Small Cap Banks: Deep Dive into ... - RBC Wealth Management

EQU

ITY

RESE

ARC

H RBC Capital Markets, LLCSteven Duong (Analyst)(207) [email protected]

September 1, 2020

Small Cap Banks: Deep Dive into Industry RevenueHeadwinds and Expected Expense CutsIndustry revenue headwinds may be more acute this cycle, but ourbanks have room to adjust• The banking industry has faced revenue headwinds for the last 20 years with cycle bottoms

occurring during recessions: Revenue pressure has come from cyclical interest rate headwinds andstructural factors, primarily from increased regulation, but also from increased competition and theimpact of technology. Net interest income has generally been in the range of 3.00-3.50% of averageassets, while noninterest income has steadily declined since the 4Q03 peak of 2.74% of average assetsand now stands at 1.38% in 2Q20. On an average assets basis, revenues have declined peak-to-trough16% in 4Q02-1Q09 and 21% 3Q10-4Q15 (p. 2).

• Despite these revenue pressures, banks have pushed the efficiency ratio down to the low 50% rangewith aggressive expense cuts and increased productivity (pp. 3-4): The efficiency ratio has generallyranged ~50-60% as banks have driven expenses down to 2.68% of average assets in 1Q19 from an ex-financial crisis peak of 3.62% in 3Q00, while productivity continues to rise as bank assets and PPNRcontinue to climb, but the level of employees has generally remained range-bound post financial crisisat an average of 2.07M FTEs. The pre-COVID efficiency ratio bottom was 53.3% in 1Q19.

• Three factors will drive dramatic expense reductions during and post-recession: 1) Accelerateddigital adoption and change in consumer and work behavior (p. 5); 2) low and flat interest rateenvironment not witnessed before (pp. 6-7); and 3) slow loan growth (pp. 8-10). We believe revenuepressures (items 2 and 3) may be more acute in this cycle than in prior cycles, requiring banks to relyeven more on item 1 to offset the revenue headwinds.

• How much can expenses decline by? (p. 11): We believe the industry will target a low 50% efficiencyratio, but individual banks will vary due to business mix and may focus on ROE/ROTCE instead. Webelieve revenue headwinds may be more challenging this cycle and may require more aggressiveexpense cuts. The prior two cycles saw expenses/assets decline 9-10% in ~2-4 years. Post-COVID, webelieve expenses/assets could decline 10-15% or higher within 2-4 years. For some of our coverage,just the expected further NIM contraction beyond FY21 alone would require FY21 expense cuts of upto ~15-20% to get ROATCE ex-PCL back to FY19 levels.

• What our banks are doing currently: We provide a more detailed overview on pp. 12-16. Notably,FCF has begun addressing the COVID-19 impact, with a recently announced profitability initiativethat includes consolidating 20% of branches by YE20 (~$8M savings). Ongoing profitability plansannounced prior to COVID-19 include SNV (~$100M by YE21) and BKU ($60M by YE21 w/$40Mexpense target well surpassed and early in 2Q20). VLY has an ongoing branch transformation initiativestarted in FY18 w/10 closings by YE on top of the 29 closed through 2Q20.

• Where we see further room for expense savings: Based on recent discussions with companies, webelieve our banks will focus on two areas: 1) branch consolidation which could provide the best returnwith further opportunities for a much deeper plan than previously thought and in a shorter timelinedue to the acceleration of digital from COVID-19; and 2) continued improvement in business processmanagement (BPM) with back-office digitalization and cloud computing.

• Our banks remain a good value proposition: We expect our banks to manage expenses lower, butdo not expect profitability to return to pre-COVID levels. That being said, we believe they remain agood value proposition, down 40% YTD and well below TBV in some cases. Our three favorite namescurrently are VLY, STL, and BKU.

Disseminated: Aug 31, 2020 06:01ET; Produced: Aug 31, 2020 06:01ETPriced as of prior trading day's market close, EST (unless otherwise noted).

All values in USD unless otherwise noted.For Required Conflicts Disclosures, see Page 17.

RBC Capital Markets2

The Banking Industry has Faced Revenue Headwinds for the Last 20 Years with Cycle Bottoms

Occurring During the Recessions

The charts to the right show the rolling 4-quarter average operating

revenues to average assets (top) and net interest income to average

assets and noninterest income to average assets (bottom) for banks $10B-

$250B in assets from the FDIC.

On an average assets basis, revenues declined 16% 4Q02-1Q09 and 21%

3Q10-4Q15. 2Q20 revenues are near 20-year lows.

Revenue pressure has come from cyclical rate headwinds impacting net

interest income, as well as structural factors impacting both net interest

income and noninterest income, primarily from increased regulation, but

also from increased competition and the impact of technology.

Net interest income has increased immediately post recession and ranged

~3.00-3.50% through a combination of NIM expansion and/or increased

loan growth. However, this cycle may be different (see pp. 6-10).

Noninterest income took a hit in the last cycle largely due to the impact of

increased regulation from the Dodd-Frank Act (DFA) and has continued to

trend lower, most likely due to increased competition and the digitalization

of banking. We do not see regulatory headwinds in the next cycle at the

same level as post financial crisis, but the regulatory environment is riskier

for banks if there is a change in political regime and the economic and

unemployment environment remains difficult, in our view.

