Guest Post: Quarterly Economic Commentary by Dorothy Jaworski

The third quarter of 2016 was relatively quiet after the surprise of the Brexit vote at the end of the second quarter.  There is a Presidential election coming and perhaps people are exhausted by it.  I cannot wait for the political TV ads to end.  But, either way, we will have a new President come January, 2017.  As far as the markets go, volatility has tamed down and prices respond to economic data releases and Fed speak, but not much else.  All I keep seeing is mixed economic data.  GDP for the 2Q16 was +1.4%, following +.8% in 1Q16.  Surely the 3Q16 will be better, but the 4Q16 will follow with a weak reading if it follows the typical pattern of the past several years.

There is NO momentum and really NO catalyst on the horizon to push GDP up above 2% to a more acceptable level, like 3% to 4%, except maybe Lady Gaga’s new album.  Job growth has been stronger than average at +1.7% each year since 2010, despite a declining labor force participation rate.  However, the job growth is not translating into higher consumer spending.  I think that job growth is symptomatic of weak productivity, which has risen by less than half of 1% from 2010 to 2015, compared to an average annual growth of 1.5% from WWII to 2009.

Our Federal Reserve keeps talking about raising interest rates.  Why?  Maybe they believe they must because rates are so low.  I think they are overlooking the fundamental causes of the weak growth - low rate environment- the high debt-to-GDP ratios- involving government, corporate, and consumer debt- and existing in every major country in the world.

Government Debt

Debt keeps mounting, especially government debt.  Let’s look at the US.  In the past 10 years, $7.9 trillion was borrowed to cover deficits but debt increased by $11 trillion, if other “spending” projects are included.  The Congressional Budget Office projects deficits at $9.2 trillion in the next 10 years and total debt issued to be another $13 trillion!  We are already over the 100% debt-to-GDP level that causes indigestion.  Other countries are in the same boat- Japan, China, all of Europe, and Australia.  Why do I write about this debt?  Because it is the high government debt levels that are crowding out private sector investment and that are pushing GDP and interest rates lower.  High government debt levels are hurting productivity, corporate profits, industrial production, and consumer spending.

Government spending is also crowding out consumers and businesses.  Recently, I have read Dr. Lacy Hunt’s materials and seen the research that shows that government spending is actually creating a negative multiplier; that is, every dollar of government spending is hurting GDP growth.  As government spending rises, GDP has fallen along with investment and productivity.  All we need to do is look around; we are living it. 

Investment managers are sitting on a near record level of cash in their funds, currently at 5.8%.  Banks are sitting on huge reserves at the Fed.  We are stuck in this endless liquidity trap for now.  So what does it mean?  Slow growth and low rates should continue.

The Fed

Someone said to me that if the Fed doesn’t raise rates now, they won’t have any tools later to use to fight recession, when it comes.  I disagree.  The Fed can use Quantitative Easing, or “QE,” again to buy bonds to keep rates low.  Janet Yellen recently said she is open to the notion of purchasing corporate debt, as is being done by the ECB in Europe, provided that Congress agrees and approves it with legislation.  Another tool that was fairly effective in the years after 2008 was Forward Guidance, which involved Fed promises to keep rates low until specific dates in the future; this tool was one of Ben Bernanke’s faves.  There is also the negative interest rate path, tried by other countries, but unproven so far.

I have noticed that the future inflation gauge published by ECRI has been rising steadily for months, with increases being larger on a year-over-year basis.  The gauge tries to forecast inflation six to nine months from now and things would be bleak if the projections came true.  I am sure the Fed has taken notice, and they, like myself, are trying to figure out if this is transitory.  I believe that it is, because the producer price index is still low and prices are not yet ready to flow through to consumers, despite higher than average increases in wages.  Average hourly earnings have risen 2.6% compared to last year.  Another factor worth noting is that gold prices have risen 19% year-to-date in 2016, but are off their worst levels; this commodity could be a safe haven for Brits fleeing Brexit.  Inflation is not a problem right now; getting GDP growth to exceed 2% certainly is.

Summary

Rates are low for several reasons- low economic growth, high debt-to-GDP levels, low inflation, and low productivity.  What do I see as I look out into 2017?  Low growth, low rates, no momentum, and high debt levels will continue to dominate.  I don’t believe inflation is an imminent threat because growth is so weak.  The Fed doesn’t either, as they project inflation to be under 2.0% into 2018.  Most notably, they seem to agree with me that economic growth will continue to be low.  Or is it that I agree with them?  Stay tuned!

