Bank Innovation: Three Ideas

I usually take more time researching blog posts than writing them. Today is an exception. Rather than searching reputable sources for how this bank or that bank innovates, I thought I would give it to you straight from the gut.

Because experience tells me that bankers are struggling with innovation. There is so much buzz about it, we are challenged to separate the wheat from the chaff. Fintech, regtech, martech (new one), AI, RPA, Chat Bot, actual bot. What's a banker to do?

At its core, innovation should solve problems. Problems we know we have. Problems we may not know we have. Customer problems. Process problems.

And who knows or can anticipate these problems better than 1) our customers, and 2) our people. 

Here is my opinion that may not sit well with some of my readers: Innovation through rapid change will rarely be led by those long in the tooth. Their experience clouds their view of the pace of change, especially if their experience is with slow, methodical, decades-in-the making change. Because we tend to believe past is prologue.

I'm full of idioms when I shoot straight from the gut.

I'm not telling you to build an innovation culture surrounded by young people. Make innovation a bank wide call to arms. But in creating a culture of innovation, don't have your long in tooth leaders shooting down innovation arrow after arrow offered by your short timers.

Here is how I think you could foster such a culture:


1.  Make Innovation Problem-Resolution Based. Nothing is more frustrating than expending organizational resources on a non-existent problem. Changing IHOP's name to IHOB comes to mind. HSBC putting actual robots in branches is closer to home. Community financial institutions' resources are already taxed by technology and regulation. Don't over-tax by encouraging innovation on problems that don't exist either internally or with our customers. So when you establish an innovation culture, the subject line of the memo proposing the innovation should be the problem the institution is trying to solve. Let your competitors waste resources on cool gizmos that only end up being resume' bullets for tech weenies.


2.  Coach Long-Timers. I've called them stoppers, sergeants, and old-schoolers. These are the people that implemented processes in the past that your innovators are now trying to solve. Like the cumbersome process that may exist in your bank to send wires. The story goes like this: a fraudulent wire got through, the bank CEO sternly directed ops personnel to ensure it doesn't happen again, and it now takes a DNA sample for someone to get a wire out. And the owner of that process is the department manager of the innovator trying to solve for a problem created by their boss. Here is where senior management will earn their leadership chops. Turn the stoppers into innovators. Or at least facilitators of innovation.


3.  Recognize and Reward. I called for a bank wide awards ceremony in a post two years ago (Five Ideas to Build an Accountability Culture at Your Bank). Innovation awards should be a part of the ceremony. Perhaps a central feature of it. Hand out a trophy. Give out meaningful cash and/or vacation time. Salute Long-Timers for fostering the culture that led to innovation. Demonstrate tangible results. Emphasize the problem solved.


These are my ideas on how to build an innovation culture that focuses innovation efforts on solving problems, real or emerging.

What other ideas do you have, or have heard of, that can move financial institutions forward fast enough to build a long-term future?

~ Jeff

A Bank Analyst Makes Recommendations. I Make a List.

What should you look for in a bank stock?

How should I know? I'm not a financial advisor. I would have to take a test to prove that I am worthy of such predictions.

But I read. And part of my reading includes Boenning & Scattergood's quarterly Bank DCF Analysis. In the report, analysts Matt Schultheis and Scott Beury laid down the criteria they recommend investors use when evaluating bank stocks:

1. Superior Growth Prospects

2. Excess Capital

3. Strong Deposit Franchises

Well, ok then Matt and Scott. I'll search on that.

I sorted all publicly traded US banks on the following criteria: year over year asset growth (2016-17) greater than 10%, tangible equity/tangible assets greater than 9%, and CD's as a percent of total deposits less than 30%. I also filtered out banks with greater than 2% non-performing assets/assets.

This netted a total of 78 banks ranging in asset size from $113 million (Republic Bank of Arizona) to $44 billion (Signature Bank). No SIFI banks. 

I then set out to single out the best bank in a few of the categories. The first was for growth, as measured by year over year asset growth. I skipped banks that grew via acquisition during that time. The second was to highlight the most favorable deposit mix, as determined by the lowest level of CDs. I know this is imperfect. There could be ample municipal deposits in checking or money market accounts. Not an ideal funding source but also not CDs.

The third category was performance judged by their first quarter 2018 ROA. Again, not ideal. But directionally correct. The fourth was value based on the bank's price/tangible book. Most of the 78 financial institutions were below $1 billion in total assets. Investors tend to favor price/book metrics in looking at smaller institutions. The lower the multiple, the more value that might be on the table for the investor.

The last category was a balanced approach between all of the measurements I used, including EPS growth. There was judgement involved and I must admit I tended to discount the smaller financial institutions because of their low trading volumes and inefficient valuations. Personal bias, I know. My apologies to Metro Phoenix Bank ($181 million in assets, 1.88%/11.83% ROA/ROE). 

The results are in the table below.

MCB - Metropolitan Bank Holding Corp., New York, NY

IIBK - Idaho Independent Bank, Coeur d'Alene, ID

SBT - Sterling Bancorp, Inc., Southfield, MI

FSDK - First Citizens National Bank of Upper Sandusky, Upper Sandusky, OH

BOCH - Bank of Commerce Holding, Sacramento, CA

Who else should be on the list?

Drop me a line with your contact info if you want the spreadsheet with all 78 banks.

~ 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.

Hot Rates - Swipe Left

Retail customers are not growing at community financial institutions.

According to my firm's profitability outsourcing service, branches have fewer retail checking accounts than two years ago. Deposit gains were made through growth in average balances per account. 

If you're a commercial bank, you may be fine if this trend is happening at your institution. So I ask you, what percent of your deposits are retail?

You should check. Because even the most commercial of commercial banks tend to have significant retail deposits. And if you are losing retail customers, how do you win them back?

Loan to deposit ratios have been on the rise over the past couple of years (see chart). Regulators are starting to ask a lot more questions about your liquidity during exams. Our ALCO meetings have done an about face from the 2012 "what are we going to do with all of this money?" to "how are we going to fund next month's loan pipeline?" 

And when you ask about funding next month, you rely on short-term, tactical fixes. We're not talking strategy here. 

