Reviewing Targeted Return on Equity Requirements

 Author: Joel Rosenberg, jrosenberg@profitstars.com

Loan volume and growth remains slow in most parts of the US while deposits continue to grow, even with many non-maturity rates as low as 0.10% at many institutions.  The result is that the average loan to deposit or loan to asset ratio has declined since first quarter 2009. Or, from a profitability point of view, more of the earning assets are in lowering yielding investments and not higher yielding loans.

The Loss of the 6% Floor

In 2009 and 2010 many institutions set a floor of 5.5% or 6.0% on most loans and kept to this floor. While there may not have been a lot of new business, mid-size and larger loans proved to be very profitable for most banks. The problem with these floors is, like any artificial control, they eventually get replaced by the marketplace. As long as the larger non-community banks were more interested in improving their charge-off problems rather than growing the business, these floors worked. Now, many of these larger banks are looking to grow and win back much of the business they lost over the past several years. Having a floor of 2.25% to 2.75% above Prime may result in profitable loans, but in order to compete these floors are rapidly disappearing. While the banks in general showed increased net interest margin in 2011, this was mainly due to declines in deposit funding costs. That avenue is becoming much more restricted. After all, how much lower can a bank price a non-maturity deposit than the current levels of 0.10 – 0.30%? As can be seen on the following chart, while the cost of deposits continues to decline, loan net income has fallen more significantly.  Declining loan yield and the smaller percentage of loans on the balance sheet is leading to declines in net interest margin.

Since it is likely that loan income will continue to decline somewhat and there may not be much room on the deposit cost side, the only way to increase Net Interest Margin (NIM) is to grow loans. As such a review of the bank’s targeted loan ROE may make sense in the current environment.

As an example, a $750,000 20 year amortizing 5 year fixed rate balloon commercial real estate loan at a rate of 6%, generates a 31.4% ROE (assumes 34% tax rate, 8.5% capital). At a minimum ROE target of 19%, this loan could be priced at 4.45% and still meet the minimum required profitability. However, in some parts of the country even 4.45% may not win the deal. The question then becomes should we lower our minimum ROE even more?  At a rate of 4.05% this loan would meet a 16% ROE target.

These are challenging times in terms of growing the loan portfolio.  However, there is business to be won, even if it means taking it from the competition. Having realistic ROE targets makes sense and reviewing an institution’s targets periodically is vital.