Growth Strategies for Community Banks

Today’s banking environment affords diverse avenues for growth according to our third roundtable panel. Acquisitions, mergers of equals, de novo, and in-store branching are all options community banks may want to consider. The challenge is determining the best path and ensuring the road to growth remains in lockstep with the bank’s strategic goals.

BANK DIRECTOR: In addition to in-market bank acquisitions, can you discuss some of the various paths to growth that are most promising in today’s banking environment?

Steve Plevin: Some alternatives are single-branch acquisitions, de novo branching, and expanding the offering of nontraditional banking services. Over the past few years I’ve primarily seen the first two, and to a lesser extent, the third. For the most part, there weren’t too many whole-bank targets available, so expansion and desired growth came from acquiring branches or establishing new ones.

Jean-Luc Servat: Another one I would add is the acquisition of whole teams–acquiring a group of lenders that can generate a fair amount of deposits, which is often a preferred strategy if you can get the right people. The tough part is that while many banks are starting to have a pretty good idea of how they want to structure their branch network–like Ray Davis at Umpqua Bank, for instance–buying someone may not make a lot of sense because you have to reconfigure everything to your model. Often it makes more sense to start de novo. But acquiring whole teams is a great, inexpensive way to go.

Steve Klein: Whether you are buying a branch or starting a branch de novo, I don’t think it makes sense to do so unless you acquire a “player” who’s got a hold on the market. It’s what community banking is about– personal relationships. And if you get involved with nontraditional products and services–insurance, securities, or mortgage banking– it’s even more essential to find a key player and managers who know what they are doing. Then you need to have them sign a noncompete contract, because you are relying on them to make it happen. In order to be successful, you have to get the right players.

Dory Wiley: It all starts with a bank setting up sound goals, following a sound path, and having lots of foresight and planning. This could be as simple as making your brand identity known, getting the right number of shareholders in the marketplace to help bring in business, and analyzing your cost structure so you can handle the growth. Many young banks focus on the asset side, only to find they’re behind on the deposit side. It needs to work the other way, since asset generation tends to be a little easier than deposit generation. So setting up your structure and having good foresight and planning are just as essential to growth as acquisitions. And finding the right people is the most important thing.

Kerrie MacPherson: The people aspect is the one that sometimes gets overlooked. It’s much easier to look for bricks and mortar, but if you find the right people, that’s the key. Even if they are not from your market, if they are the right people, they can come in and lead the market for you.

Art Loomis: One other growth avenue in rural markets is the much maligned in-store branch, which can be a viable initiative for a community bank to pursue. Then there are a couple of outside-the-box alternatives, one of which is an inverted acquisition. If you are looking for size and you’ve got a young management team, sometimes you can find a buyer with an older management team that is willing to buy you and turn over the institution to you. That’s a great way to grow your organization with the buyer’s currency. Last, in certain markets, banks may consider a sale to a mutual, which is another structure that has a community bank orientation.

BANK DIRECTOR: Business-line acquisition was just mentioned. Are there certain lines you feel more positive about in the current market?

Wiley: I have a bent toward core banking. People can get distracted with fee-generating ideas, and some of them make money and some of them don’t. With that caveat, I would say I’m sort of a contrarian and am intrigued with mortgage banking because of all the disarray in the industry right now. Typically when the cycle goes bust, it’s a lot easier to buy mortgage banks because they lose some of their prima donna attitude. It’s very difficult right before the cycle turns downward, because rates are lower and they are all doing terrific. At that point it costs you a lot of money, plus you have the impending doom of knowing the cycle will change. So I actually think now is a decent time to invest in mortgage banking, though I’m sure a lot of people would disagree. Given that most banks are asset-sensitive, I think they’ll make up the difference with widening margins as rates move up.

Servat: That sounds like a good plan; however, I would echo your earlier point on core banking. If you look back at how much energy has gone into diversifying the revenue stream, particularly for small and midsize banks, I can’t find one where it’s really been worth the effort. The core business still remains worth the effort, though some variations around the core business, such as in-store banking, may be beneficial.

Having said that, there are a couple of activities that, so far, haven’t blown up, such as factoring–if a bank does it well. Factoring is not a big contributor to growth and earnings but it certainly works, and it’s close to the core business. Then for some, mutual fund sales have worked surprisingly well. As for insurance, I don’t know–it has worked well for some banks, but it’s not a lot of bang for the effort. Then you look at banks that are involved in trust operations and it seems so natural, but my own anecdotal evidence is that you get three years of great business, then you get a lawsuit that sets you back three years. So overall, plain-vanilla, spread banking is still the basic business that keeps banks alive and well.

