Financial Institutions: What Drives Value v2

In a follow up to my last post on the subject, that was driven by my friends from Performance Trust, I was asked in the comments section of that post if there was a correlation between non-interest bearing checking accounts and price-to-tangible book multiples.

That nugget was asked by Mike Higgins, a bank consultant from Kansas City, who penned a guest post on these pages in the past. Rather than answer Mike in the comments, I opted for the wider audience distribution of a standalone post.

It's my blog. I can do what I want.

I am somewhat limited to how financial institutions report their deposit mix. Call report categories are easiest, and the closest metric is transaction accounts to total deposits. I thought this would give us what we needed.

So, is their a correlation between a bank's relative level of transaction accounts to their price-to-tangible book trading multiple?

See for yourself.

The data, courtesy of S&P Global Market Intelligence, is all publicly traded US banks with trading volumes greater than 1,000 shares per day, and that have non-performing assets to total assets less than 2%. That filtered out most of the very small, inefficiently traded financial institutions, and those with asset quality issues. I also eliminated banks that had NA in the transaction accounts/total deposits ratio.

The filters resulted in 306 financial institutions, which I divvied up into quartiles based on transaction accounts to total deposits. The top quartile, with 56.78% transaction accounts to total deposits traded at 208% price to tangible book at market close on October 4, 2018. The bottom quartile, with 24.71% transaction accounts to total deposits, traded at 145% price to tangible book. The line is linear. Which reads funny as I proofread.

So I would say: yes, community bank investors reward banks funded with a higher proportion of checking accounts with greater trading multiples. So when I wrote in June 2018, in a post titled Branch Talk, my Point 1 was that banks needed to build a cost of funds advantage by having a relatively higher proportion of checking accounts, the above chart is why.

In reviewing the data that fed the above chart, size was likely not a significant issue. All of the numbers above are medians, not averages. And the median asset size from bottom quartile to top were: $1.6B, $2.2B, $3.2B, $2.1B. Wells Fargo and JPMorgan, the nation's largest FIs, were both in the 3rd quartile.

A bonus table:

So there is a neat line in Return on Average Assets too. Price to earnings is not so neat, but I find it rarely is. Still, the message is clear. More checking, better performance, higher trading multiples.

Do you see it differently?

~ Jeff

For Financial Institutions, What Drives Value?

Not all financial institutions are publicly traded. But there are enough of them to help those that do not trade to measure what metrics drive the value of their franchise. 

So what metrics drive value? Umrai Gill, Managing Director of Performance Trust in Chicago presented his findings to the Financial Managers Society at their East Coast Regional Conference this month. Some results were surprising.

He first cited a survey performed by PT, asking their clients "what are the generally accepted drivers of institutional value?" Without identifying ranking or more details about their survey, the preponderance of responses were as follows, in no particular order: loan-to-deposit ratio, investment portfolio size, net interest margin, efficiency ratio, return on average assets (ROAA), return on average tangible equity (ROATE), capitalization, and asset size. 

Some were not very interesting to me, such as investment portfolio size, which might have been influenced by PT's specialty. Others might have been too investment community-like, such as ROATE, which doesn't count high premiums bank buyers pay for bank sellers that results in goodwill on the buyers' books, which is deducted from their regulatory capital. But others struck my curiosity to see if there were correlations between the metric and market valuations. 

And I thought I would share with my readers.The charts in the slides below was PT's analysis of data from S&P Global Market Intelligence based on June 30, 2018 financial information using market data from 08/17/18.

First, the metrics that showed correlation to price to tangible book values. Not surprising, in my opinion.

Asset Size

Efficiency Ratio

Profitability / ROAA

Next, the ratio that did not show a correlation to price to tangible book multiples, at least not over 3.5%. I was a little surprised at this one.

Net Interest Margin

Lastly, and most interesting from my point of view, were ratios that showed mixed results. In other words, they showed positive correlation to price-to-tangible book ratios, up to a point. After which, they showed a correlation, but not what bankers would hope for.

Tangible Common Equity / Tangible Assets

Loan-to-Deposit Ratio

The highest market multiples were afforded to banks with a 70%-80% loan to deposit ratio. Now that may be related to size of institution, as the very largest, JPMorgan Chase (67% loan/deposit ratio) and Wells Fargo (76%) tend to have lower ratios. But there is likely something to the fact that a bank that still has strong liquidity as represented by a relatively lower loan-to-deposit ratio in a good economy has room to improve earnings by growing loans faster than deposits. While the less liquid must price up their deposits to get funding.

And capital, well, I refer you to a prior post where I clearly stated there was such a thing as too much capital. Investors will not pay a premium for hoarded capital. Performance Trust's research puts that sweet spot in the 9%-10% tangible common equity / tangible assets range. Enough capital to grow and/or absorb recessionary losses without selling off assets at a discount to bolster capital during hard times.

Where are your sweet spots?


~ Jeff

Are Bank Products Simple, Fair, and Transparent?

I was on a road trip discussing banking with a colleague, and I mentioned that bank products are anything but simple, fair, and transparent. He said, “sounds like a blog post.”