Source: FDIC. Data is for banks with $10B-$250B in assets.

Operating Revenues/Average Assets

2Q005.96 %

3Q015.79 %

4Q026.15 %

1Q095.14 %

3Q105.78 %

4Q154.59 %

4Q185.03 %

2Q204.65 %

4.5%

5.0%

5.5%

6.0%

6.5%

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Op

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Recession Rolling 4-Qtr Operating Revenues/Average Assets

Net Int Inc/Avg Assets and Nonint Inc/Avg Assets

3Q002.77 %

4Q012.60 %

4Q032.74 %

2Q092.02 %

4Q092.24 %

2Q201.38 %

2Q003.19 %

3Q013.13 %

3Q023.51 %

2Q083.01 %

4Q103.85 %

4Q152.98 %

1Q193.54 %

2Q203.27 %

1.25%

1.75%

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2.75%

3.25%

3.75%

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Net

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Recession Rolling 4-Qtr Nonint Inc/AA Rolling 4-Qtr Net Int Inc/AA


Banks have Pushed Efficiency Ratios Down to the Low 50% Range with Aggressive Expense Cuts…

The top right chart gives the efficiency ratio and the bottom right chart

gives the noninterest expense to average assets ratio for all FDIC-insured

banks $10-$250B in assets.

Generally, through-the-cycle efficiency ratios have ranged 50-60%,

excluding the financial crisis peak.

The 4Q02-1Q07 period saw the efficiency ratio range ~53-54% despite the

revenue headwinds as banks drove expenses down to 3.00% of assets in

1Q07 from 3.31% of assets in 4Q02, representing a 9.2% decline in

expenses.

Immediately after the financial crisis, the efficiency ratio bottomed out in

4Q10 at 51.8% as revenues jumped and expenses bottomed out at 2.97%

of assets in 4Q10. Subsequently, the efficiency ratio peaked in 3Q12 at

60.1% as revenues declined and expenses increased to 3.10% of assets,

most likely due to elevated investments, potentially some mortgage-related

litigation expense, and elevated workout expenses, in our view. Expenses

declined through 4Q15 to 2.71% of assets where it remained range-bound

through 2019. As NIMs improved from increasing interest rates

subsequently, the efficiency ratio grinded lower to a bottom of 53.3% in

1Q19. Expenses declined 14% during the 3Q12-1Q19 period.

Efficiency Ratio

3Q0060.9 %

4Q0253.8 %

1Q0753.7 %

4Q1051.8 %

3Q1260.1 %

1Q1953.3 %

2Q2059.9 %

50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

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Recession Rolling 4-Qtr Efficiency Ratio

Source: FDIC. Data is for banks with $10-$250B in assets.

Noninterest Expense/Average Assets

3Q003.62 %

4Q023.31 %

1Q073.00 %

4Q102.97 %

3Q123.10 %

1Q132.98 %

4Q152.71 %

1Q192.68 %

2Q202.79 %

2.6%

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No

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Recession Rolling 4-Qtr NIE/Avg Assets


…but also Through Increased Productivity

The top chart on the right plots the level of assets per employee with

the level of employees and the bottom chart plots the level of PPNR

per employee with the level of employees for all FDIC-insured

institutions.

During the 1Q02-4Q07 period, FTE employees grew rapidly, peaking

in 1Q07 at 2.22M. Despite the rapid growth in employees, banks were

able to increase assets per employee and PPNR per employee.

Subsequent to the financial crisis, the number of employees bottomed

out at 2.03M in 1Q10, down 8.8% from the 1Q07 peak. The 4Q09-

2Q20 period has averaged 2.07M employees and the current level is

2.08M. Despite the number of employees remaining relatively steady,

assets continued to climb, reaching $9.04M per employee in 4Q19

(pre-PPP loans), and now at $10.17M (includes PPP-loans). PPNR

per employee climbed subsequent to 1Q15 as NIM pressure eased

and reached a peak of $173K per employee in 2Q19, and is now at

$160K per employee due to the impact of the interest rate

environment.

Source: FDIC. Data is for all banks.

Assets per Employee

4Q199.04

2Q2010.17

1Q072.22

2Q202.08

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1.90

1.95

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Emp

loye

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M)

Ass

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Em

plo

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($M

)

Recession Assets/Employee Employees

Average: 2.07High: 2.11Low: 2.03

4Q09-2Q20 Employees (M)

PPNR per Employee

2Q19173

2Q20160

1Q072.22

2Q202.08

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($0

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Recession Rolling 4-Qtr PPNR/Avg Employee Employees

Average: 2.07High: 2.11Low: 2.03

4Q09-2Q20 Employees (M)


Factors that will Drive Expense Reductions During and Post COVID Recession: Accelerated Digital

Adoption and Change in Consumer and Work Behavior

Though digital adoption has been growing post financial crisis, COVID-19 has accelerated this trend meaningfully by perhaps 4-5 years and may have altered our

lives and society in more permanent ways. The pandemic has taught society how to continue on with life and run an economy as best as possible with deeper

reliance on and support from technology.

