BANK EXECUTIVE BUSINESS OUTLOOK SURVEY 2015, Q4

INTRODUCTION

Caution seems to be the word on the mind of many bankers as we head into Spring. With upheaval in the world markets and economic uncertainty across the globe, it appears that many banks are taking a

more “wait and see” approach until the dust settles on a number of fronts. Specifically, the latest Bank Executive Business Outlook Survey underscores a number of interesting trends.

The decision by the Federal Reserve to raise rates last December has already started to have an impact for many banks, although that impact has been minimal so far. Many institutions have also seen an upturn in yields, particularly in Commercial and Industrial (C&I) lending.

Industry consolidation is also on the minds of many bank executives. Survey respondents indicated that they expect the banking industry to shrink by nearly 20% over the next five years. This is a continuation of what the industry experienced during the last decade, in which over 2,500 banks disappeared as the result of consolidation or failures that hit every region of the country.

Bank executives are wary about the economy. Expectations for future growth in loan demand have significantly waned from past surveys, with barely half of survey respondents expecting loan demand to increase over the next year.

I hope you find the information contained in this survey useful. As always, if you have thoughts or questions about the results, please contact Steve Kinner, Senior Managing Director, Sales, at (866) 776-6426, x3445 or Phil Battey, Senior Vice President, External Affairs, at (866) 776-6426, x3357.

Sincerely,

Mark JacobsenCEO & PresidentPromontory Interfinancial Network, LLCArlington, Virginia

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The big question of when the Federal Reserve would start raising rates was answered in December 2015.

With that decision, the Federal Reserve changed the direction of interest rate policy for the first time since the advent of the financial crisis and Great Recession.

But far from being a return to old times, banks now face a significantly different environment than any that they’ve previously experienced—from a substantially smaller industry in terms of the number of institutions to a shift in thinking regarding the role community banks will play in the lending market going forward.

In the Q4 2015 Bank Executive Business Outlook Survey, which includes the responses of 175 CEOs, presidents, and CFOs of banks across the country, respondents indicated that they expect industry consolidation to continue at a pace similar to what they have seen since the credit crisis.

Respondents reported that they anticipate the number of institutions to decline by over 1,000 institutions over the next five years, with most of the decrease coming from banks with less than $1 billion in assets. This consolidation reflects some of the challenges that banks expect to see in lending and rising costs.

Other findings from the survey include:

The December Fed rate increase is already having an impact on banks. Since the Federal Reserve increased interest rates just six weeks prior to the survey, it’s too soon to say what the long-term impact of the rate change will be, but so far, respondents report that the impact has been minimal on both sides of the balance sheet. With regard to funding, 55% of respondents indicated that their institutions have already seen an increase in wholesale funding costs. On the asset side, 42% of respondents indicated that they’ve seen an increase in yields on C&I loans.

Banks expect Commercial Real Estate (CRE) loans to continue to play an outsized role in their lending. CRE lending has grown substantially over the past 15 years as a share of community bank portfolios. Respondents indicated that they expect this trend to continue, even though they would prefer a more diverse mix that includes a larger role for consumer and C&I lending. This move towards more CRE may be partially driven by the ongoing decrease in yields on non-credit card consumer loans, which hit a 15-year low in 2015.

Barely half of respondents expect growth in loan demand to continue. Expectations for growth in loan demand dropped to their lowest level in four quarters, according to

EXECUTIVE SUMMARYFollowing the first rate increase in over a decade, bank leaders eye a future full of change.

this survey. Just more than half of survey respondents indicated that they expect loan demand to continue to increase, with the majority of those expecting an increase predicting only a moderate rise. Among larger banks (banks with between $1 billion and $10 billion in assets), only 36% expect loan demand to grow over the next 12 months.

Bankers expect to rely more heavily on wholesale funding over the next 12 months. Even with an uptick in the cost of wholesale funding, banks expect to rely on this source more than they would like.

Most bankers expect the rise in funding costs to be gradual. Despite the recent increase in wholesale funding costs, respondents indicated that they don’t expect their overall cost of funds to rise substantially; less than 3% expect a significant cost increase.

