Banking School: Effective Decision Making

On occasion I have the privilege of attending a banking conference in a swanky locale. Last month, I attended a gathering of Pennsylvania bankers at The Breakers in West Palm Beach, Florida. These conferences are typically chock full of opportunities for me to learn something. I feel it my duty to pass what I learn to you in the hope that you will benefit from it, as I have.

There were many good sessions, but the one I found particularly interesting was done by David Martin of Commonwealth Advisors. David competes with me in one of my firm's lines of business and it may not be wise of me to play him up. But I respect Dave's opinions as a result of his decades of industry experience and willingness to share his knowledge. I may not always agree with him, but I have always respected him.

His topic of the day was on making difficult decisions. Banking has changed slowly from the Great Depression to the late 1970's... a little quicker from the 1980's until 2008... and in a major shift since 2008. However, as Dave put it, "bankers and their boards often apply more sophisticated analysis to routine loan and investment decisions than they do to critical strategic decisions". If our industry is undergoing a long-term strategic shift, as I believe it is, we need to chart a course that gives us long-term relevance to our customers, communities, and shareholders.

Here are the eight steps Dave proposed for effective decision making (from Harvard Business Review on Decision Making by Harvard Business School Press, June 2001):

1. 
   
   Set the Stage: This is the collaborative problem solving stage, testing and evaluating exactly what the problems are, presenting balanced arguments, establishing an openness to solutions and constructive criticism that carries into later stages.
2. 
   
   Recognize Obstacles: Cognitive Bias... our industry's bias toward the familiar has been a significant contributor to finding solutions that are small "tweaks" to business as usual; and Group Dynamics... going along with the group, assuming group harmony is more important than accurate strategic decisions... or... individuals dominating the discussion... or... silent dissent that typically results in meetings after the meeting to undermine decisions that were made in the group. Early recognition of these obstacles that subvert the effective decision making process is critical to avoiding them.
3. 
   
   Frame the Issue at Hand: Perform a root cause analysis by repeating the statement of fact and ask the question "Why?". Then identify your decision making objectives you want to reach by defining the performance that represents a successful outcome and painting a picture of what things will look like when the problem is solved.
4. 
   
   Generate Alternatives: Brainstorm solutions. Enlist a devil's advocate. Require details from participants to avoid platitudes such as "get us to the next level". Appoint a note-taker to ensure all ideas are considered and documented.
5. 
   
   Evaluate Alternatives: Use objective analytical discipline to evaluate costs, benefits, time, feasibility, resources, and risks. Also, identify areas of uncertainty and focus on those that have the greatest impact on the outcome of your decision.
6. 
   
   Make the Decision: Set up performance metrics to track progress towards your hoped-for results. Support the decision once it is made.
7. 
   
   Communicate the Decision: Notify those responsible for implementation and that will be affected by the decision. Explain the thinking behind the decision. Clarify what is expected to support the decision.
8. 
   
   Implement the Decision: Generate short-term wins. Monitor progress and fix problems before they grow. Be direct, open, and honest and allow no silent dissent that undermines the effectiveness of implementation in order to return to the status quo.

There are many challenges facing our industry that can be solved by implementing a disciplined decision making process to lead to better strategic decision making. I am confident more will emerge once the regulations resulting from Dodd-Frank start rolling off of the presses.

Rather than allowing these challenges to build up to overwhelming proportions, perhaps we should implement strategic decision making that is disciplined, focuses on the real challenges, and generates alternatives that will lead us into the future.

Alternatively, we could bury our head in the sand, complain about lawmakers and regulators, and pretend all is well with us and wrong with the other guy (see below for the "head in the sand decision making process").

- Jeff

Mortgage Refinance: Thanks Uncle Sam!

My wife and I are in the throes of refinancing our mortgage. The impetus was trading down from a 5.875% rate to 4.375%. This week, we received our loan application package, that includes the Good Faith Estimate (GFE) of mortgage costs, on the lesser-known form HUD-GFE.