E-commerce has been growing, but COVID-19 has made certain fringe types of online purchases more acceptable and mainstream, such as online orders for

groceries. Go to a Whole Foods today and you can see workers filling up bags of online orders. One could imagine that those who order groceries online out of

necessity today may end up preferring to shop this way and continue on after a year or so when the pandemic is over.

We also see a surge in online and mobile banking from our own banks which, in some instances, reported triple the level of their deposit account openings via

mobile and saw double the level of mobile deposits. One could imagine that those previously hesitant of banking digitally may have their apprehensions

permanently eased and realize the convenience of digital to the point that they may only venture to a branch in unique circumstances.

Online education has not only become more common and accepted, but in many instances is critical to continuing education under COVID-19 as some school

systems have opted to go remote this upcoming semester and others are taking a hybrid approach. The implications on how to educate and the cost and value of

certain degrees are quite large.

Virtual meetings, or “Zoom” meetings, in the business world once thought of as uncouth and second tier have not only been accepted, but in some instances,

preferred as senior leaders are able to join meetings that budget and time constraints once prohibited. Zoom meetings have also sprouted into increased

popularity and usage of teleservices, such as telehealth where health-related services are distributed digitally.

With the acceptance of Zoom meetings, so too has been the acceptance of work-from-home (WFH). Sure, WFH won’t work for most of the workforce, but maybe

5%, 10%, or 15%? Or perhaps the whole concept of the 5-day in-office work week changes to 4 days in office and one WFH. Or WFH for a month in the summer

in a distant location to spend time with ones’ family. Perhaps WFH days will be another bargaining chip companies can offer to attract talent, in addition to paid-

time-off.

The impacts to society, business, and the economy from COVID-19 are deeply profound. We expect the increased familiarity and comfort with all things digital

from a much broader community will open doors to new avenues and ways of doing business, similar to the emergence of the sharing economy subsequent to the

financial crisis with the rise of Uber and AirBnB. We believe these changes will offer banks new opportunities to go deeper, wider, and quicker towards digital

delivery of products and services and business process management (BPM) that may offer opportunities for significant expense reductions and increased

productivity that once may not have been feasible.


Factors that will Drive Expense Reductions During and Post COVID Recession: Low and Flat Interest

Rate Environment Not Witnessed Before

In the last two credit cycles, net interest income increased immediately

post recession through a combination of NIM expansion and/or increased

loan growth (p. 2).

NIM expansion in this interest rate cycle will be challenging, in our view.

The top right chart plots NIMs for banks $10B-$250B in assets that are

FDIC-insured. Going back to 1990, NIMs have expanded during and

slightly after recessions.

NIMs expand when the yield curve steepens as banks typically borrow on

the short end of the yield curve and lend on the middle to long end of the

yield curve.

The bottom right chart plots the average treasury yield for the 3-month

(short end), 2-year and 5-year (middle), and 10-year (long end) treasuries.

Heading into and through a recession, yield curves have steepened largely

due to the short end declining precipitously, while the middle and long end

declined more moderately, creating a wider spread between the short end

and the middle and long end of the yield curve.

Given that current average yields are 0.63% for the 10-year, 0.27% for the

5-year, 0.14% for the 2-year, and the 0.12% for the 3-month, the historical

modus operandi for steepening the yield curve by lowering the front end

will likely have de minimis impact given the paltry 12bps of room to work

with on the 3-month.

It appears that the yield curve can only steepen in one of two ways: 1)

either the front end goes negative or 2) the long end rises. Negative rates

do not appear as a likely outcome currently as the Fed has noted their

resistance and there may be structural complications with the U.S. money

markets. As for the long end rising, historically, since 1981, there have

been pockets of upticks in the 10-year, but the long-term trend has been

declining from an average peak yield of ~15% in 3Q81 to the sub-1%

range currently. The chart on the next page overlays 10-year average

quarterly yields with average GDP growth of each expansionary period

(periods in between recessions) going back to 1950. Through different

political parties, wars, tax regimes, economic and monetary theories, etc.,

long-term economic growth has been declining, and 10-year yields have

tracked this trajectory for the last 40 years. It appears that other factors

drive GDP growth and interest rates merely reflect this reality. We do not

see long end rates rising meaningfully for a sustained period at this time.

Source: FDIC. Data is for banks with $10B-$250B in assets.

Treasury Yields: 10-Yr, 5-Yr, 2-Yr, 3-Mo

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Yie

lds

(%) Recession

10-Yr: 0.63%

5-Yr: 0.27%

2-Yr: 0.14%

3-Mo: 0.12%

Source: U.S. Treasury.

Net Interest Margin

2.9%

3.1%

3.3%

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3.7%

3.9%

4.1%

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4.7%

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NIM

Recession NIM


Factors that will Drive Expense Reductions During and Post COVID Recession: Low and Flat Interest

Rate Environment Not Witnessed Before

7.1 %

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4.9 % 5.2 %

4.3 %4.5 %4.3 %

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— %

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sury

Yie

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rage

GD

P G

row

th

Recession

1Q50-3Q53

3Q54-3Q57

3Q58-2Q60

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1Q71-4Q73

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4Q80-3Q81

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1Q02-4Q07

3Q09-4Q19

10-Yr Yield

Average GDP Growth during Expansionary Periods vs. Average Daily 10-Year Treasury Yields

Source: Federal Reserve Bank of St. Louis; RBC Capital Markets


Factors that will Drive Expense Reductions During and Post COVID Recession: Slow Loan Growth

The chart on the top right compares average total loan growth for the last

three expansionary periods (periods between recessions).