Reciprocal deposits play a key role for banks looking to protect deposit funding. Eighty-eight percent of respondents indicated that reciprocal deposits play a role in helping them protect their relationships with depositors and 47% of respondents indicated that reciprocal deposits are either very important or extremely important to their efforts to retain existing depositors.

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$10 Billion - $50 Billion Assets

$1 Billion - $10 Billion Assets

$100 Million - $1 Billion Assets

<$100 Million Assets

>$50 Billion Assets

Total Industry Institutions

Number of Current Banks in the U.S. Expected Number of Institutions in 5 Years

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

-30%-20%-10%

0%10%20%30%40%50%

Change in Number ofBanks < $1 Billion in Assets

Change in Number ofBanks > $1 Billion in Assets

Expected Percentage Change over Five Years in the Number of Banks

Current and Expected Number of Banking Institutions by Asset Size Five Years from NowSurvey respondents indicated that they

expect the number of commercial banking institutions to shrink by nearly

20% over the next five years, declining from about 6,300 today to approximately 5,100 by 2020.

This would continue the trend recorded over the past eight years, during which time the banking industry contracted by over 2,500 banks.

Bankers expect reductions to be concentrated among smaller banks, those with less than $1 billion in assets, which currently number around 5,500.

While the industry is expected to shrink overall, respondents expect banks with more than $1 billion in assets to increase in number, suggesting that consolidation among banks with <$1 billion currently will be the primary driver of the reduction in total institutions. Based on these results, we can surmise that banks don’t expect another rash of failures to drive the reduction in institutions.

Since 2012, there’s been a steady increase in the frequency of whole bank M&A activity. The majority of this M&A activity has been happening among banks within the same state, and the vast majority of mergers have been one-offs, as banks look to opportunistically expand or grow share within their market areas.

CONSOLIDATION AMONG SMALL BANKS EXPECTED TO REDUCE INDUSTRY PARTICIPANTS BY NEARLY 20%

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DECEMBER FED RATE INCREASE ALREADY HAVING AN IMPACT ON BANKS

When the Federal Reserve announced the first rate increase in more than a decade on December 16, 2015,

there was a fair amount of uncertainty (and speculation) about the impact it would have on banks.

Since the survey was distributed just six weeks after the rate increase, it’s too soon to say definitively what the impact will be over the long term, but so far, respondents say the effects have been minimal on both sides of the balance sheet.

Perhaps the most immediate consequence of the rate change has been felt in the wholesale funding market. Fifty-five percent of respondents indicated that they have experienced an increase in their cost of wholesale funding since the Federal Reserve raised rates.

On the asset side of the balance sheet, 42% of respondents indicated that they’ve seen a moderate increase in their C&I loan yields, and 39% have seen a moderate increase in CRE loan yields.

How Has the Federal Reserve’s Decision to Raise Interest Rates in December Affected Your Bank’s Funding Costs from the Following Sources

How Has the Federal Reserve’s Decision to Raise Interest Rates in December Affected Your Bank’s Yield in the Following Lending Categories

Significant IncreaseModerate Decrease

Moderate IncreaseSignificant Decrease

No ChangeN/A

Cost of Retail Deposits

Cost of Corporate Deposits

Cost of PublicFunds Deposits

Cost of Wholesale Funding

0%10%20%30%40%50%60%70%80%

Significant IncreaseModerate Decrease

Moderate IncreaseSignificant Decrease

No ChangeN/A

Yield on Residential Lending

Yield on CRE Lending

Yield on C&I Lending

Yield on Consumer Lending

0%10%20%30%40%50%60%70%80%

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CRE loans have been steadily growing as a percentage of community bank lending portfolios over the past 15

years, rising from an average of 20.1% in 2001 to over 30.2% by the end of 2015, while other loan types continue to dwindle in their share of loan portfolios.*

In the aggregate, respondents indicated a moderate discrepancy between their preferred mix of loans and their expectation for the composition of their loan portfolio by 2017.

On average, respondents indicated that they expect CRE to make up 38.2% of their loan portfolios in 2017, compared to a preferred allocation of 35.0%. Meanwhile, both C&I and consumer loans are expected to make up less of their portfolios than they would like.

The shift towards this expected weighting correlates with the perceived risk associated the different loan categories.

