Sunday, April 23, 2017

Are Banks Different?

Does your financial institution need to be different than the five others in town or the multitudes outside of town?

If you believe the paradigm that a business model must generate low-cost solutions or differentiated solutions in order to build a sustainable competitive advantage, then my guess would be that your answer would be yes. Truth be told though, I still hear that "our money is no different than the banks' across the street" defeatism. 

If you believe that to be true, then the pair of Levi's jeans you purchase at the JCPenney in the mall, at Walmart, or on Amazon are no different, either. Yet one of those three has built a low-cost competitive advantage, the other a unique distribution network differentiation, and the third might go the way of the General Store.

It is annual report season. As a bank consultant, and bank stock investor, I review many of them. And my opinion is, I can't tell them apart by their "Letter to Shareholders". Chairmen and CEOs alike spout undifferentiated bromides that tells me their strategy in their markets must be low cost. Because I can't make out any difference.

Below are three such letters, taken from publicly available annual reports for three financial institutions headquartered in the same large U.S. city. I removed names, numbers, and geographies. But they are public companies, so these letters are available to the public in unedited form. No reason to call them out here, as it is beyond the point of the post.

Do these banks sound alike? Do they sound like your bank? 

~ Jeff

Bank A:

To our shareholders,

Since our inception, we have used the word ‘‘Absolutely’’ as a part of our brand. We believe this word reflects our customer centric and solutions oriented approach to banking. In 2016, we decided to ask our customers for feedback on their relationship with [Bank A]. Frankly, we couldn’t say it any better ourselves.

[Customer comments were here]

We are both extremely proud of, and honored by, this feedback. We also believe there is a direct correlation between these customer quotes and our bank’s performance, and we’re very pleased to report that 2016 was an outstanding year for tangible results at [Bank A]. Numerous milestones were achieved, including record earnings, crossing $x billion in total assets, and maintaining sound asset quality. Growth in interest and noninterest income outpaced declining accretion income, resulting in a significant increase in total revenue. Disciplined execution on our strategic priorities resulted in exceptional growth in organic loans and core deposits, which combined with effective expense management, collectively yielded net income of $xx million.

In addition to our financial success, we announced two bank acquisitions during the year: [Bank acquisitions]. Both of these acquisitions were completed on [date], providing us with well-known and talented bankers and an expanded statewide footprint into new strategically compelling markets. We now have a meaningful presence and efficient footprint in seven of the eight largest MSAs in [state].
[Bank A’s] results in 2016 demonstrate our commitment to grow low-cost transaction deposits, improve our noninterest income lines of business, maintain strong credit metrics while growing loans, prudently deploy capital, and become a more efficient company.

Our payroll, treasury services, and cash management product offerings continue to provide a competitive advantage in growing core funding and allow us to successfully compete with banks of any size. We had $xx million of deposit growth in 2016, including $xx million, or x%, growth in transaction deposit accounts. Noninterest-bearing deposits comprised xx% of total deposits at year-end 2016. Our long-term success is going to be primarily driven by the quality of our deposit base and having very deep relationships with our primary depositors.

We also generated organic loan growth of $xx million, or xx%, while managing our risks effectively and without compromising our high credit standards. Our credit quality metrics continue to be among the best in the entire industry.

Positive momentum in our noninterest income lines of business carried over into 2016 as all three of our key fee income initiatives—mortgage, SBA, and payroll—had double digit growth in 2016. In our SBA business, we added a team with a national market focus and completed major improvements to our operating processes that will significantly improve productivity and efficiency. We remain very pleased with the pace of growth in payroll clients, which in turn, delivers core funding and a solid recurring revenue source.

We are making measureable progress with our commitment to become a more efficient company. Total noninterest expense, excluding merger and credit-related expenses, declined nearly x% in 2016.
Expense reductions occurred across the board in nearly every category leading to a significant improvement in our efficiency ratio in 2016. In addition to the capital deployment through two acquisitions, we maintained an attractive dividend, with a yield of more than x% based on our year-end share price, equating to a dividend payout ratio of approximately x% for the year, and we repurchased over $x million of our common shares. We continuously evaluate our overall capital management strategy and remain committed to being conservative stewards of your investment in [Bank A].

