Probing for Profitability: How Regional Banks are Adjusting to the Highly Competitive Space

There has been a concerted effort across the industry to pull back in auto lending and chase quality auto loans rather than volume for volume’s sake. While some lenders have managed to tighten credit quality as they grow or maintain their portfolios, regional banks have had a more pronounced pullback from the space.

Fifth Third Bank initiated a plan to reduce its auto portfolio 30% by 2019. Regions Bank is in the midst of a $500 million portfolio runoff this year, with another $1.5 billion reduction expected through mid-2019. Citizens Financial Group Inc. hasn’t put a figure on it yet but has initiated a similar strategy, as the company’s portfolio declined 6% year-over-year in the third quarter.

Two regional banks even exited the space entirely in 2017. Portland-based Umpqua Bank left the industry to little fanfare because auto only accounted for roughly 2% of its overall portfolio, David Chiaverini, equity research analyst of mid-cap banks at Wedbush Securities, told AFN. More noticeably, TCF Bank stopped originating auto loans through subsidiary Gateway One Lending & Finance LLC in December.

TCF blamed its exit on low auto loan yields. In early 2017, the bank moved down spectrum to capture more profitable loans and switched to an originate-to-hold from an originate-to-sell strategy. Both of those moves were expected to raise charge-offs, which did increase — by more than 60% year-over-year in the third quarter.

“We expected the yields on the portfolio to go up more than charge-offs, which happened,” a TCF spokesman told AFN. “But, ultimately, even with that higher risk-adjusted yield, we still determined that other uses of the capital will generate a higher rate of return.”

In fact, not one of the lenders listed above attributed their pullbacks to credit performance issues, despite rising delinquencies and losses across the board. Citizens Financial’s charge-offs increased 18% year-over-year in the third quarter. When Fifth Third first announced its anticipated portfolio reduction in the first quarter, the bank reported a 22% uptick in auto charge-offs. Two quarters later, Fifth Third saw an 11% decline in auto losses year-over-year. Regions does not break out its auto portfolio performance.

“There’s been a consistent message for the past year, if not longer, that some of the banks aren’t getting a good risk-adjusted return in auto, so you’ve seen a number of banks pulling back in terms of originations,” said Geoffrey Elliott, partner at Autonomous Research U.S. LP. “Generally, there has been a pullback, and the message hasn’t been that credit is terrible, it’s just that yields are compressed and there are better opportunities elsewhere.”

Yet, with delinquencies and losses on the rise, will deteriorating credit become a concern? And how can regional banks compete in this over-saturated market?

Finding Profitability Amid High Losses 

The challenge for regional banks is that they all generally stick to prime and super-prime credit tiers. That has created an “intense” competitive environment, as large banks tighten credit and captives remain “aggressive” on pushing sales to those same prime customers, Wedbush Securities’ Chiaverini said.

“The captives have been aggressive with the financing terms, and it’s kept a lid on yields,” he said. “When you look at auto portfolio yields trending over the past [year], it’s been relatively stable portfolio yields even though the Federal Reserve
raised interest rates [100] basis points during that period.”

Additionally, credit unions have crept into that prime auto space in recent years, which also pressures yields — despite the fact that we’re in a rising interest rate environment.

Three years ago, credit unions were the third-largest auto finance group by marketshare, and today they have grown loan balances 30% to move up to No. 2, just behind banks and ahead of captives. Credit union auto balances totaled $305 billion in the third quarter, compared with $370 billion across all banks, according to Experian’s third-quarter automotive finance report.

“Credit unions have done so well in picking up growth in the used-car market,” said Melinda Zabritski, senior director of automotive financial solutions at Experian. “More consumers on the new-vehicle side are moving to leases rather than loans. That has pulled marketshare away from banks, and captives are the ones doing all the leasing.”

While that competition keeps interest rates low, lenders are also dealing with charge-offs chipping away at those already diminished returns. That’s one of the reasons TCF pulled out of auto, Chiaverini said — even if the bank denies it.

“I think that loss rate pretty much was eating into the revenues,” he said. “For example, in the most recent quarter they had an auto portfolio yield of between 5.1% and 5.2%, but they also had a net charge-off rate of 1.1%. That right there takes 20% of your revenue off the table.”
TCF was also running at a high efficiency ratio — meaning that the company was not very efficient — and had to spend a lot of money to generate the revenue it did.

The bank decided to move down the credit spectrum into the near-prime space to capture more profitable loans, which also contributed to higher losses, Chiaverini said. “After they put those loans in the portfolio, the average Fico went from being in the mid-730s to 20 points lower,” he said.
“[TCF was] of the mindset that they’d get a higher yield, maintaining the credit costs at a reasonable level, and therefore make more money,” Chiaverini said. “But what ended up happening is the credit deterioration continued, and that caused
them to throw in the towel.”

BMO Harris, meanwhile, has seen increased spreads since it moved into the near-prime space, Head of the U.S. Auto Division Craig Harter said without disclosing exact figures.