Many banks that we’ve spoken with indicate that they want to build a more well-rounded portfolio, but pricing remains a challenge. Across the industry, yields on consumer loans fell to a 15-year low of 7.1% in 2015.*

*Source: FDIC Statistics on Depository Institutions

CRE LOANS EXPECTED TO CONTINUE TO PLAY OUTSIZED ROLE IN LENDING, AND ANSWERS FOR DIVERSIFYING REMAIN UNCLEAR

10.6%

29.0%

9.1%25.6%25.1%

26.8%

CRE LoansResidential Loans

C&I LoansConsumer Loans

35.0% 38.2%

Preferred Lending Mix

Expected Lending Mix in January 2017

[1] Calculated as follows: (Expected Lending Mix - Preferred Lending Mix) / Preferred Lending Mix. (Example, consumer loans would be calculated as follows: (9.1% - 10.6%) / 10.6%.

Percent Difference in Expected vs. Preferred Lending Mix1

-15.0%-12.5%-10.0%

-7.5%-5.0%-2.5%0.0%2.5%5.0%7.5%

10.0%

ConsumerLoans

C&ILoans

Residential Loans

CRELoans

Stated Ideal

Marginal Deviation

Marginal Deviation

Significant Deviation

Significant Deviation

BORROWER RISK DECREASES IN ORDER OF LOAN TYPE DEPICTED

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BARELY HALF OF RESPONDENTS EXPECT GROWTH IN LOAN DEMAND TO CONTINUE

At the end of the first quarter of 2015, nearly 75% of respondents to this survey indicated that they expected

to see an increase in loan demand over the next 12 months.

Now, as banks enter 2016, expectations for future growth in loan demand have significantly waned, with barely half of survey respondents predicting their loan demand to rise over the next year.

The expectation for future loan growth is even lower among banks between $1 billion and $10 billion in assets. Among those, only 36% expect to experience an increase in loan demand over the next year.

Correspondingly, the percentage of respondents who expect to see a decrease in loan demand is at its highest level in a year (17%).

Although the trend is moving in a downward direction, it’s important to note that the vast majority of respondents expect loan demand to remain at, or above, the levels they’ve seen in the prior year.

Loan Demand

Reported Expectation for 12-Month Loan Demand Over Past Four Quarters

0% 10% 20% 30% 40% 50% 60%

Significant Decrease

Moderate Decrease

Same

Moderate Increase

Significant Increase

What are your expectations for your bank’s loan demand 12 months from now?How is your bank's loan demand compared to 12 months ago?

Significant Increase

Moderate Decrease

MaintainCurrent

Moderate Increase

Significant Decrease

Q1 Q2 Q3 Q4

0%10%20%30%40%50%60%70%80%

7

6.9%

47.3%

11.2%34.5%

8.8%

46.7%

11.2%33.2%

Retail DepositsPublic Fund Deposits

Corporate DepositsNondeposit Funding

Percent Difference in Expected vs. Preferred Funding Mix by January 20172

-5%

0%

5%

10%

15%

20%

25%

30%

Retail Deposits

Corporate Deposits

Public Funds Deposits

Nondeposit Funding

Preferred Funding Mix

Expected Funding Mix in January 2017E ven though wholesale funding costs

have risen, banks (in the aggregate) expect to rely more heavily on wholesale

funding than they consider ideal.

Asked to identify their preferred funding mix and their expected funding mix for the 12 months ahead, respondents indicated that they anticipate to be about 4% short of their ideal volume of corporate deposits, and about 1% below their target for retail deposit volume.

To close this gap (about 2% of total overall funding), banks indicated that they would rely on nondeposit funding, increasing this category to nearly 9% of their funding mix. This would be 28% above their target of 7% of their total funding portfolio.

It’s unclear whether shortfalls in deposit funding will be temporary since the changing interest rate environment may affect the market for customer deposits.

It is interesting to note that many of the country’s biggest banks have stated that they are planning to compete more heavily for retail and corporate operational deposits as new liquidity coverage ratio regulations increase the relative value of these deposits to institutions with more than $50 billion in assets.