In comes the rate promotion. It's like 2006 all over again.

And it's too bad. Because so many readers of this blog have done an excellent job "righting" their deposit mix to be less dependent on hot money. And we have had plenty of time to anticipate funding pinches, given the three year trend of loans growing faster than deposits. 

When I asked a community bank director of marketing about rate promotions and the success at turning them into loyal, core deposit customers, she was skeptical. The very premise of how you got that customer should tell you that they value rate above all else. And what is different today than 2006 is how easy it is to move money between financial institutions, and how transparent the rate environment is. A quick search on "bank rate promotions" gave me a trove of sites to compare offers, including this Nerd Wallet article.

It is difficult enough to turn retail customers into profitable customers, as so aptly stated in this BAI Banking Strategies article. Balances and spreads drive revenues. Winning a $100,000 account isn't much of a win if you can only drive five basis points of spread from it. Better to get a $10,000 account at a 300 basis point spread, right (math)? But to fund the pipeline, I would need ten of those accounts. That is why core deposit gathering is so strategic.

If you are struggling to fund loans, it may not be too late to avoid the 2%, 13-month CD promo. Here are some suggestions:

1.  Reward existing core deposit customers - In a recent conversation with a bank marketer, they spoke of the power of word of mouth marketing among one of their customer niches. Imagine the word of mouth marketing if you shared your institution's financial success with core depositors in the form of a special dividend to them. Execution is key. Use a long-term average balance as your guide, encouraging loyalty, and keeping more of their deposits at your bank. Better than paying non-depositors, right?

2.  Flash sale to core depositors - Along the same theme, reward your core deposit customers with a "flash sale" rate promotion to gain more of their deposit dollars. Execute wisely. Do those customers have a "real" core deposit account with you, that has direct deposit going into it, and the electric bill coming out of it? Don't fear mass promoting it, as non-customers may get the feeling "hey, I want to be a customer there". 

3.  Build relationships - I hear this a lot among bankers, but don't see it a lot. As I have said on so many occasions, I have not been called by my current bank. Ever. And I think my experience is not unique. I know nobody there. But if I have a relationship with a banker, and the bank does not conspire to "screw" me (see below), than I would be open to bringing more balances to them.

4.  Don't screw your customers - See my post A Time of Reckoning for Your Bank's Core Deposits?. Having products match market interest rates automatically is an ALCO nightmare. But paying 1/3 the market rates on a customers' savings, and then bragging about it in your investor presentations, can't be a way to strengthen relationships and increase the amount of business you do with them. Could this be a reason why customers spread out their banking relationships?

If you are reading this, and you are having some liquidity pinches, it might be too late to execute on the above and get funding for next month's loan pipeline. And perhaps some wholesale approaches would work to relieve the pressure. 

But, long-term, don't give up the core funding gains you worked so hard to achieve.

What do you suggest to get more short-term retail funding into your bank?

~ Jeff

Note: Many thanks to my ABA Bank Marketing School faculty and friends for fodder for this post, including it's title. Get a couple of drinks in a bank marketer... 

IMO: American Banker's Community Bankers of the Year

On November 30th, American Banker named three Community Bankers of the Year. When I read about their selections, and reviewed their financial performance, I e-mailed Bonnie McGeer, Executive Editor at American Banker Magazine, to say that, in my opinion, they nailed it!

Not that they need my endorsement. But they did notice when I sniped at one of their past Bankers of the Year awards. Banker of the Year typically goes to larger financial institutions. But I digress.

When I read about Banker of the Year and other such recognition, I will typically look at the financial performance of the bank to see if the award holds water. There are few things more regressive to me than for a banker to receive recognition without accomplishment. It cheapens the award, and diminishes our view of the truly accomplished.

But this year was a bumper crop, I tell ya!

Mark Schroeder, German American Bancorp, Inc. (GABC)

Mark became CEO of GABC in January 1999. So he's been at it a long time. When he got the job, the bank was $637 million in total assets, had an Efficiency Ratio of 62.5%, an ROA of 0.96%, and an ROE of 9.1%. Today the bank has $3.0 billion in total assets, an Efficiency Ratio of 61.2%, and an ROA/ROE of 1.20%/10.7%, respectively. So the bank performed well in 1999, and Mark has improved on it. The bank is a consistent, German-engineered performer. 

As good as those numbers are, Mark's real home run was his total return to shareholders (see chart). From the day Mark assumed the reigns at GABC until today, the SNL Bank Index had a total return of 90%. GABC's was 424%.

Let that sink in a bit.

Credit: I got that "German engineered" quip from GABC's financial advisor.

Kevin S. Kim, Hope Bancorp, Inc. (HOPE)

Kevin's story isn't punctuated by his bank's total return since he became CEO in March 2013, although it did mirror the index. An investor would have enjoyed a 74% total return in HOPE stock during Kevin's tenure, versus 77% for the SNL Bank Index (see chart). 

No, Kevin had an impact from the moment he joined the Board in 2009, first advocating for raising more capital, and negotiating the merger between Hope's predecessor, Center Bancorp and Nara Bancorp, another Korean-American focused bank. The deal closed in 2011, and BBCN was formed. After closing another deal for Wilshire Bancorp, a $4B bank, in the third quarter, Hope became what it is today.

Financial performance is similar to when Kim assumed the reigns in March 2013. Then, the bank had an Efficiency Ratio/ROA/ROE of 45.5%/1.28%/9.13% respectively. Using this year's second quarter to avoid the Wilshire special charges, those numbers were 46.8%/1.20%/9.67%, respectively. 

What impressed me most was the bank's turnaround since Kevin joined the board, the transactions he has negotiated to significantly grow the bank, and the 32% earnings per share increase since he took over. That's right, 32%.

Anthony Labozzetta, Sussex Bancorp (SBBX)

When Tony took the reigns at Sussex Bank in February 2010, non-current loans/loans was 5.48%. Today they are 0.75%.  I should end this section right there. But I'll continue.

The bank had $452 million in total assets. Today it is nearly twice that size. Net income was approximately $1.2 million annualized. Today it's $5.6 million. Efficiency Ratio/ROA/ROE? Was 61%/0.21%/2.80%, respectively. Now: 68%/0.70%/7.79%. And the bank continues in a significant growth mode. 

