Bankers and Strategic Bets. A Slow Embrace.

There are a lot of crazy ideas out there in banking causing us to think... "remember when such and such ridiculous idea was the new craze?" And we would laugh, continue to drink our cocktail, and lament that another financial institution threw in the towel to merge with a bigger brother.

That's what I thought about while reading a recent Financial Brand post about Innovation in Banking: Killer Ideas? or Idea Killers? More talk about fintech, dinosaur bankers, and flavors of the month.

But their animation caught my attention. And it stirred images of a few strategic planning sessions I have moderated. Much to my chagrin.

How do we balance strategic direction, customer demand, and the futurist or wildly over-caffeinated millennial that tells us we have to implement every shiny new object or we'll die?

Six years ago I asked in a blog post Will Plain Vanilla Kill Community Banking? Did I get caught up in the change-or-die crowd? Was I, gulp, a futurist? When I wrote that post in January 2011 there were 7,700 FDIC insured financial institutions. Today there are less than 5,700. A 26% decline. Was I a futurist?

This brings me to the subject of Strategic Bets. They can be a strategic shift of your franchise, a new product line, or a new operating environment. Something you are not doing, will require some investment to do, and risks failing miserably. Bankers are slow to embrace strategic bets, opting for tweaks to business as usual. Which runs the risk of making the cartoon above become a reality.

Let me highlight some strategic bets for you. In the above blog post, I discussed Apple and Bank of New York Mellon.

Sticking with the Apple theme, in 2007, they launched the iPhone. Here was a personal computer company that decided... "mobile phones, yeah, mobile phones". Much like they did "digital music, yeah, digital music. Thanks Napster!" in the early 2000's. 

How about Amazon? When they started in 1995, they sold books. Maybe those millennial futurists don't remember this. Online book stores. Competing with Barnes and Noble and Borders? In 1998, they decided "why don't we sell everything online?" And boom! Now my friend orders toilet paper through Amazon Prime.

The iPhone represents 62% of Apple sales. Didn't even exist in 2006. Physical stores grew from nothing to 3.3% of Amazon sales and is likely to grow. Because Amazon, with their culture of online sales and fulfillment, had that strategic bet meeting where they agreed "new-fangled brick and mortar store, yeah, let's do that." 

Some other strategic bets that have the chance to transform or have transformed a company:

Pepsi - I listened to a podcast where Indra Nooyi, their CEO said they are focusing on their "healthy for you" line. Pepsi? Also, they are developing female friendly snacks. Apparently females like snacks that don't crunch loudly or leave a residue on your fingers, and fit into a purse. 

Overstock - Announced this year they are getting into Robo Advising. They have a heavily female customer base, and see opportunity to build an offering attractive to those that visit their stores and online space.

Leader Bank - A $1.2 billion in assets Massachusetts bank developed Zrent so it's landlord customers could more efficiently collect rent from tenants. The bank now licenses the product to other financial institutions.

SunTrust - Developed Lightstream, a national online lending platform to provide consumer loans for practically any purpose. It's proprietary technology gives consumers a virtually paperless experience. 

I think there are enough examples of strategic bets transforming businesses. Combined with the alarming rate of those that don't take strategic bets deciding to sell, shouldn't you be thinking about calculated strategic bets that could become a significant part of your future success?

~ Jeff

Banks and Bungee Cords

Your relationships, your job, your life comes with baggage. I recently made the analogy that there are bungee cords affixed to your belt. Some hold you back. Some propel you forward.

And it applies to banks too.

In a traditional SWOT analysis, there are things within your control (strengths, weaknesses), and things outside of your control (opportunities, threats). But what are the forces that propel you towards your strengths and opportunities? Or towards your weaknesses and threats?

These forces are mostly within your control. Should you choose to embrace the challenge.

Do you?

Here are the forces I see for bankers that pull them back, toward their weaknesses and threats:

1.  Regulators. OK, I'm playing to the audience. But regulators don't want you to veer off the beaten path. Keep it plain vanilla. Build a bank that thrived in 1963. Ask those bureaucrats this question: "How many businesses have you run?" Because you would swear by their swagger they were Richard Branson or Elon Musk.  

2.  Seargents. If you have hired me, or have read what I have written, you would understand that I believe there are "old-schoolers" in your organization that cause tremendous friction to progress and change. 

3.  "No Mistakes" Culture. The amount of energy that banks commit to being 100% in compliance, find no audit findings, or, gasp, no Matters Requiring Attention on their exam, is monumental, in my opinion. Some operations managers' evaluations and, in some circumstances, variable compensation is dependent on clean audits. What does that get you? Hyper conservatism in compliance. And a whole lot of "we can't do it" from executives. It's killing our industry.

