The title of the E.F. Schumacher book “Small is Beautiful” best articulates the argument that bigger may not be better. There’s no mistaking the fact that efficiency ratios and size have a negative correlation. Surprised?
Community banks are doing a bang-up job when it comes to controlling the largest expense line in a bank—people. Unlike the larger global banks that seem inclined to hire-and-fire as a knee-jerk approach to controlling staff costs, community banks are a shining example of how to get it right. In fact, the big banks have a few lessons to learn from their smaller counterparts in this area.
This is evident when you compare the efficiency ratios of community banks to the larger banks.
Efficiency ratios are a good way of measuring how a bank is doing from a revenue-to-expense perspective and here the community banks have done an outstanding job of managing costs well. Also, their locational advantage in the burbs and serving the communities there in a focused manner needs to be acknowledged and large banks can learn from this approach to the small- and medium-sized customers.
The average efficiency ratio of the top 200 community banks in the third quarter 2012 at 50 percent was significantly better than JPMorgan Chase & Co. (63 percent), Bank of America (77 percent), Citi (73 percent) and Wells Fargo & Co. (58 percent) at the end of 2012.
That said, lack of size and lack of a critical mass of transactions are drawbacks when it comes to optimizing operations and technology costs. In general, since people and real estate costs tend to be low in the locales where community banks operate, the strategy has been to replace people with people instead of people with technology. While this approach has withstood the test of time, it remains to be seen whether it will continue to be successful – especially in a world where consumers are demanding better banking products and savvier technologies, and millennials are emerging as the largest customer base for retail banking.
Let’s consider the cost of technology and how size affects strategy. Take the case of voice biometrics, a multi-channel approach to customer service whereby one platform self-serves customers’ needs for voice, email, text, chat and fax. It costs between $100,000 to $150,000 to deploy a voice biometrics technology. But in the absence of a large transaction base that can benefit from this technology, it becomes a wasteful mechanism to bring this type of technology in-house and smaller banks end up hiring more internal staff to service customers. While that is not a bad move from a short term return perspective, it’s not a strategy for the long haul. Customers today (thanks to Apple and similar companies) are gradually demanding better ways to be served by institutions that offer the latest technologies and enable day-to-day tasks like mobile banking.
Consider, too, how size affects the ability to incorporate an analytics platform, an essential tool that provides everything from customer lifetime value to pricing sensitivities or churn management. Again, this technology costs a few hundred thousand dollars, an expense that many community banks cannot justify. Unable to embrace these techniques, these institution remain locked in the same orbit while bigger banks are able to more accurately price, segment and gather key information about their customers. This helps them better serve their target customers.
While it is tough to assign a number to what size is right, it seems that banks at $5 billion and above have a better chance at embracing leading-edge technologies and operations processes—and, as an outcome of deploying superior processes, are able to achieve significant operations and technology improvements. So, what is the solution for smaller community banks? Here are some suggestions:
- Look for size elsewhere. If M&A is not an option to pool resources, look into a variety of service providers, such as Fiserv and Sutherland Global Services, which are able to extend their efficiencies of scale and operations to smaller community banks, based on global aggregated demand for these services.
- Look at buying a service wrapped with a technology, rather than buying a technology. This ensures the blended unit cost of getting both the service and the technology is low.
- Use long-term variable contracts as a technique to keep short-term pricing low, but build into the contract the language to ensure poor performance is penalized.
- Ensure that a Project Management Office (PMO) that will serve your needs in operations and technology is part of any technology service contract.
Community banks have consistently been the most important driver of economic activity in the US. When they become more efficient from an operations and technology perspective, they are a growing tide that buoys other small banks across the industry. Size and efficiencies do have a correlation, and it is very important for community banks to embrace modern techniques of managing operations and technology. By definition, community banks are small and “Small is Beautiful” indeed.