At ProBank Austin, we are always curious at this time of
year to find out what’s on the minds of our community bank clients, and in
particular, to better understand their plans and goals for the coming year.

As consultants serving clients from
around the country, we have a unique window into the thinking of community
bankers, as each year we assist our ALCO clients with the preparation of their
annual budgets. By confidentially
analyzing and comparing these annual financial plans, we are able to provide all
community bankers with insight into how their expectations for 2017 compare with
that of their peers.

Our
clients range in size from under $100 million to $3 billion in total assets. Clients included in our budget review process
this year were well distributed across the typical size classes representing
the community banking industry, as shown below:

Impact of Election,
Stock Market Gains

All of
the budgets included in this year’s review were prepared after the presidential
election, and during the time period when bank equity values experienced a
strong post-election rally. We do not
believe that either of these events, or the optimism surrounding them,
significantly affected banks’ financial plans for 2017. Even with expectations of lower corporate tax
rates, regulatory relief, and improving economic conditions, our bank clients
seemingly adopted a “wait and see” strategy and did not significantly revise
upward their budget estimates for 2017.

Interest Rate
Forecasts

Since this is the first year in recent
history with a high probability that interest rates will rise, we were interested
to see how our clients were factoring this assumption into their 2017 budgets.

Across banks of all sizes, we found
that 21% of banks built into their budgets at least one additional rate
increase for 2017. Since these budgets
were prepared between November 15, 2016, and January 17, 2017, most banks had adequate
time to take into account the Federal Reserve’s rate move in December. As you may recall, the Fed moved rates at
their meeting on December 13th, a move that was anticipated by
nearly everyone.

Given these expectations, approximately 49% of
the banks built into their 2017 budgets two rate increases of 25 basis points
each for the year. The remaining 31% of
banks prepared their 2017 budgets on the expectation that there would be no
further rate increases during the year (after the rate increase in December
2016, which will have some carryover effect into 2017).

Loan Yields and
Deposit Cost Changes

Despite the forecasts of managed
rates moving up during the year, most banks are not anticipating substantial
increases in loan yields. Continued
competition and weak loan demand are the two most cited explanations for a
muted growth in loan yields. Even though
eighteen percent of banks in the sample were forecasting loan growth greater
than 10%, the median loan growth rate of the entire sample was only 6.23%, less
than the budgeted growth rates of the prior two years, and approximately equal
to the actual growth rate between 2016 and 2015.

The impact of this modestly
optimistic budget forecast appears to limit banks’ expectations for growing loan
yields, which are budgeted to rise by 17 basis points over the ending levels of
2016. For banks estimating two
additional interest rate hikes during 2017, in addition to the December, 2016
adjustment, this represents an effective increase of approximately 23% of the
actual change in managed interest rates.

On the funding side of the bank,
deposit balances are budgeted to increase by a median of 3.40%, as compared to
the 6.23% growth in loan balances, indicating that approximately 45% of new
loan growth will need to be funded from existing liquidity, brokered deposits, or
other borrowings.

Due to this relatively low deposit
growth forecast, the distribution of rate increases across the calendar year,
and market-based lags in implementing deposit rate increases, deposit rates are
budgeted to rise at a modest pace. As
the combined result of these factors the median cost of funding is expected to
rise by nine basis points during the year.
For banks that forecasted an additional 50 basis point upward movement
in rates, this represents an adjustment to funding costs equal to only 12% of
the full movement of managed rates.

On balance, it is interesting to
note that banks are planning for loan yields to rise faster than increases in
deposit costs, thereby forecasting an improvement in net interest margins.

Other Income
Statement Changes

In addition to our review of the
changes to loan and deposit balances and rates as discussed above, we also analyzed
clients’ expectations for changes in fee income, provision expense, and operating
expenses for 2017.

Fees

The ability to raise fee-based
income in a variety of areas appears to be meeting with great resistance, as
the majority (52%) of clients forecasted their non-interest incomes to decline
in 2017. The median change to
non-interest income for the group as a whole was a -1.22%. One reason for the decline was that many
banks took gains in their investment portfolios in 2016, an opportunity that
due to rising interest rates will diminish considerably in 2017. Decreasing non-interest income was far more
prevalent among smaller banks, with 62% of banks under $500 million in assets
forecasting fee declines in 2017.

Provision for Loan
Losses

Credit
quality is expected to remain relatively strong on an overall basis, as the
expectation for an increase in the provision for loan losses is less than the
rate of growth in the loan portfolio.
Provision expenses are budgeted to rise by only 4.07%, as loan growth is
slated to grow by 6.23%, indicating an expected improvement in overall credit
quality.

Operating Expense
Inflation

Community
banks continue to hold the line on operating expense increases, despite strong
pressures from health care, salary and regulatory costs. At a time when the general inflation level
has averaged below 2%, banks have budgeted cost increases amounting to just
3.21% of total operating expenses. This is
a very positive development, as health care, salary and regulatory cost
increases would normally far exceed average inflation levels, and are very difficult
for most management teams to control.

Net Income, ROA and
ROE

Community
bank financial forecasts for 2017 do not appear to reflect the level of
optimism commensurate with prospects for an improving economy, lower tax rates
and record high stock market indices.

With nearly equal numbers of banks
budgeting net income increases for 2017 (52%), as are forecasting net income
declines (48%), overall net income is budgeted to rise by 3.89%. Median ROA across our entire sample, (which includes
many smaller banks which typically have lower ROA’s), is 0.82%. Median ROE’s are likewise modest, and budgeted
to equal 7.91%, for the entire sample.

Banks above $500 million in total
assets have an average budgeted ROA of 1.01% for 2017, and an average budgeted
ROE of 9.99%. Banks under $500 million
in total assets have budgeted ROA’s of 0.46% for 2017, and a budgeted ROE of 4.68%.

Summary

Amidst growing optimism
related to the economy, interest rates, loan demand and market indices, (especially
bank equity values), the short run financial plans of most banks in 2017 are
conservatively optimistic, indicating only a measured level of financial
improvement. Just as the Federal Reserve
has taken a cautiously optimistic forecast for the economy with a strong “wait
and see” bent, so too, have community bankers tempered their optimism for earnings
improvement in 2017.

If the
economy reacts positively to regulatory, tax or fiscal policy changes, (if and
when enacted), with strengthening loan demand, actual financial performance
could easily outperform most banks’ budgets during 2017. However, very few institutions have based
their 2017 budget on this scenario.

Growth in both loan and deposit
balances for 2017 are forecasted at achievable levels, with reasonable
expectations for loan yield increases.
If liquidity is decreased significantly due to greater than expected
loan demand or higher than expected inflation or interest rate increases, costs
of funding may outpace many banks’ conservative estimates.

Other
income statement items, such as low fee increases, modest increases in
provision expenses (in the face of higher loan growth), and operating expense
increases just slightly higher than the average inflation rate, seem mostly
reasonable and should not lead to anything other than minor variances during
the year.

As
always, maintaining growth of the net interest margin will be challenging
unless loan demand strengthens considerably, and accomplishing the planned
increase in loan yields while minimizing deposit cost of funding increases will
require consistent, sustained pricing discipline.