Thanks for reading!   10/24/16

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 Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

Five Challenges to Your Bank of the Future and Ideas to Overcome Them

I recently spoke at a Financial Managers' Society (FMS) breakfast meeting on this subject and thought I would share my comments with you.

With all of our anguish, torment, debate, and deliberation about the future of our country, our industry, and our bank, here are some common themes that I have been seeing that can be improved should bank management commit to making them happen.

Forget the things outside of your control. These five themes are firmly within your ability to make a positive impact on your future.

1. We merge, citing economies of scale, but fail to realize them. In 2006, when the median asset size within my firm's profitability outsourcing service was $696 million, the operating cost per business checking account was $586 per year. In 2016, the median sized financial institution is $1.1 billion, and the operating cost per business checking account is $710. In other words, the financial institutions grew, and the cost per account grew. This is the theme across nearly every product category. Don't believe me, check your banks' expense ratio (operating expense/average assets) or efficiency ratio as you grew.

Idea: Create measurable incentives to support centers to provide more efficient support to profit centers and for risk mitigation. For example, deposit operations' expense as a percent of deposits should decline as the bank grows. Loan servicing expense as a percent of the loan portfolio should do the same. 

2. We over-invest in under-performing branches. I recently mentioned to a community bank management team that community financial institutions are slower to close branches because their decision making goes beyond the spreadsheet and market potential. Community bankers know the town mayor, and key business leaders. So they worry about other things that go beyond the fact that their branch in that market has little chance of being profitable. But allowing branches to operate at losses takes resources away from areas that need immediate resources, such as technology acquisition and deployment.

Idea: Develop objective analyses for entering markets. If the branch does not meet profit objectives within a reasonable period represented in the original analysis to open it, close it. Make it near-automatic.

3. Our brand awareness and customer acquisition strategy is moving at a turtle's pace, not the hare pace of the industry. In my firm's most recent podcast, we discussed the recently released FDIC Summary of Deposits data that showed, with all of the negative press surrounding large financial institutions, FDIC-insured banks with greater than $10 billion in assets moved from an 80.6% deposit market share in 2012 to an 80.7% today. This phenomenon was brought home when a banker told me that, in the Philly suburbs, Ally Bank was the most recognizable banking brand. Aren't they still owned by our government? 

Idea: Develop a clear message on what your bank represents and align your culture, and all sales and marketing channels to deliver your value proposition. 

4. We embrace complexity when we should be seeking simplicity. The decline in defined benefit pension plans combined with the increases in defined contribution (401k) plans, the abysmally low US savings rate (31% of non-retired people have no retirement savings), and the increasing complexity of running family and business finances presents an opportunity for community financial institutions to make their customers' lives simpler. We should start with ourselves. For example, when onboarding a customer, an FI can perform needs assessments, risk assessments (needed for risk management purposes), and customer capital allocation needs all at once, and add value to the customer relationship. 

Idea: At account opening, build an automated business process that includes the needed Q&A to assess customer needs that spurs post-account opening follow up, know-your-customer information, and risk assessments required to risk rate customers that assigns a rating that drives capital allocations to that customers' balances and rolls up to determine the bank's capital requirements.

5. We under-invest in the people that can build our bank. Because of over-investment in areas such as regulation and unprofitable branches, we under-invest in elevating the abilities of our employees to serve as advisers to customers, as highlighted above. Also, we tend to buy key people on the street, such as commercial lenders, rather than raising them within our bank, because of the time and resource investment needed to turn junior level people into productive commercial lenders.

Idea: Build a bankwide university that includes on-the-job training, web-based seminars, in-person training, and banking schools to create career paths for junior-level people that will reduce our need to buy senior-level people on the street, and elevate the skill sets of employees to actually advise customers, rather than only sell to them.

If I were to end this post with a theme, it would be urgency. We are past the time to lament about the interest rate and economic environment, and Dodd-Frank. They are outside of our control.

We are intuitively aware of the above challenges. The good news is we can do something about them. Address them this year, this month... no, this week! And your bank will move forward to an independent future for your employees, customers, and community. 

Did I miss any challenges within our control?

~ Jeff

Evolution of Banking: Three Slam Dunk Predictions

The sheer number of strategic initiatives and technologies in the banking industry makes it very difficult to predict outcomes with any certainty. Not that me or other industry pundits don’t try.

I have been noticing some trends that are providing insights on our direction, evolution, and ultimate picture of our future.

Future Picture was coined by the US Military for defining flight mission success, and was brought to business prominence in Air Force pilot James D. Murphy's 2005 book, Flawless Execution.  Using his example of envisioning what success would look like, a bank’s Future Picture should be a detailed description of successful execution of strategy. I challenge bankers’ to describe their Future Picture.

