VBlog: Three Ways to Remain Close to Customer Using the Bank Division Approach

My western swing teaching Bank Profitability to the Oregon, Washington, and Utah Bankers' Associations Executive Development Program spurred a lot of discussion on the multi-bank charter strategy and how to grow over large geographies yet empower local decision makers and remain close to the customer. 

Here are three ideas from me. How about you?

~ Jeff

Bankers: How Should It Be?

I have been sitting on an airport tarmac for 45 minutes. Twenty-first in line. Waiting for a re-route from the tower to avoid the rain drops. Such is the way that it is.

But how should it be?

In banking, do we ask ourselves how it should be?

My firm analyzes bank processes to identify how it is, versus how it should be. But the question goes deeper than how a wire is done versus how it should be done. Answers are typically “it depends”. And what it depends on is in the eye of the beholder. Is the beholder the employee? The customer? The regulator? The shareholder?

Last year I did a blog post Build Your Own Small Business Loan Platform. In it I described having a series of options to fund small businesses. Some options were on the bank’s balance sheet, some not. What the post does not say is just because you could advance a loan to the customer, doesn’t mean you should.

Take the following example:

Suppose Jane and John Doe, owners of J&J Bikes, come into your bank for a mortgage loan. The bike shop has been doing well the past couple of years and the Doe’s want to upgrade their lifestyle into a bigger house.

So they find one. And come to your bank to finance it.

Your bank has a robust menu of mortgage loan programs. And the Doe’s are pushing their limit on loan-to-value, and debt-to-income. But based on the last two bumper years at the bike shop, they are feeling pretty good about their future and moving to a new, tony neighborhood.

You recognize that the Doe’s business is cyclical, and suffers revenue setbacks during recessions. Their ability to service the mortgage payments on their dream home would be significantly impaired if their revenue dropped as little as 20%.

But they would qualify for the mortgage with one of your loan programs. Since your bank sells the mortgage to investors, and you would meet the investor’s underwriting criteria, the risk of the Doe’s defaulting would fall on the investor. And your mortgage originators only get paid on closed loans.

Do you do the loan?

How it should be…

A relationship driven bank would be concerned about more than the risk of the investor putting back the loan to the bank. It should be concerned about the potential downward spiral of the Doe’s should the bike shop befall hard times and they can no longer service the mortgage.

The Doe’s are not the financial experts that know what would happen if they can’t make the mortgage payments. You are.

So you counsel them on the pitfalls of pushing their financial limits to live in a large home. Values of larger homes fall more in recessions because buyers become scarce. So if they can’t make payments due to a recession impacting their bike shop, they may not be able to sell their home at its current value either.

You tell them to look at past recessions, and the bike shop’s decline in revenue. And look at homes where they can sustain the mortgage in hard times.

I’m not suggesting telling them no, you won’t do it. But be the financial counselor your strategic plan wants you to be. The Doe’s may not appreciate your advice initially. But you would be their trusted advisor for a long, long time.

Or you can put them in that new high LTV loan program from your aggressive investor so you can pay your originator and hit the budget.

How should it be?

~ Jeff

Don't Bank. SoFi

After its most recent capital raise in September, SoFi, a marketplace lender that focuses on millennials, has raised nearly $1.5 billion in equity capital since its founding in 2011. By comparison, over 100 year old and $7.7 billion in asset Union Bank & Trust in Virginia had $1.1 billion in equity capital, with a market capitalization close to book value. 

Since 2011, SoFi has funded over $6 billion in loans (through December 15, 2015). And today, they are embarked on a campaign against banks.

Warren Buffett was right when he said "You never know who's swimming naked until the tide goes out." SoFi started in 2011, so the tide has not yet gone out on them. Like most marketplace lenders, SoFi claims a borrower risk rating system that is better than the FICO score. And in fact, is claiming a FICO score free zone. How good is their system compared to FICO, or other FinTechs that feel they are more evolved in credit risk management? We don't know. And I suspect we won't know. Until the next time the tide goes out.

