Kymes: Credit is still very benign despite recent headlines

Key Concepts

• EPS Beat: Earnings Per Share exceeding expectations.
• Topline Revenue Growth: Increase in a company's gross income.
• Net Interest Income (NII): Profit a financial institution earns from its lending and borrowing activities.
• Loan Growth: Increase in the total amount of loans issued by a bank.
• Annualized Growth Rate: The rate at which a quantity grows over a year, assuming the same rate of growth continues.
• Fee Revenue: Income generated from services other than interest.
• Assets Under Management (AUM): The total market value of investments that a financial institution manages on behalf of clients.
• Fiduciary Fee Income: Fees earned for acting as a fiduciary, managing assets on behalf of others.
• Credit Normalization: The process of credit metrics returning to their historical averages after a period of unusually good performance.
• Conservative Reserves: Maintaining a higher-than-average amount of capital set aside to cover potential loan losses.
• Benign Credit Environment: A period characterized by low loan defaults and minimal credit issues.
• Reversion to the Mean: The statistical phenomenon where extreme results tend to be followed by results closer to the average.
• Superior Credit Outcomes: A history of successfully managing loan portfolios with low default rates.
• TARP (Troubled Asset Relief Program): A U.S. government program established by the Emergency Economic Stabilization Act of 2008 to stabilize the financial system.
• Net Charge-offs: The amount of loans deemed uncollectible and written off by a bank, minus any recoveries.
• Basis Points (bps): A unit of measure equal to one-hundredth of a percentage point (0.01%).
• Criticized Levels: Loans that have been identified as having some degree of risk but are not yet in default.
• Pre-COVID: Referring to the period before the COVID-19 pandemic.
• Economic Cycle: The natural fluctuation of economic activity over time, characterized by periods of expansion and contraction.
• Fraud: Intentional deception for personal gain, often involving misrepresentation.
• Underwriting: The process of evaluating the risk associated with a loan applicant or an insurance policy.
• Borrower Character: A qualitative assessment of a borrower's integrity and willingness to repay debt.
• Deep Relationships with Borrowers: Long-standing and strong connections between a financial institution and its clients.
• Systemic Risk: The risk of collapse of an entire financial system or market, as opposed to risk associated with any one individual entity, group or component of a system.
• M&A (Mergers and Acquisitions): The consolidation of companies or assets through various types of financial transactions.
• Tailwind: A factor that contributes to success or progress.
• Disruption: Significant change or disturbance.
• Technology Transformation: A fundamental change in how an organization uses technology.
• Cultural Transitions: Changes in the shared values, beliefs, and behaviors of an organization's employees.
• Footprint: The geographical presence or market reach of a company.

Quarterly Performance and Drivers

The company reported a strong quarter, exceeding expectations for Earnings Per Share (EPS). The primary drivers for this beat were:

• Robust Topline Revenue Growth: Significant increase in overall revenue.
• Strong Net Interest Income (NII): This was bolstered by healthy loan growth.
• Loan Growth: The bank experienced nearly $1.2 billion in loan growth, representing a 10% annualized growth rate over the past six months. This was a major contributor to the positive financial results.
• Strong Fee Revenue: Operating revenue was particularly strong, with $123 billion in Assets Under Management (AUM) in the wealth division contributing to substantial fiduciary fee income growth.

These factors combined to create a strong topline performance, which in turn allowed for the EPS beat.

Credit Outlook and Risk Management

A significant portion of the discussion focused on the current state of credit and the company's approach to managing it.

• Industry Credit Remains Benign: Despite recent media attention, the overall credit environment for the banking industry is described as "very benign" and "unusually good."
• Conservative Reserves and Expected Normalization: The company is maintaining "pretty conservative reserves" and anticipates credit to "normalize." This means a reversion to historical averages after a period of exceptionally low defaults.
• BK Financial's Credit Underwriting Prowess: The company highlights its long-standing reputation for superior credit underwriting, citing its non-participation in TARP during the Great Financial Crisis due to strong credit outcomes.
• Unsustainably Good Credit Metrics: Current credit metrics are described as "unsustainably good."
  • Net Charge-offs: For the last 12 months, net charge-offs were less than 5 basis points, significantly lower than the typical average of 20-25 basis points for the company.
  • Criticized Levels: Criticized loan levels are very low, more than half of what they were pre-COVID, which were already considered good numbers.
• Anticipation of Increased Charge-offs: It is acknowledged that there will "absolutely be more charge-offs as we move forward through the economic cycle" as credit metrics normalize. However, these are expected to remain at good absolute levels over time.
• Addressing "Cockroach" Concerns: In response to concerns about potential hidden credit issues ("cockroaches"), the speaker emphasized that while more charge-offs are expected, banks are in the risk-taking business. The key differentiator is how well they underwrite credit.
• Fraud vs. Underlying Weakness: The speaker suggested that recent credit issues surfaced in the media were largely related to fraud, which is difficult to underwrite. Character of the borrower remains a critical underwriting factor. The company's deep relationships with borrowers are seen as a mitigating factor.
• Economy Too Strong for Systemic Issues: The current strength of the economy is seen as a reason why broader systemic credit losses across the industry are not anticipated in the near to medium term (even looking out six to nine months).

M&A as a Tailwind

The discussion shifted to Mergers and Acquisitions (M&A) and its impact on the business.

• M&A as a Tailwind: The company views M&A activity as a positive force ("tailwind") for its business.
• Opportunity from Disruption: The disruption caused by M&A events creates opportunities for the company to gain depositors and other businesses.
• Focus on Transition and Change: When other institutions undergo M&A, it often involves significant technology transformations and cultural transitions for their customers and employees.
• Leveraging Footprint: The company, with its established footprint in an eight-state region, is well-positioned to capitalize on this change and disruption by attracting talent, new customers, and prospects.

Conclusion

The company delivered a strong quarter driven by robust revenue growth, particularly from net interest income and fee income, supported by significant loan growth and a strong wealth management division. While acknowledging that credit metrics are currently unsustainably good and will likely normalize with an increase in charge-offs, the company remains confident in its superior credit underwriting capabilities and the overall strength of the economy to prevent systemic credit issues. Furthermore, the company views the disruption caused by M&A activity in the industry as a strategic opportunity to attract new business and talent, leveraging its established footprint.