And due to the bank's historically rural markets, he's #GeoJumping! See my firm's most recent podcast, minute 17:40, for a discussion on geo-jumping. I'm claiming the trademark.

An investor earned a 288% total return since Tony took the reigns, versus 115% for the SNL Bank Index (see chart). I'm one happy investor. Disclosure: I'm personally invested in SBBX.

And there are my reasons why I think American Banker NAILED IT!

What other great banks are out there that didn't win the hardware?

~ 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.

Five Things I Don't Understand

Some people see far more gray areas than I do. When common sense, reason, and facts support one direction, I am confused why we don't move in that direction.

If I listed everything I don't understand, you would be reading a long, long time. So I will limit myself to five things that recently confused me, and are relevant to banking.

1. Vision Doesn't Matter

I hear this a lot and a recent quote from General Colin Powell convinced me to put this on top. At a recent speaking engagement, he was reported to have said "If you want to make sure to keep moving forward, have a destination." I can't think of many, if any, renowned strategists that believe vision doesn't matter.

But I can't think of many financial institutions with a vision that clearly identifies a hoped for future. Most vision statements read like they came out of a Dilbert cartoon.

I think smarmy vision statements are the reason I often hear bankers and their consultants say vision doesn't matter. If you can't point to your hoped for future, communicate it and inspire your team, then maybe your bank doesn't matter. Could this be the reason for the incredibly shrinking number of financial institutions? I only wish those consultants saying vision doesn't matter would go away instead.

2. Our Money Is No Different Than the Bank Down the Street

If you believe this, then price is your only differentiator and the only way to achieve an advantage over your competitors is efficiency. Look to Oritani Financial Corp. as an example of this. But believing that you sell a commodity and pursuing a "relationship" strategy confuses me. Building a high quality staff of employees empowered with building customer relationships is more expensive than building efficient processes, using efficient systems, with a small number of high deposit branches needed to be a price leader. 

If you believe you sell greenbacks, dump the relationship platitude and get efficient.

3. We Need Experienced Bankers

Back in 2010 I wrote that our drive for experienced bankers limited banking's talent pool. Specifically, I was writing about hiring veterans. The corporate world is chock full of leaders brought in with little experience and taking those corporations to extraordinary levels. Think of Southwest Airlines Herb Kelleher, or IBM's Lou Gerstner. In banking, I identified the top 5 total return financial institutions. One was BofI Holdings Inc., whose CEO was a former consultant. Go figure.

Look through the long list of bank failures since 2008. Most were run by experienced bankers. So excuse me if I'm at a loss as to our fascination with finding more of them.

4. Finding Joy in Other's Failures

So, if you read my bio, you know I'm a Yankees fan and I'm fielding lots of questions about how I feel about Arod. Personally, I don't know Arod. Based on my limited knowledge of him, I don't think I would like him. He comes off as an extreme narcissist. But I refuse to boo the guy, or take joy in his downfall from baseball royalty. Perhaps when I reach perfection, I would be more comfortable taking pleasure in watching others fail. But I don't see that happening in my lifetime.

Failure is not testimony to your intelligence. It is testimony to your effort, and wisdom.

5. Employees Don't Match Your Strategy

Strategy shifts faster than culture. If you are moving your financial institution away from being transaction focused to relationship focused, yet leave the transaction focused people in place, you are setting yourself up for failure. How often do I hear from bank leaders that they are having difficulty getting their employees to do what they need them to do in our new banking world? 

Daily.

What is confounding you?

~ Jeff

To Branch or Not To Branch: Here Is The Answer

During periods of uncertainty lies opportunity. Vernon Hill, legendary leader of the former Commerce Bank in Cherry Hill, New Jersey, took advantage of the last time bankers were contemplating the future of branching by beating them over the head with his high profile and rapidly expanding branches. Can another Commerce Bank eat our lunch this time around?

Only if you develop a decade long strategic plan that maps the decline in branch prominence. If you are a shorter term strategist, and you want to grow, then branching remains on the table because it remains high in importance when customers are asked why they bank where they do. Even if they do not frequent their local branch, they tend to bank where a branch is nearby.

But what kind of branch? The Financial Brand did a showcase piece on innovative branch designs. I don't know which one is best, if any, but do know that the answer to proper design lies in your target customers as identified by your strategy. So, the branch question, be it design, location, and staffing, should be driven by the type of customers you are targeting, as identified in your strategy. If you haven't identified your target customers in your strategy, read no further and go do it.

But for those that know who they are targeting, the branching decision should be built on analytics. Branches represent such a significant expense, and average deposit size to achieve desired profitability has gotten so large, that we can no longer decide to branch at a location that is convenient to one of your directors.

Here are what I believe to be the critical pieces of information in determining where to branch:

1. Where are your customers now? Banks often have concentrations of customers that are in towns where they have no branches. This could be a significant starting base to grow your branch. I attended a banking conference recently where the presenter said your best source of new customers are the neighbors of your existing ones. If you have a solid foundation of households within a geography, that is a great start for a successful branch. Note I'm not suggesting branching just to bank existing customers, as that would erode overall profitability. But existing customers are the seedlings for new customers. So identify where your customers are.

2. Are there enough opportunities to bank your target customers in the new market? If you specialize in banking doctors and dentists and there are paltry few in the new market, I'm lost why you would consider going there. The exception may be that your niche rests on the loan side of the business, and funding those loans evolves from a more general strategy to generate funding. But if you can't dominate your niche in a certain geography, consider going somewhere where you can.

3. Is the market growing? Household and business growth demographics are pretty easy to obtain, either through government sources or systems such as your MCIF. Deposit growth and market share, and number of branches in a market (see tables) are available via the FDIC website. Are deposits increasing? Are competitors struggling? Are average deposits per branch increasing and of sufficient size to achieve your desired level of profitability?  

4. Are bankers available to staff the branch? In nearly every strategic planning session I attend Senior Managements place great emphasis on successful strategy execution on their people. There is no substitute to having the type of staff with the greatest likelihood of successfully executing your bank's strategy in your new market. You want to fail? Put no emphasis on branch staffing. You'll fail. I guarantee it.