Background information: Mortgage rates are at all-time lows due to continued economic weakness, Federal Reserve policy keeping short-term Fed Funds rates near zero, the Fed's policy of buying government bonds in the open market and keeping long-term rates low, and government support for Government Sponsored Entities (GSE's, i.e. Fannie Mae, Freddie Mac) that continue to finance home mortgages. My wife and I would like to lower our monthly payments over the same term we have remaining on our current mortgage. Makes sense to me, then we received our application package.

The package contained 36 pages of difficult to understand disclosures. They required us to affix our signature 23 times. The GFE estimated our settlement charges at $7,941.75. Yes folks, to refinance our mortgage through the same financial institution that currently services (although does not own) our current mortgage, we have the opporunity to pay them $8k. To be fair, only $2,175 goes to the lender, which is paydown points for getting the low rate. Another charge is to fund an escrow account, which sounds ridiculous to us considering we have an escrow account with the same lender on the same property for our current mortgage.

Other charges include title services, including insurance. This is another part of the refinance process that makes no sense. We bought our home six years ago and paid for the title search and insurance at that time. Must it be done again to refinance? Where that requirement comes from, I don't know. But it is emblematic of the perplexity of the mortgage financing business.

This is an example of "We're from the government and we're here to help" good intentions combined with bad results. I think there could be mortgage finance rules drafted in a one or two page piece of legislation that makes it easier on all of us... borrowers, lenders, investors, and regulators.

Here is what I recommend to improve the process:

- For refinancing to the same homeowner on the same piece of property, an electronic title search is all that is required for homes where title insurance has been purchased within the last ten years;

- Permissions to verify income and account information can be done on a one-page letter;

- GFE's can be made much simpler and more condense. I predict my 11 year-old could come up with a more understandable form;

- Create an automated form that enumerates tradeoffs with financing closing costs or paying them. I went through a mathematical exercise because of my knowledge of the industry, re-investment rates, etc. to make my determination. Does or could everyone do the same so they make an informed decision?

- Create an automatic query and bid system once a mortgage application is made to settlement agents and title insurers. My guess is not many of us have "relationships" with these firms, so selecting nearby agents that participate in an electronic bid system would be extremely helpful. The same could be done for appraisers. I think if hotels.com and priceline.com figured this out for hotels, we could get something going for these service providers. These costs can go on the GFE directly from the bid system.

My guess is costs for the title, settlement, and appraisal engine would come down as a result of the competition. Right now, borrowers probably go with the company(s) recommended by the lender. This puts a premium on getting and staying on the lenders' recommended lists, which probably equates to many expensive dinners and tickets to great seats at sporting events.

At the end of the day, borrowing money and using your home as collateral should be easier, much easier, than it currently is. I think if we sat back and asked ourselves, "what makes sense here", the process would be a lot different... and probably less expensive for the borrower, less difficult for the lender, and easier to regulate.  What are your thoughts on the mortgage process?

Guest Post: Second Quarter Economic Update

What’s Bothering the Markets?

There used to be an old adage in the stock market: “sell in May and go away.” This year, it certainly seems to be the case. Stock markets did quite well this year into April then began to sell off relentlessly in May; in the meantime, bond markets moved higher, especially Treasuries, as investors sought the safety of bonds. Interest rates have been driven to incredible lows. The month of June has not been much better; after trying to rally from lows, stock markets keep getting battered back. It’s almost as if there is some invisible hand keeping the Dow near 10,000 and the S&P near 1,050. Wait! These were the 1999 levels for these indices. One lost decade later, we are still there. Did you know that since 1999, the Dow has risen above and fallen below the 10,000 mark an astounding 280 times! (Thanks to Doug Ingram for that bit of history).

