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Magazine : Archives : 3rd Quarter 2011

Death By Strategy

July 21st, 2011 |

In the years prior to the 2008 financial crisis, was it possible for the boards of directors at U.S. banks and thrifts to determine whether their bank was heading for the cliff? First Manhattan Consulting Group believes that boards can learn from the financial crisis—indeed, it would be tragic if they did not—and improve their ability to exercise the fiduciary responsibility they have to shareholders.

The signs of trouble were evident from available regulatory data, if boards had known what to look for. We have identified several “alarm bells” that were predicting trouble ahead, but were often unappreciated. Our research found that banks with three or more alarm bells ringing between Q1 2005 to Q2 2007 incurred disastrous drops in stock price averaging 91 percent even though they were ranked highly by sell-side analysts in 2007.

While some banks pursued a problematic course, others were operating low risk/high return strategies. Regional banks adopting an approach we define as back to basics (BtB) were minimally impacted by the crisis. They generated a 75 percent cumulative increase in shareholder returns over a 10-year period from 2000 to 2010. In contrast, banks with strategies most different from a BtB formula saw a 60 percent average decline in shareholder value—or worse yet, failed.

Conversely, boards of banks that outperformed during the recent financial crisis clearly had a different mindset. First, they focused on different performance metrics and operated within constraints that others ignored. And second, they were not captivated by problematic measures that many equity analysts emphasize.

We advise that directors take a systematic approach to assessing their bank’s strategy including:

• Defining and monitoring alarm bells.

• Assessing the risk-return characteristics of units within the institution.

• Learning from low-risk, high-return banks.

In the remainder of this article, we will expand upon these points and illustrate how differences in strategy and risk management resulted in wide discrepancies in shareholder value over the cycle.

YOU BECOME WHAT YOU MEASURE

Selecting the right performance measures is more challenging than it appears. In fact, many of the metrics favored by sell-side analysts are problematic or even dangerous. We have correlated performance of the 70 largest regional-type banks on various metrics with shareholder value over the last decade. This work suggests that the board should parse metrics into different categories:

  • Metrics that are meritorious so long as they are not achieved by taking high risk. An example is overemphasis on earnings-per-share (EPS) growth. In the years leading up to the crisis, many banks that stretched to maximize EPS growth did so without understanding the implications of compromises being made to return on equity (ROE), the loan-to-deposit ratio—which impacted liquidity and net interest margins (NIM)—and risk-taking in troublesome loan categories.

Boards need to remember that stock prices are influenced by growth and profitability. For example, even in the risk quiescent period 1Q 2000 to 1Q 2007 before the crisis hit, back-to-basics banks focused on and sustained their ROE. Even though they had lower EPS growth than others, their return to shareholders was 50 percent higher than those that stretched for higher EPS at a sacrifice to ROE. One approach to stretching for higher EPS was to aggressively increase the ratio of loans to deposits. (We discuss this below in the section on alarm bells).

  • Performance measures that may appear logical but are not correlated with shareholder value. One example is market share. For example, after most M&A transactions, the acquirer emphasizes that the deal has improved its market share with statements like, “We were number four and now we’re number two!” It sounds like this should prove powerful. However, our multi-period analyses have found no evidence of a positive correlation between market share ranking and return to shareholders. For example, banks that were in the top three within their market had somewhat poorer stock performance in the 2005 to 2007 period then banks ranked lower in share. Why? The potential benefits of greater scale are outweighed by other factors, such as management’s ability to define a value proposition that is compelling to the customer.

A second example is fee income. For decades, analysts have emphasized the importance of fee income. And, for a small subset of banks with competencies in lower risk, high return sources of fee income this can be demonstrated. However, for most regional-type banks, this is not the case. During the period 2000 to 2007 leading up to the crisis, having a higher percent of income from fees was slightly negatively correlated with shareholder returns. How can this be? Some sources of fees carry higher risks, some require scale to yield margins, and some have unintended consequences. For example, one major source of fee income driver for many regional franchise banks was overdraft fees. When pursued aggressively these lead to customer dissatisfaction, higher churn, and lower organic-deposit growth.

MYTHS THAT DON’T STAND UP TO SCRUTINY

 How aligned are common sell-side analytic metrics to shareholder value creation?  FMCG compared a set of the 70 largest regional-type shareholder returns against such metrics and found surprising results. We found some things that should have set off alarm bells.

Banks were given an “alarm bell” if their performance was in the bottom third of the regional-type bank peer group during the pre-crisis period (defined as 1Q 2005 to 2Q 2007) on any of these measures:

  • Loan to core deposit ratio
  • Cost of deposits
  • Net charge off (NCO) volatility
  • Same-store deposit growth
  • Higher loan yields

The results are striking; the more “alarm bells” a bank had in the pre-crisis years, the further its stock performance fell from its peak. Those with no bells only lost 8 percent of their stock price from their peak in 2Q 2007 to 1Q 2011. Those with one bell fell 20 percent and those with two bells fell 24 percent. Finally, the 18 banks that had three or more bells incurred massive stock declines, and five failed. On average this group was down 93 percent from their peaks.

Surprisingly, more conservative banks with fewer alarm bells did not sacrifice stock performance in the pre-crisis period. For example, banks with fewer bells gained more value between 1Q 2000 and 2Q 2007 than those with more bells. Simply put, the back-to-basics banks achieved higher returns at lower risk in both stages of the cycle.