5. Is a reasonable site available. I'm a realist. You can set your branch up for failure if you don't find a reasonable site. The term reasonable is in the eye of the beholder, but if you are tucked in the middle of a dying strip mall, that may not bode well for your visibility and your brand. Find a location where your people can succeed.

6. Can you de-branch painlessly? This is a new question for your branch analysis. There will come a time when your contemplated branch, and other branches in your network, will be unnecessary. Customers will be accustomed to banking online and/or via mobile, advice and problem solving can happen via the phone or in-person visits to the customer, and the psychological attachment to the branch will be gone. Can you close shop without incurring significant expense? 

I don't think branching is dead. But I do think that the need for marquis, high cost branches is waning, and smaller and more tech savvy branches will emerge as the norm. I also think staff per branch will decline, but capabilities per staffer will increase. The importance of getting your next branch decision right is critical to successful execution of your strategy. Don't let your director bully you into putting one near his/her house.

How do you think branching decisions should be made?

~ Jeff

Does your bank achieve positive operating leverage?

When a significant portion of your cost structure is fixed, then growing revenues should generate positive operating leverage... the cost of generating the next $100 of revenue should be less expensive than generating the previous $100.  This fundamental logic stands behind the banking industry buzzphrase, economies of scale. The fixed cost of your IT infrastructure is less on a relative basis for a $1 billion in assets financial institution (FI) than a $500 million in assets FI.

Because it is intuitive, doesn't make it so. Over the course of the past 10 years, the number of FDIC-insured FIs decreased by 23% (see chart). The average asset size per institution increased from $753 million to $1.7 billion. Clearly, part of this consolidation wave was attributable to FIs striving for economies of scale and positive operating leverage.

Has this consolidation, partly designed to give surviving institutions scale so they can spread relatively fixed costs over a larger franchise, resulted in positive operating leverage? My research into the subject says no.

One measure of achieving positive operating leverage is the efficiency ratio, defined as operating expense divided by the result of net interest income plus fee income. The lower the efficiency ratio, the greater the profitability. As an institution grows and is able to spread costs over a larger base, the efficiency ratio should go down.

But over the past ten years, efficiency ratios have risen in every asset category in both banks and thrifts with the exception of the very largest (>$10B in assets) banks (see charts).

The efficiency ratio measures how much in operating expense it takes to generate a dollar of revenue. So what if revenues (net interest margin, or fee income) are on the decline? Naturally, the efficiency ratio will go up. To further isolate expenses, I reviewed how expense ratios, defined as operating expenses divided by average assets, fared for our industry (see chart).

For banks, expense ratios have not budged during the period that resulted in a 23% reduction in FIs. Thrift expense ratios rose materially. I reviewed my company's bank and thrift product profitability reports to see if operating expenses per account declined during the 2000-2010 period. The answer: not one spread product group showed a decline in annualized cost per account. Not one.

Let's look at a couple of highly acquisitive FIs to see if they are achieving positive operating leverage by growing their balance sheets through mergers.

Fifth Third Bancorp

Fifth Third Bancorp is a $110 billion in assets financial institution with 1,363 branches and is headquartered in Cincinnati, Ohio. It has made six acquisitions totaling $32.6 billion in acquired assets between 2000 and 2007. The largest acquisition by far was the second quarter 2001 acquisition of Old Kent Financial, a $22.5 billion in assets bank. I chose this period to offset any impact from the 2008-2009 financial crisis. Clearly Fifth Third undertook acquisitions to achieve economies of scale. Relevant statistics during this period include:

While Fifth Third’s assets grew at a compound annual growth rate (CAGR) of 13.5%, earnings per share grew at a 1.1% CAGR and both the efficiency and expense ratios were higher in 2007 than when the bank was $45 billion in assets in 2000. Positive operating leverage should result in EPS growing faster than asset size because adding the next $100 in assets should cost less than the previous $100. Has Fifth Third achieved positive operating leverage by more than doubling the size of the bank during the measurement period?

 

 

BB&T

 

BB&T is a $157 billion in assets financial institution with 1,791 branches headquartered in Winston-Salem, North Carolina. It made 21 acquisitions totaling $44.6 billion in acquired assets from 2000 through 2007.  BB&T acquired more, and often smaller, financial institutions during the measurement period than Fifth Third.  Relevant statistics include:

 

While BB&T’s assets grew at a CAGR of 12.2%, earnings per share grew at 10.8%. But the efficiency ratio remained relatively steady in spite of BB&T’s net interest margin falling from 4.20% in 2000 to 3.46% in 2007. The expense ratio declined, realizing economies of scale from its asset growth. Although EPS did not exceed asset growth, the culprit lies more in revenue generation than on realizing efficiencies from growth.

This analysis is a simple undertaking to determine if your financial institution is getting the results you want when executing a growth strategy to achieve economies of scale and positive operating leverage. If your results more closely resemble Fifth Third’s than BB&T’s, you should ask yourself why.

Economies of scale should result in lower efficiency and expense ratios, and greater profitability… i.e. positive operating leverage. If you are growing to spread relatively fixed costs over a greater revenue base, then you should measure to determine if you are succeeding. Success should result in better results to peer, industry benchmarks, and downward trends in operating costs per account. Growing absent success in these metrics means you are simply managing a more complex organization for no additional benefit. 

   

Do you measure and hold yourself accountable for reducing relative costs as you grow?

 

~ Jeff

 

Note: The above post was excerpted from a soon to be published Financial Managers Society (FMS) white paper drafted by the author.

Enterprise-wide Risk Management (ERM): Yawn

I attended an industry presentation on ERM this past week put on by RSM McGladrey.  The topic highly interested me, not because it is interesting, but because everybody is talking about it and there are differing opinions about what to do about it. What an opportunity for a non-audit, non-compliance, non-IT, and non-credit blogger to write about it!

First I would like to say that the McGladrey speaker really knew his stuff and was balanced. So often I hear commentary on ERM by advocates that think it is the next best thing to, say, online banking. Well, no it isn't. It is not likely to make your FI a lick of money. That said, here is my criteria for an ERM program:

"A successful ERM will result in reduced losses that exceed the investment made in the ERM program."

