Bankers: If We're Serious About Helping Clients, What About These Two Products?

With all of the automation of financial products, one would think managing finances would be simple. Much more so than when our grandparents saved for the coal delivery in an envelope in the night stand.

My focus today is on consumer banking. Which is becoming more challenging for the community financial institution due to heavy competition from money center and super-regional banks, credit unions, and fintech firms. Do we cede the field? Hand Wells Fargo our sword, as it were?

I don't think community financial institutions can fund themselves solely from their commercial customers. They struggle serving deposit-only or loan-lite small businesses because commercial lenders have no interest and branch skills have not been elevated to create the confidence needed to have business banking conversations. If a commercial lender has 20% in compensating balances in his/ her portfolio, that would be a win.

But what about the funding for the other 80%?

No, I think community financial institutions should develop a solid strategy for retail banking. As my industry colleague Ron Shevlin aptly pointed out in his 2015 book, Smarter Bank, money management will be more important than money movement. Actually, since it was written four years ago, I might be as bold to say that it IS more important. 

This reminds me of a scene from Date Night with Steve Carell and Tina Fey. Steve played an accountant, and informed a couple that they would be receiving a nice tax refund. To which he suggested opening a Roth IRA. Not interested. They were going on vacation. The world needs more boring advisors like Steve in Date Night. Should your institution be the bore? To help your customers make better financial decisions?

If you believe yes, how is your financial institution equipped to handle such a business model? Not just in employee capabilities, but in products?

A 2018 Harvard Business Review article emphasized a growing financial problem among our retail customers: they are not prepared for retirement. HBR proposed what to do about it. But I ask my readers, what do you intend to do about it?

As HBR puts it:

"Ultimately, the shift from defined benefit pension plans to employee-directed defined contribution 401(k)s is the major driver of the impending retirement crisis. Beginning in the 1980s, this move helped companies reduce their retirement liabilities and better meet their quarterly financial targets, but put an unmanageable burden on employees."

Helping our customers manage this burden requires a change in strategy, from one of "more products per customer", to "promoting our customers' financial well being." If your financial institution is embarking on delivering the latter strategy to your customers, I think there are product gaps. Two come to mind.

Much Maligned Products

The below products are much maligned due to high reputation risk, outsized fees, and are difficult to deliver due to high maintenance costs or regulatory/licensing requirements. But to help our retail customers navigate retirement, they are legitimate options that need a trusted person to deliver, be that an advisor or banker. 

Annuities

Many financial institutions "sell" annuities. But many advisors say this product is not worth it. Sales loads and ongoing fees are too costly compared to alternatives. And I agree. Vanguard was known as the low-fee producer, and they are transitioning account administration of their annuity products to Trans America. And I must admit, finding a legitimate website for objective comparison is difficult because annuity providers clog searches with pitches. And they sponsor websites that might appear objective.

Which screams for somebody to be on the side of the customer.

An annuity, properly constructed, can help your retail customers reduce the risk of running out of money in retirement. Much like a defined benefit plan does. A deferred annuity, or an immediate annuity, can be structured to provide fixed payments as long as the buyer lives. And to protect the buyer from pre-mature death and losing their savings, an insurance rider can be applied to reduce that risk.

It doesn't seem like this should be something that has a 2% annual expense ratio and a 6% sales load. Especially since your customers can pay no sales load and a 25 basis points fee for a robo advisor or an index fund. The costs are too great to overcome. 

This is an opportunity for a consortium of financial institutions, perhaps through their national trade associations, to develop products such as an annuity that protects community financial institution retail customers from running out of money in retirement. Without hyper-feeing the customer in the interim. 

The offloading of retirement risk from employers to employees scream for it. Why would banks sit on the sideline of such an important financial goal?

Reverse Mortgages

Or as the federal Department of Housing and Urban Development calls them, Home Equity Conversion Mortgages (HECM). There's an acronym for everything. Here's another product that requires some savvy web surfing to look up legitimate sources of information that is outside the product pushers purview. Imagine being a retired utility worker that is concerned about running out of money? No wonder they turn to Magnum P.I. and The Fonz for financial advice.

