Saturday, October 30, 2010

Constructive Criticism: The death of candor.

"When two men in business always agree, one of them is unnecessary." ~ William Wrigley, Jr.

"We would have had more time to discuss strategic objectives if Jeff dispensed of his comic routine." So went a piece of feedback I received from a participant in a strategic planning session that I was moderating. My internal reaction... argue back, defend my position, convince myself that the problem is with the person giving feedback.

But hold on, I tell myself. This is a valuable piece of information not designed to make me look foolish, but to make me a better consultant. I can learn more from a piece of constructive criticism than I can from self accolades or a feeling that all is well. Wouldn't I be better off to view this piece of constructive criticism as manna from heaven instead of an insult? In the heart of this piece of criticism is instruction on how to improve. I would be remiss to let it pass.

Dale Carnegie, in his 1944 book How to Stop Worrying and Start Living dedicates an entire section to how to keep from worrying about criticism. One technique he espouses is to constructively criticize yourself. It will help you become a better form of yourself, but also help you be more open and worry less about receiving constructive criticism from others.

I am a consultant. Community financial institutions ("FIs") pay my firm for helping them, primarily in an advisory capacity. I have found that those executives that are more open to constructive criticism tend to perform better. When performing a traditional SWOT analysis, I often quip that any bank that has significantly more strengths than weaknesses is a good sign to short the stock. High performing FIs tend to identify more weaknesses than strengths.

But today's business environment is difficult, and Community FIs' leaders are understandably more paranoid today than in the past. This elevates their defenses from accepting constructive criticism. This puts pressure on advisers to construct a message that all is well, or what is not well is somebody else's fault. But would I be doing my clients a service by telling them all is well when the facts are to the contrary? Why would an executive want to believe everything they are doing is the right thing up until the time they are shown the door?

Some resistance to criticism is healthy. In fact, I would put most criticism such as nagging, nit-picking, or the "see how I'm right and he/she is an idiot" in the unproductive category that should role off of one's shoulders like a droplet of rain. Not only is this type of criticism unhealthy in itself, but it closes us off to the constructive type.

I often write and speak about the pace of change in the banking industry. Strategic decisions made today will impact our institutions for years, and perhaps generations ahead. These decisions would be better if we had the ability to look back and evaluate our past, and openly debate the future. If we are closed to constructive criticism, our strategy will be inferior... period.

I have experienced many executives that are closed to criticism. Many are what may be termed, "message managers". They spend a lot of time managing what others say to them, their colleagues, and their Board of Directors. They set up meetings to filter and control the message. They hire advisers that tell them what they want to hear, and avoid ones they cannot control. This may appear to be a good short-term strategy, driving the institution forward without having to zig or zag. But an institution that can only be as good as one person is one that has a limited future.

Society is moving away from constructive criticism. Instead, we are gravitating to a non-constructive sound bite mentality. This makes for poor strategic decision making. As leaders, we must re-train ourselves how to give and receive constructive criticism. The future of our industry is dependent on the collective knowledge of all members of our team, be it colleagues or advisers. Let's get the conversation rolling!

Is your community FI open to candid, constructive dialog?

~ Jeff

Links to good articles on constructive criticism:

2001 Inc Magazine article:

Strategic Management Solutions (SMS) white paper:

Thursday, October 21, 2010

Guest Post: 3rd Quarter Economic Update by Dorothy Jaworski

What are the Markets Thinking?
Bond markets have been the big winners in the third quarter. Rates have fallen to incredible lows; Pimco, a large money manager, has referred to them as “Eisenhower” lows because they were prevalent in the 1950s. Treasuries are the biggest winners of all with the 2 year yield now at 0.43%, the 5 year at 1.26%, and the 10 year at 2.49%; the 5 year and 10 year yields fell 75 and 58 basis points, respectively, since late June.

Mortgage rates have followed Treasury yields down, with the 30 year mortgage rate down about 50 basis points. I believe that this extraordinary situation is actually a flight to quality because of fears that had been accumulating in the markets – over European debt, the possibility of another recession, the expectation that the Federal Reserve could begin buying bonds again, and sheer uncertainty over what the true health of the economy, fiscal policy, and unknowns, such as the impacts of health care and financial reform legislation and low consumer and business confidence.