So what gives? What is wrong with the markets now? We can’t blame it on the Internet stock bubble of ten years ago. We’ve lived through one of the worst recessions and financial market crises of our lifetimes. The stress of September, 2008 to March, 2009 was beginning to be erased by an economic recovery, as signaled by stocks that rallied over 60% from fearful lows to levels that supported growth. Then came this May and June, and it feels like the market psyche is slipping back to emphasizing the negatives. Don’t get me wrong, there are plenty of negatives to go around – Greece and Europe debt crises, China growth issues, a weak employment report for May and unemployment at 9.7%, fear of a “double-dip” recession, weakening data, the BP gulf oil spill, low business confidence, and continued deleveraging by consumers and businesses.

Government and regulators are contributing to the pessimism with financial reform legislation that does not even address some of the causes of the crisis, new FASB proposals to impose harmful mark-to-market accounting on bank loans, and the looming expiration of the Bush tax cuts in 2011. Bummers all. Jim Cramer describes it as a “malaise,” or a general lack of optimism. I describe it as the sound of thousands of vuvuzelas buzzing at a soccer match!

Is There Anything Good Out There?

Now that I have depressed you completely, let’s take a moment to cheer up. Yes! There are positives in the economy and in the markets. In the first five months of 2010, jobs grew by nearly 1 million. Granted, we lost over 8 million jobs since December, 2007, but gaining 1 million pretty quickly is good. (Now I admit many of those jobs are temporary census workers, but these are people working too). Housing prices bottomed based on the Case Shiller indices months ago and are now up almost 4% to 5% on a year-over-year basis. Existing and new home sales fell sharply in May, but this followed the unusually high months of March and April that contained the $8,000 tax credit.

Inflation and expectations for it are both low; inflation is not a serious risk as GDP growth remains steady but below levels (3% to 4%) that can be inflationary. In fact, the battle against the real enemy, deflation, is being fought by the Federal Reserve with easy money. Interest rates, especially Treasury yields and mortgage rates, are at very low levels, which can help consumers and businesses with new loans (if they ever want to add to debt) and refinancing. And our eternal ally, the Federal Reserve, has pledged to keep short term interest rates low for an extended period of time, creating a friendly growth environment indeed. Ben Bernanke has always pledged to print more money, and drop it from helicopters if need be, to kill deflation.

We worry about all of the negatives mentioned earlier. They can lead to a loss of confidence in the economic recovery that is underway. For employers to add jobs, that confidence is essential. For consumers to spend, that confidence is essential. On the positive side, we are now in the fourth consecutive quarter of an economic recovery that started last summer. Most economists believe that the growth momentum will continue at a pace of 2.7% to 3% into 2011. Then we have to worry about federal tax increases, i.e. the Bush tax cuts expire, and state and local government tax increases as these states and municipalities struggle to balance budgets. States are wrestling with reducing projected June, 2011 deficits of $112 billion, according to the Financial Times. Let’s hope the projections of GDP at 3% come true when these tax increases occur.

Putting It All Together

The economy should grow 2.5% to 3% in 2010 and about the same in 2011. This recovery is slower than those we have seen historically, but “slow,” after the crises we have endured is preferable to “no.” Negatives in the markets have been holding us back, in addition to “inventory” issues that I have continued to stress. Two of the inventory issues have been improving – manufacturers adding to goods on the shelves and the pool of available workers declining slightly – while the other two remain weak-houses on the market and bank loans declining.

Short term interest rates are low and can be expected to remain that way until economic recovery is assured and unemployment drops“way” back from its high level near 10%. We are looking at the Federal Reserve holding the Fed Funds rate at 0% to .25% well into 2011 (mid-year at least). Some economic formulas that predict the Fed Funds rate, most notably the Taylor Rule formula, show that this rate should be negative 1.75% right now, making 0% look pretty high. It’s been said that negative interest rates are not an option, thus the Fed must inject money into the system in other ways, such as buying securities. Longer term rates should rise slightly, by .25% to .50%, once the flight-to-safety comes out of the bond market and yields return to where they were before May. But large increases in long term rates are not expected as inflation remains tame for the foreseeable future and the Fed battles the evil of deflation.

