Create Operating Discipline at Your Bank

Bankers have made great strides in developing the strategies to succeed over the long-term, analyzing the customers that most value their strategic direction, and gaining the buy-in from their Boards of Directors and employees. The next challenge is to build the environment and culture where the organization moves toward its aspirational future. To create operational discipline that greases the gears toward the bank you want to be without continuous leadership intervention.

In the video blog I give one specific example of how to do that. Make your own choices on the operational discipline you need to move you closer to your aspiration.

Link in case the video doesn't appear on your device:  

https://www.youtube.com/watch?v=3BdjHvF4OAw

 

~ Jeff

Bankers: Think about what gets measured.

"What gets measured, gets managed." Why did we need Peter Drucker to point this out? Educators are forever carping about standardized tests because they are spending a lot of time on teaching kids to improve their test scores.

Baseball players are measured on batting average, on base and slugging percentages. So they are spending significant energy to improve them. Why is this a bad thing?

Because in banking, what we measure is not always consistent with where we want our institution to go... i.e. with our strategy. We measure branches by number of accounts opened. And we're surprised that Wells Fargo gets accused of opening accounts without customers' knowledge. We measure lenders by size of portfolio, and we're surprised that we drop rate, points, and covenants to get deals done.

I recently did a podcast for PrecisionLender regarding this subject for lenders entitled: Using Bank Data to Get Better Results. That's right, I did a podcast. I only learned a few months ago what a podcast was.

But if you didn't invest the twenty minutes to listen to the interview, I'll exemplify my comments about another way to measure lender performance. The age-old measure by portfolio has led to what we have today... lenders willing to make any concession to get a deal done. A done deal is the best deal.

But what if your strategy revolves around superior service to a certain commercial customer segment? How would you measure it. Most likely the size of the lenders portfolio plays a part. But should the lender be the best price if he/she provides the best advice? That runs the risk of providing Four Seasons service at Motel 6 prices.

So I suggested using different measurements, such as coterminous spread, coterminous spread less provision, pre-tax portfolio profit, and ROE. See my suggestion exemplified in the table below.

Now this lender's portfolio may be considered small, at $30.3 million in the current period. But it has been growing, while maintaining its spread. When considering the provision expense, which brings credit quality into the picture, spread has grown from 1.95% to 2.01%, all while growing the average balance of the portfolio.

You can see this portfolio took a credit hit in CP-1, as the provision spiked a bit, possibly due to a loan downgrade and the resulting provision increase. 

But overall this lender's trend is good, as represented by the ROE increase from 15.89% to 17.34%. Which brings us to a second report I suggest for lender accountability, the Schmidlap National Bank Lender Ranking Report.

It is clear from this report that Jeff's portfolio is relatively small, ranking him 8th of 12 lenders. This contributes to the bottom half ranking in Net Asset Spread on a dollar basis, Net Asset Spread Less Provision on a dollar basis and ROE.

But the portfolio is growing, ranking him 3rd, and the Net Asset Spread percentage has him 2nd, even when considering the provision. So there are some positives in Jeff's performance. Which is good because I wouldn't want to be let go from my fictitious lending job at a fictitious bank. 

Imagine the behavior that would ensue if you held your lenders similarly accountable? The performance review would go like this: "Jeff you are doing an excellent job maintaining pricing while growing your portfolio with strong credits. Your biggest challenge is continuing to grow the portfolio. For this upcoming period, Schmidlap will do x, x, and x to help you accomplish this while staying in the top quartile for spread. Let's do this!"

I know Jeff pretty well, and being ranked in the bottom half of his peers won't sit well. Let me get back to some fictitious work!

How do you measure lender performance?

~ Jeff

In Pursuit of Return on Equity

When performing ratio analysis to determine a company's profitability we should remember that a ratio has at least two data points: a numerator and a denominator. It doesn't matter if it is banking, retailing, or widget making.

In banking, the standard profitability ratio has long been return on equity (ROE). That is... until the financial crisis of 2007-08. It was in the aftermath that capital, the denominator in the return on equity calculation, resumed its place as king.

Where has the pursuit of ROE led us? Yes, it made us focus on profitability, the numerator in the equation. But it also resulted in us looking at bank equity. The smaller the E, the better the ROE, right?

Bond salesman loved the concept. They encouraged their bank clients to borrow from their respective Federal Home Loan Banks (FHLB) or chase high cost deposits to fund the bonds they sold for minuscule spreads. The logic: blow up the balance sheet, eek out incremental profits, and reduce the E. Genius! And equity analysts, who coincidentally worked for the same firms as the bond salesman, loved it too.

During the period 2002-07, when loan growth outpaced the ability to fund it, FIs took on more FHLB borrowings and high cost deposits. This was a higher spread concept, because loans typically had greater yields than bonds. Loans also typically had greater credit risk. FIs did provision for such losses, but accounting rules and how the SEC enforced them did not allow FIs to "over-reserve", whatever that means. This was determined by the high profile case the SEC brought against SunTrust in the Fall of 1998 for managing earnings through the loan loss provision. Read a summary of it from the Atlanta Fed here. The Fed research piece on the subject, written in 2000, is almost comical to read given what has happened.

So, in pursuit of ROE, banks leveraged up their balance sheet. They thinned their capital leaving them more susceptible to distress during economic hard times. This distress was clearly evident when I recently performed some "where are they now" research on the highest performing ROE FIs in 2006, the last normal year prior to the crisis (see table).

A note on the data. I searched all publicly traded banks and thrifts that existed in 2006 and sorted them by the highest ROE. But I also ensured that their prior year ROE was similarly high, in order to weed out one-time gainers. In other words, I wanted consistent, high ROE FIs.

The results are telling. Of the top 10 ROE FIs of 2006, only three are currently profitable. Two are under a regulatory agreement. The remaining five failed. Yes, failed.

How does an FI, sitting atop the ROE chain, fall so far so fast?  As mostly always the case, it was bad loans. But many if not most FIs have had loan troubles. What made so many in this group take the perp walk to the FDIC? I already mentioned their inability to put extra away for a rainy day via the loan loss provision. But the pursuit of ROE encouraged levering up the balance sheet to leave little in excess equity to absorb the losses. Inadequate loan loss allowance, relatively low equity. The recipe for disaster in bad times.

I think ROE will re-emerge as ONE important indicator of profitability. But I don't think we will make the same mistake twice. Having the past three years as history in our loan loss allowance calculations, our regulators and the SEC will probably permit us to be more aggressive in provisioning. Needing the federal government to chip in capital because we did not have enough to withstand the storm is resulting in higher capital requirements, and lower ROE expectations. Analysts take note.

What do you think should be the primary measure of FI profitability?

~ Jeff