The last cycle expansionary period of 3Q09-4Q19 exhibited the slowest

growth at 2.8% on average, compared to 8.2% in the 1Q02-4Q07 period

and 4.7% in the 2Q91-1Q01 period.

The slower rate of growth in the beginning of the 3Q09-4Q19 period was

likely due to the scarring from a deeper and more protracted recession

than in the prior cycles. The bottom right chart focuses on this period. It

took 12 quarters from 3Q09 for loan growth to reach 3% in 3Q12 and

another 7 quarters for loan growth to break 4% in 2Q14. Loan growth

peaked in 1Q16 at 6.9% for 3 quarters before declining to an average of

4.2% for the period 1Q17-4Q19.

The spike in loan growth in 1Q20 and 2Q20 was due to PPP loans.

The next page covers the near-term headwinds for loan growth (the next

1-2 years).

The subsequent page covers the middle-term headwinds for loan growth,

which touches on why we believe loan growth declined in the 1Q17-4Q19

period to 4.2% from 6.9% in 1Q16.

Source: Data is for all banks

Loan Growth Loan Growth 1Q08-2Q20

Avg 3Q09-4Q192.8 %

Avg 1Q02-4Q078.2 %

Avg 2Q91-1Q014.7 %

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YoY

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Recession YoY Loan Growth

Loan Growth 1Q08-2Q20

4Q09(7.5)%

3Q123.2 %

2Q144.9 %

1Q166.9 %

Avg 3Q09-4Q192.8 %

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YoY

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Recession YoY Loan Growth

Average 1Q17-4Q19: 4.2%


Factors that will Drive Expense Reductions During and Post COVID Recession: Slow Loan Growth in

the Near-Term

The three charts here plot the three major loan types (C&I, CRE, and

residential) with the corresponding Senior Loan Officer Survey (SLOS) net

percentage of respondents tightening standards (axis is reversed) published by

the Federal Reserve, which have been good leading indicators for loan growth

as it relates to credit concerns for the next 12-24 months.

The latest survey suggests a foreboding sign for loan growth for the next 12-24

months. Tightening at current levels has foreshadowed negative loan growth for

the last three cycles when the survey began in 1990.

The top right chart is for C&I loans. The 3Q20 reading of 71.2 is the highest

except for 4Q08 of 83.6, which saw a 19% YoY decline in 4Q09 (12-mo lag).

The bottom right chart is for total CRE. Similarly to C&I, the 74.2 reading is

highest next to the 87.0 reading in 4Q08, which saw an 8.8% YoY decline in

1Q11 (~24-mo lag).

The bottom left chart is for 1-4 residential loans. Same story here where the

54.7 reading in 2Q20 is second highest to the 74.0 reading in 3Q08, which saw

YoY negative loan growth for 15 quarters. Given the levels of forbearance and

decline in rates, the potential decline in residential loans may be delayed.

Source: Loan growth data from FDIC for all banks. Senior Loan Officer Survey (SLOS) from the Federal Reserve.

Note: Total CRE = nonfarm nonresidential + multifamily + construction and land development. CRE SLOS for 4Q13 and after is the average of nonfarm nonresidential, multifamily, and construction and land

development due to breakout change.. 1-4 residential SLOS uses the prime survey 2Q07-4Q14 and the GSE eligible survey 1Q15 and after due to breakout change.

C&I Loan Growth vs. Senior Loan Officer Survey

2Q9054.4

1Q0159.6 4Q08

83.6

3Q2071.2 4Q91

(10.0)%

2Q02(8.4)% 4Q09

(18.7)%

(40)

(20)

0

20

40

60

80

100-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1Q

90

3Q

91

1Q

93

3Q

94

1Q

96

3Q

97

1Q

99

3Q

00

1Q

02

3Q

03

1Q

05

3Q

06

1Q

08

3Q

09

1Q

11

3Q

12

1Q

14

3Q

15

1Q

17

3Q

18

1Q

20

SLO

S %

Tig

hte

nin

g (%

Rev

erse

d)

YoY

Loan

Gro

wth

Recession YoY Loan Growth SLOS % Net Tightening

Total CRE Loan Growth vs. Senior Loan Officer Survey (All CRE Average)

3Q9069.8

1Q0246.3

4Q0887.0

3Q2074.2 4Q91

(8.2)%

3Q028.8 %

1Q11(8.8)%

(40)

(20)

0

20

40

60

80

100-10%

-5%

0%

5%

10%

15%

20%

1Q

90

3Q

91

1Q

93

3Q

94

1Q

96

3Q

97

1Q

99

3Q

00

1Q

02

3Q

03

1Q

05

3Q

06

1Q

08

3Q

09

1Q

11

3Q

12

1Q

14

3Q

15

1Q

17

3Q

18

1Q

20

SLO

S %

Tig

hte

nin

g (%

Rev

erse

d)