Stock markets performed exceptionally well in September after a summer selloff that took the Dow below the 10,000 level again. The index has fallen below or risen above 10,000 an incredible 295 times since first attaining that level in 1999! (Thanks, Doug Ingram). Earnings are improving and the projected price earnings, or “PE” ratio for the Dow is 12.1 (currently 14). For the S&P 500, the projected PE is 12.5 (currently 15). These are not overvalued levels by any means. One fact I noted was that S&P 500 companies are sitting with cash levels of 10.2% of total assets at June 30th. This huge amount of cash “on the sidelines” is the result of risk aversion leading to a classic liquidity trap. As the outlook improves, these companies will seek higher returns through investments. Still, with stock markets having done so well during September, I would have expected rates to rise somewhat. Instead, they barely budged.

Catch 22
Above trend GDP growth will not come until there is job growth and job growth will not come until there is above trend GDP growth. Second quarter real GDP grew at 1.6% after growth of 3.7% in the first quarter. Real final sales are growing ever so slowly at 1.0% in the second quarter and 1.1% in the first quarter. This level of growth is too slow to create sufficient jobs to recapture the 7.6 million jobs still lost during the recession, leading to our catch 22.

So far in 2010, private employers have added 723,000 jobs, well below the pace of prior recoveries. High unemployment is restraining spending but there are signs that employment is improving. Job openings reported by the Labor Department in July were 3.04 million, representing a year-over-year increase of 30%. An August report by Challenger, Gray, and Christmas showed that layoffs have declined dramatically, to a monthly average of 56,000 since June, 2009 and have been below 100,000 for fourteen consecutive months for the first time since 1999-2000. Year-to-date layoffs are down 65% from the same period last year –good news indeed.

The Recession is Over
What if you declared the end of a recession and no one cared? Well, if you are NBER, or National Bureau for Economic Research, and you wait fifteen months to declare that the recession was over in June, 2009 (its duration was 19 months), no one will care. We declared that it was over late last summer, because we saw the strong positive change in the data. Economists certainly are a cautious breed but we should take their declaration as a positive sign that they believe the economy has achieved growth strong enough to continue. Rebuilding of depleted inventories and increased capital spending helped to get GDP growth back on track in the summer of 2009 and into 2010.

Low interest rates and easing actions by the Federal Reserve have aided the recovery, although it is strongly being debated right now whether the Fed should be doing more. Every month, we keep getting their pledge to “keep rates low for an extended period of time” and their promise that, if the economy slips further, the Fed may begin additional purchases of securities in the marketplace to add money to the system. When we needed action in the second quarter, the Fed did not act. We are improving slightly in the third quarter, so I don’t expect any action from them.

What is really needed is an approach to get banks back to lending, which is not helped by increased capital requirements and FASB’s proposal to subject loans to mark-to-market accounting, which could introduce frightening volatility into bank earnings and capital.

But, I digress… Inflation is very low right now and with yearly core inflation at 1.4% and slipping, we are approaching the lower end of the Fed’s target range of 1% to 2%. Some of you Phillips curvers believe that low inflation is one factor behind the high unemployment rate. If you are unemployed, you may not feel that the recession is over. But jobs are slowly being added, as some of the uncertainty is removed from the markets. Improvements in employment will lead to more spending by consumers and businesses, which could ultimately stabilize the housing market. Home prices are improving on a year-over-year basis, according to Case Shiller, by about 4% to 5%. Uncertainty about a housing recovery has been holding back growth. Future tax rates and compliance costs are also causing uncertainty, most notably from the still unresolved situation with the Bush tax cuts set to expire in 2011, health care costs, and financial reform costs.

Putting It All Together
We are looking at low rates for a long time. The Federal Reserve will keep the short term Fed Funds rate at 0% to 0.25% well into 2011 and likely into 2012. It’s been said that negative interest rates are not an option, thus the Fed must inject money into the system in other ways, such as buying securities. This newly created money must ultimately come through the system, into banks, and come out as loans to consumers and businesses. Until this happens and confidence gets a lift out of the doldrums, GDP will continue on its slow growth path.

