Profitability is the bottom line, but it’s not the end of the story.
Consider banks: In 2010 and 2011, Hawaii’s two largest financial institutions, First Hawaiian Bank and Bank of Hawaii, were also the state’s most profitable companies. Last year, they ranked first and third; First Hawaiian’s net income came to $216.92 million and Bank of Hawaii’s profits totaled $166.21 million.
That’s not surprising. After all, both are highly regarded in the banking industry. Forbes magazine has named Bank of Hawaii one of the best-managed banks in the country for each of the last seven years. Neither bank was hurt badly by the sub-prime mortgage debacle that laid waste to the balance sheets of so many mainland banks. Instead, both have remained steadily profitable and financially stable. And, while their ownership structure is different – Bank of Hawaii is an independent, publicly traded corporation, while First Hawaiian is a wholly owned subsidiary of Paris-based BNP-Paribas – operationally, they’re both committed to community banking. The average consumer would be forgiven for thinking the two banks, facing each other across Bishop Street, were mirror images of one another.
Yet, a closer look at the banks’ numbers suggests that they’re more different than they appear. Run a finger down the columns in their financial statements and it becomes clear that, despite superficial similarities, First Hawaiian and Bank of Hawaii make their profits in very different ways, focus on different assets and fund their operations with different liabilities. Parsing these differences is a good way to understand not only these two banks, but also how companies think about profitability in general.
By The Numbers
The best place to start is with their income statements. For banks, income comes from three broad categories. First, there’s the income they make lending money to customers. This is what most people think of as “banking,” and it’s straightforward: The bank takes deposits “borrowed” at 0 percent, or nearly 0 percent these days, and lends that money as, for example, residential mortgages at 3.9 percent interest or business lines of credit at 8 percent. The interest rate margin – the difference between what the bank pays for the deposit and what it charges for the loan – represents the return for the bank, minus taxes and expenses.
Banks also make money by investing, generally in safe, but not terribly profitable, securities like U.S. Treasuries or federal agency bonds and municipal bonds. Together, the lending and investing streams of income are called “interest income.” Banks also have a third kind of revenue called, not surprisingly, “noninterest income,” which includes fees and commissions they earn for services like trust management or financial advising. As interest rates fall, along with interest rate margins, this noninterest income becomes more important.
A glance at the income statements of First Hawaiian and Bank of Hawaii reveals their different focuses. In 2012, First Hawaiian made about 12 percent of its interest income from investments, which is fairly typical of community banks of its size. At Bank of Hawaii, investment interest income was almost 39 percent. That’s more typical of a large, national bank than a community bank. To put it in perspective, Bank of America, the second largest bank in the country, made 27 percent of its interest income from investments.
That’s not to say Bank of Hawaii takes more risks. “It’s not an excessively aggressive portfolio,” says Jeff Rulis, senior research analyst with D. A. Davidson, a Montana-based financial consulting firm. “They keep the portfolio relatively short, in terms of duration. So, while the size of the portfolio may be larger, the inherent risk is pretty moderate.” It is, though, quite different from First Hawaiian.
Let’s take a closer look at that income statement: In 2012, Bank of Hawaii earned $123 million on mortgage-backed securities (not the risky kind that almost sank the financial markets in 2008, but securities that are backed by the goverment through agencies like Ginnie Mae and Fannie Mae), plus an additional $46.8 million from other investment types, like municipal bonds, U.S. Treasuries and agency securities. In contrast, First Hawaiian, though the larger of the two banks, earned only about $55 million from mortgage-backed securities and less than $7 million in other investment income.
On the loan side, though, the roles of the banks are flipped. First Hawaiian earned $442 million on its loans and leases, nearly twice Bank of Hawaii’s $268 million. Yet, the gross earnings for the two banks are similar: $676 million for First Hawaiian and $630 million for Bank of Hawaii. So, why would the income streams of two banks with such similar reputations be so different? In order to understand that, we have to look elsewhere in the financial statements.
The Balance Sheet
“The income statement is just a reflection of activity on the balance sheet,” says Bob Harrison, CEO of First Hawaiian. “And the balance sheet difference is that our loan portfolio is $9 billion while our investment portfolio is less than half that.” That ratio is remarkably different from Bank of Hawaii, which has a $5.7 billion loan portfolio that’s actually smaller than its $7.1 billion investment portfolio. Remarkably, though, both banks say they prefer loans to securities.
According to Harrison, there are a couple reasons for this. “The way we look at it,” he says, “we’re taking deposits to reinvest in the community. And the community benefits when we lend people money, whether it’s a consumer loan, a car loan, a home-equity line or a business loan to construct a new building or expand their working capital, etc. We really see the benefit of taking one person’s deposit and putting that back out into the community as a loan to someone else. It really multiplies in the community.”