YoY

Loan

Gro

wth


1-4 Family Residential Loan Growth vs. Senior Loan Officer Survey

3Q0874.0

3Q2054.7 4Q08

(8.8)%

(40)

(20)

0

20

40

60

80-10%

-5%

0%

5%

10%

15%

20%

1Q

90

3Q

91

1Q

93

3Q

94

1Q

96

3Q

97

1Q

99

3Q

00

1Q

02

3Q

03

1Q

05

3Q

06

1Q

08

3Q

09

1Q

11

3Q

12

1Q

14

3Q

15

1Q

17

3Q

18

1Q

20

SLO

S %

Tig

hte

nin

g (%

Rev

erse

d)

YoY

Loan

Gro

wth



Factors that will Drive Expense Reductions During and Post COVID Recession: Slow Loan Growth in

the Middle-Term

The prior page highlighted tightening credit standards, which have been a

good leading indicator of loan growth for the next 12-24 months.

Beyond credit quality, interest rates have been a factor on loan growth as

well.

In looking at YoY loan growth vs. different parts of the yield curve, we

found that the front-end of the curve was generally a good leading

indicator for loan growth.

The top right chart plots YoY loan growth with the 3-month treasury yield

lagged 8 quarters (i.e., the yields actually occurred 8 quarters earlier) to

visually line up with loan growth.

Aside from the correlation, the big takeaway that we see is the

following:

In each of the last three cycles spanning 30 years, it took ~500bps of

decline in the 3-month yield to lift loan growth to an acceptable level

(8.03% to 3.03%, 6.20% to 0.93%, and 5.11% to the zero bound).

The last cycle required the 3-month yield to remain at the zero bound

for an unprecedented period of time (below 30bps for 30 quarters).

The impact of a move on the 3-month yield can be seen more readily in

the recent decline in the 1Q16-3Q16 average loan growth of 6.8% falling to

4.2% in the 1Q17-4Q19 period. The chart on the bottom right takes out the

8-quarter lag on the 3-month yield (yields occur in the period reported). We

can see that the decline in loan growth becomes noticeable once the 3-

month yield increases to ~0.60% (note that the spikes in loan growth for

1Q20 and 2Q20 are most likely driven by PPP loans, not a decline in the

3-month yield, in our view).

Assuming the industry goes through a period of loan contraction

due to credit for the next 12-24 months as the SLOS suggests in the

prior page, and if a 500bps decline in front-end rates along with

potentially maintaining the front-end at the new lower bound for an

extended period of time is required to spur loan growth, then we

think the outlook for loan growth is ominous for the industry for

possibly the next five years or so.

Source: U.S. Treasury; FDIC. Data is for all banks

Loan Growth vs. 3-Mo Treasury Yield (Lagged 8-Qtrs) Loan Growth vs. 3-Mo Treasury Yield (Not Lagged)

8.03 %

3.03 %

6.20 %

0.93 %

5.11 %

1Q110.21 %

2Q180.26 %

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%-10%

-5%

0%

5%

10%

15%

1Q

90

2Q

91

3Q

92

4Q

93

1Q

95

2Q

96

3Q

97

4Q

98

1Q

00

2Q

01

3Q

02

4Q

03

1Q

05

2Q

06

3Q

07

4Q

08

1Q

10

2Q

11

3Q

12

4Q

13

1Q

15

2Q

16

3Q

17

4Q

18

1Q

20

Trea

sury

Yie

ld (

Rev

erse

d)

YoY

Loan

Gro

wth

Recession YoY Loan Growth 3-Mo (Lagged 8-qtrs)

Loan Growth vs. 3-Mo Treasury Yield (Not Lagged)

1Q192.44 %

4Q09(7.5)%

1Q166.9 %

3Q173.5 %

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Trea

sury

Yie

ld (

Rev

erse

d)

YoY

Loan

Gro

wth

Recession YoY Loan Growth 3-Mo

Average 1Q16-3Q16: 6.8%Average 1Q17-4Q19: 4.2%


How Much Can Expenses Decline By?

We believe banks will continue to target the efficiency ratio down in the low

50% range, similar to the last two cycles (p. 4 top right chart), but

individual banks will vary due to business mix and may focus on

ROE/ROTCE instead.

Therefore, the expected decline in expenses will likely be predominantly

dictated by revenue pressure.

The top right chart plots net interest income to average assets with loan

growth and the NIM. In the last cycle, net interest income was generally in

the 3.00-3.50% of average assets range (excluding the 4Q10 peak), where

periods of an expanded NIM supported periods of slow loan growth,

periods of increased loan growth supported periods of NIM pressure, and

optimal net interest income was reached in 1Q19 when both were

relatively elevated.

This upcoming cycle appears much more challenging as we highlighted

the difficulty in expanding the NIM and the challenges facing short-term

and middle-term loan growth that will be meaningful headwinds for net

interest income. In addition, noninterest income may continue to decline as

digitalization and competition may continue to eat into this revenue stream

(refer to p. 3 bottom right chart).

Therefore, we believe banks may need to be more aggressive in reducing

expenses in this cycle than in prior. The bottom right chart shows the

expense declines for the last two cycles from stable expense peaks to

stable expense troughs. The 3Q02-1Q07 period saw expenses as a

percent of assets decline 9.8% in ~4 years. The 1Q13-4Q15 period saw

expenses as a percent of assets decline ~9.2% in ~2-3 years. Post-

COVID, we could see expenses decline 10-15% within 2-4 years

depending on the economic recovery and revenue pressures. We

would not be surprised if banks exceeded this range.