Thanks for reading! DJ 06/29/10

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.

Diseconomies of Scale

Have you ever driven on a highway by yourself and forget, if even momentarily, the highway you were on and where you were going? I hope most of you answered yes or I have to make a doctor's appointment. The same sensation you feel for that split second while driving is, at times, what I feel in some strategy sessions I am priveledged to attend.

A common discussion in these strategy sessions is 'how do we grow'? Frequently, I will ask 'why do you want to grow'? The answers typically come back with some variation of achieving economies of scale to leverage the infrastructure to enhance shareholder return. This is particularly true of today's banking reality, where regulators and politicians are heaping non value-added costs on financial institutions. So the easy answer is let's get bigger, right?

Of course there is some merit to growing to a certain size so adding another compliance officer or another branch doesn't tank this year's earnings. But the million dollar question is what is the "certain size"? A bank CEO once told me that his investment banker told him the ideal size was twice his current size, no matter what size he was at that time.

The table below, derived from averages of the last ten years of efficiency and net operating expense ratios, indicates there are advantages to being larger. But look carefully. The advantage diminishes as the asset size grows, to a point where it is not particularly compelling.

The drive for growth in banking always concerned me. Banking is driven by balance sheet, not the income statement like most industries. Banks revenues are the result of the size of its balance sheet. You want to grow revenue 10%, you must grow the balance sheet 10%, all things being equal.

Not so difficult, one might think, if you grow from a $500 million in assets financial institution to a $550 million one. But what if you're a $10 billion bank? Now you must grow another billion to get your growth. What do you do if your markets can't support that growth? You must buy other financial institutions or reach for growth outside of your power alley (either your geography or into lending areas where you have little experience). The result may be fine at first. But as Warren Buffett once quipped, "You don't know who's swimming naked until the tide goes out". Many financial institutions were found to be naked over the past year and a half.

Perhaps it is time to consider a different strategy. If, for example, slow but prudent growth leads you to grow your balance sheet, and therefore earnings, at five percent per annum. This is typically not an acceptable long-term return for equity investors.

But if you are generating sufficient profits, and you don't need to grow capital at a rapid pace to keep up with growth, you could pay higher dividends, delivering acceptable shareholder returns. In this manner you may be taking the growth your markets can deliver, without forcing you to seek growth that is beyond your control (i.e. M&A) or put undue risk on your balance sheet (i.e. lending outside your expertise).

There are strong leanings to grow. I know of banks that are located in the same small town. One grows faster than the other, and is very proud of the accomplishment. Senior management and the Board of the smaller bank lament that they have not grown as quickly. In this context, growing is not a business judgment or a shareholder return issue, it becomes an ego issue. There is no greater testament to the role ego plays in the size of a bank than to see Bank of America and Wachovia's drive to be the highest skyscraper on the Charlotte skyline. Wachovia was winning until their near collapse. But their building was impressive!

What size do you think is big enough?

- Jeff

The Folly of Peer Groups

A bank CEO once told me that peer groups get you to that lazy place. He was referring to being mediocre. Yet we continue to use peer groups in banking to guide us to where we want to go.

I am not against peer groups. My company uses them to determine where a company is at a point in time. But because financial information on competitors is so readily available in banking (we must report to the FDIC our quarterly results and it is available to all), we become over-reliant on them.

Regulators fall victim to this trap too. I have read countless exam reports that cite UBPR (Uniform Bank Performance Report) statistics as evidence that a bank is doing well or needs fixing. For example, an examination may cite a bank’s efficiency ratio as compared to peer as a reason why the bank is lacking profits (the “E”, or Earnings, in CAMELS ratings).

But UBPRs are done by asset size and region. See below for a snapshot from an Umpqua Bank of Portland, Oregon UBPR. Their peer group is all commercial banks with assets greater than $3 billion. That’s the only criteria. If Umpqua chose to measure success by these standards, they would surely strive for mediocrity. Something I doubt Ray Davis would be pleased with.