Klein: One thing that affects success is culture. Commercial banking has a unique culture and other cultures are more sales-oriented, so they clash. As for the wisdom of getting into other areas to diversify the income stream, there’s no question that margins are thin, but I agree that community banks should do what they do best, which is core banking.

Servat: Plus, it’s tough to get to the point where you are going to get the analysts or investors to believe you’ve become a “mini-Mellon.”

Klein: You can’t compete on price and product with the big banks. If you try, you are going to lose. You can only beat them at service and relationships.

Loomis: So the broad answer is, stick to your knitting, know what you do well, and just keep executing it rather than get distracted. But still, some institutions manage creative people better than other organizations. So it all boils down to the people involved and management’s ability to identify what motivates certain people.

Plevin: But if you aren’t already strong in the business you want to penetrate, you have to give a lot of thought to the internal controls aspect. In today’s environment, that can be a critical factor.

BANK DIRECTOR: Kerrie, can you add to that point from an auditor’s perspective?

MacPherson: Being sufficiently honest with your management team and the board to say, “We’re buying a business we don’t know how to do” is a big step. Because once you say that, the board is probably going to respond, “Why would we do that?” So you really do need to think it through. As for sticking to your knitting, that is probably best for institutions whose niche is in their relationship ability. A lot of these other things become successful because of scale–which is a totally different business model.

Klein: The rub is that these other businesses are commission-based, whereas commercial banking is salary-based. When people working in commission businesses do well, they resent not getting paid for their efforts. At the same time, commercial bankers making sophisticated loans often resent mortgage bankers who can make twice as much money doing something commercial bankers regard as “mechanical.”

Loomis: There is also trepidation about getting pounded by regulators for starting a business you don’t understand. At the same time, you don’t want to restrict the creative thought process. So you want to encourage smaller institutions to experiment without betting the bank. For example, there is a considerable case to be made for tagging a customer relationship with a wealth management function and trying to grow it in some way. But balancing the two takes sensitivity.

Wiley: There’s an old story about R.L. Thornton who, in the 1920s, founded MBank in Dallas, and people used to ask him, “Why did you get out of the candy business; you were so successful in that? Why are you in banking now?” And he would say, “Because you’ve only got to remember three simple things about banking: Get it in, get it out, and get it back.” If banks today can keep it that simple instead of becoming distracted, they’ll do just fine. It’s not rocket science.

BANK DIRECTOR: Can you discuss the considerations that weigh into a board’s decision to buy versus building de novo?

Klein: My experience in the last five years is that de novo branching often is not the most efficient way to get into a new market. This is especially true if you are a public company and have to worry about the impact on earnings, because there is a cost of getting to a certain critical mass. So you can either buy a branch and pay a reasonable premium or acquire a player or a group of players. This latter concept has become more commonplace. I don’t think it makes sense to pursue a new market without having someone aboard who is familiar with that marketplace and has existing relationships. It’s too expensive and too time consuming. And if you think about what you have to pay for a branch–normally a 10% deposit premium–it’s going to be cheaper, ultimately, to pay the right people, put them under contract, and let them build it and bring in a team, if possible.

MacPherson: Are you all starting to see more noncompete agreements?

Klein: Absolutely, because once someone leaves to join your team, they might just do it again. You want to offer stock-based incentives and structure the vesting so that they have an incentive to stay and play a role in the company.

Wiley: Arrogance is a key mistake made by many acquirers. As to the initial question about building versus buying, if building a branch system doesn’t hit the income statement immediately, it gets parked on the balance sheet in the form of goodwill, so many banks would prefer to buy. Whereas if you’re a long-term player, building is probably the way to go. In some cases, after the noncompete period is over, these guys will go out and start a bank– I call it “outsourced franchise building.”

Servat: There is significant excess capacity in branches right now, and several years down the road when everybody has the market share they sought, you are going to see some pullback. Banking is no different from any other industry.

Wiley: We see the same trend every time. Bankers say, “I’m going to put a hundred branches in this state because we really want to make a big splash.” Then when they get there, they realize there’s already branches on every street corner. Look at Dallas and San Francisco and Houston, for example.

Klein: It’s the Starbucks approach.

Wiley: Right. And then even if they put one up, they quickly realize, “Who’s going to bring the business to this branch?” It’s not just, “build a branch, they will come.”