Remember during the depression when the National Housing Act of 1934 created the Federal Housing Administration (FHA). Perhaps not. But during the depression, the typical mortgage was a five year balloon. So when 1/3 of borrowers lost their jobs, they were unable to re-finance when their balloon came due. Forcing them out of their homes. In came the FHA, with mortgage insurance to protect lenders, and the beginning of what is now a 30-year mortgage with a significant secondary market.

The secondary market removes unpalatable interest rate risk from financial institutions' balance sheets. Similarly, SBA guarantees reduce risk for small business lending. Reducing risk by transferring it to someone else is not new.

Marketplace lenders reduce risk for their loans similar to how financial institutions do it for mortgages and small business loans. They transfer it to investors. Many of the investors are other financial institutions! 

Sure, the originating institution retains some risk. I'm not privileged to see the contracts and know if there is recourse back to marketplace lenders for their loans. For financial institutions originating and selling residential mortgages, they retain some risk for early pre-payments or early defaults up to a certain point in time. And for fraud without a time limit. Absent those items, mortgages sold in the secondary market are at the risk of the investors.

So, too, I would suspect is the risk to SoFi and other marketplace lenders. Meaning the lion's share of SoFi swimming naked when the tide goes out is born by those that buy those loans. It is an agency problem that we saw before, in the 2007-08 mortgage crisis, when mortgage brokers and bankers, knowing they were transferring risk, pushed all sorts of loans through the system, so long as they adhered, however loosely, to the investors' underwriting criteria. What was best for the borrower was an after thought, in many cases.

Each recession is different. And certain asset classes are affected differently. In 2007-08, the first asset class impacted was residential mortgages. Banks likely felt it more in their investment portfolio as they were chock full of collateralized mortgage obligations and mortgage backed securities. Fannie Mae preferreds, anyone? 

Next recession may be different. And it will be interesting to see how the portfolios generated by these marketplace lenders perform. And who would actually own those portfolios should they tumble.

Maybe we can create another agency like the CFPB! Something to look forward to.

~ Jeff

Buy Versus Build for Financial Institutions

If I mention "buy versus build" to a bank CFO friend one more time, he's going to punch me. Why do I keep bringing it up? Because the potential acquisition targets that are available don't fit his bank's strategy very nicely. Not even like OJ's glove. So I ask, did you think about building your own franchise in the geographies that you want?

Talk to the hand. 

Acquisition pricing is on the rise. It may be tempered somewhat by the general market decline this year, but the pressure is definitely upward. And would-be acquirers are feeling it. Should they bid high, increasing tangible book dilution, decreasing earnings accretion, and reducing the deal's internal rate of return? Or should they sit on the sideline and run the risk that all of their potential acquisition partners go to competitors?

And sometimes the targets are not prizes. So I ask, if you could have the franchise you want, in the geographies you want, would you do it?

This, of course, speaks to building one. And I think bankers ought to go through this exercise when considering submitting bids on targets. What would it cost and what would be the return to build it ourselves?

I did a sample analysis with the accompanying table. I used an extended period, 10 years, to reach more mature profit numbers of a build it yourself franchise. I assumed either buying a $1 billion in assets bank, or building a similar franchise in the geographies that were consistent with your strategic plan. All "build" branches, and I assumed 13 of them, would cost $500,000 each in leasehold improvements and FF&E for leased branches.

Now I see why bankers are favoring buy. The buy scenario, because you start with $1 billion in assets spewing earnings, plus the traditional transaction cost savings (I assumed 30% pre-tax), delivers profits immediately and throughout the projection period, delivering far superior NPV.

The build scenario takes a while to get off of the ground.

The NPV and ROI numbers at the bottom of the table should not be the end of the story. When a bank buys another, it typically uses its stock as part of the consideration. The premium in our example is $60 million. But the total consideration is $150 million. If your stock traded at $20, and you used all stock, you would issue 7.5 million shares in the buy scenario. Breaking down profits per share may be a different story. Tangible book dilution would also favor the build scenario.  