Suppose a bank has a significant wealth management division. This typically drives up efficiency ratios and would therefore compare unfavorably to peers without similar operations. Should senior management focus their efforts on reducing the efficiency ratio because a short-sighted examiner said so?

No, I would think that is not the way to run your bank. I frequently tell bankers not to let examiners run their business. What qualifications do they have to do so? But bankers can’t let peer numbers run their business either.

Comparison to peer ought to be the result of executing your strategy, not the impetus behind your strategy. We have a client that evaluated their position in their markets, their potential, and therefore their best strategy to succeed. Then they identified the peers that had balance sheets similar to the one this bank strived to attain. They dubbed this peer group their “future peers”.

They then evaluated their current position and identified peers that looked most like them today. They dubbed this peer group their “present peers”. As they implement their strategy, senior management is tracking their progress from their present to future peer. In other words, they utilize a peer group as a tracking mechanism for executing strategy, not to determine the bank they want to be. That came first. In my opinion, this is a very positive manner to use a peer group.

I think banks should use peer groups as diagnostic tools, to hold themselves accountable for top tier performance, and move towards those peers that may be executing similar and successful strategies. I do not think they should be used to determine the bank you want to be or to achieve “peer performance.” To me, this would be a recipe for mediocrity indeed. How does your bank/thrift/cu use peer groups?

- Jeff

Real Estate: Love it or hate it?

Economists and government officials continue to cite lack of lending activity as a key contributor to our economic malaise. At the same time, I keep hearing from bankers about the lack of credit-worthy borrowers and regulatory pressure regarding the quality of the bank loan portfolio. I am also seeing a rise in bank cash positions and a decline in business loan (C&I) portfolios (see chart). As I understand it, government officials (excluding regulators) want banks to lend, banks have the cash to lend, bankers are hesitant to lend, and regulators would just as soon have you hire another compliance officer and purchase a U.S. Treasury.

Much of the standoff revolves around real estate secured lending. There is little doubt that bankers like real estate as collateral for loans. Countless bank CEO's, senior lenders, and bank directors tell me so. This preference resulted in real estate assets (including mortgage-backed securities) representing 44.1% of total assets at March 31, 2010 (see link below).

Regulators are slightly schizophrenic on the subject. They imposed limitations on the amount of non-owner occupied commercial real estate (CRE) a bank should carry, and they link the value of the loan to the value of the collateral backing it. How will these conflicting views on real estate work itself out over the near term?

What I suggest regulators consider is collateral alternatives. Our current slump, which started at the end of 2007 was real estate driven. When sub prime and similar loans began to default, other borrowers began tightening their belts and began to de-leverage, leading to a recession. Pundits spoke confidently and often about prime mortgages and CRE being the next shoe to drop. The result was a decline in real estate values (see table below).

Amidst all of the calamity, the median home price in the U.S. dropped 24% from 2007 through the first quarter 2010. It makes you wonder what has happened to the values of alternative collateral such as vehicles, inventory, or receivables? Are these more reliable? One regulator, on a panel at a banking conference, told a tale of a recent conversation he had with his regional director. A bank this regulator examined was increasing the level of CRE on its books beyond the 300% of capital target. The regional director voiced his concern, to which the examiner responded "what alternative to real estate as collateral should I suggest?" He didn't hear from his boss on the subject again.

Bankers, on the other hand, should study carefully the direction of the national and their regional economies. What segments are growing? Do these segments typically have real estate to offer as collateral?

Let me offer a story. Let's say Ted owns an environmental engineering firm that he started five years ago. He used his own money and a home equity loan to get it going. Today he has $2 million in revenue, $200k in capital, and 10 employees headquartered in a leased office. An opportunity presents itself to pick up five new employees. However, Ted projects the growth will put him in the red for two years. He would like to get a loan from his bank but doesn't want to use his home as collateral because he is not confident he has enough equity and his wife was none-too pleased about doing it the first time.

