The Law of Large Numbers for Banks and Credit Unions

While a colleague and I sat patiently waiting for our flight, we were discussing an upcoming strategic planning session with a client. He asked what I thought were their chances of success. I thought their future was bright, but pointed to a couple of headwinds working against them. One of them was the law of large numbers.

The law of large numbers in banking requires ever more asset generation as the bank becomes larger to sustain growth. If a bank is publicly held and management tells their investors they shoot for 10% growth, the number gets harder to achieve as the bank grows larger.

This was true of our client, where I estimated they needed between $1.5 billion and $2.0 billion of new loan production to grow their balance sheet 10%. We have many clients that haven’t achieved that total loan size in their 100 year history.

Some banks have done it. One such bank that consistently stunned competitors and analysts with hefty growth was the former Commerce Bank of Cherry Hill, NJ. They did it through rapid branching, buying business in new markets particularly from municipalities, and their reputation (self-proclaimed) as America’s Most Convenient Bank. Their CEO was not as much concerned with top tier financial performance, quarter over quarter, so long as the bank was investing in the growth engine.

Many of us do not have that luxury. So how do we get 10% growth, or deliver double-digit total return to shareholders, as we get larger? Some do it through acquisition. Acquisition criteria gets looser as the bank gets larger and the need to “feed the beast” grows.

But could there be another way? It may be difficult because while the bank was growing, the CEO was touting the growth strategy to constituencies. So changing strategic course calls for strategic leadership.

As it gets more difficult to grow, and as potential acquisition targets decline, could it be time to turn this growth engine into a cash cow? It’s the natural evolution of business. If you’re management team is ideal for your current size and not much larger, and your markets are not yielding sufficient growth, why not maximize profits and reward shareholders, not in the form of robust capital appreciation, but in dividends? Mutuals and credit unions could reward depositors in the form of a special dividend. What a great benefit to bank with you!

The accompanying table shows banks that are growing slowly, yet have superior financial performance and a strong total return to shareholders, delivered in great part by a greater than 4% dividend yield.

Perhaps the bottom two are restrained more by their markets than the law of large numbers. I particularly wanted to throw in the sub $200 million in asset bank to show bankers that it can and is being done at this size. But I ask you, what is wrong with this strategy? If the answer relates to taxes, I’m not sure you’re getting my point.

And my point is this: staking your success to a growth strategy that your management team cannot deliver and your markets cannot support requires you to make acquisitions to deliver the total return demanded by your shareholders. Following this strategy will result in poorer acquisitions, diminished ability to manage a sprawling franchise, and ultimate erosion of franchise value.

Think Sovereign Bank. Do you want to join them?

What’s your number?

~ Jeff


Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.

Grow or Die. Really?

Grow or die. Acquire or be acquired. Build it or kill it. And so go the banking platitudes. Now, perhaps those that invoke these phrases have strategies that compel them to grow. Shareholder value, so the logic goes, is created if I grow my balance sheet 10% per year and my earnings, because I'm realizing economies of scale, grow faster.

But what if you adopt the strategy of the tortoise? Go slow. Be methodical. Right size your cost structure as you go. Prune the tree frequently. Or what if the markets where you exist can't support 10%+ growth? You are pushing the proverbial rock up hill expecting your employees to beat a plodding market, year in, year out.

Calamity say the consultants, the investment bankers, the rock star banks. You must grow or die! In this environment, how could you possibly face the industry headwinds without doubling your size?

But wait a minute. If we are a public financial institution, what do our shareholders expect? Would a 10% total return be sufficient? It certainly is greater than our industry has been delivering, regardless of the size. In fact, as a disgruntled Citi shareholder, I put to you that their size worked against them. The risk on their balance sheet was (is) incomprehensible, even to them. I bought in at $50, which is now the equivalent of $500 due to a reverse stock split so they can increase their embarrassingly low share price. Today they trade at $25. Their clarion call should have been grow AND die.

What if, in the board room of a community financial institution, your strategy team decided to go slowly? What would your shareholders say to 5% earnings growth that translated to 5% stock price appreciation? Not too sexy. But what if your strong profitability allowed you to pay a 5% dividend yield. Now we have a 10% total return to shareholders delivered by a steady hand. Such was the strategy of City Holding Company, a $2.8 billion West Virginia bank. Its 10-year growth rates, represented in the accompanying table, doesn't exactly wow analysts.

But look at their 10-year total return to shareholders compared to the industry. Slow growth, combined with a 50%+ dividend payout ratio resulting in a 4.5% dividend yield delivered impressive returns. Compared to the rest of our industry, off the chart returns.

How do those that sound the growth siren square City Holding Company, and the many slow growth, highly profitable financial institutions like them?

I would like to hear from you.

~ Jeff


Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works out. You read that I invested in Citi, right?