Financial Institution Trends on the Horizon

Financial Institution Trends on the Horizon

Financial Institution Trends on the Horizon September 2017 Scott Hildenbrand Principal/Chief Balance Sheet Strategist (212) 466-7865 [email protected]

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Financial Institution Trends on the Horizon

September 2017

Scott Hildenbrand Principal/Chief Balance Sheet Strategist (212) 466-7865 [email protected]

Table of Contents I.

Market Update

II.

Organic Revenue Growth

III. Wholesale Revenue Ideas

IV. Capital Markets Update

V. M&A Market Update

Rate Overview: Historic and Current Spreads Index

2013

2014

2015

2016

09/20/17

Fed Funds Target

0.25%

0.25%

0.50%

0.75%

1.25%

2 Year Treasury

0.33%

0.53%

0.72%

0.81%

1.44%

10 Year Treasury

2.49%

2.48%

2.15%

1.82%

2.27%

2-10 Year Treasury Spread

2.16%

1.95%

1.43%

1.01%

0.83%

Bank Margins









National

136.8%

140.6%

143.1%

153.5%

180.5%

Virginia

119.5%

119.2%

120.2%

129.2%

158.2%

Average Price/ Tangible Book

• While the curve continues to flatten, we are seeing a meaningful expansion in bank valuation multiples • In this environment, how will you position your institution to increase earnings and meet expectations? National Banks includes all Public Banks $1 to 10 billion in assets. Virginia Banks includes all Public Banks in Virginia except Capital One. Source: Bloomberg and SNL Financial L.P. Quarterly averages for each year, Fed Funds Target is end of period.

2

Virginia Bank Analysis Virginia Banks Median 2014Q2 2017Q2 Balance Sheet Mix Loans/ Deposits Total Securities/ Assets Cash, Cash Equivalents & Unencumbered Securities/ Assets Non-Interest Bearing Deposits/ Deposits Cost of Funds Yield on Loans and Leases Yield on Debt and Equity Securities Return Metrics LTM Net Interest Margin LTM ROAA/ LTM ROACE Capital Metrics TCE Ratio Leverage Ratio Total Risked Based Capital Ratio Includes all Public and Private Banks in Virginia, except Capital One (75 institutions) Source: SNL Financial

82.0% 16.0%

86.9% 13.0%

18.3% 17.9%

14.4% 21.2%

0.61% 5.25%

0.52% 4.95%

2.30%

2.19%

3.78% 3.71% 0.80% / 7.61% 0.82% / 7.73% 10.3% 10.5% 16.2%

10.6% 10.8% 15.0%

3

Key Hedge Accounting Simplifications Quantitative effectiveness tests for Cash Flow Hedges are now only done at inception unless facts and circumstances of the hedging relationship changes. Qualitative assessments can be done in place of the periodic quantitative assessments The shortcut method of effectiveness testing is retained and relief is provided for inadvertent errors. The concept of ineffectiveness is removed for cash flow hedges



Effectiveness becomes a binary assessment with a wide threshold with room for error

Fair Value Hedges can isolate Benchmark Index •

Allows the hedger to exclude credit component in the coupon and isolate the Benchmark component

Partial term Fair Value Hedges are now allowed •

The maturity date of the hedge no longer needs to match the maturity date of the asset/liability

SIFMA municipal swap rate considered a Benchmark Index •

Simplifies hedging municipal bonds 4

Organic Revenue Growth: Assets • Loans: Competition – Fixed Rate Loans: A flat curve and fierce competition pressuring yields (and terms)  Back-to-Back Loan Swaps: •

An option to meet customer demand and manage interest rate risk



Drives fee income

– Floating Rate Loans:  Are there embedded credit caps?  Impact of LIBOR being discontinued

– CRE Concentration: Transitioning to more owner occupied CRE or switching to C&I?

5

Organic Revenue Growth: Assets - “Back-to-Back” Swaps To originate a loan and Back-to-Back swap: 1.

Bank issues a 10 Year floating rate loan at 1 month LIBOR + 225 bps

2.

Bank enters into a receive-fixed interest rate swap with the client, typically with a small rate markup

3.

Bank enters into an identical offsetting pay-fixed swap with a swap dealer

4.