In summary, we are blessed to operate in genuinely attractive markets with diverse growth drivers and positive economic trends, which make us very optimistic about the future for [Bank A]. Our existing markets represent a significant growth opportunity for our company. We continue to grow market share in the [metro] market, strengthen our number one market share in [region], and are excited about the tremendous opportunities we have in our new markets. 

As we reflect upon the successes of 2016, we are grateful for each client, board member, and employee that contributed to this success, and are ‘‘Absolutely’’ thankful for your continued confidence as a shareholder.

Bank B:

Dear Shareholders and Friends:

It seems the pace of change escalates as our business continues to expand. Integrity, intelligence, energy, sense of responsibility is more important than ever. The understanding that our role is to serve our customers – and each other – is critical. Attitude really is everything, and first experiences do make lasting impressions.

We try to run our businesses with these truths to guide us and our success, along with a dose of luck, indicates we are on the right track.

Mortgage grew both in production and in markets served, adding offices in [state], [state], and [state], as well as adding lenders in existing markets. Wealth Management added new product offerings and we are now building our marketing team. SBA increased production and expanded the lending footprint to include the [region] as well as the [region]. Commercial and Construction Lending continued steady expansion.

Our focus on retail branches shifted from expansion to one of efficiency and profitability for these new markets, though we remain open to new acquisition opportunities. To keep up with increasing production, we invested heavily in internal systems and software. Online Account Opening, when fully introduced, will give us another way to be accessible and user friendly.

Our financial results remained strong with net income of $x million or $x earnings per diluted share.
For you, our Shareholders, both cash dividends and book value per share increased again in 2016.
Some highlights are listed here to give a sense of our momentum:

[Financial highlights here]

[Name], with the team he has selected, is building a foundation to last and has the talent to meet our market opportunities. He will properly be named CEO of the Bank at the April meeting.
Our “Golden Rule” philosophy works. Increased Shareholder value from customer service is the result.

We thank you for your continued support and confidence in our Company.

Bank C:

For [Bank C], serving our clients means connecting with people. It means engaging at a deeper level than simply doing business or handling transactions. We are committed to leading and strengthening our relationships and serving the needs of others. For us, the best way to accomplish this is earning trust and investing in these relationships to grow our Company.

[Bank C] built its reputation by remaining firmly rooted and accessible in the communities we serve. We combined trust, loyalty and personalized relationship banking with the delivery of high touch service and life focused financial solutions. Our rich history and legacy has provided us the foundation and the inspiration to innovate and seek ways to continue to drive shareholder value.

Now, more than ever, we know that innovation paired with human interaction enables us to not only provide financial empowerment and guidance on a grander scale, but also sets us apart in the marketplace. By increasing our visibility and footprint in new as well as existing markets we are attracting, building, and maintaining a growing customer base and a more sustainable future for our internal and external stakeholders.

We launched our 95th anniversary year by remaining purposefully focused on building our brand with a deliberate charge toward the future. To make us even more agile to face and optimize new opportunities, we focused on four core strategic priorities: Bringing the Brand to Life; Defending and Growing the Business; Mobilizing the Brand across All Platforms; and Driving Organizational Excellence. As you will learn throughout this message, the successful implementation of our initiatives revealed our ability to execute and utilize technology to be responsive to our clients and grow our business.

[Financial highlights here]

[Separate discussion of each of the core strategic priorities mentioned above here]

Our legacy is who we are...Our future is what we are defining.

Lastly, we celebrated our 95th anniversary in 2016. This is a significant milestone of which we are extremely proud. I would like to thank our clients and community for supporting us all these years and for putting their trust in us, our board of directors for their encouragement to reach new milestones and our teammates who created the successes that we are reporting with their efforts and dedication.

To our shareholders, thank you for partnering with us by investing in our Company. We commit to you that we will continuously strive to build a better bank that will support our values, serve our clients and provide you a return.

We are looking forward to 2017 and the exciting opportunities it will bring.