I have never heard a bank customer say, “gee, I wish my bank relationship was more complex.” Yet we charge business checking fees based on a complex analysis, offer a 7-month special CD only to roll it into a lower yielding 6-monther if the customer isn’t attentive, and require high-interest checking customers to have 10 debit transactions, e-statements, and a partridge in a pear tree to get that rate. Sound simpler, fairer, and more transparent?

On the other side of the coin, bank customers don’t necessarily understand what it takes to run their accounts profitably. Dear customer, the Federal government requires financial institutions to monitor your account for suspicious activity and report anything untoward. That costs time and resources that drive up the cost for your checking account. That is why every overdraft fee, interchange transaction, and minimum balance fee counts. Your government drives up bank costs.

It costs $423 per year for a bank to run a retail interest-bearing checking account, based on my firm’s product profitability database. To cover that cost solely on the spread that your balances generate would require an average balance of $21,363 in your account. All. The. Time.

I have written on these pages that I thought the past practices of relying on customers to be asleep at the switch and accept rates significantly different than market rates will soon be over. Banks must shift business models to pay depositors something closer to market rates for “accumulation accounts”, which are accounts for long-term savings such as an emergency money market account, or a CD ladder.

Cost of funds advantages should be built on having relatively higher “store of value” accounts such as checking, or special purpose savings where convenience and safety are more important to the customer than accumulation.

So I don’t point out a problem without proposing a solution, I have an idea for a Simpler, Fairer, and more Transparent small business banking deposit product. Call it the Jeff For Banks (JFB) Business Banker Account. As I mentioned in past posts, I’m a narcissist and I’m trying to get something named after me.

JFB Business Banker Account

The product is a combined store of value checking account, and an accumulation money market and/or sweep account. But no sweep here into a repo where we have to pledge investment securities against balances. That wouldn’t meet the simple test.

Banks can pay businesses interest on their checking accounts. So I propose banks segment business checking accounts by their resource utilization, and create minimum balances based on this segmentation. So the college bar that drops off bags of money each morning at the local branch has a higher threshold before it doesn’t get charged a monthly maintenance fee and receives interest.

So the average balance for high utilization quartile account might be $70,000, above which the account receives a competitive interest rate, and below which the account is charged a monthly maintenance fee. Here is what the math might look like for Pete’s Corner Bar.

JFB Business Banker Account Profitability Estimates
1	Average Balance	$92,102
2	Checking Average Balance	70,000
3	Checking FTP Spread*	1,463
4	Money Market Average Balance	22,102
5	Money Market FTP Spread*	197
6	Total Account Spread	$1,660
7	Fees**	$540
8	Annualized Operating Cost per Account*	$784
9	Pre-tax Profit	$1,416
10	Pre-tax ROA	1.54%
11	Equity Allocation*	1.00%
12	Pre-tax ROE	154%
13	Total Account Cost of Funds***	0.30%
*Per TKG product profitability peer data
**Assumes one incoming/outgoing wire/month
***Money market balance * 1.25%

The bank would still charge per use fees for things like wires, ACH’s, overdrafts. And receive interchange income. But the spread should cover items presented plus profit for the bank. Imagine having 10,000 of the JFB’s Business Banker Account. Instead of 1,000 of this account, 2,000 of that account, 4,000 of another account, and 3,000 old grandfathered accounts. Which would be easier for your branch and business bankers to explain to your customers? And marketing people tell me that bankers sell what they know.

Does the JFB Business Banker account pass the Simple, Fair, and Transparent test?

~ Jeff

The Real Reason for Bank Scale: Trading Multiples

"Get big or get out." "You must be twice the size that you are to succeed." These are bromides that some industry talking heads might be telling you. I hear it and read it frequently. And in today's social media, non fact-based opinion society, if you say it enough, people may start to believe it.

I moderated a strategic planning retreat with a bank that achieved top quartile financial performance. Their growth was solid too. Their asset size was less than $500 million. A director challenged me: Does our size matter so long as we continue to perform the way we have performed? My answer: Not really, with one exception.

Trading multiples. I referenced this phenomenon in a 2013 blog post, Too Small to Succeed in Banking. In that post I opined, "As we migrate towards greater institutional ownership, stock liquidity is becoming increasingly important." What I said then likely remains true today. Institutional owners (funds, etc.) now own two-thirds of shares outstanding in publicly traded US banks. 

But why does this matter to my sub $500 million in assets bank client?

So I ran some charts for you (courtesy of S&P Global Market Intelligence).

The bottom table was a bonus so readers can see that at the end of 2017 bank p/e's relative to the S&P 500 p/e surpassed their 10-year median in every asset category. Significantly so for banks $500 million to $5 billion in assets. So, on a relative basis, valuations are higher. 2008 was an anomaly because the S&P 500 companies traded at stratospheric p/e's because they had no "e".

Back to my main point. Over the past 10 years, banks that have less than $500 million in total assets have traded at lower price-to-tangible book multiples. In every year. And the differences in multiples match up nicely by asset size. The price-to-earnings chart is a little murkier based on the choppiness of earnings. However, investors tend to value smaller financial institutions more on book value than earnings. A good earner, like my client, tend to trade at relatively low p/e's because they have great earnings. 