The dealer pays the bank the present value of the markup at inception, which is recognized as fee income

Floating-Rate Loan Step 1

20/10 Year Floating-Rate Loan 1 month LIBOR + 2.25%

Borrower

Step 2

Borrower

Bank

Back-to-Back Interest Rate Swaps 1 month LIBOR + 2.25%

Swap #1 4.45%

Step 3

1 month LIBOR + 2.25%

Bank

Swap #2

Swap Dealer

4.45% Present Value of Markup Paid in Cash

Step 4

Fee income of 2.17% of swap notional

Pricing for illustrative purposes only

6

Organic Revenue Growth: Liabilities • Deposits: – Delivery mechanism: How do you transition from the baby boomers to the millennials? – When will cost of funds be impacted by a rate hike? Since December 2015, cost of funds has only increased 9bps, despite 100bps increase to Fed Funds – Money Market Deposit Accounts: Linked to Fed Funds index allowing the bank to please their customers and potentially enter into an interest rate swap to manage interest rate risk

Historical Cost of Funds vs Fed Funds

LTM Use of Mobile Banking by Age

7.00 6.00 5.00

4.00 3.00 2.00 1.00 0.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Cost of Funds (%)

Includes all Public Banks $1 to 10 billion in assets Source: Gallup poll of over 6,000 bank customers and SNL Financial and Bloomberg as of June 30, 2017

Fed Funds Target Rate (%)

7

Wholesale Revenue Ideas: Asset Sensitive Institution Year 1 NII Volatility % -100 bps

+100 bps

Year 2 NII Volatility %

+200 bps

+300 bps

-100 bps

15.0%

+100 bps

+200 bps

+300 bps

15.0% 12.0% 9.0%

10.0%

10.0%

8.0%

6.0% 5.0%

4.0%

5.0%

3.0%

0.0%

0.0%

-5.0%

-5.0% -6.0%

-10.0%

-8.0%

-10.0% Base

Base

PROJECTED ANNUAL PRINCIPAL CASH FLOWS

Year 1

Year 2

Year 3

Year 4

Year 5

30,000

Principal

Down 100

Flat

Up 100

Up 200

Up 300

20,000

10,000

0

Annual

Cum.

Runoff Annual

$

%

Yield

$

%

Yield

$

%

Yield

$

%

Yield

Down 100

26,646

25%

3.6%

18,451

42%

3.5%

12,649

54%

3.7%

6,675

60%

Flat

20,145

19%

3.7%

18,227

36%

3.7%

13,163

48%

3.5%

7,738

55%

Up 100

16,774

16%

3.9%

15,460

30%

3.9%

8,724

38%

3.4%

6,843

Up 200

13,766

13%

3.8%

11,284

23%

4.0%

7,339

30%

3.3%

6,921

Up 300

12,907

12%

3.9%

9,597

21%

3.9%

7,782

28%

3.5%

7,136

Dollar values shown on an annual basis, percentages shown are cumulative.

Cum.

Runoff Annual

Cum.

Runoff Annual

Cum.

Runoff Annual

Cum.

Runoff

$

%

Yield

3.2%

7,069

67%

3.8%

3.7%

8,356

63%

3.9%

44%

3.8%

6,391

50%

3.7%

37%

4.0%

6,971

43%

3.9%

35%

4.1%

6,982

41%

4.1%

8

Wholesale Revenue Ideas: Asset Sensitive Institution • Spend some of the asset sensitivity to pre-invest future principal cashflows from the investment portfolio to increase current earnings: – Purchase $40 million of a mix of agency-backed MBS securities with an average yield of 2.37% and duration 3.9 years. – Fund the purchases with short FHLB borrowings at a cost of 1.34% and a duration of one month.

 Potentially Self Liquidating Strategy: may choose to pay down the borrowings with bond cash flows over time or replace the borrowings with core deposits (whether organic or via acquisition).

• Impact on Balance Sheet Earning Assets

Projected Net Interest Projected Net Interest Income Net Income Margin Yr 1 ($) Yr 1 ($)

Baseline

450,000

3.89%

17,500

5,000

Leverage

490,000

3.65%

403

262

Post-Trade (Pre-Tax)

490,000

3.65%

17,903

5,262

Change from Baseline

40,000

(0.24%)

403

262

Market valuation as of September 11, 2017, subject and indicative Assumes 35% tax rate

9

Wholesale Revenue Ideas: Asset Sensitive Institution Year 1 NII Volatility % -100 bps

+100 bps

Year 2 NII Volatility %

+200 bps

+300 bps

15.0%

-100 bps

+100 bps

+200 bps

+300 bps

15.0% 12.0% 9.0%

10.0%

10.0%

8.0%

6.0% 5.0%

3.0%

3.0%

2.0%

1.1% 0.0%

5.6%

4.0%

5.0%

3.8% 2.0%

0.0%

-5.0%

-5.0%

-4.5% -6.0%

-10.0%

-10.0%

Base

Base

Year 1 ($) $ Difference Year 1 (%)

+300 bps 19,075 1,575 9.0%

Year 1 ($) $ Difference Year 1 (%)

Post-Strategy NII Volatility: Year 1 -100 bps Base +100 bps +200 bps $17,100 17,903 18,094 18,265 -$803 191 362 -4.5% 1.1% 2.0%