~ jeff for banks

Why else would an FI embark on ERM? If the investment in ERM exceeds losses foregone, then don't invest in an ERM program. It's not worth the money. As community FIs, regulators force us to throw enough money down a black hole without us volunteering to do so.

But managing risk across organizational silos is highly fragmented in FIs. It makes sense to coordinate the effort into one area. Perhaps, as suggested by one attendee at the presentation, ERM could streamline risk management efforts to make reporting more relevant, less voluminous, and less labor intensive. If this was a by-product of ERM, then I'm in! I think your Board of Directors (Trustees for CUs) would appreciate reducing the size of monthly Board reports for monitoring risk.

An organization's risk profile looks like the bubble chart below from McGladrey's presentation. But not all risks are equal. If we were to quantify risk across the industry, Credit Risk would rank at 10 for greatest risk (on a hypothetical scale of 1 to 10), but other significant risks would be much lower such as Liquidity and Interest Rate Risk (perhaps 4's). How would a non-audit, non-compliance, non-credit person develop a ranking system for risks?

Look at past experience to determine levels of risk. For example, perform a lookback over a meaningful sample period (perhaps 10 years, or at least one economic cycle) to identify where your FI actually lost money. A second criteria could be to query your personnel with the greatest knowledge of the risk to quantify the possible loss and the likely loss from a certain risk. By developing such a discipline, the FI should determine how much resources, if any, should be dedicated to mitigating the risk.

The bubble chart above contains too much in the form of risk categories, as most categories have sub-risks. The McGladrey presenter mentioned having 20-25 risks worth monitoring and mitigating, although he was not married to it. As ERM evolves, we have to guard against monitoring so many risks that the processes that result are inefficient in their application and ineffective at preventing those risks that represent the greatest potential loss.

For example, I was evaluating processes in a client's deposit operations function where one of the ladies in the department sorted through a large stack of checks for two hours each day. I asked why she did it. She said the Bank had a check fraud about seven years ago, and therefore she had to manually review all checks over $5,000. I asked what a fraud might look like. She didn't seem clear. I asked how many she has prevented since the undertaking. She said none.

Here was an FI that allocates two employee hours per day to prevent a fraud that she probably would not prevent. The investment in resources significantly outsized the risk. I put to you that this example will be all too familiar if we implement ERM without evaluating the size and likelihood of risk. And processes, like government programs, last forever.

This past economic cycle made clear that the single greatest risk FIs face is credit risk. I don't see this changing. Even FIs that failed due to liquidity had their woes start with credit risk, including the credit risk in the FIs investment portfolio. So let's not fool ourselves into thinking that somehow "employee fraud", or some other risk, ranks nearly as high.

But there are risks that can have materially negative impacts on our business. So a CEO and Board can efficiently and effectively monitor the greatest risks to the safety and soundness of the FI, consider implementing a well thought out ERM that is focused, efficient, and effective.

Any thoughts on what such an ERM program would look like?

~ Jeff

Product Profitability Anyone? The JFB Pro-Growth Matrix

A bank attorney spoke at a recent Financial Managers' Society (FMS) meeting that I attended. His topic: Leadership. His thesis: Analytics should be the basis for strategic decision making. He offered an interesting fact: 40% of critical decisions in U.S. companies are made from the gut. This style of decision making was romanticized by Jack Welch in his popular 2001 book: Jack Straight from the Gut.

But in reading Welch's tome regarding his successful years at the helm of GE, it is clear that he was far more analytical than the book's title indicates.

Community FI's are similar to other companies in their strategic decision making. Often, critical decisions are made from the gut or based on past experience that becomes more irrelevant as industries, such as ours, rapidly transform. Such disruption gave rise to strategic advisory firms that break down strategic decisions to the facts important to increasing the likelihood of positive outcomes.

One such firm is the Boston Consulting Group (BCG), creator of the Growth-Share Matrix that depicts the potential for a company's products based on growth prospects and market share. Intrigued by BCG's concept and the ability to illustrate facts to improve decision making in FI's, I created the jeff for banks (jfb) pro-growth matrix.

Instead of using market share, as in the BCG model, I utilized net revenue per product. For loans, this was calculated as a percent of the product portfolio as follows: coterminous spread - provision + fee income. For deposit products the formula was: coterminous spread + fee income. This data was pulled from my firm's profitability database for all FI's that subscribe(d) to our profitability outsourcing service.

I chose to use net revenue instead of product profits because of the step-variable nature of an FI's cost structure. Most costs are fixed until a certain level where employees struggle to get the work done and the FI must invest in people and/or technology to increase capacity. If revenues decline, it is not typical for expenses to decline, as banks don't often let people go or scale down operations like a mortgage origination shop or a brokerage firm. Therefore, focusing on the products that drive the greatest revenue through a relatively fixed expense base would be closer to a realistic alternative for FIs.

I measured for both the fourth quarter of 2000 and 2010 to look at how our industry has changed. Change it has! Gone are the days that core deposit products generate net revenue between 4%-9%, as depicted by the "Stars" from 2000. That is because the re-investment rate, or credit for funds, for deposit products has dropped dramatically as a result of the interest rate environment today, particularly at the low end of the yield curve. Many readers may have experienced their treasurer lamenting they don't want any more deposits because they have no place to put them. That phenomenon is represented in the pullback of deposit products from 2000 to today.

But even in our historically low rate environment, core deposit products linger near the "Stars" box. Because revenues are low, some have drifted into the question marks. Interest rates are beyond our control, but if the net revenues per product decline, and much of the decline is outside of our control, then to move "Question Marks" to "Stars" may require an analysis of our expense base and the processes in place to support those products. Are we using technology to its fullest capacity? Do we still engage in outdated processes to protect from a risk that is negligible today?

Another interesting point from the jfb pro-growth matrix was that commercial real estate (CRE), much maligned since the recent crisis, remained in the Question Marks camp, albeit knocked down a notch because of the decline in the 3-year compound annual growth rate (CAGR) used to calculate the Market Growth portion of the chart. With today's elevated loan loss provisioning, CRE continues to contribute to an FIs profitability with above average net revenue generation.