Does that sound right? Earn better, and get rewarded with a lower p/e?

Fair is in the eye of the beholder. If you remove nearly 2/3 of the potential shareholder base because you have little daily trading volume, then you have less buyers seeking your shares. Supply and demand.

And that is where the economies of scale argument has merit. If you intend to remain independent, and continue to perform well and grow sufficiently, then you are likely delivering total returns acceptable to shareholders. Even without trading multiple expansion.

But if you would like to acquire a nearby financial institution, and you are trading at lower trading multiples than other would-be acquirers, you would be at a disadvantage. Your "currency" isn't worth as much as your larger competitors. Which may also make you vulnerable to an aggressive buyer's offer to buy you, if the buyer is large and has much better trading multiples than your bank.  

Fortunately, unsolicited offers are not common in our cordial industry. But we shouldn't rely on it.

~ Jeff

For Financial Institutions, Is There Such A Thing As Too Much Capital? Yes. Yes There Is.

I was on a panel at a bankers conference with an investment banker and two bank fund investors. One of the investors' opening remarks was about banks that were over-capitalized. I panned the audience to see if regulators were present.

But there were enough open jaw gapes to see that many bankers share the regulatory belief that there is no such thing as too much capital. And that may be true for financial institutions that don't take investor money. But if your bank is shareholder owned, then you may be hoarding their money. And as a bank shareholder myself, I like to make my own hoarding decisions.

I have written on these pages about a method to estimate your "well capitalized", a question your regulators may have asked you. Having done this, and seeing that your strategic plan has you comfortably above your well capitalized and trending higher, what do you do with the excess capital?

Derek McGee of Austin law firm Fenimore, Kay, Harrison, and Ford had four to-the-point ideas in a recent Bank Director Magazine article. I would like to lay out his four ideas with my take on them.

1. Dividends. "Returning excess capital to shareholders through enhanced dividend payouts increases the current income stream provided to shareholders and is often a well-received option. However, in evaluating the appropriate level of dividends, including whether to commence paying or increase dividends, banks should be aware of two potential issues. First, an increase in dividends is often difficult to reverse, as shareholders generally begin to plan for the income stream associated with the enhanced dividend payout. Second, the payment of dividends does not provide liquidity to those shareholders looking for an exit. Accordingly, dividends, while representing an efficient option for deploying excess capital, presents other considerations that should be evaluated in the context of a bank's strategic planning." 

My take: Amen Derek! In a blog post this year, Bank Dividends: Go Ahead and Drink the Kool Aid, I called for the same thing. And to use special dividends and deliberate shareholder communications to help overcome shareholder expectations mentioned above. I have not experienced a bank that made the pivot from being a growth company to a cash cow, where profits are maximized and dividends are plentiful. It is a natural evolution of a company built to endure. 

2. Stock Repurchases. "Stock repurchases, whether through a tender offer, stock repurchase plan or other discretionary stock repurchase, enhance liquidity of investment for selling shareholders, while creating value for non-selling shareholders by increasing their stake in the bank. Following a stock repurchase, bank earnings are spread over a smaller shareholder base, which increases earnings per share and the value of each share. Stock purchases can be a highly effective use of excess capital, particularly where the bank believes its stock is undervalued. Because repurchases can be conducted through a number of vehicles, a bank may balance its desire to effectively deploy a targeted amount of excess capital against its need to maintain operational flexibility."

My take: Institutional shareholders own greater than two thirds of publicly traded financial institutions' shares outstanding. And share buybacks are a favorite of theirs. The challenge is that they would like to liquidate their ownership when the value is at its peak. Meaning the financial institution purchasing its shares would likely enjoy minimal earnings accretion and create book value dilution. But, as Derek pointed out, it is a highly effective use of excess capital when the bank believes it is undervalued. One bank stock analyst thinks every bank should calculate the earnings accretion of a prospective merger versus the earnings accretion of a share buyback. If the buyback is more accretive, why do a riskier merger?

3. De Novo Expansion in Vibrant Markets. "Banks can also reinvest excess capital through organic expansion into new markets through de novo branching and the acquisition of key deposit or loan officers."

My take: When a race car enters the pits, it is losing time. If not to recalibrate, refuel, and re-tire, drivers wouldn't do it. If you compare bank strategy to a 500-mile race, banks would also enter the pits. But if you compare bank strategy to a few times around the track, you would be foolish to do so. Think of the short race as budgets, and the 500-miler as strategy. You have to be willing to accept the short-term setback of entering the pits (i.e. making strategic investments like Derek mentioned) to position you to win the race. 

4. Mergers & Acquisitions. "Banks can deploy excess capital to jumpstart growth through merger and acquisition opportunities. In general, size and scale boost profitability metrics and enhance earnings growth, and mergers and acquisitions can be an efficient mechanism to generate size and scale. Any successful acquisition must be complementary from a strategic standpoint, as well as from a culture perspective."