+300 bps 18,434 531 3.0%

$ Impact % Impact

-6.5%

Strategy

Pre-Strategy NII Volatility: Year 1 -100 bps Base +100 bps +200 bps $16,450 17,500 18,025 18,550 -$1,050 525 1,050 -6.0% 3.0% 6.0%

-100 bps $650 4.0%

-8.0%

Impact to NII: Year 1 Base +100 bps 403 69 2.3% 0.4%

Market valuation as of September 11, 2017, subject and indicative

+200 bps -285 -1.5%

+300 bps -641 -3.4%

Strategy

Year 2 ($) $ Difference Year 2 (%)

Pre-Strategy NII Volatility: Year 2 -100 bps Base +100 bps +200 bps $15,640 17,000 17,680 18,360 -$1,360 680 1,360 -8.0% 4.0% 8.0%

+300 bps 19,040 2,040 12.0%

Year 2 ($) $ Difference Year 2 (%)

Post-Strategy NII Volatility: Year 2 -100 bps Base +100 bps +200 bps $16,266 17,398 17,739 18,059 -$1,131 341 661 -6.5% 2.0% 3.8%

+300 bps 18,375 978 5.6%

$ Impact % Impact

-100 bps $626 4.0%

Impact to NII: Year 2 Base +100 bps 398 59 2.3% 0.3%

+200 bps -301 -1.6%

+300 bps -665 -3.5% 10

Wholesale Revenue Ideas: Liability Sensitive Institution To hedge a pool of municipal bonds: 1.

Bank identifies a pool of fixed-rate municipal bonds with similar coupons

2.

Bank enters into a pay-fixed interest rate swap with the dealer hedging the pool for a partial term

3.

The Bank sets the maturity date of the swap before the earliest call in the pool

4.

The swap is designated as a partial-term fair value hedge

Partial-Term Muni Bond Hedging Municipal Bonds

3.00%

3 month LIBOR + 1.25%

Bank

Swap Dealer 3.00%

New Accounting Rules Used: 1.

Hedge interest rate risk attributable to benchmark rates only

2.

Designate SIFMA index for benchmark rates

3.

Partial-term Fair Value hedge designation

11

Wholesale Revenue Ideas: Liability Sensitive Institution Year 1 NII Volatility % -100 bps

+100 bps

+200 bps

Year 2 NII Volatility % +300 bps

-100 bps

10.0%

+100 bps

+200 bps

+300 bps

10.0% 4.0%

5.0%

5.0%

0.0%

4.0%

0.0%

-5.0%

-5.0%

-4.0% -8.0%

-10.0%

-10.0%

-12.0%

-15.0%

-4.0%

-15.0%

-20.0%

-20.0%

-25.0%

-25.0%

-16.0%

-24.0%

Base

Base

• Put on interest rate protection through hedging a portion of your municipal securities – Enter into a $25 million pay-fixed swap at 3.00% for 4 years, receiving 3mo Libor + 1.25% 

4yr is a partial term hedge (new addition to hedge accounting rules)

• Impact on Balance Sheet

Earning Assets

Projected Net Interest Projected Net Interest Income Net Income Margin Yr 1 ($) Yr 1 ($)

Baseline

590,000

3.05%

18,000

5,000

Interest Rate Hedges

590,000

3.03%

(108)

(70)

Post-Trade (Pre-Tax)

590,000

3.03%

17,892

4,930

Change from Baseline

0

(0.02%)

(108)

(70)

Market valuation as of September 11, 2017, subject and indicative Assumes 35% tax rate

12

Wholesale Revenue Ideas: Liability Sensitive Institution Year 1 NII Volatility % -100 bps

+100 bps

Year 2 NII Volatility %

+200 bps

+300 bps

10.0% 5.0%

-100 bps

+100 bps

+200 bps

+300 bps

10.0% 4.0%

5.0%

2.6%

0.0%

4.0%

2.6%

0.0%

-2.6%

-5.0%

-5.3%

-7.9%

-8.0%

-10.0%

-2.6%

-5.0%

-4.0%

-12.0%

-15.0%

-4.0%

-10.0% -13.2%

-15.0%

-20.0%

-20.0%

-25.0%

-25.0%

-16.0%

-19.8%

Base

Base

Year 1 ($) $ Difference Year 1 (%)

Pre-Strategy NII Volatility: Year 1 -100 bps Base +100 bps +200 bps $18,720 18,000 17,280 16,560 $720 -720 -1,440 4.0% -4.0% -8.0%

Year 1 ($) $ Difference Year 1 (%)

Post-Strategy NII Volatility: Year 1 -100 bps Base +100 bps +200 bps $18,362 17,892 17,422 16,952 $470 -470 -940 2.6% -2.6% -5.3%

