High Performance Capital Management

High performance capital management” will be the hallmark of all winning banks in the future. Capital management is the allocation of capital and management resources to achieve the desired rate of return on equityu00e2u20ac”the shareholders’ equity. The objective is to consistently achieve a high return on equity coupled with earnings-per-share growth.

Banking is fundamentally an excellent business and banks achieving high performance capital management come in a wide variety of sizes and colors: whether national banks, large regionals, or community banks; publicly held, private, or sub-S; suburban de novos or downtown retail; high-growth or slow-growth; deposit gatherers or loan producers; the list goes on and on. Size or scope is not the determining factor of success, but knowledge clearly is.

The basic principles of good banking remain the same whatever the type of bank. Today, more than at any time in the past, we see a number of exciting innovative approaches that are dramatically affecting shareholder value based around seven fundamental driving forces.

Each of the seven driving forces must be well managed and fully integrated to achieve high performance capital management. This challenge is significant given the changing dynamics of the banking industry. The need for knowledge is critical and the time is short, but the opportunities to achieve great success exist for winning bankers.

1. Shareholder management

Expectation management is critically important. Shareholders need to accurately understand what the realistic potential returns on equity of a bank are given its market demographics and sound banking opportunities. Achieving greater returns may mean taking on more risk on the lending side. However, returns from maintaining high levels of risk in the loan portfolio are rarely sustainable unless that is the bank’s core competency. The bottom line is that shareholders with unrealistically high performance expectations may drive management decisions that will hurt the future value of the bank. In addition, there is a very real risk of focusing too much attention on short term, nonrecurring sources of income to the exclusion of building a solid base of profitable customers, products, and services.

Shareholders’ expectations as to the desired rate of return can vary dramatically. For example, some income-oriented owners of sub-S banks regularly look for pretax returns on equity of 25% or more to be earned and distributed quarterly. These owners often view their banks as a “permanent personal earning asset,” never to be sold.
Other owners want growth, growth, growthu00e2u20ac”hoping to sell the bank at a substantial premium based on size and market penetration.

For virtually all significant shareholders the most important performance measurement is the long-term return on capitalu00e2u20ac”their capital. The value of their stock, particularly if publicly held, is almost always simply a reflection of the level of earnings coupled with earnings-per-share growth. The challenge is to realistically determine what constitutes acceptable performance, good performance, and outstanding performance given the bank’s opportunities.

2. Financial Management

A clearly defined financial management strategy is essential from an owner’s viewpoint. Often, the best financial management strategies are multiphased. An example would be issuing trust preferred to buy back stock to reduce the number of shareholders in order to convert to a sub-S, which in turn satisfies the owners’ desire for current income without having to sell the entire bank. Or the strategy might be to prepare the bank to go public in order to have the currency to buy other banks. Another strategy might be to focus primarily on buying or building branches using existing capital supplemented with trust preferred to avoid dilution or because the owners simply do not want to go public.
Financial management, in the end, is about maximizing return on investors’ capital given a specific set of balance sheet conditions, recognizing that the source of most assets and liabilities is customers!

Heretofore, only the major banks had access to many of the tools that could dramatically increase earnings through balance-sheet management. Today that is changing dramatically to the benefit of all banks. As Marty Madden, a sound, innovative banker and a good friend of mine, recently observed, “The success and broad acceptance of trust preferred is an excellent example of an important financing tool that had only been available to major institutions. Now through the use of securitization, trust preferred has become a major source of capital for virtually all banks. The key was securitization, which, in the future, will impact both the value and the liquidity of broad classifications of bank assets.

Trust preferred set in motion forces that will dramatically impact all banks in the future.”
The bottom line: The result of financial management decisionsu00e2u20ac”making the right decisionsu00e2u20ac”using the right tools, and working with the right partnersu00e2u20ac”often provides an accurate, projectable, and dramatic increase in shareholder value.

3. Customer Management

Why are customers important? Customers provide the revenueu00e2u20ac”it’s that simple. Customers are the bank’s primary source of revenue except for investment portfolios in most banks. Of interest, maximizing revenue is becoming much more difficult for many banks due to more knowledgeable and highly focused competitors.

Customer profitability measurement is the essential first step for high-performing, customer-focused banks, but it is just the take-off point for maximizing overall customer profitability. For example, the personal accounts of key business customers can be exceptionally valuable. Knowing who they are is not enough. The real rewards come from using the sophisticated approaches that are available to all banks to win a major portion of their personal banking business.
The bottom line is that customer management is entering a totally new phase based on using proven tools coupled with new software solutions that empower the bank to win market share at the expense of the competition. Significant rewards are now starting to arrive for banks that have made the investment in customer information management.

