Using Strong Markets to Run Numbers and Fade “Inertia Banks”

by | Oct 20, 2021 | Corporate Governance | 0 comments

As banks rally at the same time many of them are making low ROI loans, we’re spending a minute this afternoon making sure folks know what they are getting when they buy the sector.

Is banking a good business?  A good business returns more than its cost of capital without herculean effort.  In this sense, some banks are good businesses, some are not, and the balance changes every day.  The rub is that few bankers take time to determine what loans are “good business”; most take what the market gives; the process often ends up being a political exercise to keep lenders happy. 

The paragraphs below define this in some detail, including the math at a loan level.  

“The balance changes every day” – a sober look at what the market is giving banks  Part of why banks are rallying is the assumption we will return to past rate cycles.  The narrative is that inflation has picked up recently, and so the Federal Reserve will taper and raise rates. Economic growth will continue after that and rates will end up around 2.25% in a few years. At this point banks will go back to making 4% margins and 15-20% spread returns on equity.  These assumptions remind us of the video of Hitler explaining how his plan will be implemented.  

These questionable assumptions are inline with the “Summary of Economic Projections” published by the Federal Reserve here:, with the highlight in the famous “dot plot” below:

Federal Reserve Dot Plot: Consistently wrong

In contrast to the 18 policy makers, the view from the $28 trillion (and growing) bond market is more cautious. It understands the Japan-style debt blanket over our economy, and it knows that lowering rates and buying bonds have become impulsive behavior for our central bank in times of economic stress, leading the economy into a leverage dependency, where there is so much debt that we cannot afford to pay it down without risking jumps in unemployment.

Bond market is less enthusiastic on higher rates

In this context, if the bond market is giving ~1.6% for 10 years, then about 600 of the 800 publicly-traded banks can’t earn their cost of capital and will hurt their shareholders by existing.

We’ll see from the math below that posting returns above a bank’s cost of capital will be difficult, and undifferentiated banks will see returns in the future five years look much like that past five have looked for BankFinancial (BFIN) below.  To be clear, I don’t mean to pick on BankFinancial; it is simply an example of a bank that has struggled with value creation, and an evolving M&A marketplace, in a low rate backdrop.   Notice also the similarity in the BFIN chart and the US 10 year yield above.

The Math:

In this context, take a typical prime-rate loan with a typical cost of funds, typical fees, reserves, efficiency, equity support and taxes:
You’ll have to trust that the above is about what new loan business looks like right now at the average bank. The most important variable in 2021 is efficiency (credit will return to the forefront in the future). While we can’t know efficiency ratios of lending apart from a bank’s other lines of business, we know that only about 150 banks of 792 publicly traded are below 55% in aggregate.  In other words, most banks probably can’t reach that 9.7% ROE the way they are lending today.

Not many folks want to invest in levering 11x in order to get a sub 10% return on equity.

To summarize the situation at a Sesame Street level, this is what bank investing over the next few years is likely to look like:

The red light are the “inertia banks”.  They lent against real estate at 5%, they will lend against real estate at 2.75%, and they aren’t necessarily paying close attention to whether this is their optimum use of capital.  Between PPP runoff, low spreads, mortgage decline and the return of provisions, these banks will have a tepid 2022, even with no credit events.

Some champions of the green light on the left, which are typically differentiated banks, include banks like Signature (SBNY), or lesser known banks in similar business lines such as Customers (CUBI) or Provident (PVBC), among many others (Valuations matter – do you own diligence or speak to a knowledgeable registered advisor on specific companies mentioned).

To find banks like these, create your own “Line of bank differentiation.”  We believe that over time, the more innovative a bank is around fee businesses, the greater its chances of generating attractive returns.

                                                                                            Banks at right are more differentiated

The champion, which has unified all the belts, of the middle green light is Servisfirst (SFBS). SouthernFirst (SFST) is another bank that is attempting the Servisfirst model, with some success.

The right-hand green light is why we track proxies to gauge seller motivation, and meet management teams to see where acquirers have holes in their addressable markets. 

All this comes with a caveat – $28 trillion of bond market bets may be wrong and we may see more rate hikes than expected.  This can help spreads get closer to 3.25 – 3.5% and turn that 9.7% ROE into 11%+.  However, it won’t necessarily help make undifferentiated community banks trade above tangible book.  The point is to get out of the habit of competing against Wells Fargo for commodity apartment and jumbo mortgage loans.

In this period of financial repression we are investing in banks with an angle.  Without an angle, look for those willing to partner!

The above is not advice to buy or sell specific securities.  Colarion may hold securities named in client accounts.  Readers should consult with an advisor or conduct their own diligence before allocating capital.  Colarion is licensed to do business in Alabama and other states where permitted by law.