Wednesday, April 12, 2017

Three Ideas for Banks to Reverse the "Silvering" of Their Customer Base

Are your customers older than your markets? A common theme among students that expressed concern about it during our Executive Development Program (EDP) sessions in Seattle, Montana, and Salt Lake City.

Customers leave their banks for the 4-D's: Death, Divorce, Displacement, or Dissatisfaction. Three of the four are life events outside of our control. And with switch rates that have persistantly hovered around 10% of total customers, how do we get 'em in, and keep 'em in?

Here are three ideas.

What other ideas do you have?

~ Jeff

Saturday, March 18, 2017

Bankers Bank: The Next Generation

Correspondent or bankers' bank is one of those monikers that the meaning is in the eye of the beholder. Like private banking. Or superior customer service. Whenever someone says it, I look at them with an inquisitive head tilt. Like a dog when a person talks as if the dog understands them.

I think correspondent bankers are finding their way and morphing into services that banks need. Their original purpose, as I understand it, was to use up operating, liquidity, and credit capacity in larger financial institutions to benefit nearby community banks. Need access to cash? Call the correspondent bank. Cash letter for nightly settlement, same deal. An underlying, yet important plot in It's a Wonderful Life was that Mr. Potter's bank served as a correspondent bank to the Bailey Building and Loan. He caused a liquidity crunch by not advancing Bailey credit, and offered to assume the deposits at "fifty cents on the dollar"!

Today, with the Federal Reserve, Federal Home Loan Bank, and technology that has all but eliminated paper "items", the traditional role of the correspondent bank is diminished. Not that the concept of developing scale to provide banking-related services at a lower cost than a community bank can achieve on its own is not lost. In fact, I would say it is needed now more than ever.

But they are provided by other service providers. Take my firm, that builds profit reporting models for community financial institutions based on how they are individually managed, and the products that they offer. We do this for dozens of banks. It would not be cost effective for us to do it for one bank, or even a few banks. Our investment in software and management reporting expertise would be underutilized, or the service would be too costly to deliver. The same with ALCO reporting firms. We use our scale to serve the many.

But couldn't banks use a scale-driven servicer, i.e. a correspondent bank, to provide needed services at a lower cost so community financial institutions don't see a sale as their only way to cost-effectively serve customers in a changing industry?

I think so. Let's call our little hypothetical correspondent bank Schmidlap Bankers' Bank. Here are the services I would foresee under Schmidlap's umbrella.

Many of the services identified above are already provided by firms, such as mine and ALCO firms in the form of Management Reporting. I know that bankers' banks currently specialize in Loan Participations, as bankers would prefer to share a credit with a service provider than a competitor, as many do now when they do bank-to-bank participations.

Loan servicing is another vendor driven service used by banks. In fact, there is a specialty bank in New Jersey, called Cenlar, that specializes in subservicing mortgages for financial institutions. When customers call with loan inquiries, they answer the phone with the originating banks' name, and live up to service standards agreed upon between the bank and the subservicer.

So many of these services exist under several vendor umbrellas, and financial institutions have demonstrated a willingness to outsource certain non-differentiating services. So why not have these performed by Schmidlap, a new-age correspondent bank?

This idea began germinating in my head when I spoke at the Kansas Bankers' Association CEO Summit a couple of years ago. At dinner that evening, I sat with the management team from a small, family-run bank. Very common in Kansas and across the Midwest. In fact, the average asset size of a Kansas-based financial institution was $99 million. The bankers described the difficulties in running a small bank in rural markets.

I suggested banding together, not in the form of a merger, but to form a service corporation to buy services, like identified in the diagram above, to reduce the cost of doing these things on their own. They were intrigued. I haven't seen one sprout up yet. But isn't it time?

Imagine the negotiating leverage with FIS, Fiserv, or Jack Henry if the contract for six or seven banks was struck by one entity? Sure, all of the banks would be on the same platform. But isn't that the way it is now? Except you all negotiate separately. That doesn't mean you can't set up your own product set, or your bank wouldn't be segregated with its own database at the data center.

