THINKING AHEAD A LATE-CYCLE CHECKLIST FOR U.S. REGIONAL BANKS. AUTHOR Dan Rosenbaum, Partner

Transcription

1 THINKING AHEAD A LATE-CYCLE CHECKLIST FOR U.S. REGIONAL BANKS AUTHOR Dan Rosenbaum, Partner

2 SUMMARY By almost any measure, the past few years have been good ones for U.S. regional banks: Loan growth, while having moderated in recent quarters, has been steady; net interest margins have widened; charge-offs remain near historical lows; and profitability has recovered nicely from its Great Recession trough. Recent changes to regulatory and tax policy, and favorable macro-economic conditions, are providing additional near-term tailwinds to bank performance. But like all good times, these too will eventually come to an end such is the nature of the cyclical U.S. economy. (See Figure 1.) And if we are in the late stages of the current expansionary cycle, as many economists and stock market watchers suggest with increasing frequency, the time to prepare for the pressures and opportunities downturns typically bring is now. Figure 1: U.S. Business Cycle ANNUAL REAL GDP GROWTH (%) Source: St. Louis Fed: Copyright 2018 Oliver Wyman 2

3 Here are four items that should be at the top of management s late-cycle preparedness checklist : DOWN-CYCLE COST MANAGEMENT PLAN Categorize costs into those needed for survival, for fulfillment of strategic objectives, and for discretionary activities; develop a prioritized plan for managing each STRATEGIC PLANNING Conduct a moderate down-cycle scenario analysis, and incorporate into the near-term strategic plan those opportunities that arise from the analysis; for example, actions to minimize disproportionate detractors to bank performance M&A Ensure the bank is prepared and has the dry powder to move quickly in a downturn to pursue strategic targets when they become available COLLECTION/RECOVERY FUNCTION Ensure the collection/recovery function has been modernized since the last downturn and that it has adequate capacity to manage an uptick in delinquencies Copyright 2018 Oliver Wyman 3

4 IS IT TIME TO PREPARE? One of the challenges of determining where we are in a business cycle is the absence of a single, reliable cyclical indicator. Consequently, economists often evaluate trends developing in multiple measures to assess whether the U.S. economy is in the early, middle, or late stage of an economic expansion. Some of the commonly watched signals that are increasingly being discussed in the press include: Rising short-term interest rates A period of consecutive Federal Reserve rate hikes is considered a late-cycle indicator. The Fed has been raising rates steadily since the end of Flattening of the yield curve 1 A flattening yield curve is often seen as a harbinger of below average future growth, and an inverted yield curve as portending recession. 2 While this indicator has been volatile, the yield curve has been steadily flattening since December Duration of the current economic expansion relative to past expansions 3 For the past eight business cycles (dating back to 1960), the average number of months from the trough of one cycle to the peak of the next is 65 months, with a recorded maximum of 120 months. The current business cycle is now 112 months past the end of the Great Recession in June 2009, or 47 months beyond the average business cycle. Forecasted GDP growth Recently, GDP growth has been increasing, and reached 3.5% in the third quarter of However, the Congressional Budget Office is forecasting slower GDP growth of 2.4% and 1.8% for the 4 th quarter of 2019 and 2020, respectively. 4 Corporate debt outstanding as a percentage of GDP Corporate debt as a percentage of GDP has been growing quickly over the past few years and was 45% in the second quarter of 2018, the same level it was prior to the last recession. Taken in aggregate, these gauges suggest that the U.S. is in the late stages of the current business cycle, which began about 10 years ago. While being late in a cycle does not mean that a downturn is imminent, it does mean that there is more downside risk ahead than upside. It s therefore prudent for management and boards to ensure that their bank is well-prepared for the inevitable turn in the cycle. As a first step, management should draw up a late-cycle checklist; this ought to be followed by a quick and thorough review of all items on the checklist, and then near-term remediation of any deficiencies. At the top of management s checklist should be following four items: Down-cycle cost management plan, strategic planning, M&A, and collections/recoveries function. 1 We use the difference between yields on 10 year and 3 month constant maturity Treasuries as a proxy for the slope of the yield curve; Congressional Budget Office estimates ( pdf); see Table 1; also Copyright 2018 Oliver Wyman 4

