Balancing Downward Pressure on Earnings With Strategic Progress
April 10, 2024
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7 minute read – Robust earnings eliminate a potential impediment on the road toward progress with strategic objectives. The current environment, however, is placing pressure on earnings in a variety of ways. Net interest margin compression, increasing operating expense ratios, higher projected reserves for loan losses, and potential decreases in non-interest income sources all seem to be impacting financial institutions (FIs) at the same time. Nevertheless, maintaining forward progress on important strategic objectives is imperative to achieving success over the longer term, which finds leaders needing to make difficult business decisions.
Let’s tackle 5 areas of earnings pressure to understand their causes and how to potentially improve organizational net results.
1. Margin Compression:
Funding sources have become more expensive for financial institutions as consumers seek higher deposit rates. This has resulted in more funding coming from term deposits (CDs), borrowings, and brokered deposits. All these sources carry a higher rate, on average, when compared to non-maturity deposit accounts, such as savings and checking accounts. The resulting cost of funds for FIs has risen significantly, leading to margin compression. There is an art to effective funding strategies, but even with a well-executed strategy, the cost is still higher than it was before. One of the most effective techniques for combating this margin compression is based on being very selective in what assets you are willing to add. This requires discipline to ensure the assets you are adding to your books provide sufficient incremental margin, after consideration of the anticipated higher cost of funds and any other related costs. Start by asking this question: If our organization adds this asset, will it perform well today and in the future, using a range of potential assumed scenarios
2. Increased Operating Expense Ratios:
Inflation isn’t just impacting consumers, it is impacting FIs as well. Operating expense dollars, in part impacted by inflationary pressure, are on the rise. Couple that fact with asset growth being more expensive and harder to come by, and increasing operating expense dollars could magnify the rise in operating expense ratios. So how best to address this concern? Some are cutting expenses, including marketing dollars, across the board, but a more strategic approach is highly recommended. When considering a potential expense reduction, ask yourself, “How may this impact customers with our FI or the progress of our strategy in the future?” If you can answer that with minimal impact or less, then it might warrant further consideration. It is important to maintain consistent focus in order for organizations to continue to advance strategic progress as much as possible. Using this approach can help organizations remain viable for the longer term.
3. Higher Expected Credit Loss (ECL) Expense:
The relatively recent implementation of the Current Expected Credit Loss (CECL) accounting pronouncement is having an impact on the amount of loan loss reserves that institutions need to set aside. With the possibility of an economic downturn still looming, this could compound the potential impact of CECL. While you can’t elect to ignore CECL (even though you might want to), this too will require you to be diligent in your loan pricing process to appropriately account for this potentially higher expense in your pricing models. As indicated in relation to margin compression, one way to combat this impact is to ensure that loan pricing properly incorporates adequate provisions for loan losses over the life of loans.
4. Non-Interest Income Concerns:
Regulators continue to focus on various sources of non-interest income with an eye towards placing further restrictions, which may limit the future potential of these sources of income. The Consumer Financial Protection Bureau (CFPB) continues to focus on various fees charged by FIs. In early March, the CFPB finalized a rule to cap credit card late fees at $8 for the largest credit card issuers, those with more than 1 million open accounts. These companies account for more than 95% of total outstanding credit card balances. This will also put competitive pressure on other issuers to lower their late fees as well. CFPB also continues to focus on NSF and overdraft fees, also referred to as overdraft protection or courtesy pay, which are significant sources of income for financial institutions. These fees are already roughly half of what they were industry-wide before the pandemic. Some of the recent focus is considering whether these fees should be considered finance charges under Regulation Z. Fines totaling hundreds of millions of dollars have been levied against financial institutions in relation to their NSF and overdraft protection practices.
Interchange fee income is also under pressure with a focus aimed at lowering these card transaction fees as well. All of this combines to emphasize the need for financial institutions to seek further diversification of non-interest income sources. Many financial institutions have successfully done this by identifying services that businesses and consumers are willing to pay a fee for. While this kind of transformation does not happen overnight, it is important for organizations to start working towards this objective.
5. Asset Growth (and the requisite funding sources):
Funding sources needed to support asset growth have become more expensive as rate levels have elevated. Financial institutions should evaluate all forms of funding in relation to the potential assets being funded to fight against the margin compression concern discussed earlier. Deposits are harder to come by and more expensive than they were back when rates were at or near historically low levels. On the plus side in terms of funding sources, CDs are somewhat back in fashion with consumers, although the cannibalization of lower-cost deposits must be factored into the true cost of funds. Strategic borrowings remain a solid option as a funding source that can be matched against many types of loans. The key to any funding source is to identify assets that can provide the necessary return to meet your margin requirements.
This requires a diligent approach regarding loan pricing. Ask yourself this question:
- Does this loan rate properly account, over the expected life of the loan, for: Cost of Funds, related Operating Expenses, Expected Credit Loss requirements, and any other related costs?
With these 5 areas considered, financial institutions can have a better handle on balancing downward pressure on earnings with strategic progress. In certain situations, it may even be acceptable for organizations to accept slightly lower earnings for a short period of time, if doing so will help them move forward with critical strategies that will serve the organization well over the long term. The same kind of argument can be made in relation to accepting lower asset growth numbers. However, over the long term, achieving solid asset growth helps to provide greater scale and position organizations for success in terms of advancing their products and services in a more meaningful manner for their target markets. Challenging times demand that leaders make these kinds of complex business decisions. The most successful leaders use wisdom to make the hardest choices in a manner that maintains the longer-term objectives front and center.
