Bankers: Just Do It!

"That's all fine and good, but if your bank doesn't do it or the reporting doesn't get to the front line, how can we improve?"

~ Montana Bankers' Association Executive Development Program Student

Sing from the same sheet of music. Row in the same direction. Everyone should be on the same page. 

Do we really want this? 

I'm finishing my annual tour of the West teaching bank profitability as part of various states' Executive Development Programs. Students are typically mid-level and have high potential. As part of that class, we drill down from "top-of-the-house" financial metrics, such as ROA, Net Interest Margin, Efficiency Ratio, to the most granular numbers, such as the ROE hurdle rate of a customer relationship.

Few have access to information at the line of business, product, or relationship level. Branch managers were unaware of their P&L, lenders were unaware of the ROE of their portfolio. And for me... disappointment.

Because if we want everyone from the Board Room to the customer contact person to "sing from the same sheet of music", why on earth do we have executive incentives tied to Return on Equity but hold lenders accountable for loan volume? It is inconsistent. In fact, it incents lenders to work against your ROE, promoting larger, thinly priced deals without regard for structure, duration, or capital needed to support the loan. It is the antithesis of "rowing in the same direction."

Imagine, holding lenders accountable for the continuous pre-tax profit and ROE improvement of their loan book, like the table below.

We either: don't do this (most likely), or do this but allow naysayers to poke holes into the art part of management reporting because they don't look particularly good (lack of leadership), or do this and keep it bottled up in the executive suite (nice to know). I realize my firm has self-interest in the first reason because we do this on an outsourced basis for financial institutions. But that aside, everyone should do this! Imagine the behavioral changes this would foster. Behaviors we now try to control with incentive schemes to offset the unintended negative consequences of incenting on volume. 

I recently wrote about Branch Profitability in Practice, so I won't belabor the point on holding branches accountable for continuous profit improvement.  A bank CEO recently asked me if I thought using branch pre-tax profit rankings amongst all of his bank's branches would be an incentive that is consistent with the bank's strategy. Knowing the CEO's passion about being a superior financial performer, of course it would! His top quartile branches in pre-tax profit should receive a greater bonus pool than his bottom quartile. Again, this bank has the luxury to do this, because they measure profitability of their branches. Those that don't use deposit growth, or net new accounts, or some other metric that's easy to get out of their core but may not be consistent with strategy.

Don't leave support centers in the lurch. If you incent your Compliance Department with no audit exceptions, should it be a surprise that it was next to impossible to get online account opening off of the ground when branchless banks have been doing it for a decade? How about incenting them on how quickly audit exceptions are cured? Think of the cultural change.

There are ways to incent other support centers to row in the same direction as strategy. If the executive team is incented on being efficient compared to peer, wouldn't it be consistent to incent the Loan Servicing Department on their operating expense to average loans? That combined with loans serviced per Loan Servicing FTE would make for a transparent incentive that has that Department singing from the same sheet of music as the overall bank.

I think I've thrown enough management bromides at you.

We continue to talk about implementing the solutions to serve our most valuable customers without having any idea who the most valuable customers are. Imagine if the lender had 50 relationships, 10 over his/her ROE hurdle rate (white glove service), 20 hovering at or under the hurdle rate (take action to get them over it), and 20 are far under the hurdle rate (efficiently serve them). But we don't do it.

Imagine if the branch gave the best service to those customers most valuable to that branch. If only they knew who they were. Maybe we should.

Instead of accepting how we currently do it, perhaps we should do it like it should be done. In a changing financial world full of shiny objects and the need for focus, we should know the profit trend of the residential lending department, our commercial lenders, our branches, and our most valuable customers. How else would we know they are the most profitable?

Stop accepting incentives not consistent with strategy. Don't leave profitability behind in your data journey. 

Just Do It!  

~ Jeff

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

Winter Squalls

It’s mid-February and I’m watching a snow squall outside, reminding me that it can be bright and sunny one moment and turbulent the next.  As we try to navigate our way through this volatile time in the markets and in the economy, we seem to get surprised almost daily by large moves in the stock markets, already in correction territory, in the bond markets with rapid interest rate increases, in the highest inflation in 40 years, and in the tense situation surrounding Russia and Ukraine.  And I don’t mean to sound downbeat, but the Federal Reserve is about to raise interest rates amid an economy that is already showing cracks.