5 DEVELOP A DOWN-CYCLE COST MANAGEMENT PLAN During the last cyclical downturn, many banks experienced a painful squeeze to operating margins as top-line revenue declined faster than costs could be shed. (See Figure 2.) In many cases, the long-running focus by banks on revenue growth, with less emphasis on the cost side of the business, resulted in a lack of preparedness once the cycle turned. Figure 2: Net Banking Income and Non-interest Expense for U.S. Commercial Banks (Indexed) Top-line revenue declines into recession Squeeze Recession-related expenses increase, and many fixed costs are tough to reduce quickly Q4 average revenue Q4 average expenses Source: S&P Market Intelligence (data is for all U.S. commercial banks), Oliver Wyman analysis As we move towards the end of the current business cycle, the time is right to think through how costs will be handled as revenue softens. Management should certainly continue the hard work undertaken over the past five years to lower overall operating costs, develop a cost-conscious culture, and variabilize the bank s cost structure. This latter activity is particularly important going into a downturn, as it will help to support operating margins as top-line revenue weakens. But in an economic downturn, the priority shifts from continuously improving costs, to making swift and major decisions about which spending to stop. This involves categorizing and prioritizing all of the bank s costs, and then using this information to develop a downcycle cost management plan. Banks that do this will find themselves in a strong position to address the inevitable cost pressures that will come once the cycle turns. Copyright 2018 Oliver Wyman 5

6 HERE S WHAT TO DO: Inventory all of the bank s activities and the associated costs staff, thirdparty vendors, and others and profile their drivers and correlation to a cyclical downturn. Using a current year, line-item budget is a good place to start this process. Understanding how some costs will increase during a downturn such as collections costs, legal costs, and other expenses will be useful to the prioritization process below. Group each of the activities (and their costs) into one of three main categories: survival, strategic, and discretionary; then aggregate each category to understand whether managing discretionary costs will be sufficient to help support profitability when the cycle turns down: Survival activities are the very basic ones required for the bank to operate Strategic activities are those considered necessary for the bank to achieve its near- and medium-term objectives Discretionary activities are those that are not needed for survival or strategy they are all the remaining activities Use challenge sessions with activity owners and neutral/objective participants to move activities between categories, as warranted, and to keep a check on discretionary activities (and their costs) migrating into the survival or strategic categories. Develop a prioritized and sequenced plan of action to reduce or eliminate specific activities, starting with discretionary and then moving into strategic, based on agreed-upon bank performance triggers such as bank revenue forecasts showing a decline of X% in the next two quarters. Apply this approach to categorize and evaluate all proposed/new activities are they required for the bank s survival, or for achievement of nearterm strategic objectives? Or are they discretionary that can be completed in the near term, before the cycle turns? In an economic downturn, the priority shifts from continuously improving costs, to making swift and major decisions about which spending to stop Copyright 2018 Oliver Wyman 6

