Monday, October 23, 2017

Bankers: What's Your Art of War?

I will occasionally quote Sun Tzu from his seminal book, The Art of War. I am not trying to imply that winning battles and winning in a competitive marketplace is the same thing. One leads to lessons learned, perhaps a loss of wealth, but never death and conquest.

But Sun’s wisdom cannot be ignored. He was a Chinese general, strategist, and philosopher that lived over 2,000 years ago. His book is a must read at military academies and business schools alike.

One such quote I would like to share and discuss practical application is:

If you know the enemy and know yourself, your victory will not be in doubt.

I use this quote as it relates to a financial institution’s situation analysis, environmental scan, or whatever you choose to call it. What I believe Sun meant: the general that knew his enemy’s weaknesses, and exploited them, and knew the enemy’s strengths, and avoided them, wins.

And I believe this to be the case with your competition.

I am moderating a planning retreat for a client this week. And in so doing, we have prepared a peer group financial condition and performance analysis for the bank’s strategy team. But it doesn’t go far enough. Executive Management’s personal knowledge of, and research into the strengths and weaknesses of their competitors is essential to building a strategy to expose their weaknesses and dodge their strengths.

Some information will be based on competitive actions in the marketplace. Much of it, however, can be gleaned from publicly available information.

Let’s go through the data with one such competitor.

FFKT Farmers Capital Bank Corporation (the “Company”), Frankfort, KY

FFKT is a financial holding company which had four wholly-owned bank subsidiaries at year-end 2016. The Company provides a wide range of banking and bank-related services to customers throughout Central and Northern Kentucky. It had four bank subsidiaries including Farmers Bank & Capital Trust Company ("Farmers Bank"), Frankfort, Kentucky; United Bank & Trust Company ("United Bank"), Versailles, Kentucky; First Citizens Bank (“First Citizens”), Elizabethtown, Kentucky; and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”), Newport, Kentucky. In February 2017, the Company merged United Bank, First Citizens, Citizens Northern, and FCB Services, Inc. (“FCB Services”) into Farmers Bank, the name of which was immediately changed to United Bank & Capital Trust Company (the “Bank”).

At year-end 2016 the Company had the following wholly-owned nonbank subsidiaries: FCB Services, a data processing subsidiary located in Frankfort, Kentucky; FFKT Insurance Services, Inc., (“FFKT Insurance”), a captive property and casualty insurance company in Frankfort, Kentucky; and Farmers Capital Bank Trust I & III, established to issue Trust Preferred Securities (“Trups”), a hybrid Tier 1 Capital instrument.

How do I know this without having inside information about the Company and Bank? It’s in their Annual Report. FFKT is not a client, and I do not know any non-public information about them. 

The Company had asset quality problems, which they appear to have beaten. In 2013, their non-performing asset/asset ratio was near 5%, down to 2% today. Still high relating to other financial institutions, but the trend is very favorable.

The Company did two things to increase profitability either at the end of last year, or early this year. One was to consolidate bank charters from four to one, the cost of which was accrued mostly during 2016 and was executed in February of this year. The other was to restructure its balance sheet by pre-paying senior debt, deleveraging its balance sheet and increasing its net interest margin.

And it has worked. Investors' patience paid off in a second quarter ROA of 1.08% and a 9.40% ROE. Where will the Company turn to keeping the positive trend? Since investors have been patient for the Company to rebound, it is fair to assume that there is little appetite for strategic investments that don’t have very quick payback periods. And upon review of the balance sheet, there is opportunity to improve today and impact financial performance in the very near term.

The Company’s yield on earning assets was 3.92% for the second quarter, placing it in the 25th quartile amongst its peers. The culprit is a low loan/deposit ratio that has been as low as 67% in the past five years, but has grown to 73% in the second quarter. Although the loan portfolio has not grown much. The increase in loan/deposit ratio was mostly attributed to sparse loan growth combined with deposit decline. Commercial Real Estate ("CRE") loans grew from 29% of total loans in 2013 to 38% in the second quarter.

So the bank is growing CRE loans to improve its yield on earning assets.

I discerned all of this from public information either in their SEC (Annual Report) or FFIEC (Call Report) filings.

But there’s more. In their Annual Report, the Company disclosed its CRE underwriting criteria as follows:

Commercial Real Estate
‘Commercial real estate lending made up 41% of the loan portfolio at year-end 2016. Commercial real estate lending underwriting criteria is documented in the lending policy and includes loans secured by office buildings, retail stores, warehouses, hotels, and other commercial properties. Underwriting criteria and procedures for commercial real estate loans include:

● Procurement of Federal income tax returns and financial statements for the past three years and related supplemental information deemed relevant;

● Detailed financial and credit analysis is performed and presented to various committees;

● Cash investment from the applicant in an amount equal to 20% of cost (loan to value ratio not to exceed 80%). Additional collateral may be taken in lieu of a full 20% investment in limited circumstances;

● Cash flows from the project financed and global cash flow of the principals and their entities must produce a minimum debt coverage ratio of 1.25:1;

● For non-profits, including churches, a 1.0:1 debt coverage minimum ratio;

● Past experience of the customer with the bank;

● Experience of the investor in commercial real estate;

● Tangible net worth analysis;

● Interest rate shocks for variable rate loans;

● General and local commercial real estate conditions;

● Alternative uses of the security in the event of a default;

● Thorough analysis of appraisals;

● References and resumes are procured for background knowledge of the principals/guarantors;

● Credit enhancements are utilized when necessary and/or desirable such as assignments of life insurance and the use of guarantors and firm take-out commitments;

● Frequent financial reporting is required for income generating real estate such as: rent rolls, tenant listings, average daily rates and occupancy rates for hotels;

● Commercial real estate loans are made with amortization terms generally not to exceed 20 years; and

● For lending arrangements determined to be more complex, loan agreements with financial and collateral representations and warranties are employed to ensure the ongoing viability of the borrower.’