Does this make sense? Consider the following:

  • Loan-to-core deposit ratio. Banks that stretched for higher loan-to-core deposit ratios were more dependent on “hot money.” They were also less likely to be lending to their existing deposit relationship customers. Ultimately, this model increased the cost of funding, resulting in banks stretching for higher—which is to say riskier—asset yields to maintain margin. The result? Banks with a high loan-to-core-deposit ratio in 2000–2007 had much worse performance during the crisis. The 20 percent most conservative banks maintained a loan-to-core-deposit ratio of 87 percent from 2005 to 2007. In contrast, the most aggressive 20 percent of banks had aggressive loan-to-core-deposit ratios of 166 percent.  Their performance crashed, with a total shareholder return of a negative 67 percent. Those with other bells ringing as well did even worse.
  • Net charge off volatility. Having higher charge-off volatility in 2005 to 2007 was an “alarm bell” predicting greater shareholder losses in late 2007 and beyond.  Even though loan losses were low in this period, those with lumpy charge offs were signaling more severe problems to come.
  • Same-store deposit growth. This measure is analogous to the key metric for retailers, namely “comp same store sales.” While many assume that the variation in banks’ ability to grow deposits is small, this is not the case: The fastest 20 percent of regional banks grew their retail and small business deposits by 9 percent per year in the 2005 to 2007 interval, while the lowest 20 percent on this measure actually saw their deposits shrink by 1 percent per year. Without core deposit growth, it was easier to fall into the trap of expanding the loan-to-deposit ratio.
  • Loan yields. As a group, banks that achieved higher yields on their loans in 2005 to 2007 were not compensated for the incremental risk. Instead, banks that stretched for yield prior to the crisis were punished via higher charge offs.

THE CASE FOR A STRATEGY COMMITTEE

A high priority for boards is ensuring that the bank defines a strategy to achieve selected financial results while identifying and steering clear of “alarm bell” risks. We believe that a management-level committee forum, which we refer to as a STRATCO, can be effective. Some institutions flow STRATCO deliberation outcomes into the executive committee of the board and the risk committee of the board.

A key role for a STRATCO is assessing the strategy and financial structure of the institution. Some strategies are lower-risk and, perhaps surprisingly, offer high returns for those that build the necessary competencies.

  As noted above, grouping regional banks based on the strategies they have followed over the past decade is illuminating. While many observers perceive most regional banks as quite similar, our analysis reveals that there are material differences. And such variations can make a monumental difference in performance.

To illustrate, consider back-to-basics banking. As noted above, most banks that operated this BtB model delivered superior returns consistently throughout the last decade. Since this model involves many decisions that lower the risk profile of the bank, it was not surprising that BtB banks tended to materially outperform in the post-crisis period. What is surprising is that these same banks also outperformed during the “risk quiescent” period which ran from the first quarter of 2000 to the second quarter of 2007. They were lower risk, with higher returns in both phases of the cycle.

A STRATCO should define an appropriate set of alarm bell categories tailored to the bank, and set constraints for each. Once completed, the bank’s multi-year plan and quarterly results should be scrutinized for the possibility of undesirable consequences if bells start ringing. This effort should draw on insights that can be gained from defining subsets of banks that outperform with lower risks. This will often lead to changing the definition of which banks should be in the institution’s peer group.

 In addition, a STRATCO should oversee strategic planning and other related “levers” that impact shareholder value. A selection of issues includes:

  • Identifying opportunities that offer profitable revenue growth with acceptable risk.
  • Ensuring that the strategic planning process delivers useful outputs and decisions for the corporation, lines of business (LOB), and support areas.
  • Reviewing the risk-adjusted financial trajectory of each LOB relative to goals and assessing the progress of the corporation and LOBs relative to key initiatives.
  • Articulating how the bank will “win” in acquisitions, including fit requirements, pricing guidelines, success measures and integration principles.

A STRATCO should also oversee strategic risk issues, including:

  • Reviewing the business plans developed annually by each line of business for alignment with the bank’s risk appetite.
  • Overseeing ad hoc analyses on such issues as risk associated with entry into new markets and products.
  • Reviewing the competitive, economic and regulatory environments to identify new threats, such as the Dodd-Frank Act’s projected impact on multiple lines of business.
  • Looking at concentration of earnings issues.

To be successful, a STRATCO should be able to rely on risk-adjusted profitability reporting at the corporate, line of business and segment levels, as well as competitor pricing analysis and sensitivity analysis around the success of key strategic initiatives.

The financial crisis and the regulatory requirements in its aftermath have added new burdens to directors and management. Rather than simply executing new regulatory imperatives by rote, banks should seize the opportunity to develop and execute strategic plans that consider the right measures to pursue, and are mindful of the “alarm bells” that can give fair warning to a plan off course, before the consequences lead to underperformance—or a trip to bank heaven.  |BD|

James M. McCormick is president, William N. Callender a managing vice president and Andrew Frisbie a vice president at First Manhattan Consulting Group, a New York-based management consulting firm that has specialized in serving the financial services industry for more than 30 years on a wide range of top management issues addresssing strategy, marketing, risk management and technology.