7 LINK A MODERATE DOWN-CYCLE SCENARIO TO NEAR-TERM STRATEGY Most large banks have spent years and significant financial and human resources building stress-testing and related infrastructure, primarily to comply with regulatory mandates. The main focus of these efforts has been to determine the impact on bank capital and liquidity from baseline (continued moderate economic expansion), adverse (moderate recession), and severely adverse (severe global recession) scenarios. From our experience, the task of performing the analysis is usually owned by a combination of a bank s finance, risk, and treasury functions. Oftentimes the CFO will present the findings from stress-test analyses to regulators, the CEO, and the board. If all looks good, a box is checked, and the business moves on. If issues arise, financial engineering solutions are often explored first, followed by tweaks to existing business activities. The typical goal is to remediate stress-test issues with minimum disruption to current businesses. The linkage to overall corporate strategy is weak. Yet the insights that surface from down-scenario planning are exactly what s needed to inform strategy late in the business cycle. Such insights such as which businesses appear to be disproportionate drivers of credit losses during a down cycle should spark highly productive conversations at the executive, board, and business levels around, for example, the down-cycle benefits of slowing some businesses and accelerating others, whether to acquire non-interest income generating businesses to diversify revenue or whether to exit some businesses. Banks that actively use stress testing can leverage existing infrastructure for this strategic exercise. Banks that do not have such infrastructure can perform down-scenario analyses using high-level financials and a set of reasonable assumptions for how different business drivers will be affected in a cyclical downturn. 5 While analytical rigor is important, it does not need to be at the level of a regulatory stress test. What s most important is to complete the analysis, and soon. 5 For a more holistic discussion of linking strategy to resource management and prioritization, see Oliver Wyman s Strategic Financial Resource Management ( Copyright 2018 Oliver Wyman 7

8 HERE S WHAT TO DO: Engage the bank s central strategy team and leaders from each major business unit as a single team to lead the effort. The teams traditionally responsible for these types of exercises finance, treasury, and others will be involved; however, strategy, working together with the business, will likely provide different perspectives and insights than the more technically-oriented teams. The bank s CEO should sponsor and support the effort, given its importance for strategy, the bankwide organizational involvement the effort entails, and the need to instill a sense of urgency. Assess the impact on bank KPIs (profitability, capital, and liquidity) from two or three likely down-cycle scenarios such as shallow recession, moderate short recession, moderate prolonged recession (but not a severely adverse scenario) leveraging existing stress testing infrastructure or creating high-level scenario models Identify the disproportionate drivers of negative performance and have the team leading the effort develop a preliminary list of insights, potential opportunities, and associated tradeoffs to mitigate their impact. Build consensus within the executive team on where we are in the cycle, the expected range of financial outcomes from the down-cycle analysis, and preliminary insights into the key drivers of performance; then solicit strategic options from the executive team to stabilize and/or maintain performance through each downcycle scenario. Prioritize each identified strategic option based on factors such as impact on financial performance, complexity to execute, and potential impact on competitive position; build consensus for those selected for implementation. Communicate and implement the selected strategic changes, adjusting the bank s strategic plan accordingly, tracking progress, and holding leaders tasked with execution responsible for delivery of results. The bank s CEO should sponsor and support the effort, given its importance for strategy, the bankwide organizational involvement the effort entails, and the need to instill a sense of urgency Copyright 2018 Oliver Wyman 8

9 PREPARE FOR OPPORTUNISTIC M&A With bank valuations well above their average over the past 10 years 6, M&A currently looks like an expensive strategy to grow the bank and/or build operating scale. However, when early signs of a cyclical downturn appear, valuations should soften quickly, thereby bringing many targets into an attractive range. Since competition can be fierce for weakened banks with good geographic and/or customer franchises, knowing in advance who to approach, the maximum price to pay, and who the competing suitors are likely to be (and their strengths and weaknesses as buyers), are all factors essential to M&A success. HERE S WHAT TO DO: Prioritize targets that help with the late-cycle checklist such as aquisitions that could meaningfully lower the combined bank s cost structure (thereby improving flexibility and long-term operating scale) and bring a fee-based business that the acquiring bank can leverage and expand. Get to know the CEO and/or board members of high-priority target banks now, on an informal basis. Except for financially troubled banks, which may be resolved by regulators or a worried board, the adage that most banks are sold, not bought typically holds true. Sellers want to know that their businesses and employees including members of the executive team are going to buyers who will value and retain them. Be extra diligent evaluating a target s loan portfolio, particularly when proceeding with an acquisition before the cycle has turned. Most acquiring banks use a due diligence approach that involves reviewing every criticized asset and sampling assets that are performing. Increasing sample sizes for performing loans should be considered, as should ensuring that the target s credit grading approach is sufficiently conservative; if it isn t, re-grading, followed by discounting, is appropriate. Ensure the board is prepped and ready for potential M&A, including the criteria that will be used to assess candidates, the formal processes and authorizations required by bank bylaws to permit an acquisition bid and bind the bank once acquisition terms have been reached, and the roles of the overall board, specific board members, and different board committees in the acquisition process. Beyond bank M&A, cyclical downturns typically bring opportunities to acquire businesses that other banks or venture capitalists are forced to shed, and talent that is looking for greener or at least more stable pastures. 6 Average of monthly price-to-book values for the SNL Financial U.S. banks >$10bn index from is 116.5% versus 133.3% in October 2018 Copyright 2018 Oliver Wyman 9