With short term rates anchored by Fed policy, long term rates will remain in check as well, due to subdued inflationary expectations. I do believe that the bond markets are wrong right now – that longer term rates are too low and that they will make their adjustment with the 5 year Treasury returning to 2% and 10 year Treasury returning to 3% in the next six months. However, even with these adjustments, rates are still incredibly low, and still “Eisenhower” low!

Update on My Favorite Machine – the Large Hadron Collider,“LHC”
The LHC is now speeding protons around its circle at the speed of light and crashing them into each other at total energy levels of 7TeV, which is still only one-half of its planned energy levels of 14 TeV in 2016. They are researching particles generated by the collisions. It took 100 years for scientists to discover all of the known particles in physics and only 4 months for the LHC to rediscover them. Sadly, the recession affected funding to the programs and upgrades have been delayed by one year. The Collider will have planned shutdowns in 2012 and 2013 and is expected to keep running until 2030.

Thanks for reading! DJ 09/29/10

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

Sunday, October 17, 2010

The Economy of Scale Myth: Go Big or Go Home

I wrote a post a couple of months ago regarding diseconomies of scale under the premise that at some asset size-point, getting larger does not impact your efficiency and expense ratios in a material way (see link to that post below). Yet in spite of my efforts, bankers and industry experts continue to bang the drum for economies of scale. I decided to take a second look at the data to see if I was wrong in my premise.

I have been wrong in the past, and readily admit to my errors. I do not possess the personality that requires me to be right, especially in the face of evidence to the contrary. My wife and daughters tell me I'm wrong all of the time. So if my investigations into financial institutions' (FIs) economies of scale indicated that size does matter, I will say so.

Clearly size matters to some point. Banking has a step-variable cost structure that requires a certain amount of fixed expense investments that demonstrates excess capacity until an FI grows to some asset size. The devil is in the details of "some" asset size. Empire builders and investment bankers tend to argue for Mega-Bank, which supports many M&A transactions and higher executive compensation. However, as I searched my database for the top 100 return on average assets (ROAA) FIs for the 2nd quarter 2010, only six percent were over $1 billion in assets. Yet strategy sessions, competitor discussions, and CNBC focus primarily on the Mega Banks.

A note on my data collection. I searched for FIs that had greater than an 1.8% ROAA in EACH of the last four quarters. This tended to eliminate those FIs that benefited from one time gains and focused on those with consistent financial performance. I then manually went through the list to eliminate all of the special purpose institutions and subs of much larger institutions to get a more accurate list. Of the top 100, six were greater than $1 billion in assets, 55 were between $100 million and $1 billion, and 39 were less than $100 million in total assets. The table below shows the medians in selected financial ratios.

Countless strategy sessions I have been privileged to attend speak of what Bank of America and Wells Fargo are doing (not in the top 100). Very few speak of WestAmerica Bank in San Rafael, California (2.05% ROAA, $4.7 billion in assets). WestAmerica is primarily a business bank. Greater than 77% of their deposits were in core deposits (non-CDs) and their cost of funds was 28 basis points. So many banks are trying to reduce their dependence on commercial real estate and construction transactions by becoming more of a commercial bank, yet so few look to WestAmerica to see what they are doing to succeed. Instead, we focus on what Jamie Dimon is saying. We should focus more on what David Payne (WestAmerica's CEO) is doing.

If you are a senior executive of an FI smaller than WestAmerica and I am privileged to have your readership, are there smaller success stories? Must you be over $4 billion to be successful?... Yes to the first question and no to the second. Ninety four of the top 100 ROAA FIs were less than $1 billion in assets.

I have spoken and written about niche banking in the past. I offer an example of an FI that is currently succeeding at it: Live Oak Banking Company in Wilmington, North Carolina. Live Oak opened its doors a little over two years ago and yet it has met the four-quarter criteria of having an ROAA greater than 1.8% over the past four quarters. Live Oak opened to provide capital and other services to the veterinary, dental, and independent pharmacy businesses (see its About Us link below). The bank sells a high percentage of the loans it originates but keeps servicing rights to maintain relationships. At June 30, 2010 it had $209 million in assets and a 2.82% ROAA.