The problem, he says, is that the bank simply can’t find enough loan opportunities that it feels comfortable making. At the same time, people and businesses have been hoarding cash, especially in the wake of the Great Recession. As a result, the bank’s core deposits have grown by 53 percent over the last four years. First Hawaiian, in effect, is sitting on $5.5 billion in excess cash.
“That extra money,” Harrison says, “we put in our investment portfolio. It’s very high quality. We take very, very little risk. In fact, the vast majority of our investments are in Treasuries, government agencies, etc., etc., because that’s not an area where we’re willing to take risk. That’s just where we put our extra money. Where we’re really ready to sit down with someone and understand the risk is in our loan portfolio. And the difference, the reason we prefer loans, is that, although it’s more work, the yield is higher on the loan portfolio.”
Bank of Hawaii CEO Peter Ho says much the same thing, notwithstanding the very different asset portfolios of the two banks. He points out that, over the last three years, the Bank of Hawaii’s deposits have grown 14 percent. “That’s a big number, even on an annualized basis,” he says. “On the other hand, loan growth has tracked closer to the state GDP, so we’re probably going to end up having about a 3 percent per annum growth on loans versus a 4 percent or 5 percent per annum deposit growth, and that effectively creates the need to invest.”
Like Harrison, Ho also notes that the securities investments are not the bank’s first choice. “If we had our druthers, frankly, we’d lend it all,” he says. “The reason why is because there’s a higher yield associated with lending money as opposed to investing money.”
However, despite the banks’ very similar sounding philosophies, their balance sheets are almost entirely different. Consider their investment portfolios:
- Bank of Hawaii owns $782 million in municipal bonds; First Hawaiian has zero.
- First Hawaiian holds $3.5 billion in U.S. Treasuries and agency securities; Bank of Hawaii has $6.1 billion.
- Nearly $3.6 billion, 27 percent of Bank of Hawaii’s total investment portfolio, is in “held-to-maturity securities”; First Hawaiian, once again, has zero.
In total, First Hawaiian, the larger of the two banks, holds $5.5 billion in investment assets compared to Bank of Hawaii’s $7.1 billion. (How’s that for “excess liquidity”?) The percentages are even more striking: only 38 percent of First Hawaiian’s total earning assets are in investment securities vs. 55 percent for Bank of Hawaii. How do we account for this difference?
The Loan Portfolio
The answer is also on their balance sheets. Let’s look at the loan portfolios: Both have a similar amount in real estate loans, but very different amounts in other loan types. First Hawaiian has more than $900 million in individual loans on the books, more than twice as much as Bank of Hawaii. The difference in commercial loans is even more dramatic. First Hawaiian holds commercial loans (including lines of credit and commercial real estate loans) totaling $2.3 billion compared to $537 million at Bank of Hawaii. And First Hawaiian’s $8.9 billion total loan and lease portfolio is more than $3 billion larger than its competitor’s. That $3 billion difference in loans that First Hawaiian was able to make largely explains why Bank of Hawaii had so much more excess cash that it had to invest in securities. That, despite the fact that First Hawaiian parked another $1.6 billion of its excess liquidity in the Federal Reserve System, where it earned almost no interest at all.
According to Ho, the decision of where to put your excess capital is tied to that question of liquidity. “The Fed is considered the most liquid of marketplaces,” he says. “On the other hand, more than half of our balance sheet is in U.S. Treasuries. So, that’s the same thing as liquidity. If I needed to sell bonds tomorrow, I hope to hell I could find a buyer for a U.S. Treasury or we’re all in big trouble. That’s the way we look at liquidity: If tomorrow morning, half of our depositors came in and said, ‘We want our cash right now’ – obviously that’s not really going to happen, but if it did – would we have the liquidity to support that? And the answer is yes. We could take the securities and sell them, $7 billion or whatever it is, and say, ‘Fine, here’s your money.’
“A loan is a little different. With a loan, I can’t call up a customer and say, ‘I know I made that loan to you and said you didn’t have to pay me back for 30 years, but I’ve got a customer at my window and he wants to be paid and I don’t have the money.’ ”
The Growth Question
Although the balance sheet makes it easy to see how the two banks ended up weighted toward different asset classes, explaining why is somewhat harder. Let’s take a closer look at First Hawaiian’s $2.3 billion commercial loan portfolio. Not only is this four times the size of Bank of Hawaii’s portfolio, but it grew 31 percent in 2012 while Bank of Hawaii’s actually shrank 3 percent. And, if you look at the other banks in the state, Bank of Hawaii’s situation is the more typical of the two.