And what of things like Marketing and Human Resources? Each bank should have their own professionals. But it is difficult for banks to have the level of sophistication in terms of systems, such as CRMs or HRIS, or the resources (or geography) to hire the very best professionals. Many view Marketing and HR as collateral duties of one executive or another. Both of these functions, in order for community financial institutions to thrive, must elevate their game.

For HR, provide the best talent, employee development, and compensation systems. For Marketing, financial institutions must implement more sophisticated approaches to attracting new customers, and better serve existing ones. It's no longer good enough to run an ad, order a tchotchke, or staff a booth at the trade show. Marketers must identify the most profitable customers for gold-tier service, and implement a plan for the next tier customers to turn them into gold-tier.

Those executives and systems might be more than a community financial institution can afford. But as part of Schmidlap, that level of sophistication can be yours! There could be a geographic limitation so Marketing and HR within Schmidlap could not serve two banks with, say, greater than 20% market overlap.

I've said enough! You get the point. Incoming ICBA chairman, Scott Heitkamp of ValueBank in Texas, said at the trade association's annual convention that he is concerned about the 30% decline in banks with less than $10 billion in assets since the financial crisis. He is hearing that community banks either can't afford or don't want to deal with the regulatory burden.

Can a re-invented bankers' bank inject newfound confidence into community banks, and up their game to compete over larger geographies with more sophisticated support functions?

~ Jeff

Friday, March 10, 2017

Which Bank Will Blink on Rate?

It happened. I received an e-mail this week for a 13-month CD special. The ad insisted it would make me happy. Instead, sadness. Sad that this bank thought I wouldn't notice they were front-running a likely Fed rate hike. Sad that the bank fell back on old tricks, getting customers to bite on an odd-lot CD term that will reprice at a lower rate when it matures. Sad that they got my e-mail address.

Staring down the barrel of a rate hike, and the specter of future and faster hikes, how does your institution feel about how fast you will have to reprice deposits? Because we are coming off of unprecedented times folks. Times that had the average balance of a money market account go from $47 thousand at the end of 2005, to $129 thousand today (data taken from my firm's profitability peer database). 

Why do you think that happened? And what will customers do with that money when deposit rates become more enticing?

I know your ALCO models predict what might happen. But if we dig deep, we know we don't know. That doesn't mean we can't look around us to predict pricing pressures applied by our competitors, like the bank that solicited me for the 13-month CD.

So I took a look at metrics, publicly available in Call Reports, that were indicative of a competitor's need for funding, and therefore will drive their pricing decisions.

I focused on the St. Louis MSA. Why St. Louis? I have friends that are getting married there in the next few months, and they work for one of the banks on the below list. Together. Same bank. I will defer to them on the wisdom of this. St. Louis also has a good baseball team. And they are not likely to win as many World Series as the Yankees in my lifetime.

I looked at the top 10 deposit market share banks that were not SIFIs. True, SIFIs had a 52% market share at June 30, 2016. But the below top 10 own 29%. Not an insignificant amount. And SIFIs' need for funding is much more complicated as they have greater access to the capital markets, and don't necessarily rely on drawing funds from St. Louis.

Here is the list, their St. Louis MSA market rank, in-market deposits and deposit market share at June 30, 2016.

Once I identified the community banks, my next task was to identify the financial metrics that highlighted their need for funding as rates rise, and therefore the likelihood that they would be early movers in the pricing game. Here are the metrics I used:

-  Deposit Growth minus Loan Growth (year over year)
-  Loans / Deposits
-  Securities / Assets
-  Pledged Securities / Securities
-  Time Deposits / Deposits
-  Borrowings / Assets
-  Cost of Funds

I ranked each of the above banks based on each metric, assigning the bank a "10" if they had the top rank, and a "1" if their ratios were lower. So, if UMB Bank NA had the lowest Loan / Deposit ratio, as they did, they received a "1" for that metric. If Central Bank of St. Louis had the highest Loan / Deposit ratio, as they did, they received a "10". That means that each metric received equal weight in my analysis.

I tallied all of the scores to determine which bank needed the funding the most, and were therefore most likely to be first mover in elevating rates and putting competitive pressures on other market participants. The results are below.