My take: Derek's "complementary" comment was right on. Listen to my firm's most recent podcast on M&A cultural integration featuring an interview with Jim Vaccaro, Chairman and CEO of Manasquan Bank, that is in the process of merger integration as I type. In addition to a cultural fit, the geography and balance sheets should be complementary, and the earnings accretion should exceed what the buying institution could achieve on its own. Tangible book value dilution, which tends to get a lot of play in the investment media, should not be to the level to cause long-term downward pressure on the buyer's stock price. 

Out of the four, M&A is the least within the control of the financial institution, as this takes a willing partner.

What other uses of excess capital do you propose? 

~ Jeff

The Federal Home Loan Bank System: Lender of Next-to-Last Resort

"The FDIC recently has observed instances of liquidity stress at a small number of insured banks." So opened the Summer 2017 FDIC Supervisory Insights issue. And so went your exams.

At a recent banking conference an industry consultant said, matter of factly, that in times of stress your Federal Home Loan Bank (FHLB) borrowing capacity would dry up. Nobody challenged him, including me, by the way. But when I mentioned the comment to the attending FHLB rep, she was not particularly happy.

This has happened before. Regulators and consultants promulgate this untruth. And having heard it so much, bankers are beginning to believe it. 

This week I sat in a bank CEO's office where he complained, ranted really, about his latest exam and the regulators' perception of liquidity risk, driven by the aforementioned Supervisory Insights. He was confident in his bank's liquidity position, but felt regulators could artificially create a liquidity problem.

Their conversation goes something like this: pretend that your non-core and wholesale funding dries up, and you are unable to attract local funds via rate promotion because of our restrictions on rates paid above the national rate cap. What would you do? Prepare for that.

I recently wrote that I thought bankers would have to prepare to offer rates more in line with the market. I noted that there was a greater than 100 basis points difference between what a customer could earn on an FDIC-insured Goldman Sachs Marcus account than what they could earn in your bank's money market account. And that bankers are going to have to build the infrastructure that allows them to be closer to market.

The national average rate for a money market account at the end of last year was 0.09%. The Fed Funds Rate was 1.25%-1.50%. So, according to the FDIC rate cap "guidance", you could not exceed 84 basis points on your money market accounts at December 31, 2017 if you were under regulatory scrutiny. Sixty six basis points less than the Fed Funds rate at that time.

I monitor trends. I know loan/deposit ratios are going up, and liquidity ratios are going down (see charts). But what are the chances that your liquidity position plummets, you lose access to your

correspondent line(s), you can't attract local deposits, your municipalities withdraw, and your FHLB line "dries up", all at once? As the FHLB rep mused to me, it could happen if say, an extreme black swan event much worse than the 2007-08 financial crisis happened.

More to the point, she directed me to her FHLB's president's message on their website where he wrote: "As long as markets remain open, and a member has pledged sufficient qualifying collateral and is willing to purchase the requisite amount of capital stock, the Home Loan Bank will always continue to lend to our members to help you meet your community's needs." 

We need a smarter discussion on liquidity. Before we create an artificial liquidity crunch.

The consultant at the above mentioned conference did have some solid recommendations that I would like to share, even though he is a competitor. Pretty magnanimous of me, right?

1. Create detailed funding concentration risk analytics, that includes:

     -  Stratify funding using a liquidity matrix

     -  A deposit loyalty study (to classify what regulators consider non-core as core)

     -  Determine a local rate cap (to use vs. the federal rate cap)

2. Conduct forward looking stress tests that include realistic contingency funding strategies

3. Train board members

4. Update liquidity policy and contingency funding plan to be consistent with the above process

Are you feeling pressure internally or from regulators on liquidity?

~ Jeff

Who Am I?

Who I am is in the eye of the beholder, right?

Quick note: I mostly blog about banking. Today I blog about myself so you can have a better idea of the person behind the writing.

I am a recent member of my local Rotary Club. New members typically give what is termed a "Classification Speech" to the membership. I was no different, and was tapped to deliver mine last month. So I called the club president to ask what I should talk about.

"Anything you want" he said. He later regretted it. Giving me an open mic is ill-advised, as my wife would tell you.

I formatted my Classification talk in "Who Am I" format, much like how Admiral James Stockdale quipped in a 1992 Vice Presidential debate. I delivered it extemporaneously, so I don't have the exact words I used on that day, just an outline scrawled on a piece of paper.

But here is the essence of what I said.

Who Am I? I am John and Joyce Marsico, my parents. My dad died of Hodgkin's Lymphoma when I was six years old. Eleven months from diagnosis until death. He was the local McDonald's manager. My mom was a stay at home mom, which was more typical in those days. Work life was different then. If my dad took weeks off to get and recover from chemo, he wouldn't be paid for that time. So after chemo, no matter his condition, he went to work to keep the family money flowing.

When he passed, my mom was left with three boys, ages 8, 6, and 3. No income. And little life insurance. She went to work, and we lived off her wages and the social security survivors benefit. In spite of those tremendous challenges, she kept us in Catholic school for fear that without a father, we were at greater risk to getting into trouble or hanging out with some bad kids.