Source: FDIC. Data is for banks with $10-$250B in assets.

Noninterest Expense/Average Assets

3Q023.33 %

1Q073.00 % 1Q13

2.98 %

4Q152.71 %

2.6%

2.8%

3.0%

3.2%

3.4%

3.6%

3.8%

1Q

00

4Q

00

3Q

01

2Q

02

1Q

03

4Q

03

3Q

04

2Q

05

1Q

06

4Q

06

3Q

07

2Q

08

1Q

09

4Q

09

3Q

10

2Q

11

1Q

12

4Q

12

3Q

13

2Q

14

1Q

15

4Q

15

3Q

16

2Q

17

1Q

18

4Q

18

3Q

19

2Q

20

No

nin

tere

st E

xpen

se/A

vg A

sset

s

Recession Rolling 4-Qtr NIE/Avg Assets

1Q13-4Q15: -9.2%

3Q02-1Q07: -9.8%

Net Interest Income/Average Assets, Loan Growth, NIM

2.75 %

2.95 %

3.15 %

3.35 %

3.55 %

3.75 %

3.95 %

4.15 %

4.35 %

4.55 %

4.75 %

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

NIM

& N

et In

t In

c/A

vg A

sset

s

YoY

Loan

Gro

wth

Recession Rolling 4-Qtr Net Int Inc/AA YoY Loan Growth NIM

Source: FDIC. NIM & net int inc/AA is for banks with $10-$250B in assets, loan growth is for all banks.


Current Efficiency/Profitability Initiatives

Company Mkt Cap

($B)


People's United

Financial, Inc.

$4.6 • No formalized initiatives currently: PBCT does not have currently a formalized expense/profitability initiative. Below

are key items that touch on expenses/profitability. Their average trailing 4-qtr efficiency ratio is 54.4%.

• UBNK cost savings: 55% cost savings ($88M) from reduction in FTEs, branch consolidation, elimination of public

company costs. On track to realize 75% in FY20 and 100% after.

• Business Transformation Office (BTO): The BTO was in the works for a few months and formally announced in

August 2020. The BTO will focus on digitization, product strategy and management, process optimization, and Fintech

partnerships as COVID-19 has sped up client digital adoption.

• Bots and Automation: PBCT has a robotic process automation team that is capable of extracting data, such as

information for PPP loans and BSA compliance.

• In-store branches: PBCT has ~150 full service "stop & shop" branches in a hub & spoke model. These stop & shop

branches are open 37% more hours/week and have 37% less in expenses vs. traditional branches.

New York

Community

Bancorp, Inc.

$4.3 • No formalized initiatives currently: NYCB does not have currently have a formalized expense/profitability initiative.

Below are key items that touch on expenses/profitability. Their average trailing 4-qtr efficiency ratio is 47.6%.

• Systems conversion to cloud: NYCB converted its core systems to Fiserv’s cloud product from its locally-maintained

platform. We expect to see expense savings in 4Q20 with most of the savings coming from the elimination of

maintenance costs as fewer employees will be needed.

• Updating digital: NYCB will be launching its new mobile app and online banking product with Zelle the end of August.

• Bots and Automation: Started looking into bots last year and currently using in several departments. NYCB is planning

on expanding throughout the company. There remains a significant amount of paper processes that could be converted

to digital.

• Work-from-home (WFH): The company believes that there will be some permanence to WFH option as companies are

realizing that offering this option may make sense for certain positions. From the company’s standpoint, WFH may open

more hiring opportunities in lower-cost areas.

Valley National

Bancorp

$3.1 • No formalized initiatives currently: VLY does not currently have a formalized expense/profitability initiative except for

completing its branch transformation by the end of the year. Below are key items that touch on expenses/profitability.

Their average trailing 4-qtr efficiency ratio is 50.5%.

• Branch transformation: Started program in FY18 that looked at branch profitability and implemented FY19 w/74

branches identified, of which 20 closed by 1Q19. Another 9 closed 1Q20 (6 related to ORIT acquisition). Expecting

another 10 for remainder of FY20. COVID-19 has sped up client digital adoption, which may allow for further changes to

the branch footprint in a shorter timeline.

• Transformations in FY17-19: Began focusing on cloud architecture, data hub and big data in FY17. FY18 saw use of

Salesforce, nCino, and Encompass, the start of branch transformation, enhanced treasury services, cloud/streamlined

loan origination, and instant issue debit cards. FY19 saw implementation of data center, core banking, and branch

transformations.


Current Efficiency/Profitability Initiatives (cont’d)

Company Mkt Cap

($B)


Synovus Financial

Corp.

$3.3 • Synovus Forward: Profitability initiative announced in the beginning of FY20 w/~$100M pre-tax income target to be

fully achieved by end of FY21 on a run-rate basis.