Time deposits have declined on a CAGR basis since 2007, as noted in its position on the chart. In 2000, time deposits had a CAGR of 4.65% and net revenue of 0.53%. Today, CDs CAGR is -8.69% as FIs backed away from this expensive funding source because there is no loan demand. Why book a CD when its current coterminous spread is negative, which is where it stands today? But even when CDs had a positive spread, this product remained unprofitable.

Lastly, the sheer gaggle of products in the "Question Marks" quadrant indicates an opportunity for FIs. Using analytics, product managers have the opportunity to migrate marginally profitable products into either "Stars" or "Cash Cows". Knowing where you do and don't make money is a critical starting point, and positive action based on analytics can improve your FIs financial performance.

How do you use analytics for critical decision making?

~ Jeff

Guest Post: First Quarter Economic Update by Dorothy Jaworski

The World Around Us

World events are impacting our markets. Unrest in the Middle East has already changed governments in Tunisia and Egypt. Protests and internal fighting in Libya have led to an international coalition bombing the country in order to establish a “no-fly” zone. Saudi Arabia and Bahrain also face protests. Triple tragedies in Japan from the 9.0 magnitude earthquake, the giant tsunami, and the ongoing nuclear emergencies have us all unsettled.

Moody’s Rating Service never sleeps and has downgraded the debt of Spain, Greece, and yes, Japan. Oil prices keep rising and we’ve seen a 15% increase in gas prices since year end 2010. So far, about half of the positive economic impact of the surprise 2% reduction in social security taxes and small business tax cuts are gone because of higher gas prices. It may not take long before the remainder is gone, too.

It is no surprise then that the confluence of these events chipped away at the stock market rally and set into motion the inevitable correction. Stock markets had been rallying nicely since the Federal Reserve unveiled their $600 million quantitative easing program, commonly known as “QE2,” in November. Actually, stock markets are up nearly 100% since the Fed was in the midst of their first quantitative easing program in early 2009. One of the Fed’s QE2 goals, as stated by Chairman Bernanke, was to improve the stock market. In that, it has succeeded.

But the other stated goal was to keep longer term interest rates low or push them lower; this has not been accomplished. The bond markets had other ideas, selling off continuously since November, until three year through ten year Treasury yields had risen by over 100 basis points, peaking at increases of 130 to 140 basis points over November levels. It was not until stocks began to correct in early March that rates began to fall some-what, or about 25 basis points, as investors bought Treasuries and other bonds in a flight to quality because of all the uncertainty in the world.

Fundamentally, stocks should continue to do well in this, the third year of the rally. Corporate profits are strong and companies are sitting on a $2 trillion stockpile of cash. Mergers and acquisitions are continuing at a brisk pace. Prospects for economic growth are gradually improving, with 3% to 3.5% expected this year, and consumer and business confidence has been rising. The S&P 500 forward price-earnings ratio of 13.5 times is well below the historical norm of 15.5 times, so there is room to continue the upward trend, if world events cooperate, that is.

The Missing People

I usually do not obsess over economic data but I have been trying to figure out why the unemployment rate managed to drop from 9.8% to 8.9% in just three months, without a commensurate improvement in the number of jobs created. There has not been a drop of this magnitude in the unemployment rate in so short a time since 1958, when I was an infant. So, let’s look at some of the recent numbers and you will probably join me in asking “Where are the missing people?”

Payroll employment rose by 407,000 in the past three months, or an average of 135,000. Household employment, which incorporates the self-employed, rose by 664,000, or an average of 221,000.

Now, let’s look at the other data: Over the past three months, the number of people reported as unemployed has dropped by 1,028,000, the pool of available workers dropped by 1,206,000, and the total labor force dropped by 704,000. Where are these people, when there were not enough jobs created to account for the drop in unemployed persons? Why are they missing? If they didn’t get jobs, where are they?

We are creating average monthly payroll growth of 135,000 and household growth of 221,000, or barely enough to absorb new entrants into the workplace, and we are supposed to believe that the ranks of the unemployed dropped by over a million and the unemployment rate has miraculously dropped by nearly 1%! Ridiculous!

Growth for 2011

Economists were stampeding over each other to raise their GDP forecasts to 3.5% from 3.0% for 2011 earlier this year after the surprise tax cuts for consumers and businesses. Even the Federal Reserve raised their forecast range to 3.4% to 3.9% from the prior 3.0% to 3.6%. Then they all got another surprise from surging oil prices (currently over $100 per barrel) and gas prices (currently up almost 50 cents from the end of 2010), so the higher growth projections may have been a bit premature. At this point, we will probably see the originally projected 3%, given the still rising oil and gas prices, high unemployment, higher interest rates, and still weak housing markets.

To put this 3% growth rate into perspective, it would be only slightly better than 2010’s rate of 2.7% and equal to the average rate of GDP growth from 2000 to 2004. But 3% is tremendously above the recent average between 2005 and 2009 of 1.0%. We long for the glory days of the 1990s, when the average growth rate for the decade was 3.8%.

But, dream on, because the long term historical average is 3.2% since World War II, so we are close to average. I will note that GDP for 4Q10 was a record $14.86 trillion (annualized basis), which is above the prior record set in 4Q07. Consumers, businesses, and governments – state and local – are improving slowly. Very slowly. Enough to keep the Fed on hold with short term interest rates near zero – until unemployment falls from today’s high levels – from real job creation not just missing people.

Putting It All Together

Since my NCAA bracket did not turn out too well – I had Temple, Pitt, and Syracuse among others – I am forced to focus on the rest of the madness in the world. It really is true that our markets are closely tied to what is happening elsewhere and not always what is happening at home. Other than protests and natural disasters, there is one theme that has been garnering attention – that of soaring food and energy prices.

Some of the Middle East protests are in response to higher food prices, which, according to the IMF, are setting new records. So far, these dramatic price rises have not worked their way permanently into the prices of other goods and services. That is because our economic recovery is still fragile and increases in prices may not be sustainable.