In today's society, we call people hero's for not so heroic things, like scoring a goal, or being in a film. Today someone called Kurt Russell and Goldie Hawn "inspirational". Try going to work the day after chemo. 

I am the husband of Jackie. We were high school sweethearts. I was working the charm on her since Mrs. McTighe's high school English class. Took three years. Got married when I was 21, she was 20. Everything we have we built together. Nothing was given to us. Today, if you saw us walking down the street together, you would think I was rich. Well I am. Not in the money way.

I am a sailor. I served in the Navy because my father, grandfather, and uncles served. And I could've used the funding to pay for college. It was a tremendous adventure. I remember being taken out to my first ship that was sailing into the Mediterranean Sea, the USS Coral Sea, an aircraft carrier. I was flown out on a C-2 Cod, the only cargo plane (at the time) to be able to land on carriers. It had one window on each side, and I got the window seat. Coincidentally (or not), the chaplain was in the seat next to me. Aircraft carriers are mighty big ships, but very small airfields. I survived. Many of my old Navy friends remain my shipmates.

I am the father of two girls. As I mentioned above, I grew up in an all boy household. Girls, as I entered adolescence, were awesome. I didn't know why I played ball with Jane all the way up to middle school, and suddenly I was ok with being her cheerleading base! As a dad, I knew. So God sent me two to test me! Ok, maybe that's exceedingly narcissistic. Raising girls was difficult for me because I had no frame of reference. And the emotional ups and downs of growing up is more pronounced on girls than boys, in my experience. It weighed heavy on me when my girls went through it. But they made it through with flying colors! So far. Fingers crossed.

When our first was born, my wife and I were stationed in Rota, Spain. Twenty one hours of labor, the last three pushing. My wife, not me. I just experienced a couple uncomfortable hand squeezes and a difficult glare when I ordered pizza. After those 21 hours, the doc decided on a c-section. After trying to push my daughter out for so long, she had a conehead when she was born. So my first words when she was born was not "beautiful", or "wow". It was "is that normal?". It was normal, by the way. 

I am a bank consultant. When I first started, I worked primarily on mergers and acquisitions, where my boss told me that my job was 20% math, 80% psychology. It hit home when we were negotiating a transaction that the handshake-creating concession was to allow the chairman to keep his Bentley. Psychology. 

My kids still don't know what I do. In simple terms, some of what I do can be described by example. I watched a banker in deposit operations reviewing checks. She was flipping them one at a time. I asked what she was doing. She said checking for fraud. I asked what fraud looked like. She didn't know. I asked how long she did that per day. She said one to two hours. I suggested she stopped doing it. 

Perhaps that's an oversimplified example of some of the things that I do. But it's true. 

I am a Rotarian. Truth be told, I probably wouldn't have joined Rotary if not for my friends Dan and Kevin. But I was getting to the point where I was growing tired of the excuse that I travel so much that I can't commit to much. Travel is the primary reason I had to hang up the whistle as a lacrosse coach. 

I was getting a haircut one day at Manny's barber shop. I call him the hip-hop barber because he was playing hip-hop the first time I visited. While getting my haircut, Manny took a call. After getting off the call, he explained that he had to schedule a haircut for a bed-ridden young man, who had a catastrophic accident years ago. He had been cutting his hair for years. What made Manny's generosity even greater, was the young man lived 30 minutes away. 

That's charity for your fellow man. And that's why I had to be more than the contributor to the family checking account.

~ Jeff

Did you know? That since Rotary's first effort to eradicate polio from the face of the earth in the Phillippines in 1979, polio cases are down 99.9%! How about that! *Mel Allen voice*

Bankers: Bring On The Change

On the shores of the Ammonoosuc River, alongside the hotel where the famous Bretton Woods conference took place in 1944, I talk about the onslaught of change that has recently occurred, and will continue to occur in our industry.

Change: Is your institution ignoring it, trying to stop it, or adapting to it?

How much grief will I get comparing employees to beavers?

Fiserv: Give Your Clients a Test Bank

Community banks are struggling to build a training curriculum to develop branch bankers of the future. Aside from moving from a transaction to an advice, sales, and service culture, they also struggle with operational training.

Why?

The story of declining branch traffic, and the resulting reduction of branch transactions, is reducing the repetition of common and uncommon transactions alike, and therefore the opportunity to improve operational skills of branch employees.

When I was a branch banker over 20 years ago, I went to headquarters, stood at mock-up teller lines with a dozen of my colleagues, and a trainer drilled us on running common transactions with enough repetition to imprint the "how to" in our brains. Well, at least my colleagues brains. I never claimed to be an operational wizard.

Some banks still do this. But with branch turnover down due to a weak job market, and the industry moving to universal banker, these training test beds are on the decline, in my experience. As they should be. No reason to institutionalize what is quickly becoming an outdated model... tellers standing behind the rigid teller line anxiously awaiting for the flood of customers that no longer come.

So how do banks increase proficiency with transaction processing? Most accomplish through on-the-job training (OJT), in my experience. But with common transactions being done less frequently, particularly in smaller or more rural branches, and uncommon ones perhaps happening once per month or less, how are branch bankers getting the reps needed to become proficient?