4.  He's/She's Not Ready. This is a common reason I hear why banks don't elevate forward thinkers to the executive suite. They fear those "crazy ideas" they have in management meetings, or the fact that they are willing to accept some risks old school bankers would not. Better to keep them suppressed deep in the bowels of our organization and let others pilfer our future customers than to risk innovation through calculated risk taking.

Here are the forces that I see can propel bankers forward:

1.  Allowing Experimentation. And, 'gasp', failure. I'm not talking "bet the bank" failure. But a failure that may bust your budget is not Armageddon. It is an opportunity to learn, and help you implement the next innovation. Not the reason to look back 10 years and think, 'we tried and failed 10 years ago and, dag nabbit, we are not goin' to try again!'

2.  Fire Seargents. They are not that important to your organization. In fact, they are destroying it. And when you give them their packing papers it sends a message to the masses... "We are a forward looking bank. Backward thinkers take notice."

3.  Continuous Learning. A bank that believes everyone, from the CEO to the newly hired loan operations clerk, should learn, will have a far better chance to being the one bank that survives the non-stop tide of bank consolidation.

4.  Run the bank by strategy, not by budget. Strategy forces banks to look far out into the future. Running by budget forces bankers to look to next year. Where is the puck going, versus where it is. We intuitively know that our industry would not have yielded so much market share to outsiders if we could think outside of our budget. 

So you have bungee cords hooked to your belt. Where are they pulling you?

~ 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

Bankers: Don't Hate the Dividend

Me to Bank CEO: Have you considered, instead of a growth strategy, maximizing profits and paying out most of it in dividends? CEO: *crickets*

And so it goes with my suggestion that slow growth, superior profits and high dividends is a viable strategy. Particularly for financial institutions in slow growth markets. This strategy could also manifest itself in mutuals and credit unions, as they can pay a bonus dividend to core depositors out of their robust profits.

But as I told one banker yesterday, not many are drinking my Kool Aid. 

Growth is sexy. With growth comes accolades. Management gurus spew bromides such as "grow or die". And so our industry has been cut in half in the past twenty years, because so many of us chose the latter.

I think it may have been a business professor that told me growth above and beyond market growth would only last for a short time. The bank CEO, mentioned above, was asking for my opinion on his growth and acquisition strategy. His market grew at 3.6% the prior year. The market leader, of the "too big to fail" variety, actually grew market share from the prior year while the CEO's bank declined in market share. So they weren't succeeding taking business from the 800 pound gorilla to sustain growth. Nor was their market growing at a pace that would fuel book value and EPS. Hence my suggestion.

When I suggested it he sought examples. I didn't have the answer off the top of my head but he motivated me to look at the strategy from a total return perspective. I have an affinity for total return because it focuses on what you deliver to your shareholders, regardless of how you deliver it. Capital appreciation plus dividends, no matter the proportion. My suggestion to the CEO was 4% EPS growth combined with a 5% dividend yield delivering a 9% total return.

Getting back to my research, I reviewed all publicly traded banks and thrifts with between $1 billion and $5 billion in total assets. I eliminated any bank with greater than a 2% non-performing asset/total asset ratio to control for credit quality challenges that impacts profits and trading multiples. The results are in the below table.

I admit that the lower dividend paying banks delivered a better three-year total return than the higher dividend banks. But not materially so. Certainly not a slam dunk that motivates the vast majority of bankers to opt for a lower dividend, higher growth strategy.

The remaining ratios are very similar: ROAA, price/book, and price/earnings. Shareholders don't appear to penalize the higher dividend strategy by ascribing lower trading multiples to those banks' stock valuations. In fact, by growing slowly, maximizing profits, and paying the majority of profits in shareholder dividends (or depositor dividends for mutuals and CUs), one could argue that this is a lower risk strategy and avoids the roller coaster "high-highs" and "low-lows" that banking's high fliers tend to experience during economic cycles. Lower risk shareholders should expect slightly lower returns. So it is intuitive, right?

But no. Instead, those in slow growth markets set sail hoping to perpetually grow faster than their markets will allow, and rely on acquisitions to stoke their growth. Grow or die. Are we going to get a different result than we have gotten?

~ Jeff

Perception Versus Reality: Do People Get More From Credit Unions Than Banks?

The Credit Union National Association (CUNA), the credit union equivalent to the American Bankers' Association (ABA), states that credit unions exist to serve members, returning earnings to members in the form of lower loan rates, higher interest on deposits, and lower fees.

