The environment for bank earnings has been weak for some time now, which is no surprise to those of us that own shares of the behemoths in the industry. A perfect storm of weak demand for loans, along with banks' general aversion to risk and an unbelievably restrictive legal and regulatory environment has sent shares of companies like Bank of America (NYSE:BAC) and Citigroup (NYSE:C) into the proverbial doghouse, in investors' minds. So that got me thinking; what can BAC do to think outside the box and actually show some revenue growth, along with increasing interest margins? We'll discuss my idea briefly here.
Banks in general, and BAC in particular, have had a tough go of it lately in terms of meshing the need for loan growth and credit standards in a regulatory environment in which more and more capital is required to satisfy regulators. Thus, we've seen deposits growing at BAC for years, without commensurate loan growth. Some of that is on purpose, in order to de-risk the bank, after years of excesses eventually led to massive losses during the financial crisis. However, some of it was simply because BAC doesn't have the customers it needs to efficiently lend out its liquidity. Thus, a lot of that excess liquidity ends up on loan at the Fed in the form of excess reserves, or in the Fed Funds market.
These two avenues both pay interest, and both are quite safe and liquid; however, both are terrible investments in terms of margins, as each pays around 25 basis points, a rate that has persisted for years now. This means that BAC is lending hundreds of billions of dollars it can't allocate efficiently, meaning a large portion of its balance sheet is a drag on earnings. When the bank as a whole is earning 100 basis points of return on assets but $300+ billion is earning next to nothing, there is ample room to grow revenue and interest margins.
This led me to the exercise we're discussing here, and one thing I've seen other financial institutions do is more personal loans. These are typically high-interest, unsecured loans to individuals in small amounts, usually less than $10,000. These loans can be used for anything, but as we know, many of these loans are known as "payday" loans, wherein a borrower has bills to pay and a loan is extended in anticipation of the borrower receiving their paycheck and paying the loan off. These extremely short-duration, extremely high-interest loans are receiving enormous regulatory scrutiny, and BAC should steer well clear of this disaster. However, the methods of this kind of lending can be applied to more traditional personal loans.
BAC's financials don't give us the benefit of breaking down the types of loans that it's making, although I wouldn't expect this kind of granular data in consolidated financials. However, others that do provide personal loans typically issue them in short durations of a year or so, and they carry relatively high interest rates, depending on the borrower's credit-worthiness. By relatively high, I mean something on the order of 10% to 20% in annual interest which, in comparison to a 3.5% mortgage loan, is quite attractive. I'm putting it to BAC management to consider initiating large quantities of these loans, as its enormous installed customer base, branch network and global reach could mean millions of customers.
Now, BAC would, of course, need to be prudent in its lending standards, but these loans should be less risky than credit card loans. If you think about credit cards, they are basically the same thing, except there is no stated maturity date. Given that anyone with a pulse can get a credit card, any kind of underwriting standards with personal loans should make them less risky than BAC's enormous credit card business.
So where would the money come from to fund these loans? I mentioned Fed Funds and excess reserves in the opening, and I think that is a great place for these loans to be funded from. BAC's most recent 10-Q shows that BAC has over $120 billion in reserves just with the Fed and over $215 billion in Fed Funds sold at the end of the March quarter. That is an enormous amount of liquidity that, while not all available to lend of course, could provide huge firepower in terms of personal loan growth.
How much BAC needs to keep at the Fed in reserves is a moving target that is impossible to quantify. However, we do know that whatever the number is, it's less than the $120 billion that is there now. But even if we exclude this from the exercise, BAC still has $215 billion sold in Fed Funds earning close to nothing in overnight loans.
In my example, if we assume a million personal loans made at an average of 15% interest and a balance of $5,000, which is very achievable given BAC's customer base, we're talking about $5 billion in loans and annual interest of $750 million. Given that BAC's deposit cost is very low, most of this would flow into net interest income, and BAC's existing loan production personal could add this line on in a big way without material incremental expenditures.
My example, while admittedly simplified, shows that BAC could risk even a small amount of its excess liquidity and take some calculated risks to grow revenue and profits. With hundreds of billions of dollars earning 25 basis points in interest, I think BAC management should think outside the box and use a sliver of that liquidity to boost its net interest income prudently. Just my little example would potentially add 5 to 7 cents of EPS, and we're only talking about $5 billion in loans. Over time, this line of business could add 10 or 20 cents of EPS, while risking very little capital in the process.
Disclosure: The author is long BAC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.