It can be highly subjective and difficult, particularly in an era of unprecedented change. But I would like to share three strategic directions where the train has either left the station, or is boarding.

1. Branches must be larger to survive. According to my firm’s profitability database, branches generated revenue (defined as consumer loan spreads, deposit spreads, and fees) as a percent of branch deposits of 3.50% in 2006. Today, that number is 2.08% due to the interest rate environment, the regulatory environment (reducing deposit fees), and customer behavioral changes. Therefore, the average deposit size of branches grew, to over $60 million at the end of 2015 (see chart). This trend is not likely to change, as bankers are more apt to prune their network and increase overall branch profitability. And the customer. Don’t forget them. They use branches less, although many still identify branch location as important to bank selection.

2.  Technology expenditures will grow faster than overall expenditures. I recently performed this analysis for a client, identifying the “Data Processing” expense as a percent of total operating expenses for all FDIC insured banks as identified in their call report. Surprisingly, it represented only 4% of total operating expense.  Note this excludes IT personnel expense. But the number is growing faster than overall operating expense (see chart), meaning that IT expense is becoming a larger proportion of operating expense. It is disappointing that this trend is slowing so banks can meet their budgets and profit objectives, regressing back to old habits of cutting IT projects to make budget. But overall, banks are seriously evaluating technology to improve efficiencies and their clients’ banking experience.

3.   Robotics are coming. It was only recently I began to believe this. But there are opportunities being evaluated and implemented to automate repetitive processes to reduce overall costs, minimize risk, and speed the process. A couple examples where automation and/or robotics are ripe to improve processes include reviewing remote deposit checks, currently eye-balled by humans. Not scalable. The x-point evaluation could more quickly and effectively be accomplished by a robot. Another area where automation is coming is BSA case evaluation, where the bank’s BSA application identifies potentially high-risk client activity and a program goes through several standardized checks to clear the case or elevate it for human intervention, reducing the overall number of cases needing human review.

These aren’t the only changes. Just the ones that I believe are coming, no matter who tries to stop them.

So why try to stop them?

~ Jeff

Thank You Mr. Stumpf!

Bank reputations were on the rise. After the financial crisis of 2007-08, led by making mortgage loans to people that had little resources to repay them, banks were climbing from the reputational abyss.

Then came September 8th, when the Consumer Financial Protection Bureau (CFPB), and the Office of the Comptroller of the Currency (OCC) jointly announced the issuance of a consent order to Wells Fargo that included $185 million in fines due to the widespread, illegal practice of secretly opening up customer accounts without the customers' consent. Fifty million of the settlement was to go to the City and County of Los Angeles, which brought a lawsuit against the bank a year ago for the same charge. For further discussion among my colleagues on this subject, click here for our podcast.

And the stench of that little news item is likely to sully the reputations of financial institutions across the country. Don't believe me? How many subprime mortgages did you make where your customers had little hope of repaying? And did the bursting of the housing bubble hurt your bank's reputation? 

Wells Fargo is so large, that many people view them as a proxy for the whole banking industry. Much like Apple or Samsung might be viewed as a proxy for the whole smart phone industry.

What does reputation get you? For Wells Fargo, it gets you $32.9 billion. Or lost them $32.9 billion. That is the decline in market value they suffered from August 31st to this writing. Thirteen percent of their market value, vanished like a puff of smoke in the wind.

According to Cutting Edge PR, sources of information that impact influencers (CEOs, senior business execs, analysts, institutional investors, etc.) are as follows:

Source of Information                          Proportion

Personal experience                                  64%

Major business magazines                        37%

Articles in national newspapers                35%

Word of mouth                                          31%

Articles in trade journals                           30%

Television news                                         14%

Articles in local newspapers                      14%

Television current affairs programs           13%

Is Wells Fargo lighting up the newswire? Yes. Will commentators start dropping Wells Fargo from the discussion and start generalizing that this is typical bank practices? I have little doubt.

I said it before in a previous post on branch incentives, and I'll say it again. Bankers should hold business line managers accountable for the service levels, profitability, and profit trends of their business units. When you begin to drill down and start measuring widgets, employees will gravitate to finding widgets. Which is exactly what Wells Fargo did.

And if you think this culture started recently. Guess again. Google the much lionized former Norwest and Wells Fargo CEO Dick Kovacevich that touted the "eight is great" cross-sell ratio. Stumpf has worked for Norwest/Wells for thirty four years. 