Servat: That is the Starbucks strategy, but three years from now, there is going to be significant retrenching for a lot of key banks after they squeeze people out of their market.

Loomis: Let’s say you have a $200 million marketplace–a community-bank-franchise orientation–and you expect to achieve a 20% market share over 10 years if you do it de novo. You are talking about a $40 million branch when it’s mature. Whereas if there is a $40 million branch in that marketplace and you pay a 10% premium for it today, you’ve got a $4 million cost to own that franchise initially and then you hope to produce profitable business from it. In the latter case, you won’t immediately lose money, so you have to compare this to the cost of getting the branch started from scratch, hiring the right people, and calculating how many years you carry the loss such that it offsets that $4 million acquisition premium. Admittedly, in slow-growth markets, you may prefer to buy as opposed to go in de novo.

Klein: I don’t think it makes sense to go in cold and then go through the expense you are talking about.

Servat: In my experience, if people can get to break-even within 24 months, it works. If you can’t, you probably want to head back.

Loomis: First Manhattan Consulting Group did a study where it looked at banks that successfully branched de novo to find out the attributes of those organizations. The only determinative variable it could isolate was whether the institution had previously executed de novo branching successfully. It had nothing to do with the marketplace. In reality, community banks just don’t get that many chances to try.

BANK DIRECTOR: Many issues we’ve discussed are tied to the risk management function of the board and how risk averse they need to be when considering strategic options. How should boards balance risk with growth opportunities?

Klein: There are many ways to make money. If you have the discipline to integrate them, that’s fine, but if you compare how much time and effort you’ve spent trying to buy and integrate these entities to what the margins are, you may be better off staying with something that will improve your more traditional lines of business.

MacPherson: You need to explore whether or not you have the expertise or whether you can develop it, but in either case, you need to do it in a measured way.

Wiley: Planning is so simple, but a lot of people forget it. It really means setting goals in a systematic way. Many people get sidetracked, and often, emotion overrides good business judgment.

Servat: That’s human nature.

Wiley: Yes, and they think it’s fun and they want to win–it’s a competitive thing. But when it’s all over and the investment bankers go home, somebody’s got to integrate it–make it work and pay for itself. That’s where it can get tough if you’re not a disciplined buyer.

Servat: I don’t think boards can plan enough; I don’t think they can discuss these issues enough; I don’t think they can hear certain things enough. At one time they probably had a core strategy and they may need to repeat it among themselves like a mantra, because it’s too easy to fall in love with a new idea and forget that it doesn’t fit the plan. One problem related to this is that the annual board retreat has become too routine. Directors need a way to keep the planning effort fresh and keep themselves focused, rather than simply being exposed to it once a year.

Plevin: There is something very formulaic about the annual retreat approach taken by a lot of community banks. My experience has been that the banks that are most effective address strategic planning regularly, where part of every monthly board meeting is dedicated to discussing the strategic plan and what steps are being taken to implement it and adapt it. It’s a continuous process.

Klein: It is probably more realistic to recommend that boards visit it quarterly for a 15- to 20-minute session. Having boards think strategically within the confines of their limited time to do regular business is difficult, but there is great value in it. Many banks adopt a strategic plan, then put it on the shelf and dust it off a year later. That won’t accomplish what they want.

Servat: Sometimes it is extremely difficult for directors to participate in a discussion in a large room where many members are going to be hesitant to share their thoughts or ask a question. To counter this problem, we have a client who takes one director out every month for a one- or two-hour session. This helps draw the director out and gives him or her an opportunity, in a nonthreatening setting, to share his or her concerns.

Loomis: One of the distinguishing characteristics of successful boards and successful institutions that conduct strategic planning is they embrace change by confronting reality. They don’t have their head in the sand; they are not ignoring the fact that net-interest margins are getting squeezed, for instance. They are diligently looking to consider other avenues that make sense. The other thing is execution: You hold people responsible for their budgets, their forecasts, the initiatives they want to pursue. You also need to have variance analyses and contingency plans in place.

Wiley: I love that comment about confronting reality. It always excites me when you have a CEO or a leader get up in front of the board and say, “It’s simple: Here’s what we are worth as a sale, but here’s my view on why we are worth more and here’s my plan to achieve it.” How many executives have the guts to do that? Anybody who is truly focused on ROE and the shareholders should not be afraid to do that. That’s confronting reality. That’s what needs to be done.

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