This one is close to home because I described it to my mom to alleviate her concerns about outliving her money. She owns her home outright. As many seniors or near-retirees do. A reverse mortgage is a legitimate product almost totally avoided by financial institutions due to reputation risk. Imagine the scenario, mom takes reverse mortgage but fails to tell her children. She passes and nobody keeps up with the payments. The bank forecloses. Geraldo is called in. Adult children on TV in tears. Holding grandchildren that thought the house was going to pay for school and give them a leg up on life. Sad.

This is not an unsolvable risk. It may, and likely does, require financial institutions to look beyond the mandatory disclosures. Because as I hear it, heirs not knowing about the loans are a big problem. Couldn't we solve for this and other risks and maintain our position as our retail customers' advocate?

A reverse mortgage requires little organizational effort in today's technology world. The loan origination resources wouldn't be materially different than a home equity loan. Loan maintenance would be even less. We already track that borrowers pay their real estate taxes on regular mortgages. The biggest difference will be at the end of the loan, where the full balance is due when the owner sells the house or passes away. And that effort and risk can be priced into the loan, without gouging.

But if we do have a retirement crisis, a reverse mortgage can be part of the solution.

Product Promoter or Retail Customer Advocate

Helping retail customers prepare for and navigate retirement can be a strategic objective of your institution. It is particularly important as so many Baby Boomers are taking their gold watch every day. Many if not most are ill-prepared for what is next. Becoming their advocate can be the best advertisement for attracting younger retail customers to your bank.

Because there are a lot of hucksters out there. Pushing Product.

~ Jeff

Too Small to Succeed in Banking

Conventional wisdom: The onslaught of new banking laws, regulations, and regulatory activism requires scale to absorb costs. Or, the rapid pace of technological change and the sophistication of hackers requires resources not found in small community banks.

There is truth to conventional wisdom. But with all generalities, there are exceptions. And in banking, lots of exceptions. How do I tell the $250 million in asset client that I just visited that they are too small to make it, even though they sport a 1.47% ROA? The financial institution landscape is littered with banks and credit unions like my client.

Almost two years ago I wrote that bank shareholders were changing. (see The Coming Bank Consolidation) Community bank investors used to be the local insurance agent, mortician, and family that sits next to us in church. Today, many of traditional bank investors put their money in mutual funds, and leave the investing up to fund managers. No longer does the local barber show up at our annual meetings complaining about the pastries. Instead, professional money managers call to tell us how to run the bank.

As we migrate towards greater institutional ownership, stock liquidity is becoming increasingly important. Occasionally money managers call me with their criteria for their fund. One criteria is typically float and volume. Under 10,000 shares trading volume you say.... fuggedaboutit! 

My firm is occasionally called upon  to value banks that don't trade. Part of the valuation includes a discount for the lack of liquidity. Not a term foreign to other industries, by the way. In determining the discount, we look to trading markets to see the discounts applied, if any, to thinly traded bank stocks compared to their high volume brethren.

I recently ran an analysis of banks that trade over 10,000 shares per day, to those that trade 500-10,000 shares per day. The results are in the table below.

I controlled for financial performance (greater than 1% ROA), and asset quality (less than 2% NPAs/Assets). Of course, more performance and market data factor into trading multiples, but I couldn't control for everything. The result: Low Trading Volume financial institutions trade at a price/tangible book ratio of 110.5%, and a price/earnings ratio of 12.1x, compared to High Trading Volume FIs at 160.6% and 13.2x respectively.

What do I think community banks can do about the disparity?

1. Get a real investor relations program. Bankers think we should actively court investors when we need capital. Not so. Trading multiples are a direct result of supply and demand. If you want greater multiples, build demand... always.

2. Focus on retail investors. Community bankers think they can tap the institutional market. Investment banking firms tell them so. The truth is, institutions willing to invest in a bank that trades 2,000 shares per day are typically those that expect to exit the stock by selling the bank. How else can they exit your stock at such low trading volume? One benefit of having local, retail investors is they tend to have greater patience when implementing strategic change. To institutional investors, you are a number on a spreadsheet. If you take institutional money, plan their exit before they invest anything.