• ~$45-$65M to come from expense savings: ~$25M from 3rd party spend, ~$20M organizational efficiency,

~$10M real estate consolidation. Contract renegotiations to drive 3rd party spend that should span throughout

FY21 as contracts expire with benefit in various expense lines. Organizational efficiency to be driven by

elimination of business layers with impact on the salaries line. For real estate, we estimate SNV achieved

~$1.5-$2M of the $10M target in 2Q20.

• ~$35-$55M to come from revenue initiatives: ~$20M from enhancements in analytics and sales capabilities,

~$15M from optimization of pricing tools and execution, ~$10M from targeted growth opportunities. Overall

objective is to provide a more complete relationship.

• Expanded COO role unified go to market team in FY18: SNV reorganized its business lines in FY18 to Community

Banking, Wholesale Banking and Financial Management Services, with all reporting to an expanded COO role at the

end of FY18. Originally, the COO position only primarily led the Technology and Operations team, but now is the single

point of leadership for the business lines, Technology and Operations team, and the Product and Treasury Management

team.

• Efficiency ratio: Their average trailing 4-qtr efficiency ratio is 54.9%.

Webster Financial

Corporation

$2.6 • No formalized initiatives currently: WBS does not currently have a formalized expense/profitability initiative. Below


• Continued investments in infrastructure: WBS increased its infrastructure investment YoY by $2.1M in 1Q20 and

another $1.7M in 2Q20. The company has been working on business process automation in the middle and back office,

which should lead to reduced headcount.

• Opportunities to shrink the real estate square footage: WBS noted how consumer preferences are changing with

more effective delivery of products and services digitally leading to less reliance on banking centers. Management

expects to be more aggressive in managing the real estate square footage along with others in the industry.



Company Mkt Cap

($B)


Sterling Bancorp $2.4 • Advanced Digital Technology Program: STL entered into a strategic partnership with Deloitte in 4Q19 to implement

its Advanced Digital Technology Program, which focuses on deploying leading technologies in the delivery of products

and services to clients, middle and back office operations and IT infrastructure. The initial phase focuses on 4 areas:

• Migration to a cloud-based technology infrastructure that is designed to substantially improve data processing

capabilities and information security (originally had 3 data centers, now down to 2 and 1 is going to the cloud).

• Deployment of robotics process automation (RPA) technologies to streamline bank operations. The company

began implementing RPA late last year.

• Enhanced digital banking applications to expand self-service capabilities and speed to market for new banking

products and services.

• Deployment of AI-enabled virtual, Digital Assistants to significantly enhance customer service experiences

across multiple channels. STL recently announced its new AI virtual assistant, “Skye.” STL estimates that Skye

would resolve 50% of the inquiries and would initially handle all of the 3+ million customer service calls each

year. We expect Skye will offer some improvement in headcount, while also allowing the company to grow

without compromising on customer service.

• Branch rationalization and staffing: Upon acquiring Astoria Financial in 4Q17, STL increased its financial centers to

128 from 40 and has been focused on consolidating its footprint ever since, which stands at 78 as of 2Q20. The

company expects to close an additional 2 financial centers in 2H20, bringing total FY20 consolidation to 6 financial

centers. We believe there may be further opportunities for consolidation and re-staffing in the future as the company

experiments with different ways to cover its footprint and reallocate resources. We also believe there may be further real

estate reduction related to the back office in the future.

• Digital bank: STL launched its digital bank, Brio Direct, in mid-2019, which provides a channel for low all-in cost deposit

generation.




Company Mkt Cap

($B)


BankUnited, Inc. $2.1 • BU 2.0: BU 2.0 is a profitability initiative announced in the beginning of 2019 with a pre-tax income target of $60M by

2021, of which, $40M from cost savings and $20M from revenue lift.

• The initiative centered around the following:

• Reorganizing its structure to focused commercial verticals.

• Launching and enhancing products to deepen relationships, such as launching a corporate purchasing

card and enhancing its treasury management product and operations that include an improved pricing

model and re-vamped sales strategy.

• Focusing on small business opportunities by optimizing its branch network, enhancing its sales force

effectiveness, and re-launching its small business platform.

• Streamlining its credit and risk structure that includes reducing time to close and an automated

underwriting platform initially for loans under $250K.

• Improving operational efficiency through improving vendor spend and RPA and process re-engineering.

• BKU surpassed its $40M cost savings in 2Q20, well earlier than expected, reaching $47M and believes there

could be further opportunities around the real estate footprint, further automation, and optimizing vendor spend.

BKU is still targeting $20M in revenue lift, but the timing is delayed. The commercial purchasing card is

launching in 3Q20 and small business initiatives are proceeding. The automated underwriting platform is

delayed and launching later this year with a parallel test run to understand effectiveness. Treasury management

continues to be an area of significant enhancements.

• Cloud technology: BKU partnered with Amazon and expects to be able to shut down its internal server farm by YE.

• Goldman Sachs partnership: BKU announced its partnership with Goldman in early July to provide investment

advisory and retirement plan consulting services to its corporate clients. The partnership allows BKU to provide a

missing piece in its product suite, while remaining focused in its areas of strength without incurring overhead and

generating additional fee income.

• New customer derivative platform: BKU launched a new customer derivative platform that is improved with better

economics than the previous provider.




Company Mkt Cap

($B)


Investors

Bancorp, Inc.

