Thursday, January 27, 2011

Will "Plain Vanilla" Kill Community Banking?

I was at a strategic planning retreat a few weeks back where a colleague lauded the concept of bankers getting back to plain vanilla community banking. I hear and read this often. Most recently Valley National Bancorp's highly respected CEO, Gerald Lipkin stated:

"The positive [fourth quarter] results are attributable to management's common sense and highly focused approach to traditional banking — gathering deposits and making relatively low-risk loans."

I will venture to say I hear and read similar comments so much that it should be considered "conventional wisdom". This line of thinking requires the person promoting it to believe that community financial institutions (FIs) somehow got away from this concept, and by doing so their profits plummeted during the financial collapse of 2008.

But if you read or watch interviews of CEOs of community FIs from 2008 forward, you will be bombarded with the message that they didn't engage in the things that led to the collapse. They mostly meant sub-prime residential mortgage lending. I would contend that this statement is true. Community FIs, in general, did not make loans to those with little wherewithal to repay them. So how did they get away from "plain vanilla" banking?

I don't think Community FIs departed from their business model at all during the crisis. Perhaps, one can argue, that because of the recession and the decline in credit quality FIs have been playing defense, and getting back to "plain vanilla" banking means beginning to play offense. But the notion that FIs got away from this model is, in my opinion, bunk. They have been using that model for decades.

Is the premise that doing "plain vanilla" banking acceptable? Valley National had an ROA in the fourth quarter of 1.08%. Pretty good by today's standards. So will continuing to operate "as is" work infinitum? I doubt it. Customer preferences are changing more rapidly than bankers are willing to change their business models, in my opinion. FIs are not like speed boats, where the driver can change course on a dime. It's more like the Titanic heading into an iceberg. You can't flip a switch on a "plain vanilla" bank model, and turn yourself into something different.

This requires bankers to look into the future to determine the course of customer preferences and where they can gain a competitive advantage. If banking changed at the pace of technology, we would be out of business. Take Apple, Inc., for example. Sometime in the mid to late 1990's, a clairvoyant leader at Apple thought that Mac sales would not drive this company forward. So they strategized. They determined where computing was going. They widened their strategic thinking to the world of multi-media and telecommunications. Where could they make a difference, be a first mover, corner a market? Below are tables indicating the significant change in revenue sources at Apple over the past eight years.

In 2010, Mac-related sales represented a paltry 20% of total sales. What if Apple stuck with "plain vanilla" desktop computing. They would probably be out of business. They made a strategic bets on iPods and music (now representing 18% of total revenue), iPhones (now representing 39% of total revenue), and the up and coming iPad (now representing 17% of total revenue).

Naysayers will point out that FIs are not tech companies, and it's a fair point. But what about Bank of New York Mellon. Below is their segment reporting from 2001 and 2010. They changed categories, but it is clear that this Bank moved away from traditional banking and determined that the best chance for success was in asset/wealth management and securities processing.

A similar argument could be made for the former Commerce Bank of Cherry Hill, New Jersey. Many scoffed at the business model of rapidly erecting high-cost/high-profile branches to pursue a targeted retail strategy. They point to Commerce's demise, having to sell to TD Bank to get out from under regulator scrutiny. But it wasn't the business model that failed, it was their executives. The business model flourished, taking market share in bucketloads from "plain vanilla" FIs.

The "plain vanilla" model still has legs. But how much longer can these FIs continue to do what they have always done? I frequently hear "customer service" touted as a point of differentiation, but fail to see how one bank's service is better than another. I also hear "relationships", but note that very large FIs build relationships too. And if a community FIs' relationships are so strong, how come customers will walk for minor rate variations?

In my opinion those that follow "plain vanilla" without making the strategic moves to remain relevant will march all the way to the cliff. Sure, those business owners are used to doing business a certain way and have predictable expectations from their FI. Those "seasoned" customers that hold a lot of the wealth and therefore the deposits also have predictable expectations. But what about the next generation business owner and depositor. Will they expect the same?

I doubt it. They all have iPhones and iPads. What will your strategic bet be?

~ Jeff

Photo of a company that stuck to a "plain vanilla" business model:

Wednesday, January 19, 2011

Guest Post: Fourth Quarter Economic Update by Dorothy Jaworski

Rates Give Us a Wild Ride

Bond market behavior in the fourth quarter of 2010 was one for the record books. Interest rates fell to levels that I have often described as “crazy low.” The two year Treasury yield fell to 0.33% in November, while the five year Treasury fell to 1.05% and the ten year fell to 2.49%. In most of our lifetimes, these rates were unimaginable. What was causing these levels? Was it fear that the economy will not grow? Or was it the often debated and highly feared deflation? Then, just as rates hit these lows, Ben Bernanke and the Federal Reserve announced another gigantic quantitative easing program, called “QE2” by the markets, where they stated they will purchase $600 billion in Treasuries through mid year 2011. The intent was to keep the crazy low rates low, or push them even lower. So what happened?