The economy seems to be slowing, despite glowing reports like the +6.9% growth in real GDP in the fourth quarter, strong payroll growth in January with the unemployment rate at 4%, and inventory building that could be the first step in solving supply chain issues.  In fact, inventories accounted for +5.0% of the +6.9% GDP growth, leaving only +1.9% in real final sales, which is very weak compared to +8% to +9% in the first two quarters of 2021.  Many businesses are seeing labor shortages, as we are still several million payrolls short of where we were in early 2020.  Inflation may be a large culprit in slowing growth as people cut back on discretionary items to be able to afford the necessities of life - food, gas, electricity, etc.

Stock and bond market volatilities are also seeing winter squalls and are sending messages about shifting investor sentiments about risk.  The Fed is about to embark on another tightening campaign and will raise short-term interest rates starting in March and will likely make moves faster than most investors expect.  They will have ended their bond purchase program and will shift in a few months to letting their massive assets (currently close to $9 trillion) begin to run off.  Investors have seen this movie before and are fearful of recession in 2023 or 2024.  Credit spreads have begun to widen.  At the same time as Fed tightening, the fiscal policy of handing out “free money” has apparently ended and the consequential explosion of demand will abate.  They have to stop; our Treasury debt is massive at over $30 trillion.  People know the “free money” and easy Fed policy were certainly not “free” and they are paying the price with inflation.

Interest rates have risen dramatically since the beginning of 2022, with the 2 year Treasury up .76% and the 10 year Treasury up .42%.  With inflation so high, we have negative real yields, which means over time good returns on investment are difficult to attain, so we may see cuts in business investment.  Interest rates also seem distorted compared to equity returns, with the 10 year Treasury at 1.92% and the S&P 500 forward dividend yield at 1.57%.  Shouldn’t these be the other way around?  As rates have risen, the yield curve has flattened, with long-term points of it inverted (20 year and 30 year).  Flat and inverted yield curves are not a good sign before the Fed even raises rates once.

As mentioned earlier, consumer spending likely will slow as excess demand fades.  The old misery index, defined as unemployment plus CPI inflation, tells the story of everyday living.  The index is currently at 11.5% in January (4% plus 7.5%), which is the highest since 10.4% in May, 2012, but not near the all-time high of 22.0% in June, 1980.  Oil is above $90 per barrel and gas prices are above $3.80 per gallon.  Consumers may reach a “tipping point” where they cut spending dramatically because of their anger at energy prices getting too high.

Finally, the index of leading economic indicators fell by -.3% in January, which was the first monthly decline since the beginning of 2021.  It portends slowing growth six to nine months from now.  Fed policy also works with a lag of six to nine months.  The end of 2022 could be very interesting from all angles, including the federal mid-term elections, and may still be full of winter squalls.

 

Real GDP

We just experienced one of our strongest GDP growth quarters, with real GDP at +6.9% in the fourth quarter of 2021.  Inventory building accounted for the vast majority of that growth, or +5.0%.  Real final sales grew only +1.9%, which is weak, and followed only +.1% in the third quarter.  GDP for all of 2021 was +5.7%, following a year of decline in 2020 of -3.4% due to Covid-19 lockdowns.

Too much stimulus from the federal government drove demand too high in 2021.  Nominal GDP was +10.6% in the first quarter and grew to +13.9% in the fourth quarter as consumers shifted to buying goods rather than services, and supplies could not keep up.  We’ve heard all about the supply chain issues - from manufacturing to distribution- from cargo ships to trucking.  The federal stimulus also drove our national debt levels to over $30 trillion, or 123.4% of GDP.  As we learned during the expansionary decade of 2010 to 2020, GDP greater than 90% for several years will lower GDP by one-third.  Growth only averaged +2.2% during that time, albeit with the bonus of low inflation.

Consumer spending, which represents about two-thirds of the economy, is already weakening as excess demand fades.  Consumer confidence is at relatively low levels, mostly attributed to the inflation shock.  Prospects for growth this year are decent at +3.8% GDP and most estimates project lower growth of +2.5% in 2023, which is back to the lower equilibrium growth rate of just over 2%.  Can the Fed carefully engineer the slowing of growth without risking recession?  We shall see how aggressive their tightening campaign is.