According to Ho, this simply reflects the slow growth in the state GDP. “Shouldn’t loan growth be pretty much correlated almost exclusively to growth in the marketplace?” he asks. “Assuming you’re just doing what the economy is giving you, that people are borrowing for what the economy allows them to do, and business activity reflects the economic environment, our sense has always been that our lending activity should always loosely track whatever is happening in the economy. When it doesn’t, that’s when you start to potentially see bubbles being created.”
“The other thing to bear in mind when you look at bank balance sheets,” he says, “is where are the assets coming from? We know where our investment assets are coming from. They’re coming from the U.S. Treasury, for the most part, or from municipalities, including Hawaii. But where are the loan assets coming from? That’s a separate question. For us, the vast, vast, vast majority of our loan assets are sourced right here in the Islands and in Guam – we have a large Guam operation – and the source of repayment, the people and businesses underwriting those loans, are also right here in the Islands.”
He suggests that might not be the case with First Hawaiian. By way of explanation, he returns to the notion of the state’s GDP.
“Let me ask you,” he says, “do you think there’s something different in the way they approach their loan portfolio if the economy is growing at 3 percent and their loans grew at 31 percent? Where could those loans be coming from?”
One possibility is that First Hawaiian is poaching business from other banks in Hawaii. In fact, Harrison points out that, during the financial crisis in 2008, when other banks started to pull back on their lending, First Hawaiian’s loan portfolio experienced the most dramatic growth in the bank’s history. He attributes this growth to the bank’s consistent lending standards: “We don’t lower our standards when the economy is good, and we don’t raise them when the economy is bad.”
But Ho notes that this doesn’t account for the growth of First Hawaiian’s loan portfolio in 2012. “Over the period of their 31 percent growth, I think the loans outstanding were pretty much stable to flat for the other banks in Hawaii. So, it’s not coming out of this market. So, where is it coming from? Is it coming from France? Is it coming from California? It’s just hard to believe it’s coming from here.”
Harrison acknowledges that First Hawaiian does, indeed, have clients on the mainland. “Do we do anything in France or in Europe? No. Do we have some stuff on the mainland? The answer is yes. We do some loans for customers that are here and have operations on the mainland and for some of the big national chains that have business here in Hawaii. But if you look at the growth in our commercial loan portfolio over the last several years, the vast majority of that was right here in Hawaii.” Even in 2012, he says, most of that 31 percent growth was local business.
But if First Hawaiian seems to be more successful in its lending operations, Bank of Hawaii does much better on the investment side of the house. That’s not surprising, given their different asset bases. Where First Hawaiian earned a measly 1.1 percent return on its investments, Bank of Hawaii made 2.4 percent, a tidy return for the banking industry. Bank of Hawaii also outperformed First Hawaiian in the noninterest income category, $190 million to $167 million, even though it’s the smaller bank. This likely reflects Bank of Hawaii’s large trust management business.
It’s interesting to note that the differences between First Hawaiian and Bank of Hawaii aren’t all on the asset side of their balance sheets. There are also dramatic differences on the liability side, especially in their deposit portfolios.
For example, Bank of Hawaii has more than $1 billion in demand deposits – essentially, the money deposited in customer checking accounts. To the layperson, it might seem odd to call a deposit a liability. After all, this is money the bank can use to make loans or invest. But it’s also money the bank owes back to its depositors. In fact, the term “demand deposit” refers to the fact that depositors can ask to have their money back at any time.
Even so, demand deposits, savings deposits and money markets, known collectively as “core deposits,” are the most attractive balance type for banks. In part, that’s because time deposits, like CDs, tend to increase interest risk for the bank: The bank is locked into paying a specific interest rate for a year or more, regardless of whether market rates go up or down. Peter Ho points out, “Basically, banks that have more core deposits than time deposits are considered to have a better deposit profile. That’s why we focus on demand and savings deposits. And, because we haven’t seen tremendous growth in demand on the lending side, we haven’t really had to try to raise time deposits.”
First Hawaiian, in contrast, has less than half the demand deposits of Bank of Hawaii. And although its total core deposits are more than Bank of Hawaii’s – FHB has nearly $1 billion more in money market deposits – a larger percentage of its assets are in time deposits.
Maybe the most startling items in a bank’s financial statement are its earning ratios. Analysts pay special attention to a couple of these: return on assets (ROA) and return on equity (ROE). It’s worth noting that First Hawaiian and Bank of Hawaii both perform well above their peer group in these categories. When you compare the two local banks, First Hawaiian has a slightly larger ROA (1.35 percent vs. 1.22 percent,) while Bank of Hawaii has a better ROE (a remarkable 17 percent, vs. 8.2 percent.)