3. Perform. There is a positive correlation between financial performance and condition, and trading multiples, period. 

Banks that trade at low trading volumes trade at lower multiples and may be shut out of the institutional market for capital. Those that don't build retail investor demand for their shares may be required to sell if they need capital. You may be too small to succeed, but not because you can't deliver superior performance. But because nobody will invest in your bank.

~ Jeff

Where will banks get their next dollar of capital?

Retained earnings.

I make a living helping financial institutions be as profitable as feasible. Why? To perpetuate their business model. This is how I feed my family.

But profits have been under pressure since 2008. First, FIs experienced pressure in their investment portfolios, purchasing Fannie Mae preferred's and other FIs trust preferred securities. Next, our over-exposure to construction and land development loans came to roost. Then commercial real estate fell under pressure as the economy teetered and rent roles declined.

Many banks had to replenish lost capital. The government stepped in to help, and taught us to ignore the guy/gal that knocks on our door and says "I'm from the government, I'm here to help." Absent or in concurrence with government-injected capital, FIs sought fresh capital.

But retail investors were nowhere to be found. This was one of the points made by Lisa Schultz of Stifel, Nicolaus, Weisel, an investment banking firm that specializes in FIs, at a recent Pennsylvania bankers conference.

Ms Schultz said retail investors were absent for all industries, not just FIs. She opined that they opt instead to invest in mutual funds, hedge funds, etc. Therefore, all of the action to attract capital was in the institutional market. I made this point in a past blog post, opining that the change in our shareholder base would be a significant factor driving future bank consolidation.

The change in shareholder focus, as presented by Ms. Schultz, is represented in the tables below. But this changing focus is from the institutional shareholder perspective... not the retail investor. The future investor will be concerned with quality growth that enhances shareholder value, combined with dividend policies that are mindful of capital preservation. I'm not sure how an FI will meet the 20%-30% capital appreciation, combined with sufficient liquidity, to meet "future", i.e. institutional, investor demand.

As if the shifting focus of the institutional investor wasn't challenging enough, what about the difference in what retail versus institutional investors value, and how they plan to exit their investment (see table below).

Tough luck finding your institutional investor at the local coffee shop bragging that they own stock in your institution. They could care less about how much resources your FI dedicated to the local food bank.

Here is what I think community FIs can do now to prepare for this shift in attitude:

1. Maximize retained earnings to reduce the need to visit the capital markets.

We have gotten a multi-year pass in generating profits because of the financial crisis and the subsequent teetering economy. Now it's time to cowboy up. How productive are your front line employees? How efficient is your back office? How well have you leveraged technology? Have you over-reached with your compliance program? If you don't have the answers, you better start looking for them.

2. Get a real investor relations program.

Investor relations is marketing. Marketing is much more than advertising. And your marketing message must be delivered long before you ever need capital. You must spin a story that gets locals excited about your bank. Yes, financial performance will play a significant role, but a supporting role to the story you tell about how your FI is a critical component to local communities. Retail investors may have shifted to investing in mutual funds, but the local community bank is probably one of few chances locals can invest in a company down the street.

3. If you must tap the institutional market, choose your partners carefully.

Ms. Schultz specifically addressed this issue in her presentation. Search for institutional investors that share your FIs objectives. Where did this fund invest? How long did it hold the investment? How did it exit?

4. Prepare for the exit strategy from the time of investment.

Receiving significant institutional investor dollars does not mean a fait accompli in terms of having to sell your FI so the investor can get out of the stock. However, if you don't plan for the investor's exit when they make their investment, the clock may run out when they are ready to go. Make evaluating strategic alternatives a regular part of your strategic planning, developing financial projections for a stretch case, base case, and stress case. See my post on this subject here. Also, make financial performance, investor relations, and stock trading liquidity a part of your strategy from the git go. If not, you'll find your FI might have up and went.

Where will your FI get it's next dollar of capital? I would like to know.

~ Jeff