Rates spiked upward, quickly and almost in defiance of QE2. Congress entered the mix and extended the Bush tax cuts for two years and unexpectedly added new tax cuts for consumers and businesses. Near the end of December, the two year Treasury had risen to 0.73%, the five year had risen to 2.16%, and the ten year rose to 3.47%. Why did rates spike when the Fed obviously wanted them low? Was it the belief that the economy will finally grow or was it Bernanke’s comments on 60 Minutes and in the newspaper that he wanted the stock market to rise? I believe that these comments prompted the markets to sell Treasuries (and all other bonds for that matter) and buy stocks.

Mortgage rates went on the wild ride too with the 15 year rate dropping to 3.25% and the 30 year dropping to 3.875% in early November. By close to year end 2010, both rates were about 1% higher, at 4.25% and 4.875% respectively. This is not good news to the Fed, who obviously thought that low rates could help the struggling housing market.

Alas, this market seems to be slipping once again; housing prices bottomed in April, 2009 and recovered until October, 2010, before resuming a decline. The Case Shiller home price indices have lost their momentum; the year-over-year change in the 20 city index turned negative to -0.8% after nearly ten months of increases. The inventory of unsold homes stands at the equivalent of 9.5 months worth of sales, representing over 3.7 million homes. Add to this the expected foreclosures yet to come and there is a tremendous overhang of supply. No wonder the markets are under pressure.

The Economy is Recovering Slowly

The recent economic data has shown signs of improvement, with GDP growing at a 2.6% rate in the third quarter of 2010; however, this rate is not high enough to increase jobs enough to reduce the unemployment rate. Consumer confidence is still below average at 52.5 in December. And it is no wonder – unemployment is high, housing is weak, income growth is weak due to low inflation, and deleveraging/saving is still occurring. Notwithstanding the strong holiday shopping season, where sales were reported by MasterCard to have risen 5.5% over 2009, consumer spending proceeds at a slow pace.

Congress extended the Bush tax cuts at the end of 2010 for an additional two years (oh, joy, we get to go through this again in 2012) and added a consumer tax cut of two percentage points on social security tax for 2011 and a business tax break for investments in plant and equipment with accelerated deductions. Combined these tax breaks can provide up to 0.5% in GDP growth for 2011, giving us a chance to hit the 3% potential GDP level where jobs can be created in sufficient quantity to reduce the unemployment rate.

While the tax breaks will be good news for 2011, they are bad news in 2012 as GDP will likely slide by the same 0.5% when their effect is removed.

What Will You Remember Most About 2010?

2010 was an eventful year to put into the books. The Fed kept easing with QE1 early and QE2 late. The bond markets turned on the Fed at the end of the year and rates rose. A volcano named Eyjajallajokull (still no one can pronounce it) erupted and disrupted travel in Europe for weeks, a BP oil rig exploded causing a giant oil spill in the Gulf of Mexico, a European debt crisis riled the markets as Greece and Ireland faltered, a “Flash Crash” in May sent the Dow Jones Industrial Average down 1,000 points, or 9%, in minutes because of “fat fingers” and sent investors out of stocks, vuvuzelas buzzed at the World Cup matches, and the Large Hadron Collider started smashing lead ions instead of protons and got closer to recreating the Big Bang on a small scale.

Locally (editor's note: Philadelphia area), we survived last winter’s Snowmegeddon, and our sports teams gave us exciting times. The Flyers gave us a great ride into the Stanley Cup Finals, Roy Halladay pitched a perfect game and a no hitter, and Cliff Lee returned home to pitch with the Fab Four. The new Miracle in the Meadowlands in December did much to grow the legends of Michael Vick and DeSean Jackson, but the Pack put an end to the excitement.

The S&P 500 rose 13% in 2010, while the Russell 2000 rose 25%. Commodities continued their bubble performance, with gold up 29% and oil up 15%. Bonds turned in a slightly positive performance for the year, despite the dramatic fourth quarter selloff in all things fixed income.

What About 2011?

I love to project, but I, like most analysts, get caught up in the moment. Rates just rose about 100 basis points for most longer duration securities while short term rates did not budge. I believe that the economy will achieve 3% GDP growth for 2011, despite the nagging issues and no help from the housing market. Unemployment may be able to fall below 9% with 3% GDP growth. Inflation will remain low – with core CPI (excluding food and energy) between 1.0% and 1.5%. As we know, food and energy prices have been rising, so overall CPI could exceed 2%.

The Federal Reserve will not raise short term interest rates during 2011; their statements basically have told us they will keep rates low for an “extended” period of time. More importantly, they will not raise rates or tighten with unemployment at such high levels. Long term rates already rose in the fourth quarter, but I expect these rates to continue to fall back and trade within a narrow range all year, provided inflation stays tame.

One risk to my forecast is that if gas prices continue up from the current $3.00 per gallon, GDP will slow, unemployment will stay high, and all bets are off.

Putting It All Together

When I wrote my last newsletter in September, I referred to the then low rates as “Eisenhower” lows, which then fell to “crazy lows.” When I wrote the following: “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!” I never dreamed that that type of price action would occur so violently in just a six week span! Stay tuned!

Thanks for reading! DJ 01/08/11

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.