Branch Talk

"The legacy [of build it and they will come] is an inefficient allocation of resources dedicated to supporting a less relevant delivery channel..."

So went an informative branch research report put out by my old friend and excellent bank stock analyst, Matt Schultheis of Boenning & Scattergood. At lunch recently, he said that the battle for retail deposits has already been won. Won by the national banks. It is a very similar point I made in an article to soon appear in a trade publication. 

With all of our hubris about how great community banking is compared to national banks, we are not winning market share from them. 

Here are some additional points I made to Matt via e-mail after I read his branch research piece. Edited for your clarity and context. All comments are my own, as his firm is a broker-dealer which would require a monumental amount of compliance review and disclosures. To wit, the research report actually used the term "Flavor Aid" instead of "Kool Aid" because it is likely a compliance person wouldn't let them use the obvious. #AddingValue

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Point 1: Pricing is becoming more transparent and I believe it will be increasingly difficult for banks to maintain deposit betas of 12 to 25, as [the research report] demonstrated in Exhibit 2. It is much easier now to switch from a local bank money market account to a Goldman Sachs Marcus account than last year, and it will be even easier next year.

That is why I suggest banks build a cost of funds advantage by 1) having a relatively higher proportion of non-interest bearing checking, and 2) a relatively higher proportion of "store of value" accounts like interest bearing checking and special purpose savings. I define store of value accounts as those where depositors are looking for safety and ease of use/access more than rate. Such as having a real estate taxes savings account.

Point 2: I am not sure deposit market share is the metric for branch success [as mentioned in the research report]. I believe it is branch deposit size, growth and spread delivered by those deposits. The challenge with the 3,000 square foot to a 1,500 square foot branch transformation is that larger branches tend to have more deposits.

A former bank CEO, responding to my questioning one of his branch's multi-million dollar expansion, said he got $40 million MORE in deposits when he did it. The math looks good in that context. Great actually.

Over and over we see these tiny, cutesy, 1,000 square foot branches maxing out at $20 million in deposits. I say put in a big branch and get $60 million, which is the average branch size in our profitability outsourcing service. The deposits per square foot calculation works out marvelously. Perhaps lease part of the branch to a CPA or a small insurance agency or something that tends to serve the same customers you are targeting to recoup some of the build-out and real estate taxes that come with a larger branch.

Point 3: You can "spoke" from the larger hub, as the research report suggests. And if your spoke maxes out at $15 million over a reasonable time, then close it and transfer those deposits to your hub. At an 80% retention rate, Charlie Sheen would call that #winning. Another strategy would be to measure the profitability of the hub/spoke region, rather than holding every individual branch accountable for spreads and profits. Although either is better than total deposit or number of accounts goals.

Point 4: The median direct expense of a branch as a percent of deposits in our profitability database is 98 basis points. That's 98 basis points that a branch bank can't pay in interest to their depositors that Ally Bank can pay. Perhaps that's overly simplistic as Ally has elevated digital expenses, low pull-through rates, and higher back office expenses because they have no branches.

But let's say that accounts for 20 basis points on the margin. Still a 78 basis point beta. Banks have to figure out how to sell the advantage of their branch network, which by the way survey after survey says customers want, and figure out a way to lower the 98 basis points direct expense of branches or support center expenses. Preferably both in order to lower that 78 basis points. Because customers won't accept that size of a haircut for the convenience of having a branch. But I believe they will accept some haircut.

By the way, the 98 basis points direct expense is off of a $60 million average branch deposit size. That means it costs ~ $588k in direct operating expense to run a branch. If you go with a wee-little branch, perhaps you shave off $150k of that. If that branch maxes at $20 million, then your branch direct expense of the "branch of the future" is 2.17% of deposits, versus 98 basis points for the "branch of today". Which is better?

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Thought you might enjoy our exchange.


~ Jeff

Is the pie getting smaller?

I have what I consider a very astute friend. He’s a relatively young guy (in his 40’s), and seems to be very smart with his money. I perceive him as being a very good bank customer. When he told me he does a family balance sheet every year, he piqued my interest. I asked if he would be willing to share it with me in common-sized format, changing the numbers to percents of his total assets.

He only counts his financial assets and liabilities, and only counts fixed assets such as his home if he borrowed against it. Having a mortgage and an auto loan, he therefore counted his estimated market value of the car and home in his assets and included the loans in the liabilities. The results of his efforts are in the accompanying table.

My suspicions were confirmed. Less than 14% of his family’s assets were in a bank. Brokerage companies and mutual funds were the benefactors of the majority of his financial assets. His mortgage, the only significant liability, was with a credit union. The credit card balance was de minimus, and as you would suspect is with a large bank.

Is my friend’s balance sheet typical? I would not base strategic decisions on such a small sample. But perhaps we should reflect on our own family’s balance sheet and use a little common sense. In my opinion, my friend’s situation is probably typical for a family in their 40’s. It is perhaps not typical for those in their 70’s, as they may have more in the bank. It is these customers that give the banking industry the false sense of security and results in only minor tweaks to business as usual.

Banks can also look at the nationwide growth in deposits for comfort. In the past ten years, deposits in FDIC-insured institutions grew approximately 7.4% annually*. But wait, in the past two years, deposit growth slowed to 4.7% annually.

I suppose the good news is there are fewer banks almost every day. Through mergers or failures, the flock is being reduced. That may also give us the false sense of security that all will work out for those that survive. But I suspect it’s not. Preferences are changing, particularly from one generation to the next. Younger families are putting their serious money outside of the banking system.