So the bank has rigorous underwriting criteria for CRE loans done within policy. I have found this typical for banks emerging from credit problems.

Growing the portfolio fast enough to improve near term performance, and being mindful that they don’t want to revisit their credit problems of the past, indicates that this Company may be willing to sacrifice price for quality, therefore making them aggressive pricers in the market to get deals done. What I term the “it’s better than we’re getting in the investment portfolio” philosophy.

Competing banks should take note, and position themselves to win business accordingly, either on speed, service, structure, or deeper relationships with borrowers.

All of this information and more are publicly available about your competitors, even if they are not SEC filers. All must be Call Report filers.

Could I be wrong? Of course. But the combination of publicly disclosed information on a competitor, plus your bankers’ knowledge of how they act in the marketplace, can give you a competitive advantage over them should you invest the time into the research, and respond accordingly.

Know your enemy.

~ Jeff

Wednesday, October 11, 2017

Bank Lending: Shifting Emphasis from CRE to C&I

Although bank commercial real estate (CRE) lending has been more profitable than commercial and industrial (C&I or Business Loans), both now AND immediately after the financial crisis, regulatory CRE guidelines are causing financial institutions to consider a switch of emphasis to Business Lending.

Here are my thoughts on how to do so.

Your thoughts?

~ Jeff

Sunday, October 01, 2017

Bank Products: Blah Blah Blah

At a recent banking conference, Ray Davis of Umpqua Bank took center stage to tell of his journey from a small, Oregon community bank to a regional powerhouse. He mentioned products only briefly. And product was not part of the bank's success. I thought, Why?

Stuck on the topic, I jotted down the products that I remembered from when I landed my first banking job in 1985 while Davis spoke. I never claimed to have a great attention span. And I used those hotel notepads. Someone has to use them. Here was my list:

Products Circa 1985
Mortgage loan
Car loan
Personal loan
Home equity loan (?)
Business loan and line of credit
Commercial mortgage loan
Construction Loan

Checking account (business and personal)
Savings account (business and personal)
Certificate of deposit (business and personal)

Merchant services (?)

Then I wrote down how that list has changed.

New Products: Circa Today
Money market accounts (although could be classified as hyped savings)
Sweep accounts/cash management

The hedging and options might be categorized as features of business loans, versus products in and of themselves. But let's not quibble over insignificance.

What do you notice about the above lists?

What I notice is there is little difference in the products of today and the products when MacGyver developed improvised explosive devices with his shoes.

Bank products, at their base, have not changed. So, perhaps, instead of developing complexity in our product set, we should look to develop simplicity. Wouldn't we all benefit from more simplicity?

What sparked this post was a recent article in written by Mark Gibson and Kevin Halsey of Capital Performance Group in Washington DC. It was a precursor to a presentation they gave at the ABA Marketing Conference in New Orleans titled "How to Build Remarkable Products". One of their slides from that presentation is below.

This slide, and another I was privileged to see, dubbed as one of the most popular by the authors, speaks nothing of product. In fact, I will confess to you that when I hear bankers talk about products, product management, product design, etc., I have no idea what they are talking about. Bank products have been the same since I've been in banking.

Yes, there are different features to products, such as high interest rates for checking account customers that engage in specific behaviors, or option-based CD's as developed by Neil Stanley of The CorePoint. Still a checking account. And still a CD.

Distribution is different. Back to my notepad, I penned the 1985 distro points as person-person, in-branch, telephone, and ATM. Today we could add online, mobile, and social (for customer service). As a list, not very impressive.

However, in terms of customer utilization, distribution has been massively disrupted.

Sure, bankers can tick off all of the new features added to that standard product list, as mentioned above. But new products? Hardly.

So why not simplify? Like Southwest did when they went with one airplane model. Why not have a personal checking account, that is non-interest bearing up to a certain average balance, which could differ based on customer utilization that could easily by solved by AI, and bears interest above that level. Same with business checking, now that we can pay interest on those accounts. 

Savings accounts could easily have sub-accounts. Like the proverbial envelopes in the night stand drawer that tucks money away for certain things such as Emergency, Vacation, and Holiday. I believe PNC did this with the Virtual Wallet account. To me, Virtual Wallet is nothing more than a practically thought out savings account. 

I recently commented to a bank's strategy team that I thought the days when bankers could rely on sleepy money are coming to an end. The 13-month CD special trick, where the CD reprices at the lower 12-month CD when it matures, is over. A business model that relies on the stupidity of your customers will die. Imagine a customer getting a text from a financial management app that says "your bank is screwing you". It may not say that, but it would say that a CD is maturing and the rate it will role into is below market.

No, we can no longer rely on sleepy money. But perhaps we should focus Marketing on touching the customer in every phase of the buying journey instead of concocting schemes to complicate products, tinker with pricing, and rely on Rip Van Winkle customers. This is what I believe my friends at Capital Performance Group were emphasizing.

If I were a marketer, I would focus on simplicity in product design. And sophistication in the customer acquisition or relationship expansion funnel.

But I'm not a marketer. 

~ Jeff