In the wake of the financial crisis, the “value” of a community bank is generally discussed in the context of the community: the relationship bankers have with their customers and community and their understanding of local economic conditions and opaque credit opportunities. In many cases, the community bank also stands as an important small business in the community, albeit as a credit provider and employer.
While these factors are important, another gauge of the “value” of a community bank is its ability to earn a fair return for its stakeholders. Without an adequate return to investors, retaining or even attracting new investment could become more difficult for community banks. This article examines the historical trend in community bank returns on equity (ROE) over the last 10 years and highlights the gap between current and historical pretax returns.
Return on equity is more than simply net income divided by average equity. It can be more completely expressed as return on assets (ROA) relative to an equity multiplier or, more simply, the degree of financial leverage at a bank. Return on equity can be further understood by employing a DuPont analysis technique. This technique dissects ROA into the sub-components that drive asset utilization, or total revenue/average total assets. From here a bank’s expense ratio can be segregated into the components that encompass total operating expenses/average total assets. More succinctly, this analysis breaks down bank or industry performance into revenue management and cost management.
Given the complication posed by the U.S. tax code, which drives many small, closely held banks to elect Subchapter S status, it may be preferable to consider ROE on a pretax basis. While pretax results do not eliminate all biases, they may help improve the comparability of community bank results.
Historically, a well-run community bank offered a predictable pretax ROE. As shown in Figure 1, average pretax ROE for banks $10 billion and under from 2002 through 2006 was an attractive 17.9 percent (and within a predictable range of 16.9 percent to 19.2 percent). A balance of revenue-collecting opportunities, a modest cost structure and appropriate leverage were the hallmarks of this performance.
The next five years proved more turbulent. From 2007 through 2011, the average pretax return on equity for community banks nationwide deteriorated to 13.3 percent at year-end 2007, turned negative in 2009 at -2.8 percent, and rebounded to a low but positive 8.4 percent by year-end 2011. This precipitous decline in pretax ROE is understandable given that the five-year average for provision expenses more than tripled to 0.91 percent of average assets, up from 0.29 percent during the previous five years. Of course, this adjustment was necessary to replenish loan loss reserves as commercial real estate and residential real estate loan losses skyrocketed.
An important but somewhat disguised trend, interrupted by the financial crisis, was that community bank returns on equity (excluding securities gains) were in a decadelong period of decline. The trend is illustrated in Figure 2. The decline was driven by a narrowing in the spread between asset utilization and operating expenses.
As bank health nationwide continues to recover after the financial crisis, it is possible ROE will settle in at a lower-than-precrisis historical rate, leading to a resetting of performance expectations by community bank stakeholders. This could be a transitional adjustment or may represent a structural change for the industry.
In either scenario, there may be important repercussions. For example, a lower return expectation might encourage consolidation between healthy institutions in order to gain greater scale and spread out operating costs. Alternatively, changing expectations may reshape the thinking of bank management on fixed investments, such as facilities, and further shift the emphasis to electronic delivery mechanisms. Only time will tell whether community banks will be able to return to precrisis levels of profitability.
Keep up with what’s new and noteworthy at the St. Louis Fed. Sign up now to have this free monthly e-newsletter emailed to you.
Fed in Print: An index of the economic research conducted by the Fed.