Would your bank lend to Ted? Let's take the story further, assuming the firm secured a C&I loan from a bank. Now the economy goes in the tank and the firm has a pretty bad year. He puts some additional equity in the business to get them through, but when submitting his financials to the bank, the loan now doesn't cash flow. Will the bank write down the loan at the behest of regulators or on their own accord? Will they encourage Ted to refinance with another bank? Or will the bank see Ted through this difficult period?

If you're a regulator reading this, my guess is you would make the bank take a larger provision and/or write down the loan. If you're a banker reading this, my guess is you wouldn't make that loan without real estate as collateral. But we have to ask ourselves how long we can continue to lend to commercial building owners while avoiding lending to the businesses, like Ted's, within the building? It's those businesses that are likely to drive our economy in the future.

This has been an unusually long post. So I must summarize. Real estate continues to be a reliable source of collateral to lend against, even considering the recent downturn. Regulators should take note. But the businesses likely to fuel the U.S. economy into the future may not have real estate to offer as collateral. Bankers should take note and be prepared to finance them.

- Jeff

FDIC: Quarterly Change in C&I Loans

http://tinyurl.com/25rz9a

FDIC: Real Estate Assets as % of Total Assets
http://tinyurl.com/27go23m

National Association of Realtors: 1st Quarter 2010 Median Sales Price of Existing Family Homes
http://tinyurl.com/2692z7x

Branch Math: To branch or not to branch?

Opinions are wide and varied on the subject of branching. Trends indicate that more customers are using electronic means to interface with their bank and are visiting branches much less. However, customer surveys continue to favor branch locations as a critical factor in determining where to bank. In the mid 1990's, many industry professionals feared branch extinction. The former Commerce Bank of Cherry Hill, New Jersey proved these fears wrong by racking up impressive growth and profitability numbers through de novo branching.

But as branch lobbies become emptier, senior managers are wondering again if branching is becoming a dinosaur. I predict branches as we know them will slowly become obsolete. I do not know the date of their obsolescence.

I do think banks must be more exact in the communities they select and the types of branches they build. Reasons for branching into a community are wide and varied. But typical themes I have heard include: a builder saved a pad site for the bank; a senior manager lives in that community; and the CEO has a second home there. Before branches popped up on every street corner, margins were greater, and the cost to erect a branch was not so dear, this approach may have still yielded positive results. Today, a branch built without rigorous analysis is more likely to be unprofitable and a candidate for closure.

Here are a few questions senior managers should ask themselves prior to branching:

1. What customers are the focus of our strategy?

2. Where are concentrations of these customers located?

3. What are the market demographics of the communities where these customers are located (growing, shrinking, etc.)?

4. How many competitors are there?

5. Is average branch deposit sizes growing or shrinking in these communities?

6. Do we have the ability to attract quality bankers to serve these communities?

7. Are there attractive sites to open a branch that is convenient and consistent with our brand?

After answering the above, senior managers may want to get busy with Branch Math. I built a branch profitability model designed to estimate the income statement impact of a prospective branch (see below).

Assumptions, such as deposit growth, can be tested looking at other branches in the community or nearby communities, and past experiences the bank has had opening branches. Senior managers can model base, worst, and best case scenarios in order to make an informed decision and give the Branch Administrator and prospective Branch Manager a template to guage success.

Note that the branch is charged the opportunity cost of building the branch (i.e. the interest income foregone by buying land and paying a builder to erect the branch). This gives senior managers an idea of the higher hurdles they are creating for hitting profit targets if they build a palace. I often see this expense overlooked.

The future of banking is being determined at a pace not seen since the Great Depression. Much of it is being decided in the halls of Congress. But most is being decided in the minds of our customers and prospective customers. Part of that future will be the importance of branches. To give new branches the greatest chance to succeed in this evolving world, we must inject greater analytical rigor in determining where to branch, and the type of branch to construct. In a highly competitive marketplace, having a higher percentage of branches delivering desired profitability will help your bank stand out in the crowd.

- Jeff