Q3 2019 Regional and Community Bank Results: A Sigh of Relief

Wall Street approached third quarter 2019 bank earnings with a fair amount of trepidation.

After all, the yield curve continued compressing during the quarter, expectations called for loan growth to moderate, and rumblings grew louder about a potential economic downturn leading to cracks in the credit environment. The impact of the Financial Accounting Standards Board's Current Expected Credit Loss (CECL) standard, which takes effect for most public companies at the beginning of 2020, added to concerns. In the end, community and regional banks delivered solid results and conveyed reasonably optimistic outlooks. We analyzed 262 banks with assets between $1 billion and $50 billion that reported results through October 31 and our key insights are highlighted below.

EPS surprised to the upside. Third quarter results proved better than expected with 66% of the banks in our analysis exceeding consensus EPS expectations. Reflecting these stronger than anticipated results, the KBW Nasdaq Regional Banking Index (KRX) increased 5.4% from October 4 (the last trading day before bank earnings season started on Monday, October 7) through November 1, as compared to a 3.9% rise in the S&P 500. The KBW Nasdaq Bank Index (BKX), which tracks share price performance of larger banks, rose 8.8% during the same period.

Economic outlooks unchanged. A majority of banks across regional geographies reported ongoing healthy economic trends. A bank located in the Southwest observed little change in business activity and noted strong loan and deposit pipelines. A northern California-based bank continued to feel good about the economic backdrop, which is little changed from this time last year. A Southeast bank stressed that customers were in good financial positions and reasonably positive about both the economy and their continued growth prospects. The CEO of a Midwest bank commented that near full employment and a recession don't typically occur together. A Northeast bank anticipated economic activity remaining at recent levels and did not think the U.S. was on the verge of recession. Several banks mentioned that concerns around the trade war and headline risks emanating from Washington, D.C. are driving sentiment in the wrong direction but are not yet impacting loan pipelines.

Loan growth exhibited seasonal softness. Loan growth at the median bank in our analysis decelerated to a 5% annualized pace in the third quarter from nearly 7% annualized growth last quarter. However, the third quarter tends to be seasonally slow for loan growth, and pipelines generally pointed to stronger loan growth next quarter.

2020 loan growth forecasts called for more of the same. Most institutions characterized the economic backdrop as stable, and as such loan growth projections for 2020 look a lot like 2019. A Tennessee-based bank, for example, projected low double-digit loan growth for 2019 and foresees no reason for 2020 growth to be any different. A Pacific Northwest bank continued to view mid-single digit loan growth as a reasonable expectation for next year and a Florida-based institution anticipates mid-single-digit loan growth in 2020.

NIM pressure picked up in the third quarter. The median bank recorded three basis points of NIM contraction in the third quarter versus the second quarter due to the challenging interest rate backdrop. By comparison, NIM fell by only one basis point at the median bank last quarter. The larger banks in our sample experienced the most intense margin pressure, with the 69 banks with assets of $10 billion to $50 billion reporting a median NIM decline of six basis points. With the 10-year U.S. Treasury yield recently rebounding, several banks anticipate less intense asset yield pressures in the fourth quarter of 2019.

Deposit costs began to stabilize. Following a 25 basis point decline in the federal funds rate in August and September, deposit cost pressures have begun to wane. The cost of deposits for the median bank increased by only one basis point in the third quarter as compared to seven basis points last quarter. To put this in perspective, consider that deposit costs at the median bank rose 26 basis points year-over-year in the third quarter of 2019. Given the interest rate backdrop most banks still envision near-term NIM pressure. However, anticipated deposit cost declines in the fourth quarter of 2019 should provide some NIM support.

Deposit growth remained strong. Deposit balances at the median bank increased at an annualized rate of 6% in the third quarter, up from 4% last quarter, and non-interest-bearing deposits increased 14%, up from 7%. Most institutions expect to post continued strong deposit growth.

Healthy credit metrics continued. Those looking for signs of an economic downturn in the form of deteriorating credit metrics found little support. Non-performing loans at the median bank were stable with last quarter and down 5% year-over-year. The median bank's net charge-off (NCO) ratio was up just one basis point from last quarter. The average NCO ratio of 0.14% for the banks we analyzed remains quite low and loan loss provisions declined 1% from last quarter and 2% year-over-year. Some one-off credit issues developed in the third quarter and were primarily related to Shared National Credits (SNCs), leveraged lending, energy loans and certain C&I loans. Importantly, the limited number of banks that reported credit challenges viewed them as idiosyncratic rather than systemic or driven by underlying economic weakness.

Clarity on the impact of CECL emerged. Expectations for banks to quantify the impact of CECL on Day 1 were high heading into third quarter earnings season. Banks presently operate under the incurred loss standard that delays recognition of credit losses until it is probable a loss has been incurred. Under CECL, which is widely considered the biggest change to bank accounting in decades, banks are required to estimate expected losses over the life of the loans. Most mid-sized institutions guided to a 20% to 40% increase in their allowance for loan losses as a result of this accounting change. For banks with significant acquired loan portfolios, the projected total percentage allowance increase ranged from 50% to 100%. CECL's Day 1 impact on capital levels is anticipated to be modest and mitigated by the three-year phase-in from a risk-based capital standpoint. Community banks generally declined to offer much in the way of CECL updates as they remain focused on completing their model validation processes.

Banks of all sizes remain reluctant to share their loan loss provision results under their parallel CECL runs. Most institutions acknowledge their provisions will be higher under CECL, but don't want to provide specifics around the magnitude of the change since it depends on economic assumptions at the time. An Arizona-based bank commented that if its reserve increases 20% to 30% due to CECL, its provision will likely rise by a similar amount provided there is no change to its economic outlook. We see the potential for negative consensus 2020 EPS revisions over the next three months as the Street refines its provision forecasts to account for CECL's go-forward impact.

Bank M&A activity influenced by one large deal earlier this year — BB&T and SunTrust. Looking at announced bank M&A deal value so far in 2019, most would consider it a banner year for industry consolidation. The $49.4 billion in announced bank and thrift deal value year-to-date (through November 1, 2019) is already 62% above 2018's $30.5 billion total. However, most of this deal value stems from the $28.3 billion merger announced between BB&T and SunTrust in February. Excluding this transaction, the annualized run-rate of announced bank deal value of $25.3 billion is 17% below full-year 2018 levels. M&A ambitions were not a major focus of most banks' third-quarter 2019 conference calls.

U.S. bank and thrift M&A trends

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Please contact a member of our dedicated regional and community bank practice to discuss your IR or PR program or to add other members of your team to our distribution list for periodic updates on trends impacting the sector.

Matthew Keating, CFA
Mkeating@finprofiles.com
310.622.8230

Larry Clark, CFA
Lclark@finprofiles.com
310.622.8223

Tony Rossi, CFA
Trossi@finprofiles.com
310.622.8221

Kevin Dobbs
Kdobbs@finprofiles.com
310.622.8245