“Traditionally, we have been a super-prime bank, but a year ago we made the decision to look at the near-prime space, and that’s where we’ve tried to expand and see if we can capture more of that business,” Harter said. “We’re not talking about subprime business, so we feel any move we make is very measured. Wedo know if you see an increase in spread, it usually comes with an increase in delinquency and losses, but nothing that’s out of where we have put our risk objectives for the future.”

However, a strategy of moving into near-prime loans isn’t very common right now. Instead, most lenders are opting to maintain or lower origination volume, Autonomous Research’s Elliott said. “Generally, lenders have all [pulled back] by curtailing the number of channels
they are originating loans through,” he said. “It could be paring back the number of dealers they are working with, it could be [they stopped] requiring third-party originated loans.”

Citizens Financial ended a flow agreement with Santander Consumer USA in mid-2017, and Regions Bank exited a third-party arrangement with an undisclosed partner around the same time. SunTrust Banks is looking to maintain its portfolio as it moves forward, but back in 2014 the company executed a strategy to move “modestly” down the credit spectrum, said the bank’s Head of National Indirect Lending Chuck Jones. If lenders are going to pursue a similar strategy, they have to make sure their collection and servicing teams are able to take on the challenge. Everyone has to make an assessment on what kind of profitability they are getting and [whether] they want to take that chance to go down [spectrum],”

Jones said. “As we normalize — we’re in the largest economic expansion we’ve ever had historically — if that turns and you go down [spectrum] at the wrong time, then you have strong headwinds against you. You’re going against something you’ve never gone through before, and as an organization you may not have the ability to execute on it.”

The Growers 

Some midsized banks see an opportunity to grow into the void left by their peers and larger players like Wells Fargo Dealer Services, which has experienced multiple double-digit year-over-year portfolio declines.

“As we’ve seen some of the competition pull back, we see it as an opportunity to expand from where we were a few years ago,” BMO Harris’s Harter said. “We’re looking to move back into markets where we retracted from in 2015, and we’re still strategically looking at other opportunities across the country to put a presence and sales reps back into the field and try to capture more business.”

Earlier this year, BMO Harris switched to a three-tiered system from a fixed flat-rate dealer compensation model. That’s one factor that has helped the lender return to markets like Iowa and Michigan, where it used to be more competitive. “[Tiered flat rates] are something different from what [the industry] saw from us in years past, and so it definitely gets their attention when we come back in,” he said. “Some of the markets where we have not been in the past but are just getting into — I’d name California and Pennsylvania — we’re very new as far as
our entry, but [our dealer compensation model] is something that will help us as we look to get dealers up and running.”

M&T Bank was also looking to pull back in the space in early 2017 despite a 22% gain in its portfolio year over year in 2016, Winter said. Now the bank is looking to grow again as competition has pulled back.

“It speaks volumes that you have M&T highlighting that they had good growth [in the third quarter of 2017] from indirect auto, which is a real change,” Wedbush Securities’ Winter said. “They referenced better loan yields with competitors pulling back.”

The prospect of deregulation and lower taxes is also spurring the possibility for growth in the regional bank space.

In November 2017, a bipartisan Senate group reached a deal to raise the threshold that determines whether banks are determined to be systemically important financial institutions (SIFIs). That move — to $250 billion in total assets, up from the $50 billion — could exclude banks such as BB&T, Key Bank, and SunTrust from having to comply with a stricter set of regulations.

“[SIFI] would impact a lot of the regional banks,” Autonomous Research’s Elliott said. “In auto lending I’m not sure there is a big impact, but it will give all those banks a boost.”

Analysts are predicting that the move, if passed, would spur increased merger and acquisition activity. In theory, smaller banks that might have held up potential mergers over fears of meeting the threshold with the SIFI designation would be able to merge with other banks on the fringe and still stay below the $250 billion line.

“You see a lot of [possible M&A] activity in community banks, but it depends on what kind of regulatory relief comes for them, because the smaller the institution, the higher the pressure is to comply and have all the staff and resources,” SunTrust’s Jones said. “Depending on how the regulations come out, it could really change the landscape. But until we know what it looks like, I don’t think we can really address that.”

At $210 billion in total assets, SunTrust slides in under the newly proposed SIFI threshold, which lead some analysts to speculate about whether it would prevent the bank from engaging in future acquisitions. However, SunTrust Chairman and Chief Executive Bill Rogers addressed those issues during a CNBC interview at the Goldman Sachs U.S. Financial Services Conference.

“We have no reason to think we can’t do something from a consolidation standpoint, that’s just not been our profile and focus,” Rogers said. “We’re not going to stop or slow down because there is a line of $250 billion. We’re going to grow and invest in our businesses, and when we exceed that line, we’ll be ready and have the capital and systems in place to respond from a regulatory standpoint.” While a fair amount of uncertainty lays ahead, banks overall are still pretty satisfied with their auto portfolios.

“A lot of the regional lenders I’ve spoken with have made really strategic and very tactical decisions to realign their auto portfolios, so there has been a little bit of a reshuffling of looking at how much of their overall holdings do they want to have in auto,” Experian’s Zabritski said. “Banks have been losing some marketshare, but they still have the largest outstanding balances of any lender out there.”