Nearly four years ago, I tested the higher interest on deposits claim in a guest post with the exact title on The Financial Brand, an industry publication geared towards marketing executives at banks and credit unions. The reaction that I received, in person, via e-mail, and in the comments were a little sharp-edged. Clearly this remains an emotional issue.

When the going gets tough, go to the facts. In 2011, banks paid higher interest on their interest bearing deposits than credit unions throughout the measurement period. 

When I re-ran the analysis, what was true back in 2011 still holds true (see chart).

There is a difference in my analytics. I searched on banks and credit unions between $500 million and $5 billion in total assets. I took a wider swath in 2011 with institutions between $100 million and $10 billion. Today's analysis reduced the amount of very small financial institutions.

I continued to control for commercially oriented banks by limiting to banks with less than 30% commercial real estate or commercial business loans as a percent of total loans. Those banks tend to have higher level of business deposits, which tend to drive down cost of deposits. However, to further control for this, I only selected interest expense as a percent of interest bearing deposits, not counting checking accounts that pay no interest.

Based on the above, for the sum total of all interest bearing deposits, banks pay higher rates, on average.

Surprisingly, changing the institution size did tell a different story in non-interest expense to average assets, or what is termed the expense ratio (see chart).

Perhaps the financial crisis, which credit unions survived surprisingly well with the exception of corporate credit unions (similar to bankers' banks), woke up credit union leadership to scrutinize operating expense to increase profits. 

Yes, you read profits. Where do you think credit unions get their capital? If credit unions suffered a similar fate to many community banks, they couldn't back up the truck for shareholders to pony up equity to help absorb losses. Becoming more profitable was the logical solution to building up capital positions.

There are probably other reasons at work. In 2011, those expense ratios for credit unions were in the fours (greater than 4%). That was likely due to my going down to institutions with $100 million in assets. While I did the same for banks, many smaller banks are privately owned, one branch operations with very low expense ratios. By raising the bar to $500 million, my analysis likely raised bank expense ratios by excluding those hyper-efficient small banks, and reduced credit union expense ratios by eliminating very small, inefficient institutions.

As the charts show, there is little difference in expense ratios, on average, for the measured institutions. 

I think both trend charts show something that previously happened between thrifts, savings banks, and commercial banks: the homogenization of business models. In the late 1990's, many traditional thrifts entered commercial banking with both feet. The result is falling net interest margins for banks and rising net interest margins for thrifts, long term. Thrift expense ratios began to rise as they took on the more expensive commercial banking teams.

Credit unions are shedding their Select Employer Group (SEG) strategies by adopting community charters or by adding so many SEGs that nearly everyone qualifies to join. They have entered commercial banking to the extent permissible by their regulators. So I expect financial performance ratios to begin looking more and more like their bank competitors.

Except for the shareholders. And the taxes.

Do you thing credit union and bank business models getting more similar?

~ Jeff

What is the better banking strategy: low expense v low deposit costs?

Here is a question that dogs us: should we follow a strategy that drives top quartile performance in operating expenses or cost of deposits? If your answer is "yes", your execution better be flawless. Because the two don't often go together. In my search, described below, only one bank made top quartile performance in both categories.

The low operating expense bank typically comes with a limited branch network. Bank futurists think this a good thing since branches are millstones around our collective necks. So in order to attract deposits, these banks tend to use premium rates to get people comfortable with not having a nearby branch. 

Low expense banks tend not to have sophisticated commercial banking operations too. Preferring instead to focus on residential real estate lending combined with transactional commercial real estate lending. By transactional, I mean the bank may resort to price to get deals, and not extensive customer relationships, as many of these customers don't value relationships anyway.

Conversely, low cost of deposit banks tend to have more expansive branch networks to get core retail and business account balances. Anecdotally, the most often heard reason a business customer objects to opening an operating account at a bank is because it lacks a nearby branch. But, admittedly, that could just be an objection that is not the "real reason".

Also, low cost of deposit banks tend to be heavy commercial lenders, both commercial real estate and business loans. That requires a good product set, and lots of resources. Asset-based lending requires much greater borrower interaction than plain vanilla commercial real estate lending.

So which strategy results in better performance? I went to the numbers (see table), and it's tough to tell.

I searched for banks of a certain size ($1B - $20B in assets) to eliminate trading anomalies from very large and very small banks. I also controlled for capital levels and asset quality to limit the number of factors impacting pricing. 

The picture is not totally clear on which strategy delivers the better returns or higher trading multiples. To be sure, both sets of top quartile banks are well run and rewarded with relatively high trading multiples. And they have delivered very good results, as indicated by their 3-year price changes.