I predict that Midland States Bank will be the first to offer a compelling rate to raise deposits in a rising rate environment. They have a relatively small securities portfolio, high Loan / Deposit ratio, and their loans have been growing faster than their deposits, among other indicators.

Call this method the Jeff For Banks method to predict rate warriors. I can be a narcissist.

There are some tight scores immediately below Midland States, and upon looking through the data I believe Central Bank of St. Louis would be next, in spite of it having a slightly lower score than the three above it tied for second. Their Loan / Deposit ratio was 98% and their securities portfolio was similar to Midland States, at only 10% of assets. Reliance and Midwest, conversely, have securities portfolios of around 22% of assets to fund their growing loan portfolio. So the scoring system is not absolute, especially when there is clumping such as in the second through fifth ranks.

My friends' bank looks like it can sit on the sidelines during a rate war, a good position to be in. Unless they succumb to competitive pressures, and that parked money in money market accounts starts following rate around St. Louis. 

Who will blink in your markets?

~ Jeff

Saturday, February 25, 2017

Netflixed: Co-Founder of Netflix Tells Bankers How It's Done

This past week I attended the American Bankers' Association National Conference for Community Bankers (NCCB). At such affairs, I like attending the general and education sessions for my own knowledge, and for the benefit of my clients and readers.

The NCCB was no different. If there was one session that struck me like a lightning bolt, it was the general session, with keynote speaker Marc Randolph. It was riveting, and challenging. And I'm not too sure bankers are up for the challenge. 

Riveting because he spoke about the founding of Netflix. The idea was not a lightning bolt, as Netflix co-founder Reed Hastings tells of his late fee epiphany when returning the movie Apollo 13. Rather, it evolved during long commutes between Hastings and Randolph. In other words, car pooling planted the seeds of Blockbuster's demise. This factoid is sure to get me social media shares from environmentalists.

The tale of the early years of Netflix is very instructive to an industry experiencing change. Think banking. The talk was challenging because Randolph's keys to being successful in such an environment may, and should scare bankers.

Marc Randolph's three keys to business success:

1.  Tolerance for Risk

Number one is already turning off readers. Low risk tolerance is suffocating. Why? It promotes a "no mistakes" culture. When you have low tolerance for risks and mistakes, you lose innovation. Who will stick their neck out in such a culture? Who will endure five failures to discover that one idea that turns your business model on its head and plants the seed for an enduring future? Bankers may hate the analogy, but Blockbuster was not willing to gut their main revenue source to build out and promote streaming. Does the term "disintermediation" in banking sound familiar?

2. An Idea

And it doesn't have to be a good idea. When Netflix decided to forego late fees their business took off. If Randolph was writing a letter to himself how he thought Netflix would evolve in five years it would not have read like it played out. But they tried anything and everything to get subscribers, and more revenue into their company. They had many failures. The idea wasn't an "in the shower" epiphany. But after trying several things, the one that stuck ended up being the hurdle that would eventually lead to what we have today. An idea. Not a good one. As Randolph mentioned, many of us have great ideas in the shower. Few of us get out of the shower and do something about them. In a culture with a low tolerance for risk, would one of your bankers step out of the shower and do something about their idea? Would such a person even work for your bank?

3. Confidence

It takes confidence to fail several times, and to get up and keep going. As Rocky once said, it's not how many times you get knocked down, but how many times you get knocked down, get up and keep moving forward. That's right, I made a Rocky reference. Say what you will about the Italian Stallion, when he was in the ring, he had confidence to go toe to toe with the best in the business. Think about little $5 million in revenue Netflix, going toe to toe against multi-billion dollar Blockbuster. 

I will close by paraphrasing Randolph. Business success is not about coming up with the best or even good ideas. It's about building a culture to try lots of bad ideas.

And with our own culture in banking, to try few ideas and even fewer that have not proven tried and true, do we have the culture to succeed in a changing industry.

Should we build such a culture? And if so, how?

~ Jeff

Saturday, February 18, 2017

Capacity Planning in Banks: Three Measurement Ideas

Joe Lender's loan portfolio grew $5 million last year. The Trust Department's revenues grew nine percent. The Market Street branch's core deposits grew to 64% of total deposits. All objective measurements for front liners.