I should also note that I did not tax effect the Leasehold Improvements and FF&E expenditures. They do count as operating expenses over time but are capitalized and expensed over their useful lives. So I took the conservative approach.

When you build, you select the locations, employees, and markets. Maintaining your culture is easier, as opposed to acquiring an existing culture. 

One reason to buy versus build, however, is the accounting treatment. Sad, but true. The transaction expenses are mostly expensed immediately upon transaction consummation, and do not impact the bank in the next quarter or subsequent periods. The premium paid over the target's book value is mostly put into goodwill on the buyer's balance sheet and is never expensed so long as the buyer suffers no impairment on the acquired franchise. So any "investment" in an acquired franchise has little tail effects on the acquiror's income statement, with the exception of the per share numbers, mentioned above.

The build scenario, on the other hand, can be said to inflict pain over multiple periods. Because the investment and operating losses run through the income statement, albeit over time for the leasehold improvements and FF&E. So senior executives tend to favor buying, so they don't have the long hangover of building it themselves. 

Am I missing something?

Do you run a buy versus build analysis when considering a strategic entry into new geographies? Because target prices are getting higher.

~ Jeff

Why Does a Fintech Darling Need a Bank?

According to a recent American Banker article, WSFS Financial Corporation struck a deal with Zenbanx, a Silicon Valley-based neobank, mobile only player. Zenbanx offers a unique, multi-currency bank account that targets world travelers or those that frequently send money overseas. Its founder is Arkadi Kuhlmann, the former CEO of ING Direct. 

Arkadi was a frequent speaker on the FinTech rubber chicken circuit, being viewed as a visionary industry disruptor. 

I suppose he was. First online bank, the imminently recognizable Orange Account, yadda yadda yadda. Mr. Kuhlmann has basked in the Orange glory. Except the bank never achieved greater than a 0.55% ROA and a 6% ROE. Say what you will about ING Bank USA, but don't say it was very profitable. And it sold in 2012 for around book value. So its brand didn't blow away its buyer, Capital One, either.

But I digress. The point of this post, and I do have one, is that Zenbanx needed a bank to get off of the ground. Should we be surprised? The much lauded Simple sold to a bank (BBVA). Moven account holders use CBW Bank, a small $22 million in asset bank based in Kansas. Fee income driven by interchange fees account for 96% of CBW's revenues. That bank has an 8.90% ROA. You read that right. If Moven driven deposits keep coming in, CBW may have to raise capital to support the balance sheet.

There are others that are part of a bank or rely on them to distribute their wares. See the table from SNL Securities regarding various features of online accounts from FinTech and banks alike.

Why do FinTech firms rush to banks? I have my opinions. Leading among them is deposit insurance. Followed by regulation. With a firm dose of capital. Banks have or are well-schooled in all three. FinTech firms are not and do not. So they seek out relationships with financial institutions, and build a business model that can live on parts of the payment system, ceding other parts to their bank partners.

Banks get a slice of the payment stream, as in CBW's case. And they get the spread from balances being delivered by FinTech "disruptors", like Zenbanx. The risk is that these disruptors become wildly popular, and start to over-take the partner bank's traditional balance sheet, turning it into something it is not and does not wish to be.

That was my first reaction to the announced Zenbanx-WSFS deal. WSFS has fared well since its near failure during the early 90's S&L crisis, and weathered the 2007-08 recession relatively unscathed. And they entered the partnership carefully, keeping regulators fully apprised of the relationship so they hopefully don't run afoul of BSA-AML laws and regulations. The bank has done well as a community bank.

Let's hope after their FinTech partner becomes more mature, WSFS remains a community bank.

~ Jeff 

The Sun Sets on the ABA's National Conference for Community Bankers

On February 14-17 the American Bankers Association held their National Conference for Community Bankers. I made my first trip to the conference because I was asked to moderate a CEO Exchange, where bank CEOs sat, round-table style, discussing their most pressing issues.

