the industry. Provisions for credit losses remain at low levels due to limited recent historical losses and the absence of any significant headwinds. Additionally, as discussed below (see efficiency ratio) community banks are realizing meaningful reductions in the cost of their operations. Finally, pricing on both sides of the balance sheet has continued to improve. Community banks are beginning to demonstrate improved capabilities at utilizing data and information to drive pricing and terms on loans and deposits, thereby improving net interest margins for the industry segment as a whole (see net interest margin).
Community banks continue to demonstrate improved capabilities to control operating costs and maximize the amount of revenue supported by their operating frameworks. Impressively, the segment’s average efficiency ratio has declined to 65.84 percent for 2017 from 68.97 percent in 2016. In addition to the improved earnings experience discussed above (see return on average equity) this improvement has been bolstered by enhanced regulatory compliance processes, a notably reduced regulatory burden, a measurable return on investments in technology, and, in some instances, the positive effect of the continued industry consolidation.
Community banks continue to see the benefits of a measurably improved credit environment. In addition to being able to deploy a modestly higher percentage of their deposits into loans – the loan-to-deposits ratio has increased from 77.09 percent at Dec. 31, 2016 to 78.64 percent at Dec. 31, 2017 – community banks have seen meaningful improvement in credit performance, evidenced by a decline in the ratio of non-performing assets to total assets to 1.35 percent at Dec. 31, 2017 from 1.36 percent a year earlier. These results reflect the fact that community banks are being disciplined in their credit growth and are effectively managing both new and existing credit relationships. At the same time, community banks, on average, have kept the allowance for loan and lease losses (ALLL), as a percentage of total loans and leases, relatively constant at 1.34 percent as of Dec. 31, 2017 in comparison to 1.39 percent at Dec. 31, of 2016.
Although there have been some isolated instances of softening in credit performance, the effects of these situations do not appear to have surfaced in the allowance levels at community banks. With the future application of the change in the accounting standard for recording the effect of estimated credit losses approaching (2020 for public companies and 2021 for non-public companies) there may be some movement in these numbers however, the industry has not given any foreshadowing to significant upward movement in the allowance coverage ratios.
Net interest margin
Because most community banks do not have the benefit of significant non-interest income, net interest margin remains the primary driver of profitability. Fortunately, the current interest rate environment and prudent pricing, as noted above, have led to continuing improvement in the net interest margin (NIM). Specifically, NIM for the community bank segment subject to our analysis of KPIs, increased from 3.67 percent in 2016 to 3.78 percent in 2017. Also contributing to this increase has been a higher than expected level of elasticity on deposits. Community banks, generally, have not experienced notable pressure to increase rates in response to recent or anticipated Fed movements, and non-interest bearing transaction accounts have generated higher balances due to the continued strength in the economy. Although there are some early signs of new large entrants into the deposit market (e.g., Amazon, SoFi), community banks appear to continue to be a preferred destination for depositors.
For more information on the key performance indicators, or to learn how Baker Tilly banking specialists can help your financial institution, contact our team.