$2.0 • No formalized initiatives currently: ISBC does not have currently a formalized expense/profitability initiative. Below


• Gold Coast cost savings: 45% cost savings (~$4M) with 75% in FY20 and 100% after with the potential to realize

even more savings.

• Significant investments made pre-COVID:

• Systems and platforms: On the systems side, ISBC made meaningful investments in its systems to reach

BSA/AML compliance and have the restrictions lifted at the end of 2018. ISBC uses Fiserv cloud-based

platform.

• Products: On the product side, ISBC developed a new loan origination system that included the nCino platform

with SalesForce, an enhanced cash management product suite, a more functional mobile app and online suite

that includes Zelle, and an online escrow product. Since COVID, mobile deposits and Zelle transactions have

doubled from pre-COVID levels with online banking enrollment and active users up as well. The increased client

use of digital helped to offset the decline in branch traffic. We expect this trend may be permanent post-COVID,

which may allow for a rethinking of the branch footprint, in our view. The company has done some branch

consolidation, but not anything meaningful in our view.

Provident

Financial

Services, Inc.

$1.1 • No formalized initiatives currently: PFS does not have currently a formalized expense/profitability initiative. Their

average trailing 4-qtr efficiency ratio is 58.0%.

• SB One Bancorp cost savings: 30% cost savings (~$13.5M fully achieved in FY21) with ~16% from compensation

and benefits and ~10% from data processing contracts, as well as 3 branch closings. 75% in FY20 and 100% after with

the potential to realize even more savings.

First

Commonwealth

Financial

Corporation

$0.8 • Project THRIVE: Project THRIVE was announced during its 2Q20 earnings call with two dozen initiatives:

• 20% branch reduction: FCF plans to reduce its branch footprint by 20% by the end of the year, which is

expected to generate $8M in branch costs with $6M falling to the bottom line after re-investment, and would

help to keep the company’s near-term quarterly expenses in the $51-$52M range. Planning began about 2-3

months earlier as the impact of COVID became more evident. Most of the branches are in legacy markets with

the highest deposit concentration (~2/3 in western PA, 1/3 in OH). Depending on the environment, we believe

further branch rationalization is possible.

• Other projects include the launch of its corporate treasury management platform for corporate banking in June,

upgrading to third generation Zelle (currently using a Jack Henry product), and development of fourth

generation integrated online mobile banking.

• In 2Q20, FCF opened 992 deposit accounts via its mobile online platform, which is 3x 1Q20. We expect this

trend is likely to remain permanent and may shift further investments and branch rationalization down the road.


Companies mentionedBankUnited, Inc. (NYSE: BKU US; $23.38; Outperform)First Commonwealth Financial Corporation (NYSE: FCF US; $8.20; Sector Perform)Investors Bancorp, Inc. (NASDAQ: ISBC US; $7.75; Outperform)New York Community Bancorp, Inc. (NYSE: NYCB US; $9.05; Outperform)People's United Financial, Inc. (NASDAQ: PBCT US; $10.58; Sector Perform)Provident Financial Services, Inc. (NYSE: PFS US; $13.18; Sector Perform)Sterling Bancorp (NYSE: STL US; $11.67; Outperform)Synovus Financial Corp. (NYSE: SNV US; $21.87; Sector Perform)Valley National Bancorp (NASDAQ: VLY US; $7.51; Outperform)Webster Financial Corporation (NYSE: WBS US; $27.50; Outperform)

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Distribution of ratings

RBC Capital Markets, Equity Research

As of 30-Jun-2020

Investment Banking

Serv./Past 12 Mos.

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Small Cap Banks: Deep Dive into Industry Revenue Headwinds and Expected Expense Cuts

September 1, 2020 17

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RBC Capital Markets is the business name used by certain branches and subsidiaries of the Royal Bank of Canada, including RBC Dominion Securities Inc., RBCCapital Markets, LLC, RBC Europe Limited, Royal Bank of Canada, Hong Kong Branch and Royal Bank of Canada, Sydney Branch. The information contained in thisreport has been compiled by RBC Capital Markets from sources believed to be reliable, but no representation or warranty, express or implied, is made by RoyalBank of Canada, RBC Capital Markets, its affiliates or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in thisreport constitute RBC Capital Markets' judgement as of the date of this report, are subject to change without notice and are provided in good faith but withoutlegal responsibility. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice. This material is prepared for generalcirculation to clients and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The investments orservices contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt aboutthe suitability of such investments or services. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guideto future performance, future returns are not guaranteed, and a loss of original capital may occur. RBC Capital Markets research analyst compensation is basedin part on the overall profitability of RBC Capital Markets, which includes profits attributable to investment banking revenues. Every province in Canada, state inthe U.S., and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered totheir residents, as well as the process for doing so. As a result, the securities discussed in this report may not be eligible for sale in some jurisdictions. RBC CapitalMarkets may be restricted from publishing research reports, from time to time, due to regulatory restrictions and/ or internal compliance policies. If this is the case,the latest published research reports available to clients may not reflect recent material changes in the applicable industry and/or applicable subject companies.RBC Capital Markets research reports are current only as of the date set forth on the research reports. This report is not, and under no circumstances should beconstrued as, a solicitation to act as securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a



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