But what about support centers? Loan Servicing, IT, Deposit Operations et al? Perhaps they look busy. I have actually heard that before. One CEO said he judges capacity by looking out of his office window at 6pm. Are there cars in the employee lot? Perhaps it's time to add resources. If not, the request for an additional FTE is denied!

How can executive management, most of whom did not come from support centers demanding more resources, decide if they should give it to them?

I have some ideas.

1. Number of Accounts and Operating Cost Per Account

One statistic I turn to for clues on the capacity of a support center is how they were operating at their peak. Let's discuss the accompanying table.

With the exception of one period with a slight upward blip, this bank has been losing checking accounts over the eight periods measured. Yet the bank has not been reducing aggregate costs because the operating cost per checking account is more than it was eight periods ago. According to these data points, this bank supported eight percent more checking accounts at 13% less cost eight periods ago.

This data point suggests an 8%-13% available capacity.

2. Benchmarks

Data are like humans. Rarely perfect. When data does not support our theory, we tend to point to its imperfections. So it goes with benchmarks. There are no apples to apples comparison with a basket of banks data compared to yours. But does it represent a relevant data point to consider? The chart below suggests another relevant point of information so an executive can determine the capacity of a support department.

In this bank's case, the number of deposit accounts per deposit operations FTE has been declining. When deposit accounts were greater, this bank achieved the benchmark median. As number of accounts declined, personnel did not, and this metric fell below the benchmark. At the current period, the bank is 7% below the median benchmark and significantly below the top quartile. Time to reduce resources, or at a minimum challenge the department to become more efficient?

3. Recognizing Economies of Scale

A third data point to consider when determining capacity in a support center is how much resources as a percent of the relevant balance sheet item does this center consume (see chart)?

I have written, spoken, and debated that to achieve economies of scale, you must reduce relative resource consumption as you grow. I have also pointed out that many financial institutions fail to achieve it. This is a key fact in why many mergers don't achieve the economic benefits touted on merger announcement day. To realize economies of scale at your bank as you grow, incorporate the discipline to reduce relative resource consumption per support centers.

Given the above table, should this executive increase resources available to the Deposit Operations Department?

I don't believe taking one data point of the three mentioned above would be enough. As I contend, there are imperfections to each, imperfections that you can rest assured the Deposit Operations Manager will point out to you when considering a resource request.

But the margin for error declines when you consider multiple data points to make a more informed decision. I'm not suggesting seeking data ad nauseam. There is a declining value to adding more data. At some point a leader must lead.

And in Schmidlap National Bank's case, the Deposit Operations Department can do better.

What other data should be considered in determining support center capacity?

~ Jeff

Friday, February 03, 2017

Guest Post: Quarterly Financial Markets and Economics Update by Dorothy Jaworski

Happy 2017, everyone!  Who is ready for all of the change that is about to be upon us?  A new President will be inaugurated tomorrow, January 20th, and Donald Trump has promised change.  He has used his slogan of Make America Great Again to show that his focus will be on the US and the US economy.  His election has already brought change to the financial markets, sending stocks rising 6%, as measured on the S&P 500 index, and sending interest rates to their highest levels in years.  Clearly, the markets expect change.  After Trump becomes President, the markets are expecting actions that will mean positive change for the economy,

Analyzing what change will mean to economic growth is clearly a challenge.  I wrote in October that there is no momentum and no catalyst to push GDP much above 2.0%.  The thought of change may have tried to do that, but change itself may not accomplish it.  For so long, we have been stuck at 2.0% growth.  Since the recovery began in June, 2009, real GDP growth has averaged 2.3%.  Most recoveries in the US have averaged far more than that.  This recovery is already 90 months old and growth has not yet reached its potential.  In the past ten years, the economy has not managed even one year of 3.0%+ growth.  So what has been holding us back?  First, we have inordinately high debt levels, especially in the federal government sector, of nearly $20 trillion.  Actual non-financial debt in the US totals about $70 trillion, or 370% of GDP.  Debt at multiples above 100% begins to hurt the economy.  Debt at multiples above 250% to 300% has been proven to dramatically slow economic growth and push inflation downward.  The last seven years are proof.  Debt is not going away, change or not, and will keep pressure on growth.

