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

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