The format was to first ask a couple of group questions. My first regarded attendees growth strategies. Did their markets support their growth aspirations? If not, do they intend to grow by expanding, taking market share from competitors, or merging. 

I would say the answers were yes, yes, and maybe, with only a small number stating they were exploring strategic combinations with like-sized institutions. I salute banks that forge forward independently. But perhaps considering a strategic alliance with a like-sized financial institution can give the combined institution greater resources to compete, and greater liquidity and possibly trading multiples for shareholders.

In terms of taking business from others, the primary, head nodding answer as to how to do it was apple pie. The community bank takes deposits from your community, and then lends into your community, with decision makers based here, where the financial institution's employees live, work, and volunteer.

The second group question regarded capital. Where would the smaller financial institution get its next injection of capital, should it need it? Most relied on retained earnings/profits, as expected. Some rely on a relatively small group of local investors, including employees and board members. Read my post on using an ESOP here. A minority were exploring subordinated notes, that can be issued at the holding company and down-streamed as common equity into the bank, should it need it.

After group questions, the Exchange turned to round-table discussions among the CEOs. Below are some of the questions addressed, and a summary of ideas on how to attack these challenges.

If you could make one change in law or regulation that would provide you with the greatest regulatory relief, what would it be?

• The CFPB should tailor their rules for appropriately sized financial institutions.
• Eliminate the right of rescission. Nobody uses it.
• Change the CTR threshold.
• Reduce the BSA workload.
• Disband the CFPB.
• Revise HMDA so it doesn't require so much bank resources.
• QM and TRID delays closing times and disproportionately impacts rural banks (makes mistakes punitive). 

Where is the greatest competition for loans?

• Credit Unions, Insurance Companies, and 3rd parties are competing for commercial real estate loans.
• Farm Credit, particularly in rural markets, are a significant threat to community banks.

Have you experienced a trend of easing underwriting standards over the past year?

• Commercial real estate loan spreads are shrinking.
• Competitors are lengthening loan terms (10yr fixed rate)
• Attendees are being more selective on these loans that are aggressively priced or structured.
• One reaction: make better use of 504s (SBA loans) to reduce risk.

How will you attract the next generation of leaders, employees, and customers?

• Employees: Pay aggressively. Give them increasing responsibility. Identify keepers early.
• Employees: Use stronger screening processes.
• Employees: Internship programs for college students.
• Employees: Have good wellness programs.
• Employees: Use them for process improvement/special project teams.
• Employees and customers: Target bounce-back millennials/ ones that leave the area but miss home and come back. 
• Customers: Put millennials in meaningful roles to attract millennial customers.
• Customers: Use technology such as text messaging to wish happy birthday, low balances, etc.

How are you assessing and managing cyber risk?

• Professional certifications.
• More aggressive testing.
• Customer education (i.e. wire transfer vulnerability, etc.)
• Have to make the resource commitment to manage it.
• Regulators frequently drive risk mitigation.
• FFIEC testing.

The above are simply bullet points for difficult challenges. This is why the round-table discussions surrounding these issues was so important to attendees. To get the full benefit, you will have to attend. 

It's not so bad. It was in Palm Desert this year and in Orlando next year! A welcome respite from winter, and beneficial exchange between community bank senior executives!

~ Jeff

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A Financial Institution Investment Banker Had Questions. Here Are My Answers.

My colleagues and I are frequent speakers at industry events. At one such event, a financial institution investment banker approached my colleague and handed him a list of questions he would like answered during his speech. My colleague gave it to me the next day, and I provided my answers thinking he wanted them. Not really. Just thought I would be interested in the questions. So I think: Blog Post!

The list of questions read like the script used to convince banks they can't go it alone. But I'm a cynic. And should give the investment banker the benefit of the doubt. Here we go...

1. What should a financial institution's target levels be in the following?

Return on Tangible Equity (ROTE): ROTE is a crap ratio. Not my term, but one told to me by a bank stock analyst, and I agree with him. If you don't want intangibles, don't do premium deals. If it was such a good deal, then measure ROE. ROTE is just an investment banker talking buyers into doing expensive deals and to not be accountable for the intangible.  