Some are being deployed to a bank's busiest branch, typically the headquarters office, for some OJT before being deployed into the branch network. This is a natural reaction to get reps, and be productive once sent to their primary branch.

But how can your core processor be helpful?

Those that have been through the painful core processor conversion experience know that the Fiserv's and Jack Henry's of the world establish a "test bank" to get your people proficient at all sorts of interactions with your soon to be deployed core.

My question: Why give this up?

I reviewed all data processing expenses for Southeast banks with assets between $800 million and $1.2 billion in total assets. Community banks. The results of my analysis are in the chart below.

In terms of the Call Report, Data Processing Expense category, these banks spent on average almost $1 million in 2015. And the trend is decidedly up. Not a small sum.

In my firm's profit improvement engagements, we see wild fluctuations in core processing expenses. Telling me: 1) banks buy different services from their core processor, and 2) there should be negotiating flexibility given the dollars involved.

What I suggest is negotiating a "test bank" that remains open for continuous training with your employees. Not just branch employees, but everyone that interacts with the core. This will improve the effectiveness of your OJT program, increase transactional proficiency, and allow your bank to dedicate more resources to higher level employee development. It will also retire "Mickey Mouse" and "Donald Duck" as customers. Bankers know what I'm talking about.

There's enough margin in that Fiserv contract to make this happen. Make it so!

~ Jeff

Should Bankers Pursue an Asset Driven or Core Funded Strategy?

My firm is 15 years old. And approximately every five years, we performed an analysis to determine how the stock market rewards financial institutions for different strategies. In particular, does the market reward banks that drive net interest margin through a high yield on earning assets, or a low cost of funds?

The first two times we did this, the low cost of funds banks won, hands down. So I assumed that this is the way it was, and therefore is the way it will be. But we recently revisited the analysis for an "asset-driven" client... i.e. one that focuses on loan production, and backfills with funding as they figure out how to pay for the loan pipeline. This strategy typically leads to a higher cost of funds as the bank turns to higher rate deposits, brokered deposits, or FHLB borrowings because it's quicker than winning deposit relationships.

The following charts show the results. Sorry for column overrun but wanted to make them bigger and I have no idea how to do that other than blowing them up. I digress. Fortunately, I have two daughters and am very familiar with being told I'm wrong. If not for my two angels, the below charts might have broken my confidence. 

The charts show the price/tangible book and price/earnings multiples of two sets of banks. As the Criteria states, we took banks with between $800MM and $3.0B in total assets with healthy net interest margins and profitability. The size range is consistent with our bank client. We then divided the result into the top 10 yield on earning assets banks, and the top 10 (lowest) cost of funds banks. And then charted their trading multiple trends. Yes, there were two cross-over banks that made both charts. Quite an accomplishment, in my opinion.

The low cost of funds banks are no longer the clear winner, as the yield on earning assets banks sport a greater price/tangible book multiples. 

Mind=blown.

What caused the shift that improved asset driven banks trading multiples to be comparable to core funded banks? I have my opinions. Note the next chart.

Yeah, I know. Charts again from Marsico. Hey, I'm a strategy-finance wonk.

My firm measures the profitability of products for dozens of community financial institutions. As part of that service, we roll up bank specific products to common products so we can compare each client's product profitability to that of a peer group. Think home equity and commercial real estate loans, business checking and personal money market accounts, etc. 

As a result, we can determine the spreads (using actual yields for assets and costs for funding offset by a funds transfer price) of all products on the asset and liability sides of the balance sheet. The trend of those spreads are in the chart. Notice in 2006, when the Fed Funds rate stood at 5.25%, and the yield curve was inverted, liability spreads exceeded asset spreads.

Then the Fed started dropping short term rates (quickly to 0-25 bps) and the yield curve went positively sloped. Loan spreads quickly exceeded deposit spreads. And loan profitability followed in quick succession. 

So for an extended period of time that includes present day, loan spreads exceed deposit spreads, and loan profitability has mostly exceeded deposit profitability.

Therefore, asset driven banks were rewarded with greater overall profitability than core funded banks, and trading multiples moved to greater parity.

But it won't always be so. 

I thought you would like to know.

~ Jeff

FinTech and Community Banking: Built for Marriage?

Recent news of Prosper scaling back and OnDeck Capital's ongoing losses has taken a little shine off of the FinTech apple. Doesn't this happen with every meteoric rise?

Recently a former bank director and active bank stock investor asked me about the rise of FinTechs and how it impacts community banks. Here is my answer to him.

"I think technology firms are going to change banking forever. So if bankers that you talk to reminisce about the good old days when they could shake hands, make loans, and win relationships, run away.'

'But the death of the community bank is exaggerated. Banks have customer trust. FinTechs have yet to earn it. Banks have customers. FinTechs want them. Banks have regulatory experience and regulators are now figuring out how to regulate FinTechs (good luck!). Banks have capital. Many FinTechs have sold to banks or seek investments from them (Note: I am on the advisory board to Hip Pocket that was currently cited by Finovate as a great prospect for bank strategic seed funding). Banks are FDIC insured. FinTechs are not. Banks have deposits. SoFi has none.'