$ Impact % Impact

-100 bps -$358 -1.9%

-24.0%

Strategy

Impact to NII: Year 1 Base +100 bps -108 142 -0.6% 0.8%

Market valuation as of September 11, 2017, subject and indicative

+200 bps 392 2.4%

+300 bps 15,840 -2,160 -12.0%

+300 bps 16,482 -1,410 -7.9%

+300 bps 642 4.1%

Strategy

Year 2 ($) $ Difference Year 2 (%)

Pre-Strategy NII Volatility: Year 2 -100 bps Base +100 bps $18,200 17,500 16,800 $700 -700 4.0% -4.0%

+200 bps 14,700 -2,800 -16.0%

+300 bps 13,300 -4,200 -24.0%

Year 2 ($) $ Difference Year 2 (%)

Post-Strategy NII Volatility: Year 2 -100 bps Base +100 bps +200 bps $17,842 17,392 16,942 15,092 $450 -450 -2,300 2.6% -2.6% -13.2%

+300 bps 13,942 -3,450 -19.8%

$ Impact % Impact

-100 bps -$358 -2.0%

Impact to NII: Year 2 Base +100 bps -108 142 -0.6% 0.8%

+200 bps 392 2.7%

+300 bps 642 4.8% 13

Market Update: Capital Markets – What is Happening? • 1Q17 was the highest quarter for capital raises since 2Q14, and the second highest since 2010 • Sub Debt and Common Stock raises have been increasingly more common

Post-Crisis Capital Landscape

$20.0

$5.0

$18.0

$4.5

$16.0

$4.0

$14.0

$3.5

$12.0

$3.0 ($ Billions)

($ Billions)

Crisis Capital Landscape

$10.0 $8.0

$2.5 $2.0

$6.0

$1.5

$4.0

$1.0

$2.0

$0.5

$0.0

$0.0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2007

2008

2009

Preferred Stock

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2010

Common Stock

Includes underwritten capital raises by banks and thrifts with assets less than $50 billion Source: SNL Financial as of September 6, 2017

2011

TARP

Senior Debt

2012

Sub Debt

2013

2014

2015

2016

2017

Trust Preferred

14

Market Update: Capital Markets – Why is this Happening and Why Should You Care? • Why? – Sub Debt: Many banks are raising sub debt to fuel organic growth, address regulatory issues due to a concentration, or provide financing at the holding company level – Common Stock: 

Market Timing: Attractive issuer pricing



This increase in capital is being used to fund M&A transactions or organic growth

• Why Should You Care? – These banks will need to quickly deploy the excess capital, which increases competition in your market for loans and deposits. – Further, the capital could be used for acquisition financing, causing market disruption.

15

Market Update: M&A – What is Happening? • The M&A market has been very active

• As consolidation in the banking space continues, aggregate annual deal value has been increasing, while the number of deals has been decreasing – Traditional buyers have become sellers Historical Change in Number of Banks

Historical M&A Transactions $80

300

New Banks

Failed Banks

Merged Banks

Aggregate Deal Value

Net Change in # of Banks

200

100

400

Number of Deals

$70

350

$60

300

$50

250

$40

200

$30

150

$20

100

$10

50

(100)

(200)

(300)

(400)

(500)

(600)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Sources: FDIC as of June 30, 2017 and SNL Financial as of September 6, 2017

2013

2014

2015

2016

2017 YTD

$-

Number of Deals

Deal Value in Billions

0

0 2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

16

Market Update: M&A – Why is this Happening and Why Should You Care? • Why? – Economy of Scale: Biggest driver of acquisitions/combinations (Out of the 39 public and private banks to cross $10 billion since 2010, only 4 have grown organically) – Bank stock valuations have increased (Price to Tangible Book has increased over 25% from 1Q16) – Deposit Growth: High growth banks are looking for deposits and focusing more on acquisitions. Core Deposit Premiums are at their highest since 2008 even in this low interest rate environment

• Why Should You Care? – Even if you are not for sale, your competitors may be and are trying to ramp up deposits, which will impact your cost of funds – Market disruption can create opportunities and challenges

Historical Deposit Premiums vs. Cost of Funds 12.00

0.70 9.97

10.00

0.65 7.76

8.00

8.17

0.60 6.01

6.00

4.00

0.55

4.80

0.50

3.22

2.00

0.45

0.00

0.40 2012

2013

2014

2015

Tangible Book Premium/ Core Deposits (%)

The 39 banks to cross $10 billion excludes StifelFinancial Corp. and Sallie Mae Bank (non-traditional bank models) Includes all announced nationwide bank and thrift deals with deal value greater than $15 million and Public Banks $1 to 10 billion in assets Source: SNL Financial, as of June 30, 2017

2016

2017

Cost of Funds (%)

17

Feel free to reach out with any questions: Scott Hildenbrand Principal/Chief Balance Sheet Strategist (212) 466-7865 [email protected]

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