Wednesday, October 21, 2015

Different Paths to Superior Bank Profits

I frequently moderate strategic planning retreats. A recent discussion surrounding bank peer groups was very interesting. I have written and spoken about using peer groups constructively versus striving for "above average". This discussion related to the different paths superior performing banks took to achieve their notable profits.

There were many more than three banks in the peers we reviewed. But the three banks highlighted in the table below achieved superior results. So the board and management team wanted more discussion on what their numbers were telling us.

Bank 1's superior profits start with their yield on loans, complemented by their loan to deposit ratio, which resulted in a very good net interest margin in spite of their relatively high cost of funds. This is a typical profile of what I term an "asset driven" bank. It leads with the loan, solving for funding as it fills its pipeline. This usually results in a relatively higher cost of funds, as the quickest way to line up funding tends to be rate. I also suspect that this bank, absent seeing more data, might have had a one-time event such as recapturing some profits from the loan loss reserve. Because it's profits, at 1.51% return on average assets, seems high based on its other ratios, even though it sports a great yield on loans.

Bank 2 has a relatively low loan to deposit ratio which impacts its NIM, even though it has a solid yield on loans. They just have fewer loans relative to their balance sheet than Bank 1. And we know that the bond portfolio delivers smaller yields than loans. Rather, this bank achieves superior profits by an impressive efficiency ratio. This ratio measures how much in operating expense it takes a financial institution to generate a dollar of revenue. So the lower the better. In Bank 2's case, it takes 52 cents to generate that dollar. Since they don't generate significant fee income or have the NIM of Bank 1, we can assume this bank is cheap. As I often say, they can squeeze a nickel through the eye of a needle.

Bank 3 does have a +90% loan to deposit ratio, yet has the lowest net interest margin of the lot. The reason for their low NIM is their yield on loans. I suspect this bank prices aggressively to get loan deals. What this bank does considerably better than most, is in their Cost of Funds. In other words, it generates low-cost, core deposits. In fact, it's percent of CD's to total deposits was 14%.  I often comment that low cost of funds banks, or high core deposit funded banks, receive favorable stock trading multiples because they have built something that is difficult to replicate. This bank currently trades at 195% of book value. A significant premium to market, even though their earnings multiple is in line with the market. The bank is a strong earner.

It is important to note how strong earning banks achieve their results. Because when setting strategy, you have to chart how the strategy leads to profits. If you intend to generate superior results by creating a difficult to replicate core funded bank, it would be good to set sail with that course in mind. 

Because without identifying your destination, no wind is favorable.

~ Jeff 


  1. Jeff – Another insightful and spot-on post. There are a number of ways to cut a peer group. I’ll give you a different angle at a similar set of metrics you presented. First, I like to develop a peer group based upon the “spend” of an organization. For a given investment in operations, I want to know what I am getting relative to others who are deploying similar amount of resource (say +/-10 to 20%) and where they are directing their resources.

    Here is my measurement set broken down into the five P’s of performance:


    1. Loans (% Assets). I prefer to look at this as a percentage of assets instead of deposits.

    2. Relationship Deposits (% Assets). Checking & Savings which are a proxy for PFI status.

    3. Non-Interest Income (% Assets).


    4. Net Non-Interest Income / Strategic Balance. Net non-interest income factors in the cost associated with non-interest income generation (efficient use of expense dollars). Strategic balance is loans plus relationship deposits. It tells me how effectively my resources are being deployed. It also eliminates interest rates from the productivity equation.


    5. Net Charge-Offs (% Loans). Helps me to understand loss tolerance.

    6. Loan Loss Reserve (Multiple of Net Charge-Offs). Helps me to understand how much insurance is maintained for losses as a multiple of net charge-offs, not loan balance.


    7. Loan Yield.

    8. Surplus Funds Yield (includes investments, overnight funds and cash). If it’s not on a depreciation schedule or goodwill, outside of minimum requirements, it needs to be earning something.

    9. Cost of Funds


    10. Return on Average Equity. I’m more concerned about my return on investment than return on assets.

    11. Net Worth (% Assets). Tells me about the leverage of my investment in the bank.

  2. Mike,

    Good comparison of using ratios to measure specific strategies. Loans/Assets are becoming more in vogue as financial leverage (using borrowings to fund investment securities) has declined as a long-term strategy. Financial leverage would have skewed the loan/asset ratio.

    The Productivity metric (#4) I have not heard of before and it is interesting.

    Thank you for the comment!

    ~ Jeff