 

Inflation

Oh, the monster!  Oh, the misery!  We all hate inflation.  The prices of just about everything that matters to us are rising- food, energy, medical care, housing and rent, new and used cars, electricity, clothing…the list can go on.  The CPI started 2021 at +1.4% to +1.7%, rose to +5.4% by mid-year, and ended December at +7.3%.  January rose again to +7.5%.  Inflation has eroded spending power with real incomes dropping -4% by the end of 2021, even though wages were rising +4.5% year-over-year.  The Fed started out saying inflation was “transitory” but had to admit later it was “persistent.”  Now we will see if the Fed can keep it from becoming “sustained,” with wage inflation from tight labor markets filtering into the prices of all goods and services. 

Inventories of existing homes has been extremely tight, at 1.6 months’ worth of sales in January, driving recent year-over-year prices on homes up +17.5% to +18.5%.  Higher mortgage rates will undoubtedly reduce demand, with 30 year mortgage rates now above 4% reducing affordability.  CoreLogic expects price increases to decline to +3% to +10% during 2022.

We scream at how bad inflation is when it is at its worst.  There are some clues that inflation may stop rising or recede soon, as supply chains get repaired and more goods flow.  We saw inventory building of a huge scale in the fourth quarter, so a surplus of goods, at a time when demand is declining, is not a prescription for higher prices.  Backlogs are declining in a sign that goods orders are being met.  The flood of government stimulus has faded and the declining budget deficit to GDP, from 5% in 2020 to less than 1% now, points to lower inflation in the year ahead.

Productivity has been on the rise, with capital investment in technology and machines, and may serve to keep unit labor costs in check and profit margins stable.  The dollar has been strong, keeping import prices lower than they otherwise would have been.

Inflationary expectations built into the Treasury market show inflation declining over time:  2 years at 3.55%, 5 years at 2.93%, and 10 years at 2.50%.  if the markets thought inflation would be 7% or higher, yields would already be there.  Even Larry Summers, one of our nation’s biggest inflation hawks, thinks CPI will fall back some to 4% this year.

 

Supply Chains and Labor Shortages

They are connected.  The huge increase in demand exposed the flaws in our systems.  Delivery issues, especially from ocean freight and port back-ups, left many manufacturers short of goods to run production lines and store shelves were left bare.  Labor shortages also played a key role.  Spikes in new Covid-19 variants led to record high employee absences.  But workers are still leaving the labor force from the Great Resignation, retirements, child care issues or costs, burnout and work-life balance, or starting their own small businesses. 

The unemployment rate is down to 4%, but we are only at 87% of pre-pandemic worker levels and are missing 2.9 million people.  The pool of available workers is at 12.217 million in January, which is 2 million higher than in early 2020.  Yet, mysteriously, we are still short workers. 

 

The Fed

We are entering another cycle of Fed tightening.  They will be raising the Fed Funds rate starting in March and are likely to raise it a total of four to five times (.25% each) by the end of 2022.  They met their objective of getting unemployment back to full employment, estimated at 3.5% to 4.3%, and now they must tighten against the highest inflation in 40 years of +7.5% and the tightest labor market in terms of wages increases in a decade, at +5.7% in January.

Market interest rates have risen in anticipation of Fed tightening.  In just six weeks, the 2 year Treasury is up .76%, the 5 year is up .40% and the 10 year is up .42%.  Both 15 and 30 year mortgage rates are up even more at +.80%.  The Fed is very happy to have the markets do some of their job for them.   Remember that Fed policy operates with a lag.  By the end of 2022, we should see the economy slowing and hopefully inflation receding.

Finally, all of you Phillips Curvers are rejoicing right now.  After 10 years of warning us that low unemployment leads to high inflation, you have finally gotten your moment of Schadenfreude!  Enjoy and thanks for reading!

DJ  02/19/22

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 Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

She also was our guest on my firm's January 2022 podcast, This Month in Banking. To listen to that episode on interest rates and the economy, click here or go to wherever you get your podcasts.