WHOLESALE FUNDING EXPECTED TO FILL SMALL GAP IN DEPOSIT FUNDING OVER THE NEXT 12 MONTHS

[2] Calculated as follows: (Expected Lending Mix - Preferred Lending Mix) / Preferred Lending Mix. (Example, retail deposits would be calculated as follows: (46.7% - 47.3%) / 47.3%.

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Significant Decrease

Moderate Increase

MaintainCurrent

Moderate Decrease

Significant Increase

Q1 Q2 Q3 Q4

0%

10%

20%

30%

40%

50%

Significant Decrease

Moderate Increase

MaintainCurrent

Moderate Decrease

Significant Increase

Q1 Q2 Q3 Q4

0%10%20%30%40%50%60%70%80%

What Are Your Expectations for Your Bank’s Funding Costs 12 Months from Now? (responses from last 4 quarters)

How Are Your Bank’s Funding Costs Compared to 12 Months Ago? (responses from last 4 quarters)The vast majority of respondents

surveyed over the past four quarters have predicted a rise in funding

costs. Since Q1 of 2015, the percentage of respondents expecting funding costs to increase within the next 12 months has remained above 65%, and the latest survey is no exception, as rates finally start to tick up.

It appears that, as a result of the Federal Reserve’s decision on interest rates, expectations for a funding cost increase were realized for many banks. In April 2015, only 13% of respondents indicated that they had experienced an increase in funding costs over the past year. In January 2016, that number rose to 36%.

The number of banks that have experienced a decrease in funding costs has also shifted over that same time period, declining from nearly 40% to just over 18% of respondents at the beginning of 2016.

However, even as funding costs start moving upward, few banks seem concerned about the possibility that rates will suddenly spike, at least over the short term. The percentage of respondents who expect funding costs to rise significantly over the next 12 months was just 2.3% and has never risen above 3.1% in our surveys over the past year.

GROWTH IN FUNDING COSTS EXPECTED TO BE GRADUAL

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RECIPROCAL DEPOSITS PLAY KEY ROLE IN PROTECTING DEPOSIT FUNDING

L ast summer, the Federal Deposit Insurance Corporation (FDIC) issued a Notice of Proposed Rulemaking that

suggested changes in the deposit insurance assessment system for small banks (those with assets of less than $10 billion). The changes would have resulted in higher assessments for small banks that rely on noncore funding of any type.

Since that time, and in part due to widespread banker feedback, the FDIC revised the proposed rule to avoid penalizing small banks that use reciprocal deposits for vital purposes at their banks.

According to this survey, reciprocal deposits play an important role in strengthening relationships that community banks have built with depositors. Eighty-eight percent of respondents noted that reciprocal deposits have some level of importance in their effort to protect their relationships with depositors, and 47% indicated that reciprocal deposits are either very important or extremely important in helping them protect their depositor relationships.

A large majority (65%) indicated that they would increase their use of reciprocal deposits if they were legally recognized as nonbrokered by assessors.

Not at All Important

Somewhat Important

Moderately Important

Very Important

Extremely Important

0% 5% 10% 15% 20% 25% 30% 35%

Importance of Reciprocal Deposits in Helping Banks Protect Relationships with Depositors

Responses from banks with assets of more than $10 billion are not displayed because of a lack of statistical representation within that asset-size band. See methodology on page 10 for details.

Significant Decrease

Moderate Increase

MaintainCurrent

Moderate Decrease

Significant Increase

Between $1 Billion and $10 Billion in AssetsLess Than $1 Billion in AssetsAll Respondents

0%

10%

20%

30%

40%

50%

If Reciprocal Deposits Were Legally Deemed to be Nonbrokered, What Effect Would It Have on Your Institution’s Use of Reciprocal Funding Sources?

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Promontory’s Bank Executive Business Outlook Survey was conducted online over the

course of two weeks from January 25 to February 5, 2016.

The survey was delivered via email to bank CEOs and presidents at 4,750 banks throughout the United States and garnered a 3.7% response rate, with leaders from 175 banks completing the survey. Of these 175 respondents, 94 were CEOs and/or presidents (54%) and 81 were CFOs (46%).

Compared to the asset-size breakdown of the overall banking industry, the sample of respondents skews slightly towards larger community banks, banks with assets between $1 billion and $10 billion.

SURVEY METHODOLOGY AND RESPONSE

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