But what do those numbers mean? ROA is fairly straightforward. It tells investors how efficiently a company exploits its assets. In First Hawaiian’s case, the company was able to earn an annual return of 1.35 percent on the assets it had at hand in 2012. Those might seem like tiny returns, but they put the bank in the top quartile among its national peers.
Here, it’s worth pausing for a moment to consider the business model of banking. If you had $16 billion dollars to invest, would you be happy with a return of just 1.35 percent (or 1.22 percent, in the case of Bank of Hawaii, still above average for the industry)? Historically, the stock market has yielded annual returns more like 7 percent. Why would anyone want to be in the banking business if a good year earns less than 2 percent? Here’s the one-word answer: leverage.
After all, only a small percentage of the money a bank lends out or invests belongs to the shareholders. Most of it comes from the deposits of its customers. When you put your paycheck into your checking account (at zero percent interest) the bank may turn around and lend that as a mortgage at 3.9 percent interest or as a line of credit at 8 percent. In practice, of course, some percentage of that loan comes from shareholder equity and some percentage comes from deposits. At Bank of Hawaii, the shareholder equity amounts to only 7.2 percent of its assets. First Hawaiian, which has more equity than all the other banks in Hawaii combined, still only owns 16.3 percent of its assets. That means every dollar that First Hawaiian invests of its own is leveraged with more than five dollars of deposits. Consequently, First Hawaiian’s ROE is a healthy 8.2 percent. And Bank of Hawaii, because it has far less equity – that is, a much higher percentage of the money it lends out or invests comes from depositors rather than shareholders – has a whopping 17 percent ROE, among the best in the nation.
Jeff Rulis, an analyst who covers Bank of Hawaii, puts it this way: “If you’re generating over a 1 percent ROA, or more than a 5 percent ROE, that’s pretty good. And if you’re generating a double-digit ROE, which Bank of Hawaii has for years and years, that’s very rare.” So we don’t want to read too much into these numbers.
It could be that the different levels of equity just reflect the differences in ownership. Bank of Hawaii, as an independent, publicly traded corporation, is more sensitive to the concerns of investors. And investors pay particular attention to a company’s ROE.
After all, ROE represents the money available to be returned to the shareholders, either as dividends or by growing the company and increasing the value of its stock. In theory, a lower ratio of equity to total assets means a higher return for investors. Of course, a bank still needs to maintain enough equity, cash reserves, etc. to cover depositor withdrawals and to weather economic downturns. One need only look to the banking crisis of 2008 to see what happens when financial institutions leverage their assets too far. But for a healthy, well-managed institution like Bank of Hawaii, deciding upon the correct level of equity capital – how much of the profits to keep as retained earnings to grow the company, and how much to return to investors as dividends – is a strategic decision.
On the other hand, First Hawaiian, as a wholly owned subsidiary of BNP, doesn’t have to placate thousands of shareholders, just one. As the single shareholder, BNP is entitled to the entire ROA. In fact, in 2012, First Hawaiian returned all its profits, and then some, as dividends to its single owner. Bank of Hawaii wasn’t far behind, returning 70 percent of its profits as dividends to shareholders.
This is a good place to re-emphasize that, despite the wildly different balance sheets, these two banks also have a lot in common. The differences are real, but they probably don’t overshadow the similarities. Rulis, the D. A. Davidson analyst, points out that the differences between the two banks could simply be two competitors staking out different turf in the marketplace.
“Maybe one or the other says, ‘Do we really want to bash heads with those guys?’ If I’m First Hawaiian management, for example, do I really want to go after mortgage banking from the fee side when Bank of Hawaii has been there forever? Maybe we should just retrench in something we’re better suited to garner business in.”
First Hawaiian’s Bob Harrison hints at the same thing. “With commercial and industrial lending, it takes a different group of bankers to work with those kinds of customers. We like that and we’re very comfortable with that. A lot of the folks on our senior management team, myself included, have grown up with that.”
Phill Rowley, CEO of Treasury Management Services Inc., which advises banks on how to manage their assets, also agrees. “It seems to me, you’ve got two banks here that have discovered their niches. One is more consumer-oriented and the other more commercial-oriented.” Some banks, he adds, are just more comfortable making loans while others favor investing.
For his part, Peter Ho doesn’t think the banks are as different as the numbers seem to indicate. “I really don’t,” he says. “I think both banks are obviously committed to the Islands. I think both banks take the customer’s interests and the community’s interests as truly core values in the organization. And I think both organizations are pretty conservative, as you would expect community banks that are both over 100 years old to be. So, I’m not sure I see too much in the way of meaningful or operational differences.”
Then again, it’s hard to ignore the numbers.