Regional Banks – Margin Sensitivity Driven by Deposit/Loan Ratio, not Gap Ratio

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

October 29, 2013

Regional BanksMargin Sensitivity Driven by Deposit/Loan Ratio, not Gap Ratio

  • While asset-sensitivity, as measured by the “gap ratio”, has caused bank stocks such as MTB, CMA, and KEY to be traded for leverage to a rising rate environment, it does not explain any meaningful portion of variation in net interest margins. In short, while the efficacy of the gap-ratio in forecasting stock price performance may be self-fulfilling, it has no basis in outcome net interest margins.
    • The year-ago gap ratio explained 60% of subsequent variation in stock price performance for our sample of regional banks, but only 4% of variation in net interest margin.
    • The reason is that more specific portfolio characteristics and the margin impact of management actions through a given period overwhelm the impact of the initial gap ratio.
  • We view MTB and CMA as over-valued and unsatisfactory plays on margin-expansion in an up-rate environment. We prefer WFC which will experience margin expansion as the high deposit-to-loan ratio of 127% (see Exhibit) normalizes with the yield curve.
  • KEY also has a high deposit-to-loan ratio but, over the last 3 years, has had an average cost of deposits of 1.26% (the highest in our sample) versus 0.41% at WFC (the lowest in our sample). We prefer WFC because this low-cost suggests customers are relatively rate-insensitive and hence that deposit balances less prone to attrition as rates rise.
  • While forward rates have fallen over the last 6 weeks (in part with the nomination of Janet Yellen as Fed Chairman), forward markets are still indicating meaningful rate increases from today: a 3-year swap rate of 2.1% by mid-2015 compared with 0.7% today and 6-month Libor of 1.1% compared with 0.35% today.

Exhibit: Rates on Loans and Deposits from 2009-2012 and 2013Q2 Deposit/Loan Ratios

Overview

Investors have bid-up the more “asset-sensitive” banks such as MTB, CMA, and KEY on the grounds that their net interest margins provide the most leverage to rising rates; as a result, these three banks depart from an otherwise strong relationship between valuation and forward return on tangible equity (see Exhibit 1).

Exhibit 1: Tangible Price/Book versus Forward Tangible Return on Equity

Indeed, MTB, CMA, and KEY are three of the four most positively gapped banks in our sample with gap ratios of 87%, 85%, and 77% respectively (see Exhibit 2). The gap-ratio is a measure of asset-sensitivity and is defined as a ratio whose numerator is the value of assets re-pricing or maturing within one year net of the value of liabilities re-pricing or maturing within one year, and whose denominator is the gross value of rate-sensitive assets re-pricing or maturing within one year.

Exhibit 2: Gap Ratios by Bank

Furthermore, the year-ago gap ratio in 2012Q3 explains 60% of the variation in stock price performance over the last year (see Exhibit 3) with two of the positive outliers, KEY and RF, being among the banks who have most increased the gap ratio over the period and the third, COF, having distinctive portfolio economics because of a tilt towards credit card loans.

Exhibit 3: Stock Price Performance and Year-Ago Gap Ratio

All of this would be unremarkable if the gap ratio actually explained net interest margin dynamics, but it does not. The 3-year swap rate increased 45 basis points over the period from 0.44% at end 2012Q3 to 0.79% at end 2013Q3 suggesting that positively-gapped banks should have tended towards margin expansion. In practice, only RF showed margin expansion (see Exhibit 4) and, more generally, the 2012Q3 gap ratio does not explain any meaningful portion of the variation in margin across the sample.

Exhibit 4: Net Interest Margin and Change over Last Year

The reason is that margin impact of management actions through the year overwhelmed the impact of the initial gap-ratio particularly given short rates fell (6-month Libor fell to 0.37% at end 2013Q3 from 0.64% at end 2012Q3) with ramifications for the deposit book, in terms of both flows and spreads. In short, while the gap-ratio may be a useful, because self-fulfilling, tool for forecasting short-run stock price performance it is not useful for forecasting margin dynamics.

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