'Somewhere in between the two extremes of 'ignore FinTech', or 'FinTech will rule the world', will be the future for community banks. Collaboration between banks and FinTech firms has already begun, and I expect it to continue."

How do you anticipate the future of these two industries come together?

~ Jeff

Note: I am not a licensed financial advisor. So do not buy or sell stocks based on anything you read here. The government requires a test. Go to one of those folks.

Earnings Guidance? Buy Side Wall Street Says Think Long-Term. Sell Side Wants Tax Rate.

In February, Larry Fink from Blackrock sent a letter to publicly traded CEOs to think long term and to stop giving earnings guidance. Specifically, he said "Today's culture of quarterly earnings hysteria is totally contrary to the long-term approach we need."

Let's see if bankers are heeding Larry's call on their first quarter earnings call.

Christian Bolu - Credit Suisse to Goldman Sachs CFO Harvey Scwhartz: "Tax rate was a bit lower in the quarter, just curious how we should think about the go-forward tax rate?"

Schwartz - "In terms of the go forward I guess if I was to give the best estimate, I'd say something similar to last year."

Bob Ramsey - FBR & Co. to BofI Holdings CFO Andy Micheletti: "I guess putting it all together, next quarter you'll have less Block [from acquisition of H&R Block portfolio]; sounds like your loan yields are stable-ish; plus you have some lift from the equipment finance; and deposit costs maybe tick up with a little growth. Does that put you somewhere in the ballpark of 4%? Or what is the right range for next quarter?"

Micheletti: "Yes, Bob, I think we're still in that 3.80% to 4% range. I would lean to the higher end of that, given where we're coming out, without the Block impact. But certainly in the 3.90%s would be fair."

Michael Rose - Raymond James & Associates to BB&T CEO Kelly King: "Can you give us your thoughts, in light of the environment, in terms of what we could expect for the efficiency ratio"?

King: "I think we will end up this year with improvement. It may be in the 57ish kind of range. Pretty confident about that."  

Dave Rochester - Deutsche Bank to Great Western Bancorp CFO Peter Chapman: "And then just one last one on the margin. Just trying to get your sense for the trend that we should see from here?"

Chapman: "Not much change really to what guidance we have given in the past. So as we have said, Dave, I think if rates remain low, if it ticks down a point or two a quarter, then we wouldn't be surprised with that." 

Chris McGratty - KBW to UMB Financial Corporation Chairman & CEO Mariner Kemper: "And given the stock movement, should we be assuming that those 2 million shares [stock buyback] will be used kind of consistently through the year?"

Kemper: "You know, all I can really tell you is that we certainly think we are very thoughtful about how we think about how to deploy our capital. I know you want more but that is about all I can give you."

Amen Mariner!

To be fair to these banks and their executives, equity analysts bombard them with questions each quarterly call to help them with their projection models. What are they to do? 

In the spirit of Larry Fink's comments and wishes, as one of the largest investment funds in the world, and to be consistent with my belief that managing for the long-term opens doors to investments that can transform your financial institution for an enduring future, here is a sample analyst question and a proposed answer.

Joe Spreadsheet - Bank Stock Investment Firm, Inc. to Chris Evert, CEO of Schmidlap National Bank: "So, Chris, I have this spreadsheet in front of me and I have to enter in an effective tax rate to spit out net income projections. I don't want to be surprised next quarter when I make my estimates, what number should I put in cell F72?"

Evert: "Joe, our long-term strategy has been to transform our bank into a core funding machine, and away from the asset-driven strategy that resulted in large amounts of wholesale funding. As we make this strategic transition, our loan to deposit ratio will fall and, if successful, will result in greater margin as a result of lower cost of funds, offset somewhat by a lower yield because we are becoming more liquid and more assets will be in our investment portfolio. We'll manage taxes from there. Good luck to you buddy on cell F72."

How do you think we can transition from this "here's what we promised the investment community next quarter" to using the investment community to give us discipline in executing long-term strategy?

I'd like to hear from you.

~ Jeff

Bonus: Lloyd Blankfein, CEO of Goldman Sachs, talks about Fink's letter on CNBC Feb 3rd.

http://www.cnbc.com/2016/02/03/cnbc-exclusive-cnbc-transcript-goldman-sachs-chairman-ceo-lloyd-blankfein-speaks-with-cnbcs-squawk-box-today.html

Bankers: How Should It Be?

I have been sitting on an airport tarmac for 45 minutes. Twenty-first in line. Waiting for a re-route from the tower to avoid the rain drops. Such is the way that it is.

But how should it be?

In banking, do we ask ourselves how it should be?

My firm analyzes bank processes to identify how it is, versus how it should be. But the question goes deeper than how a wire is done versus how it should be done. Answers are typically “it depends”. And what it depends on is in the eye of the beholder. Is the beholder the employee? The customer? The regulator? The shareholder?

