Sunday, August 01, 2010

Diseconomies of Scale

Have you ever driven on a highway by yourself and forget, if even momentarily, the highway you were on and where you were going? I hope most of you answered yes or I have to make a doctor's appointment. The same sensation you feel for that split second while driving is, at times, what I feel in some strategy sessions I am priveledged to attend.

A common discussion in these strategy sessions is 'how do we grow'? Frequently, I will ask 'why do you want to grow'? The answers typically come back with some variation of achieving economies of scale to leverage the infrastructure to enhance shareholder return. This is particularly true of today's banking reality, where regulators and politicians are heaping non value-added costs on financial institutions. So the easy answer is let's get bigger, right?

Of course there is some merit to growing to a certain size so adding another compliance officer or another branch doesn't tank this year's earnings. But the million dollar question is what is the "certain size"? A bank CEO once told me that his investment banker told him the ideal size was twice his current size, no matter what size he was at that time.

The table below, derived from averages of the last ten years of efficiency and net operating expense ratios, indicates there are advantages to being larger. But look carefully. The advantage diminishes as the asset size grows, to a point where it is not particularly compelling.

The drive for growth in banking always concerned me. Banking is driven by balance sheet, not the income statement like most industries. Banks revenues are the result of the size of its balance sheet. You want to grow revenue 10%, you must grow the balance sheet 10%, all things being equal.

Not so difficult, one might think, if you grow from a $500 million in assets financial institution to a $550 million one. But what if you're a $10 billion bank? Now you must grow another billion to get your growth. What do you do if your markets can't support that growth? You must buy other financial institutions or reach for growth outside of your power alley (either your geography or into lending areas where you have little experience). The result may be fine at first. But as Warren Buffett once quipped, "You don't know who's swimming naked until the tide goes out". Many financial institutions were found to be naked over the past year and a half.

Perhaps it is time to consider a different strategy. If, for example, slow but prudent growth leads you to grow your balance sheet, and therefore earnings, at five percent per annum. This is typically not an acceptable long-term return for equity investors.

But if you are generating sufficient profits, and you don't need to grow capital at a rapid pace to keep up with growth, you could pay higher dividends, delivering acceptable shareholder returns. In this manner you may be taking the growth your markets can deliver, without forcing you to seek growth that is beyond your control (i.e. M&A) or put undue risk on your balance sheet (i.e. lending outside your expertise).

There are strong leanings to grow. I know of banks that are located in the same small town. One grows faster than the other, and is very proud of the accomplishment. Senior management and the Board of the smaller bank lament that they have not grown as quickly. In this context, growing is not a business judgment or a shareholder return issue, it becomes an ego issue. There is no greater testament to the role ego plays in the size of a bank than to see Bank of America and Wachovia's drive to be the highest skyscraper on the Charlotte skyline. Wachovia was winning until their near collapse. But their building was impressive!

What size do you think is big enough?

- Jeff


  1. I recently made a comment on analyst Ron Shevlin's Marketing Tea Party blog that was along these lines.... glad to see you have some numbers to back it up. The "right" size and the "right" growth rate are unique to each institution.

    -Morriss Partee,

  2. Hi Morriss,

    If you searched by efficiency ratios, there are plenty of smaller financial institutions that rank pretty high. My favorite: Bank of the Wichitas, $120MM in assets has a YTD efficiency ratio of 55%.

    I should note that the very large financial institutions have a very low Net Op. Exp./AA because they have significant fee-based businesses that make up 50% or more of their revenue stream, driving that ratio down.