Consumers likely will pull back spending in response to high prices, leading to weakening economic growth. We count on the Federal Reserve to watch inflation developments closely and they are seeing excess capacity, high unemployment, low wage and salary gains, and continued weak housing markets.

Today’s issue is to reduce unemployment; tomorrow’s issue may well be fighting inflation. Expect the Fed to keep short term rates low for an “extended period” of time, just as they promise us each month. Expect the Fed to remain angry over the bond market’s reaction to their QE2 program. For all we know, they may be plotting QE3. Stay tuned!

Thanks for reading! DJ 03/21/11

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

 

Book Report: The Lords of Strategy by Walter Kiechel III

B+ This book, written by a journalist and former editor of Fortune magazine and editorial director of Harvard Business Publishing, tracks the growth and philosophical evolution of strategy. It focuses on three strategy firms in particular: Boston Consulting Group ("BCG"), Bain & Company, and McKinsey & Company. In its entirety, I would suggest that it would be a very beneficial read for banking industry consultants, and a beneficial read for executives at community FIs.

How business is done is often, if not mostly, evolutionary. Understanding how  we moved from the days when small businesses in small towns dominated the landscape, to how merchants operated in our large pre-industrial revolution cities, the emergence of large industrial firms, the birth of the corporate man, to where we are today is important to understanding today's business climate.

Management "fads" came and went. These fads were often touted by strategy firms and their army of elite business school educated consultants. This book tracks the evolution of strategy from its early days in the 1960's at BCG to where we are today. Strategy's emergence, and its evolution, being driven by what the author terms the "fiercing of capitalism", i.e. the escalation of competition beyond a few firms and the shortening of competitive advantage driven by technology.

This created fertile ground for strategy's ascendancy and the firms that touted its virtues. Understanding the genesis of strategy and its evolution is an important step in its development and implementation at community FIs and is the basis for my recommendation for the book.

From my perspective, it was interesting to note how strategy became in vogue and how our pre-eminent strategy firms differed in their approach. Creating teams to ponder in a conference room, ruminating how strategy should be formulated and executed is foreign to relatively small consulting firms like mine. We don't develop techniques in our firm's interior. Instead, we develop it across the table from clients, while on the phone with colleagues, or at conferences listening to experts and gauging bankers' opinions.

My world is foreign to BCG's, but it was instructive for me to learn of their methods. Knowing how they do it can only help me do it better. I think it can help you too.

Here is what I liked about the book:

1. Gave detailed descriptions of how strategy came about at BCG, and how it grew and flourished not only at that august firm but also Bain and McKinsey;

2. Introduced the key players in strategy's development, not only at the above firms but also at Harvard Business School;

3. Described strategy through each stage of its evolution, and used interviews with key players in the evolution.

Here is what I didn't like:

1. Focused only on three strategy firms and Harvard Business School. Did other B-schools or consulting firms participate in a material way?

2. The author gave me several vocabulary lessons, such as when he said an author "continued to sound the tocsin" (sound the alarm). Fortunately, I read it on a Kindle and could highlight and get definitions for the difficult words. This is probably a pet peeve of mine, and I should be more thankful that I can now use "tocsin" in a sentence.

But the book is very well put together and thorough in its review of how strategy came to be. I found it a very worthwhile read and recommend it to you.

~ Jeff

Book Report note: I will occasionally read books that I believe are relevant to the banking industry. To help you determine if the book is a worthwhile read for your purposes, I will review them here. My mother said if I did not have something nice to say about someone, then don’t say it. In that vein, I will only review books that I perceive to be a “B” grade or better. Disclosure: I will typically have the reviewed book on my Amazon.com bookshelf on the right margin of this blog. If you click on any book on the shelf and buy it, I receive a small commission; typically not enough to buy a Starbucks skinny decaf latte with a sugar-free caramel shot, but perhaps enough to buy a small coffee at Wawa.

Core Deposits Drive Value

The title of this post is common community FI phraseology. I hear it often, and use it often. My epiphany came when I performed research for a client that subscribed to the Return on Equity school of thinking. This FI had a high percentage of funding coming from CD's and FHLB borrowings, a relatively low loan to deposit ratio, and focused on generating profits within the investment portfolio.

The FI performed very well on an ROE basis. Its relatively low net interest margin, due to high funding costs and low yield on earning assets, was more than offset by very low operating costs. The FIs CEO lamented at his low trading multiples. I decided to dig into why his multiples were so low. It turned out that the best indicator for trading at high multiples was a low cost of deposits. I performed this research about ten years ago.

Dial forward to today and I decided to test again if the cost of deposits as value driver is still true. The results are in the table below. I searched for profitable banks & thrifts with at least 1,000 daily trading volume that had non-performing assets to assets less than 3%. The search yielded 101 banks and 30 thrifts. Not a large number but in order to get reasonable values I had to control for inefficient trading and asset quality.

Banks in the top quartile (best) cost of deposits traded at a 17.4% premium to bottom quartile performers in price to earnings multiples and a 35.5% premium in price to tangible book multiples.

Thrifts top quartile performers traded at an 18.9% and 30.2% premium on price to earnings and price to tangible book, respectively.

But could this be relating to their margin or yield on earning assets? I tested for yield on earning assets and the answer was no, there was no positive correlation between trading multiples and yield on earning assets.

There are imperfections to this analysis, though. Upon review, larger banks with greater trading volume also trade at higher multiples. This is probably the result of a greater pool of institutional investors due to volume requirements. Additionally, although trading multiples are beginning to show signs of improving, the overall trading of the banking sector has not returned to normal.

But ten years ago my analysis demonstrated that FIs with better deposit mixes and therefore lower cost of deposits enjoyed greater valuations. And today, the results are very similar. So why do so many FIs doggedly stick to asset-based business strategies?  Some, such as Sandy Spring Bancorp (see slide below), have been generating value from the liability side of their balance sheet and continue to do so.

According to Sandy Spring's latest investor presentation, the bank pursues a "strategic focus on small business, middle market and affluent retail customer relationships". Anecdotally, most small and mid-sized businesses do not borrow. So serving them, one would think, would require a focus on deposit relationships.

