As we have written before, the size and performance correlation is overrated in banking. In good times, asset size does have an affect efficiency and hence earnings, but in bad times, size negatively impacts earnings. If you take the business cycle into account, over a 20+ year period, there is little correlation between size and banking. As a rule of thumb when a bank grows risk increases. Few bankers understand how to grow assets at decreasing or steady marginal credit and operational risk. While we presented a quantitative case for how banks often destroy themselves by growing earnings (HERE), today we update the analysis and take another look at second quarter bank earnings by size.
Second Quarter Bank Performance
The raw data for the second quarter of 2017 is below. We have charted return on equity (ROE) by asset size category and then overlaid the number of banks in that category. If size and performance were perfectly correlated, you would see that the four, trillion dollar or larger sized banks produce the highest ROE. That is not the case, as the most profitable banks for 2Q are the 11 banks that are between $50 and 100B and those banks that are between $100mm and $250mm.
Correlations and What Size Matters
Statistically, size and return performance are only correlated by 21%. The reality is that size and ROE are strongly correlated but only up until $224mm of asset size. Past $224mm, the correlation becomes extremely weak. Remove all banks below $225mm in asset size and the correlation is a meager 3%, or almost completely uncorrelated.
Interestingly, the same is true of revenue generation. While revenue and asset size is highly correlated (97%) with causation, revenue and return are uncorrelated. That is, while you are likely to generate more revenue if you are a larger bank, it is only 27% correlated to profits. Again, if you remove the smaller banks under $225mm, then revenue and profitability are actually NEGATIVELY correlated. That is to say, that the larger your revenue production, the less return you are likely to generate. The correlation is a negative 3% for this point in time.
How Does the $10B Asset Mark Impact Return
As an aside, and more for our edification, we wanted to know how crossing the $10B threshold of asset size impacts return. To look at the regulatory cost associated with going over $10B (Durbin Amendment, FDIC insurance cost, etc) it is about another $10mm of pre-tax costs or, as detailed below using historic averages over the past five years, we are talking about 2% in ROE and 24 basis points in return on assets (ROA).
Putting This Information Into Action
Banks need to produce above their cost of capital as they grow or they dilute shareholder value. Producing under your cost of capital means with each dollar a bank puts on their balance sheet, profit margins likely get reduced.
Growing without a plan for how to gain efficiency is the primary reason why more banks don’t gain more profit as they grow. The most common mistake is to increase assets while not lowering incremental costs. This is most often done when banks put a greater number of smaller sized loans on their balance sheet without increasing pricing or when a bank adds a new business line that has equal or lower profit margins than their core business does.
Banks often convince themselves that they can “grow into their infrastructure” or that they can add another $500mm of loans to their platform. This is rarely the case. These banks might be able to add some loans to their platform without increasing costs, but normally banks have limits to their fixed cost infrastructure. Banks tend to get used to their operational cadence so when they add another $100mm of loans, they hire the same number of people per assets. As banks grow, they become more profitable and then tend to use some of that profit to hire more or increase their cost base. The up and down motion that you see in the chart above is all too common. More to this point, hiring and profit go hand in hand and are 89% correlated.
Before you grow, be laser focused on your operating leverage and your cost structure. If you can hold or reduce costs while growing both assets and revenue while producing above your cost of capital - growth, and profit will be highly correlated.
Submitted by Chris Nichols on September 06, 2017