I guess eight isn't so great after all.

And the Schleprock cloud hovers above us all.

Thank you Mr. Stumpf.

~ Jeff             

Bankers: Bring On The Change

On the shores of the Ammonoosuc River, alongside the hotel where the famous Bretton Woods conference took place in 1944, I talk about the onslaught of change that has recently occurred, and will continue to occur in our industry.

Change: Is your institution ignoring it, trying to stop it, or adapting to it?

How much grief will I get comparing employees to beavers?

Politics: Can We All Just Get Along?

I do not venture into politics much, either in this blog or in person. But our environment is so toxic, I would like to take a crack at identifying shared goals by most of us.

1. We all want to reduce the number of impoverished people. We have different ideas on how to do it. I think capitalism is a better solution than socialism, as the latter creates so much more of an underclass. Except for the bureaucrats. They tend to do well in socialism. The more you disperse economic power in a society, the better, in my opinion.

2. Many successful capitalists turn into jerks. I think, by and large, this is because they want to solidify their position, and the by-product is keeping others from achieving it. That is why in large corporations executives might make it difficult for up and comers, fearing they might be unseated by them. This is also why top executives get paid so much. I wouldn't stop companies from paying executives so much, but would insist on transparency and not allow a company to deduct executive comp that is greater than some multiple of company average compensation on their Federal taxes. But better to have many, many successful capitalists, than a few successful bureaucrats. Successful capitalists are the "do-ers" of society. They create jobs. Not government. If you don't trust me on this, study economics. At most colleges. Not all. I also want to encourage a society where capitalists do well, and give their excess to charitable endeavors. Like Warren Buffet is trying to make happen.

3. Our tax system is way too complex. I would make the personal and corporate marginal tax rate the same. Somewhere around 20%. I put a simple tax solution in a post way back in 2012. See it here. This will cause disruption among accountants and tax lawyers. Taxes would be so easy and transparent, these professionals wouldn't be needed by individuals or corporations. Think of all the tax compliance savings!

4. Government spending. Until we reverse the alarming trend of national debt to GDP, we must spend less than revenue growth, and balanced budgets have to be the norm rather than the exception. I wouldn't do a balanced budget amendment, because elevating infrastructure investments and spending during recessionary periods makes sense to me. But until that time, Federal spending growth should be less than GDP growth. Oh, and the last balanced budget under President Clinton was spurred, in part, by Pay-Go. That system where new "programs" would have to be paid for by eliminating other programs that cost the same or more. I would put that structural discipline in place right away.

5. Federal government operation. Our rules are ridiculous. Bills would be cleaner, and more linear. No slapping on stupid amendments for pork. If it has enough support, have the pork get its own bill. And bringing a bill to the floor for vote would be easier. One requirement I would insist on is having a litmus test for programs designed to help society. If they don't meet a pre-agreed upon social objective over a reasonable time period, they automatically die. No vote needed. We tried to fix a social ill. It didn't work. Let's move on. And not worry about those that lose funding sending out press releases that we don't care "for the children".

6. Speaking about lawmaking, there are way too many laws and regulations for society to follow. Nobody, and I mean nobody, knows them all. In fact, most if not all of us break the law every day. This creates a ripe environment for tyranny, that we see playing out in front of our eyes. Don't like someone? Figure out a law they broke and go after 'em. Think about it. If I were in charge, there would be less, and the objective would be far less, rules and regs to follow, reducing the ability of powerful law enforcement and government bureaucrats to move against its citizens. And making it easier to enforce and comply, both individually and economically. Watch the bureaucrats squirm about this one.

7. World relations. We want to influence societies to be free. But our own freedoms are being eroded by the growing body of laws and regs, mentioned above, and political correctness which has curtailed our ability to solve problems. So we should take care of our own problems to show the world that, as our society matures, we make corrections to enhance freedom. And create a worthy example that other countries would like to emulate. But dictators. We have to be active in keeping them in check. If we were isolationist, our world would be a different, and much worse place, in my opinion. But our international forays would be selective, proportional, and  given the resources and the fortitude to win. Isolated cells of terrorists need not worry about a US Army battalion. But they would have to worry if they actively seek to harm our citizens. Their end will not be pleasant. But it may not be all over the news media, either. Oh, and trade. Free trade works. Few economists believe otherwise. The rub is that they must be enforceable and punitive for cheaters, making cheating so unpalatable that parties to the agreements abide by what they signed. There is a lot of angst against free trade now, but as a society we voted for free trade by buying less expensive stuff that must be made by labor that is less expensive than our own. And lets face it, union work rules made us noncompetitive in manufacturing. Shame on us.