Secondly, productivity has been very poor over the past five years or so.  Since 2011, productivity has fallen by -.4%.  Compounding the issue has been a reduction in the labor force, with retirements removing skills from the workforce, discouraged workers, and skills mismatches resulting in people not able to find appropriate jobs.  Corporate profits have been held back as costs rose on a relative basis as productivity fell.  Third, the explosion in regulations over the past eight years has served to hinder businesses, especially new small business formation, and has drained valuable resources as compliance costs soared.  Bank lending has not been the catalyst it used to be for improved growth in this recovery compared to prior ones; maybe we can point at regulation after regulation being forced onto banks and higher, more restrictive capital requirements.  Maybe change will be coming.

What Will Change Look Like?
Change has already resulted in higher stock prices and higher interest rates.  I mentioned that interest rates have risen dramatically since Election Day.  The two year Treasury yield reached 1.26%, its highest level since August, 2009 and the ten year Treasury yield reached 2.58%, its highest level since September, 2014.  The quick jump in rates in late 2016 is reminiscent of the increases in 2013, with rates rising in both cases up 100 basis points in just over 100 trading days.  The markets must think that GDP growth will soar on January 21st.  I have news for them; it takes a lot longer for fiscal policy to translate to growth than you think.

President Trump has promised several policies that should improve economic growth, and Make the Economy Great Again.  He has promised the elimination of many regulations that are strangling businesses.  If bank regulations are lifted, lending and thus growth can improve.  Some regulations have had a negative impact on the markets, such as the Volcker Rule, which has reduced liquidity in the marketplace by restricting trading activities.  I have a theory that some of the rate increases and drop in bond prices were due to reduced liquidity and lack of market making.  I cannot quantify how much at this time, but I am sure it’s there.  Other regulatory reform promised by Trump involves energy production, which could improve growth and serve to keep gas and oil prices lower, keeping inflation at bay.

Corporate and personal tax cuts were promised, with the corporate rate dropping from 35% to 15%.  I don’t know if that large a cut would occur, but these actions will add to economic growth.  I saw an estimate that 50% of the effect of tax cuts flows through to growth in the first eighteen months.  To be truly effective, tax cuts should be paired with cuts in government spending so that there is not additional borrowing to fill the deficit.  In the early 1980s, the Reagan tax cuts took two years to push GDP growth above 3.0% and that was with a Federal Reserve, run by Paul Volcker, who was aggressively lowering rates.  Trump has a Fed, run by Janet Yellen, who continues to believe that they need to raise rates.

Rebuilding our infrastructure is another proposal, but I think government borrowing would increase- either from paying for projects or from tax credits to companies to do the work.  If government borrowing continues to increase, it will add to the crowding out effect on private investment, and not adding much to growth.  But I am in favor of much of this infrastructure improvement and am so tired of having to drive to dodge potholes.

Growth Forecasts
Economists are mixed on their reviews of the Trump proposals and change on GDP growth.  The latest Fed forecasts, released in December, 2016, have ranges for 2017 for GDP of 1.9% to 2.3% and 2018 at 1.8% to 2.2%.  Wait!  That is no better than the 2.3% since 2009.  And the Fed felt compelled to raise rates and to say they will keep raising them?  I think they must be looking at a few signs of inflation and thinking they must tighten now.  If inflation sticks, they will be right, since it will exceed their 2.0% target.  More than likely, high debt levels will keep it under control.  The latest Bloomberg survey, released in January, 2017, has GDP in 2017 at 2.3% with rising rates.  Wait!  That is no better than the 2.3% since 2009.   Some of the “higher” projections are from private economists, Dr. Don Ratajczak and Brian Wesbury with 2017 at 2.6%.  Dr. Ratajczak has 2018 at 2.9%.  The lowest I have seen is for real GDP below 2.0% for 2017, because high levels of debt keep growth and inflation at reduced levels.  With many of these forecasts, I wonder:  Why did rates rise so much?

Thanks for reading!  DJ 01/18/17

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.