It appears as though Sandy Spring is winning, having 23% of their deposits in non-interest bearing DDAs and a cost of deposits of 0.49% in the fourth quarter. They trade at a 16.2x earnings multiple and at 130% of tangible book. It should be noted that Sandy Spring is headquartered in Maryland, a state that has experienced its fair share of credit challenges, hence the relatively low price to tangible book multiple from other top quartile banks.

Do you believe core deposits drive value? If so, why, and if not, why not?

~ Jeff

Special note: I am not making stock recommendations here. So don't call your broker to make a trade based on what I write. If you saw the performance of my stock portfolio, you would know what I mean.


Disclosure: My company has served as a strategic advisor to Sandy Spring within the past twelve months.

Experienced Bankers Wanted for Mediocre Bank

"He's not ready" is the response I often hear when I ask why a sharp banker is not part of the FIs senior leadership team. I hear it from senior leaders, industry executive recruiters, and industry consultants. But when I hear this, let me share with you what my internal voice is saying: "I want to make myself feel better by diminishing your perception of the value this clear up-and-comer can bring to our team."

If the talented individual we are speaking of is not yet good enough to serve in a similar role to me, then, ipso facto, I must be more talented than him. That is one reason I was so impressed with a southeast bank president that said to me "look around, you don't see many executives over the age of 45 because they don't get it [the new way of doing business]." This CEO must not have bought the "he/she's not ready" line.

This attitude is not exclusive to executive ranks. I recently recommended an acquaintance of mine to a regional business banking executive who agreed to take a look at his resume. The result: doesn't have business banking experience. This was true, but knowing the "type A" nature of this individual, I had little doubt he would be successful learning "credit", knocking on doors, and building relationships. Instead, this bank wanted an experienced banker. To which my internal voice said: "experienced at doing commercial real estate transactions and scoffing at directives asking him to build a full relationship."

Another version of the above is when I hear "he doesn't understand credit." I have heard this from FIs currently experiencing credit problems. Apparently it is worse to hire someone that must learn credit than to hire one that has already proven challenged in the endeavor.

Dave Martin, an industry consultant with NCBS, recently wrote in an American Banker opinion piece (see link below, may require subscription) "when we put the wrong person in a job or allow the wrong person to stay in a job, we undermine our businesses." But personnel issues are frequently cited by FI executives as to why they are not succeeding in this strategic initiative or that. And they are not willing to make the necessary changes to move their business forward. Instead, they are in search of "experienced bankers."

Arkadi Kuhlmann, founder and CEO of ING Direct USA, was quoted in a recent Harvard Business Review piece on hiring practices by Fast Company cofounder William Taylor (see link below), "if you want to renew and re-energize an industry, don't hire people from that industry. You've got to untrain them and then retrain them. I'd rather hire a jazz musician, a dancer, or a captain in the Israeli army (see link below to my post on hiring a vet). They can learn about banking. It's much harder for bankers to unlearn their bad habits." If you believe the concept of hire for attitude and train for skill is true, how do you remake your employee base?

First, the FI should clarify the strategy. Understanding where you are going is a critical yet under appreciated step in identifying the people needed to get you there. It requires vision and a roadmap to achieve the vision. Do you know where your FI is going?

Second, you must identify key positions that are important cogs in the wheel to executing strategy. I already made reference to banks that want full relationships with their business customers yet their lending team is chock full of commercial real estate transaction folks with little interest beyond their current pipeline. But if relationship building is the strategy, are your branch personnel up to it?

I have witnessed FIs build confusing and inefficient workarounds to the shortcomings in branches. One reason is that experienced branch managers tend to come from the old school, where taking care of customers once they come in the door is job 1, followed closely by ensuring the branch balances and branch cash is not off. Well, last I checked, not nearly as many customers are coming into branches anymore.

FIs pursing the "relationship" strategy fail to recognize that a relationship occurs between two people. If you hire for attitude in the branches, and get a good go-getter with a positive outlook as branch manager, but proceed to pay her minimally with little upside, she will seek promotions out of the branch. This recently happened at the branch where I bank.

Branch manager is often a destination position for those that were promoted through the teller ranks and have no need to be the bread winner. For those type A people we may want in the branches, branch manager is frequently a waypoint position until something better comes up. Not a particularly effective way to execute on a relationship strategy. But branch managers are critical to our strategy.

The manner at which we hire and fire in FIs reminds me of the different styles of George Steinbrenner and the Pittsburgh Steelers' Rooney family. Steinbrenner would make key hires relatively quickly, and would fire them if they didn't work out. The Rooneys, on the other hand, invest significant time into hiring the right people and stick by their decisions (see link below). In banking, I have witnessed us hiring like Steinbrenner, and firing like Rooney. I suspect we should choose one method or the other, and use execution of our strategy as the measurement of whether a person will work out for us.

For community FIs to remain relevant to customers and prospective customers, we must choose a strategy that delivers either a competitive advantage through differentiation or cost leadership. Fortunately, there are still opportunities to deliver cost leadership for some of us, although I would deem it to be a difficult slog to have lower costs than the very large FIs. If we want to differentiate, then how? Most strategy sessions I attend require that the community FIs people be superior in the manner at which we execute strategy. So I ask you, who is executing your strategy?

Do you believe in the "hire for attitude" philosophy or the "hire experienced bankers" one?

~ Jeff


Dave Martin's American Banker piece, "If he hollars 'bad fit', let him go."
http://www.americanbanker.com/issues/176_42/if-he-hollers-let-him-go-1033869-1.html?zkPrintable=true

William C. Taylor's Harvard Business Review piece, "Hire for Attitude, Train for Skill"
http://blogs.hbr.org/taylor/2011/02/hire_for_attitude_train_for_sk.html

My blog post "Be all that you can be"
http://jeff-for-banks.blogspot.com/2010/05/be-all-that-you-can-be.html

New York Times piece "Rooney Method: Build Methodically and Await Rings"
http://www.nytimes.com/2011/02/03/sports/football/03rooney.html?_r=1&nl=todaysheadlines&adxnnl=1&emc=tha27&adxnnlx=1299413029-4gsue0vxqubNBTcVprKO+Q