4. Products And Services

The basic challenges regarding products and services are reflected in the banker’s ability to answer the key questions: What do our customers really want from us? How satisfied are they with our bank and its services? Are they using other banks’ services? Why? What is the likely potential of new products and services to entice customers to our bank? Are our future products suitable to being delivered electronically? What is the relative importance of the service component versus the pricing component for attracting and keeping customers?

The commodity challenge is this: How do you respond to the truism that over time markets commoditize virtually all bank products and services? The Starbucks solution to the challenge that “coffee is just a commodity . . . the second cup is often free” is to continually add quality, freshness, and convenience, and it works on a grand scale. For many banks, adding contact with a person, the same person, is effectively meeting the commodity competition for their best customers.

5. Pricing Management

“Price is what you pay. Value is what you receive.” For example, if you have a proprietary service delivered by highly trained professionals that has great value to customers, you should charge a significantly higher price than for a commodity product. Competing on value is quite different than competing on price.
Price management can dramatically improve bank profitability as well as retain customers. The future challenge will be “how to do pricing right” from the viewpoint of increasingly knowledgeable customers, regulators, and consumer groupsu00e2u20ac”no easy task given the very aggressive pricing being implemented by some banks, especially regarding service charges.

6. Risk Management

The key word in risk management is “management.” It’s not about avoiding risku00e2u20ac”that’s what bankers get paid for. It’s about managing risk. The eight basic risks from a regulatory viewpoint sound like a full employment act for legions of government employees. They are: legal risk, credit risk, compliance/regulatory risk, strategic competitive risk, experience/knowledge risk, reputation risk, transaction risk, and opportunity risk.
Risk management is ultimately all about “risk versus reward.” The worst-case scenario is when an institution takes a huge amount of risk for very little reward. For example, perhaps now is not exactly the right time to aggressively market low fixed-rate loans to be retained in the bank’s portfolio. Risk/reward needs to be constantly reevaluated as conditions change or new management techniques become available.

7. People Management

With regard to performance, Bob McGoffin, a high-performance banker and a long-time friend, says, “It’s 100% people.”

Technology obviously has a major impact. But the winning combination is the right people working in the right organization structure supported by the right technology. For example, the act of separating sales and service, and supporting them by user-friendly technology to gather a total picture of a customer’s relationship with the bank, can make a major difference in revenue growth. A critical side effect will be to change some of the skills required to be a good and successful banker in the future.

With all that said, there will never be a substitute for good banking judgment. Shareholders are the real beneficiaries of “good banking judgment” that often is reflected in things a shareholder never sees: a loan not made, a risky customer leaving the bank, a problematic potential employee not being hired…the list goes on. At the end of the day, performance really is 100% people.

Relative Performance

One of the country’s best and most thoughtful investors, Rusty Rose, once said to me with regard to evaluating performance, “Alex, it’s all relative.” For bankers, the key relative performance measure is determining what their return on equity is compared with banks in the same type of economic environment that are dealing with the same market dynamics.

Banking is a reflective business, reflecting local challenges and opportunities. The late Tip O’Neill once said, “All politics are local.” In the same way, almost all banking is local. Clearly some banks successfully move out of their home market, sometimes with highly specialized products and services targeted to very specific customers, but the most successful strategy is simply to offer great customer service in markets where it’s missing.

Setting Priorities

Bankers should focus on how they can achieve the greatest impact or a series of small impacts to improve return on equity. This is sometimes called picking the low fruit first. Identifying opportunities is critical, focusing on what the bank’s major achievable opportunities are, both long and short term. Will they be easy or hard to accomplish? And most important, what can the bank realistically achieve, given its current capabilities? Being both opportunistic and highly realistic leads to solutions that will have a quick, positive, and predictable impact on the return on equityu00e2u20ac”which research has found is always good for shareholder morale.

The Bottom Line

High performance capital management is about bringing the seven driving forces discussed above together with one objective: increasing long-term return on equity for shareholders. Every decision impacts the return on equity, whether it involves having a well-thought-out strategic direction or making other right loan decisions or whether it is a small act of outstanding customer service. Longer term, one of the best solutions is to capitalize on a powerful combination of accurate information, listen to the experiences of other leading bankers, and work with world-class partners who truly understand the issues. The good news is that virtually every bank has the capability to achieve high performance capital management.