If you believe this trend to be true, what is your strategy to deal with it? Should you accept it at face value and set your sites squarely on competitors to fuel your growth, going toe to toe for their customers’ 14%? Do you buck the trend, trying to win back a greater percentage of the next generations’ balance sheet, increasing wallet share to, say, 25% or greater? Or do you expand into lines of business that are already taking business from you, i.e. brokerage or mutual funds? Perhaps you should send up the white flag on retail and focus on businesses that tend to have a higher percentage of financial assets with banks?

I think the answer lies somewhere within the preceding paragraph, and perhaps a combination of the above. What seems clear is that sitting back and doing nothing assures your future. You will have none. Put up the for sale sign. Investment bankers could use the business.

- Jeff

*Source: FDIC

Deposits: Do you want a relationship or fries with that?

Regulators have been particularly harsh to those banks whose business plans call for other-than-traditional deposit acquisition. If your bank has brokered deposits, Internet deposits, jumbo CDs, rewards checking, and in some cases CDARs, a regulator near you may be calling to order you to seek more traditional funding.

This line of reasoning centers on cost of deposits and equates high-cost deposits with less loyal customers… commonly referred to as “hot money”. What it fails to consider is the true cost of deposits, while focusing myopically on one element of cost… interest expense.

Internet depositors most likely have no affinity for the bank in which they do business. They troll the web for best rate banks, assuming one depository with FDIC insurance is no better than another. They will keep their money with your bank so long as the rate is at or near the top. I concur with regulators that if loyalty is the measure, than surely this money is “hot”.

Or is it? Internet depositors are very transparent about how to win their loyalty. If you are consistently among the best rate, you can be nearly assured of winning their business. Non-Internet depositors, on the other hand, can spin a myriad of different reasons for banking with you and/or not banking with the guy down the street. I think we all can agree that predicting loyalty is easier with Internet, and yes broker-driven depositors rather than our own core depositors.

But a business model that focuses on this customer base comes at a high cost, so the logic goes. The bank that pursues wholesale and/or Internet deposit gathering will likely incur higher interest expense than those that pursue traditional deposits from “core deposit” customers. But does this come at a higher total cost?

The chart below shows four banks, each with different deposit gathering strategies. ING Bank is a pure Internet play that builds on its brand power and competitive rates to drive deposits in its virtual doors. At first, it was a pure Internet high cost money play. As its brand evolved, ING and its well-known Orange savings account has been able to attract deposits that are not priced at the top of the market.

First Internet Bank of Indiana is primarily a pure Internet play that does not enjoy the same brand splash as ING. Its deposit rates are typically at the top of the market. It should be noted that both ING and First Internet are losing money. This is as a result of the asset side of their business, not the liability side. Dismissing their deposit gathering strategy due to their inability to generate profits on the asset base would not give these strategies their fair consideration.

Hudson City Savings Bank is a traditional thrift that gathers mostly CD deposits through a relatively Spartan branch network. It operates in densely populated areas, attracting large amounts of CDs per branch utilizing aggressive pricing. Most of their deposits come from the areas surrounding their branch network.

Fulton Bank, headquartered near my home, follows a traditional commercial bank strategy, pursuing the operating accounts of businesses from areas surrounding their branches. They pursue a retail strategy to generate additional funding for their commercial lending line of business. The traditional deposit gathering strategy of a commercial bank tends to have the lowest interest expense because of the relatively higher levels of core deposits, and therefore is highly favored by regulators.

Upon reviewing the chart, you will note that Fulton does not demonstrate the lowest cost. That is because I have added the banks’ operating expense (non-interest expense / average assets) to the equation. Traditional commercial banks tend to be more expensive to run than thrifts and Internet banks. To dislike wholesale deposit gathering in favor of core deposit gathering because of the interest expense only is wrong, in my opinion, which is supported by the accompanying chart.

A similar case was made in a comment letter to the FDIC on behalf of BancVue, a software development company that provides Rewards Checking product technology to community banks. Rewards checking, as many know, pays high interest rates on checking accounts, provided the customer utilizes the account as prescribed using electronic statements and bill pay (to reduce operating costs), and debit transactions (to increase “other revenue”). The FDIC considered these deposits to be high cost, and therefore would not allow banks that fell below well capitalized to offer it.

In the comment letter, BancVue representatives stated “These criteria either result in reduced overhead costs (e.g., electronic statement versus paper, mailed statement), lower risk (e.g., direct deposit) or provided additional income (e.g., interchange from debit card usage) for the bank and enabled the bank to pay a relatively high "reward" rate of interest. These criteria also result in REWARDChecking accounts being even more stable and reliable sources of funds than conventionally priced checking accounts.” These comments fell on deaf ears, and at this writing Rewards Checking and similar programs are disallowed at banks not considered “well capitalized”.

Here again, regulators myopically focused on interest expense, to the exclusion of all other costs and offsetting revenue.

I am not advocating using wholesale funding. I firmly believe that franchise value is driven by deep relationships with customers that would be difficult for competitors to replicate. Raising money via rate is pretty easy to duplicate. These deep relationships should result in greater net interest margins, higher customer wallet penetration, and a stickier customer base. But to write-off business models that utilize a higher percentage of “hot money” because of higher interest expense denies customers of having choices, limits competition, and further turns the banking model into one homogenized glob. We certainly don’t need 8,000 banks in such an environment.

Do we want an industry whose business model is limited to the good graces of our regulators?

- Jeff

BancVue’s comment letter to the FDIC
http://www.fdic.gov/regulations/laws/federal/2009/09c16AD41.PDF