10 PRIME THE COLLECTION/RECOVERY FUNCTION For those bank executives who are thinking about a potential turn in the economic cycle, collections/recoveries are already top of mind. But for those who may not have physically visited or assessed the state of their collections operation for many years, the time to do so is now. Significant advances in collections technologies and techniques, such as approaches based on behavioral science and sophisticated digital channel techniques 7, mean that banks can improve both scale and outcomes with a low-to-moderate investment of time and resources. HERE S WHAT TO DO: Evaluate the current state of bank capabilities versus state-of-the-art to identify any major gaps; then prioritize areas and take action to close the most significant gaps. Pay particular attention to four high-impact areas: Ensuring that digital channels are properly equipped and available in collections, allowing customers to interact how and when they want, in the most efficient and effective manner for the bank Determining whether there is a plan regarding how customers will be reached with the right offer at the right time, and hence collecting more effectively and efficiently Establishing whether there s a process to proactively identify at-risk customers early, before the cycle turns; also, the accuracy and completeness of customer contact information, especially for at-risk customers Discerning whether behavioral and innovative techniques and advanced analytics, are being used to develop collections strategies tailored to individuals motivations to repay, rather than the traditional one-size-fits-all approaches that typically were used during the last cyclical downturn Define specific targets/ indicators for recoveries and collections performance based on the moderate down-cycle scenario discussed above. This exercise sets an expectation for how collections/recoveries will need to function and the performance it will need to deliver as delinquencies rise. Consider starting to cross-train non-collections servicing staff to handle collections accounts if it s not possible to make the investments needed to ensure the function is operating at or near state-of-the-art such as investment in digital channels, advanced analytics, and behavioral techniques. Additional collections capacity can be added faster, and generally at lower cost compared to contracted capacity, by temporarily importing staff into collections from other customer service functions, when needed. 7 For more insight on new approaches to collections, see Oliver Wyman s Digitally-enabled credit collections ( oliverwyman.com/our-expertise/insights/2018/jan/digitally-enabled-credit-collections.html) Copyright 2018 Oliver Wyman 10

11 Times are generally good for banks currently, thanks to macro-economic tailwinds and important operating improvements made by management in the years following the Great Recession. However, the natural cyclicality of the U.S. economy means a downturn will eventually come. Precisely when this will occur is unknown, but several previously green indicators are now flashing orange, and given our distance now (in months) from the last recession, there is clearly more downside risk now than upside. The good news is that strong bank earnings and the lack of an imminent downturn means management and boards have a window albeit narrow in which to review and focus on the late-cycle checklist that will make a difference when the cycle turns. Copyright 2018 Oliver Wyman 11

12 Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. For more information please contact the marketing department by at info-fs@oliverwyman.com or by phone at one of the following locations: AMERICAS EMEA ASIA PACIFIC Dan Rosenbaum is a partner in Oliver Wyman s San Francisco office. He focuses on regional bank, digital, and commercial banking strategy. He can be reached at Dan.Rosenbaum@oliverwyman.com The author would like to acknowledge and thank Alper Yildirim, Engagement Manager, for his valuable contributions. Copyright 2018 Oliver Wyman All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.