8. Elections. Any candidate that wants to run for office, must complete a two-page resume to a non-partisan website. Page one denotes the candidate's experience. Page two has the candidate's answers to five key questions for the office sought (i.e. federal questions for federal office), in 50 words or less for each question. This is so voters like me can review candidate's qualifications and positions before getting into the voting booth. In PA, where I live, there is a tough US Senate race underway, and the ads the candidates run are ridiculously irrelevant and designed to stir up emotion, and not make us better voters. I say ignore that idiocy. Read the two-page, vote smartly.

9. Safety Net. I'm all for a transitional safety net to help our fellow citizens pick themselves up and get on their feet again. I'm all against turning families into lifelong government dependents, which I think is the consequence of a safety net without the transitional philosophy. If someone hurts their elbow and can no longer do the manual job they once did, we don't re-train to do other jobs not dependent on the elbow. We put them on disability for life. C'mon. This makes so much common sense, that the cynic in me thinks those that support lifelong government assistance (either in word or deed) are just bribing people for their vote using other peoples' money. And relegating the lifelong "drawers" to the lower economic rung for life. Sad.

Why doesn't the media cover much of the above? Instead, they assemble a panel of talking heads to discuss a tweet. 

Not sure there would be many that object to the above. Ok, accountants and lawyers, and union leaders. Other than them, why is everyone else shouting at each other?

Who's onboard?

~ Jeff

Board Composition: What Does the Best Bank Board Look Like?

In April 2016, Delaware Place Bank in Chicago was placed under a Consent Order (CO). One article within the order read as follows:

"the Bank shall retain an independent third party acceptable to the Regional Director of the FDIC’s Chicago Regional Office (“Regional Director”) and the Division, who will develop a written analysis and assessment of the Bank’s management needs (“Management Study”) to evaluate the management of the Bank."

This is a common article and my firm performs several of these annually. The CO went on to say:

"As of the effective date of this ORDER, the board of directors shall increase its participation in the affairs of the Bank, assuming full responsibility for the approval of sound policies and objectives and for the supervision of all of the Bank’s activities, consistent with the role and expertise commonly expected for directors of banks of comparable size."

In the same article, the CO compelled the bank to elect an additional director with banking experience. And there lies the rub. By including this provision, the unwritten assumption was that appointing a director with banking experience will make this bank more safe and sound.

Will it? Is there evidence that proves it is so?

What makes an effective banking board? Is there one recipe?

We are often asked this question, either formally (through a Management Study or Board evaluation engagement) or informally, And the answer is, it depends.

It depends on the bank's strategy, geography, risk parameters, and personalities of existing board members. I have seen banks with former regulators on the board fail, and banks with farmers on their board thrive. I do not think there is one answer for all.

To further my point, I evaluated publicly traded, SEC registered banking companies between $500 million to $3 billion in total assets. I searched for the best, and not so much, ROE banks based on their five-year average ROEs. I excluded banks that had negative ROEs, recently converted during that five years from the mutual form (which elevates their "E"), or had standard deviations greater than 4 from their five-year ROE. In other words, they were consistently good, or consistently bad.

Then I reviewed their board composition. The top six results are as follows.

How does this differ from the bottom six? See their board composition below.

There were retired bankers in three of the six top performing banks. Wait! There were retired bankers in three of the six bottom performers. CPAs, another common piece of expertise desired on a high performing board, were on all six bottom performing banks. CPAs were only on two of the six top performing banks (assuming the CFO was a CPA, which was not mentioned in their bio). Attorneys were on four of six top and bottom performing bank boards.

The prize for most board billable hours goes to Robert Gaughen Jr., and Randy Black, CEOs of Hingham Institute for Savings and Citizens Financial Services, respectively, for having the most attorneys on their board. Perhaps the answer is not only have an attorney on the board, but lots of them.

There were no former regulators on the boards of the above banks. At least they wouldn't admit to it in their bio.

The point of this review is that there is no one answer as to what makes a good functioning board. In my experience, a board that maintains management accountability for business performance and ensures management operates within the risk guidelines established by the board and commemorated in bank policy, is a good performing board. It doesn't matter if that board includes a baker or candle stick maker.

What do you think makes a high performing bank board?

~ Jeff


P.S. I received an e-mail from a banker asking me the insider ownership of the above banks. So here you go! The bottom performing banks have a greater level of insider ownership. And from eye balling it, the bottom performing banks have a greater level of institutional ownership too.