But to answer the ROE question, the long-term average should be >10%. Why? Because an investor in an equity security should expect a 10+% total return. So it serves as a proxy, of sorts. It is different, for each bank however. What if a bank trades at 125% of book? Then a slightly greater than 10% ROE would be required to deliver a 10% total return. It's math.

Note that I said long-term ROE because it should be better in a strong, expanding economy and worse in recessions AND periods of strategic investment. Dropping ROE to 8% to make strategic investments so the financial institution can elevate it to 11% makes total sense to the CEO and Board that manages for long-term performance. Not so much to the CEO and Board worried about his/her next analysts' call.

Tangible Equity/Assets: This depends on the financial institution's risk profile. They should calculate their unique "well-capitalized" by estimating the risk on their balance sheet per balance sheet item, now and as projected. I like the Basel III approach of setting a base level that they don't want to go below (4.5% in Basel III's case) with a 2.5% buffer in place in good times so when times are not so good, the buffer serves its purpose. But the risk buffer should be set by each institution based on the risk on their balance sheet and projected to be on their balance sheet. My guess is that if every bank did this, their target capital range (base + buffer) would be between 7%-9%.

ROA: Greater than 1% should be achievable by most financial institutions, as so many are currently doing it. For institutions with meaningful fee-based businesses, the number should be greater because a profitable fee-based business will deliver "return", without adding "assets".

Efficiency Ratio: This is totally dependent on the business model and growth trajectory. Not many investors complained about the old Commerce Bank (NJ) efficiency ratio of 70+% when they were delivering 20+% profit growth.

Organic Growth Rates: If they exceed their markets, then they are above average, right? So it depends, in large part on their markets. Earnings growth should exceed balance sheet growth. That's positive operating leverage that so many financial institutions struggle with. Earnings growth plus dividend yield should be close to or exceed 10%, in my opinion. If markets can't support it, expand, take it from the competition, or acquire!

2. What is the total non-interest expense to have full internal staffing? 

I have no idea how to answer this one Mr. Investment Banker.

3. What is a financial institution's cost of equity? 

I bet he was looking for a CAPM calculation, as I see this often in investment bankers' presentations. But no. I'm a simple man.

For slower growth, conservatively run banks I would estimate ~10%. For fast growth and/or banks pursuing a higher risk strategy, I would estimate 13%+ for common equity, as investors should demand more for that business model. For convertible preferred, I would estimate the coupon until the conversion date, then the cost of common equity. If it is not mandatorily convertible, then it's the coupon plus the cost of common equity mentioned above. Convertible preferreds are ridiculously expensive because they dilute common returns while sitting back clipping coupons, in my opinion.

4. What asset size is critical mass? 

You know when there is a rule, and someone throws up an exception to the rule that might represent 1% of the total universe subject to that rule? Banking has plenty of exceptions to the critical mass asset size estimates bandied about by bankers, consultants, and investment bankers. My firm's first podcast highlighted the average size of all Sub S banks in the US as $273 million. Small. Yet their average ROA was 1.36%. Sub S banks represent ~ 1/3 of all financial institutions in the US. 

So there are myriads of exceptions to the economies of scale conventional wisdom. I would say, however, that banks with <$500MM in total assets have unique challenges relating to technology investments, stock liquidity, and management succession that will make things difficult. They also suffer significant stock trading discounts to larger banks, even though they may perform better. The change in community bank shareholders from retail to institutional also works against smaller banks, as institutional shareholders typically have float requirements (i.e. so many shares must trade per day). That's where the small banks challenges lie, in my opinion. Not in their ability to deliver superior financial performance. Because they are doing it.

5. Should banks form a bank holding company (BHC)?

I've already taken up enough of my readers' time than to answer this boring investment banker question.

What are your opinions of the above questions?

~ Jeff