Last year I did a blog post Build Your Own Small Business Loan Platform. In it I described having a series of options to fund small businesses. Some options were on the bank’s balance sheet, some not. What the post does not say is just because you could advance a loan to the customer, doesn’t mean you should.

Take the following example:

Suppose Jane and John Doe, owners of J&J Bikes, come into your bank for a mortgage loan. The bike shop has been doing well the past couple of years and the Doe’s want to upgrade their lifestyle into a bigger house.

So they find one. And come to your bank to finance it.

Your bank has a robust menu of mortgage loan programs. And the Doe’s are pushing their limit on loan-to-value, and debt-to-income. But based on the last two bumper years at the bike shop, they are feeling pretty good about their future and moving to a new, tony neighborhood.

You recognize that the Doe’s business is cyclical, and suffers revenue setbacks during recessions. Their ability to service the mortgage payments on their dream home would be significantly impaired if their revenue dropped as little as 20%.

But they would qualify for the mortgage with one of your loan programs. Since your bank sells the mortgage to investors, and you would meet the investor’s underwriting criteria, the risk of the Doe’s defaulting would fall on the investor. And your mortgage originators only get paid on closed loans.

Do you do the loan?

How it should be…

A relationship driven bank would be concerned about more than the risk of the investor putting back the loan to the bank. It should be concerned about the potential downward spiral of the Doe’s should the bike shop befall hard times and they can no longer service the mortgage.

The Doe’s are not the financial experts that know what would happen if they can’t make the mortgage payments. You are.

So you counsel them on the pitfalls of pushing their financial limits to live in a large home. Values of larger homes fall more in recessions because buyers become scarce. So if they can’t make payments due to a recession impacting their bike shop, they may not be able to sell their home at its current value either.

You tell them to look at past recessions, and the bike shop’s decline in revenue. And look at homes where they can sustain the mortgage in hard times.

I’m not suggesting telling them no, you won’t do it. But be the financial counselor your strategic plan wants you to be. The Doe’s may not appreciate your advice initially. But you would be their trusted advisor for a long, long time.

Or you can put them in that new high LTV loan program from your aggressive investor so you can pay your originator and hit the budget.

How should it be?

~ Jeff

Don't Bank. SoFi

After its most recent capital raise in September, SoFi, a marketplace lender that focuses on millennials, has raised nearly $1.5 billion in equity capital since its founding in 2011. By comparison, over 100 year old and $7.7 billion in asset Union Bank & Trust in Virginia had $1.1 billion in equity capital, with a market capitalization close to book value. 

Since 2011, SoFi has funded over $6 billion in loans (through December 15, 2015). And today, they are embarked on a campaign against banks.

Warren Buffett was right when he said "You never know who's swimming naked until the tide goes out." SoFi started in 2011, so the tide has not yet gone out on them. Like most marketplace lenders, SoFi claims a borrower risk rating system that is better than the FICO score. And in fact, is claiming a FICO score free zone. How good is their system compared to FICO, or other FinTechs that feel they are more evolved in credit risk management? We don't know. And I suspect we won't know. Until the next time the tide goes out.

Remember during the depression when the National Housing Act of 1934 created the Federal Housing Administration (FHA). Perhaps not. But during the depression, the typical mortgage was a five year balloon. So when 1/3 of borrowers lost their jobs, they were unable to re-finance when their balloon came due. Forcing them out of their homes. In came the FHA, with mortgage insurance to protect lenders, and the beginning of what is now a 30-year mortgage with a significant secondary market.

The secondary market removes unpalatable interest rate risk from financial institutions' balance sheets. Similarly, SBA guarantees reduce risk for small business lending. Reducing risk by transferring it to someone else is not new.

Marketplace lenders reduce risk for their loans similar to how financial institutions do it for mortgages and small business loans. They transfer it to investors. Many of the investors are other financial institutions! 

Sure, the originating institution retains some risk. I'm not privileged to see the contracts and know if there is recourse back to marketplace lenders for their loans. For financial institutions originating and selling residential mortgages, they retain some risk for early pre-payments or early defaults up to a certain point in time. And for fraud without a time limit. Absent those items, mortgages sold in the secondary market are at the risk of the investors.

So, too, I would suspect is the risk to SoFi and other marketplace lenders. Meaning the lion's share of SoFi swimming naked when the tide goes out is born by those that buy those loans. It is an agency problem that we saw before, in the 2007-08 mortgage crisis, when mortgage brokers and bankers, knowing they were transferring risk, pushed all sorts of loans through the system, so long as they adhered, however loosely, to the investors' underwriting criteria. What was best for the borrower was an after thought, in many cases.

Each recession is different. And certain asset classes are affected differently. In 2007-08, the first asset class impacted was residential mortgages. Banks likely felt it more in their investment portfolio as they were chock full of collateralized mortgage obligations and mortgage backed securities. Fannie Mae preferreds, anyone? 

Next recession may be different. And it will be interesting to see how the portfolios generated by these marketplace lenders perform. And who would actually own those portfolios should they tumble.

Maybe we can create another agency like the CFPB! Something to look forward to.

~ Jeff