So, which one is better? I think it depends on each financial institution's individual circumstances. Do you operate in slow to no growth markets? Perhaps a low operating expense/cash cow strategy is appropriate. 

Is your FI in business-rich markets and your niche is concierge-like service to tech firms? Well the low cost deposit strategy with higher expense ratios may be appropriate. 

Whatever strategy you choose, I implore you... to choose. The zigging and zagging, the all things to all people, the yes, yes, and yes strategies are misallocating resources and driving our financial institutions into homogenized and commoditized, irrelevant, soon to be sold and quickly forgotten memories that our 7,000 brethren that have been sold since the early '90's have become.

Are we going to let it happen?

~ Jeff

Banking Billboard Strategies v2: Nordstrom or Wal*Mart?

Welcome to the second installment of Banking Billboard Strategies.

In this episode, we have a bank that can't decide what it wants to be when it grows up. Does it want to be best price? Or best service? Undecided? No worries. Go for both! There is nothing like draining the treasury by investing in top notch personnel, systems, and processes, and charge little for the effort. I can't think of a business that has succeeded with this model, but maybe one will come to me.

   Follow the artist, Shannon Marsico on Twitter or Instagram

Do you know any financial institutions that are making this work?

~ Jeff

Banking Billboard Strategies: Version 1

Welcome to Banking Billboard Strategies v1.

I tend to envision strategy flashing on marquee billboards. Here is how I see the end result of a multiple day big bank retreat conducted in a Kiawah Island resort conference room, prior to a round of golf, massage, cocktail hour with Talisker 8-year-old single malt scotch, and topped off with a Maine lobster dinner, no truffles because of the poor economy.

   Follow the artist, Shannon Marsico on Twitter or Instagram  



~ Jeff

Bankers: Circle the Wagons Around Your Strategy

Whether you are a bank, thrift, or credit union, I hope you have a strategy for 2013 and at least three to five years into your future. If not, you better assemble the troops and determine the bank you want to be, or you run the risk that your customers don't see you as anything but just another bank (or thrift, or credit union, what have you).

So often, though, FIs develop specific objectives, like mentioned below, and limit the input on how exactly to accomplish the objective to a few people. I propose something different this year. Run a New Year's Resolution Contest for your employees to use the collective brain power of everyone on your payroll to achieve your objectives.  Here is how it can work...

Once your strategy team (typically senior management and the entire board or committee of the board) determines your FIs course and identifies what success would look like in terms of goals, the next step is to lay out the tasks necessary to achieve those goals.

To kickoff the contest, the CEO, or other strategic leader, can draft a companywide e-mail as follows:

"SUBJECT: NEW YEAR'S RESOLUTION CONTEST

Dear Colleague,

Schmidlap National Bank has proven to be an excellent resource for professional practice firms (lawyers, accounts, doctors, dentists, etc.) within our markets. Your hard work has given us a premier reputation and a 12% market share.

Your board of directors has adopted a strategic plan that includes the following strategic objective and goal:

Strategic Objective: Be recognized as the best FI to professional practice firms in our markets.

Goal/What success looks like: Achieve a 15% market share for operating accounts in the professional/technical NAICS category in our markets by year-end 2014.

We are seeking your valuable input on how to achieve this goal. Specifically:

Identify what you believe to be the one task that would have the greatest impact in achieving our goal. For example:

Sample proposed task to achieve goal: Develop a once per year professional practice forum at the Ritz/Carlton that includes a program designed to help professional practices run better and position Schmidlap as an expert in professional practice cash flow management.

Send your best idea directly to me no later than January 30th. Your idea will be presented anonymously to senior management, who will select the best ideas to achieve our strategy.

Those whose ideas are selected will receive: Recognition at our annual employee awards event. A position on the team formulated to execute on the Strategic Objective. And two additional paid time off days.

Although we cannot execute on all tasks presented, we thank you in advance for your thoughtful ideas and your continued support in Schmidlap National Bank's success.

Sincerely,

Joe Buck

CEO"

What are your thoughts on this idea or do you have another idea to engage your employee base in executing your strategy?

~ Jeff

jfb Toons: Bank Strategy Execution

Welcome to my first installment of jfb Toons, a cynical look at how financial institutions operate.

In this version, I migrate from the strategy development retreat to how that strategy is translated to day to day execution. I am occasionally confronted with facilitating plans for clients, only to come back one year later to find little has changed.

If I were to fill in the gap between strategy development and how it is executed, this is how I think it would go...

~ Jeff