Extreme niche banking like Live Oak's may not be in the cards for your FI. But that doesn't preclude you from having a line of business or product set that you are known for, excel at, that delivers superior profits. After all, who wants to be known as "just another bank"?

Let's not be absolutists, claiming that economies of scale are needed, or that being highly specialized is critical. But the evidence clearly shows that there are financial institutions generating superior returns that are not Wells Fargo, PNC, et al. Let's not limit our universe of business models to study to a select few that have rolled the dice with the scale game.

What FIs do you admire that may not be the biggest kid on the block?

~ Jeff

jeff for banks blogpost: Diseconomies of Scale

Live Oak Banking Company - About Us

Saturday, October 02, 2010

Does it all have to be about the spread? My thoughts on fee income.

In a previous post I mentioned that my wife and I are refinancing our mortgage because of the extraordinarily low rates available (see link to that post below). As part of the process we received the Good Faith Estimate (“GFE”) of costs associated with obtaining a mortgage loan. A key and expensive component of the cost is title and settlement services. My lender suggested some service providers from their list, but we have a relationship with a local law firm that provides those services. This got me thinking about such services being offered by banks.

According to the GFE, title search, insurance, and settlement services will cost $2,073.75. Now, without giving you too much personal information, we do not live in a mansion. Our house is 2,000 square feet and its value is slightly greater than the average in our community. I recently heard on a personal finance show that the commissions to title agents are 70%-80%. Let’s assume they are something less for refi’s, say 50%. That would equate to over $1,000 of net revenue to the title/settlement agent for each transaction. I repeat that this is a residential real estate transaction refinancing an average home. Commercial real estate transactions and McMansions would generate greater revenue.

Given community banks’ propensity to do real estate transactions, why wouldn’t such a fee-based line of business flourish?

My company measures the profitability of products and lines of business for community financial institutions (“FIs”). Part of this service includes measuring how banks do, or don’t, make money on their fee-based products and lines of business. The chart below demonstrates the pre-tax profit margin since 2006 of all of the fee-based products for those Fis that subscribe to our service.

Community FIs, in general, are not making money with these products. Of course, there are exceptions, such as one of our clients that makes greater than a 20% pre-tax profit margin in their Trust and Retail Investments line of business. But as a general rule, community FIs have not been very successful in this arena. With the potential for diminished deposit fee income due to Reg E and the Durbin Amendment of the Dodd-Frank Act, perhaps FIs should figure out why this is so.

Retail investment services is one common service offered by community FIs and one that has confounded me as to why we can’t generate greater revenues and profits. According to a recent Wall Street Journal article (see link), the minimum commissions and fees expected of an Edward Jones broker is $30,000 per month, or $360,000 per year. Edward Jones’ business model is a main street model, having offices in small to medium sized towns across the country. One would think that a bank broker, similarly located and having the benefit of bank in-house referrals, should be able to outleg the Jones broker. However, Kehrer-LIMRA studies of bank broker productivity tend to hover around $250,000 of annual production.

As an industry, we should be successful in retail investment sales. Bankers, in spite of the recent and daily beatings we have taken in the media, remain a go-to source for trusted financial advice. As the table below indicates, publicly traded brokerage firms make a net profit margin of 17.81% at the median. I realize that the current environment has been challenging for them, but they still are generating profits as an industry. That profit margin includes taxes and all costs associated with their business, such as human resources, finance, and Charles Schwab himself. Therefore, shouldn’t we expect similar returns from our programs? Yet we settle for breakeven or worse. We should set our sights higher.

If we have a broker for every five or so branches, or covering $200 million of our deposit base, we should expect production in the Edward Jones area of $360,000, but certainly no less than $250,000. If we have four such brokers, generating $1 million in fee income, then we should expect a minimum of $200,000 pre-tax profit, fully absorbed. That means paying their share of HR, finance, etc.

Retail investments is one area where community FIs are well-positioned to succeed. But those fee-based lines of business that are consistent with your strategy should be explored, proper attention should be given, and profits should be expected. Those FIs that profitably meet the greatest amount of financial needs for customers already on their books will drive revenues and value that will be difficult to replicate. That is an enviable position indeed! What are your thoughts on complementary fee-based lines of business?

~ Jeff

Wall Street Journal article on Broker production:

Blog post on mortgage refinance: