How Strategic Plans for Community Banks Should Change

May 21st, 2018

strategy-5-21-18.pngThe commercial banking industry is undergoing a structural transformation. The Federal Reserve’s response to the recession in the last decade has had a continuing, unanticipated impact on community banks. Yet most banks are relying on legacy strategic planning tools and processes that won’t allow them to see – and solve – upcoming problems.

Quantitative easing (QE) pumped funds in the marketplace (deposits), while banks contended with an extended low interest rate environment. Moving forward, as QE is reversed, deposits will be withdrawn while interest rates gradually rise. Already, the largest banks are sucking up the best deposits, which will leave community banks scrambling for funds.

All banks do strategic planning. Most banks tend to extrapolate accounting data to generate pro forma reports and analysis. Prior to 2008, this process worked well, and many consulting firms and banks developed analytical tools and processes to help in strategic planning.

But dependence on these traditional strategic planning tools and processes is risky. Accounting statements camouflage critical data that is relevant to bank pro forma performance and strategic planning. This data may not have mattered prior to the recession, but it is essential in today’s banking environment.

The monetary policy of the last decade has led to hidden time bombs in banks’ balance sheets, masked by traditional financial reporting and ignored by most market analysts. Unfortunately, the inevitable rising rate environment will expose this harm, blindsiding most bank management, investors and shareholders.

Year to date, declining gross loan yields have been offset by declining cost-of-funds (primarily deposits) and an increase in the supply of these deposits. During this extended post-recession period, net interest margins (NIMs) have remained relatively strong, creating a pattern of reasonable earnings, year after year. Unfortunately, in a rising rate environment this process will reverse itself.

Many banks will attempt to use the ALCO process to mitigate these trends. Unfortunately, ALCO is primarily a short-term tuning process, not a long-term strategic tool. It is not designed to solve long-term gross yield and cost-of-funds issues. Given that the “Normalization Period” will extend for several years, corrective actions using ALCO may serve to further aggravate the long-term situation.

Community banks need to focus on methods designed to meaningfully change the mix, rate and duration of their asset portfolios. They must also recognize that deposits, whose availability and pricing have been taken for granted for several years, will be of increasing importance in the years to come.

Community banks need to be prepared to move away from their dependence on traditional analytics that cannot identify, quantify and provide solutions to these unprecedented problems in the U.S. community banking market.

Given the slow turnover rate of loan portfolios, any real change in a bank’s assets and their composition by type, rate and maturity can only be accomplished through the merger and acquisition (M&A) M&A process. Similarly, improving loan-to-deposit ratios and deposit composition can only be truly accomplished through M&A.

But many banks are not even including an M&A scenario in their strategic planning exercises. And that is a big mistake. While there is no guarantee that an appropriate target exists, or, if it exists, that it is available for sale at the appropriate price, it is imperative that community bank management explore this possibility thoroughly before resigning themselves to more traditional and less effective approaches to solving the upcoming problems.

Banks that successfully use M&A in an appropriate manner have an extraordinary opportunity to separate themselves from the pack.

For banks that are prepared to explore the M&A option, CEOs and boards should realize that times have changed. Traditional M&A valuation techniques and dependence on ratios such as multiple-to-book and payback period are no longer relevant and generally misleading.

It is necessary to analyze in depth, not only the fixed and floating interest rates built into a target's loan portfolio, but also the individual duration and maturities of their loan portfolios as they extend into the future. Traditional accounting systems tend to obscure this critical data, and the commonly used extrapolations of GAAP financial statements generally lead to misleading and erroneous conclusions.

The increasing value of deposits needs to be quantified in the appropriate manner. Again, traditional techniques for valuing deposits are either too short-term oriented or based on methodologies used in entirely different economic environments, rendering their conclusions meaningless.

M&A can be a powerful catalyst to solve problems in today’s complicated banking environment. It does not have to tie up too much bank time or management resources, if it is done correctly with the right analytics.

kmustafa

Kamal Mustafa, the former global head of M&A at Citibank, is the chairman of the Invictus Group, an M&A advisory firm.