2007: Time for a Clean Sweep

Very often, Iu00e2u20acu2122m asked to speak on the future of community banking. It is a subject that drives me to absolute dread. I might make predications like my predecessors. Remember these gems?

u00e2u20acu0153There will be no more bricks and mortar!u00e2u20ac

u00e2u20acu0153Customers will pay fees just to talk to a teller!u00e2u20ac

As I reluctantly engage my crystal ball, I see a frightful flurry of inefficienciesu00e2u20ac”even in high-performing banks. My best advice to community bankers is, u00e2u20acu0153Clean up your actu00e2u20ac”enhance your value!u00e2u20ac It is time to unearth the opportunities that lay dormant in your institutions.

Net-interest margins are not enough

The community banking industry will not be able to survive on bread aloneu00e2u20ac”that is, their net-interest margins. And history is proving my point. The average bank in the country has seen its net-interest margin declining, a trend that seems to thrive regardless of interest rate cycles and flat yield curves. Yet the average bank in the country produces an 11% ROAE and has had a healthy 16% total return over the last five years.

The average bank looking to net-interest margins for profitability is indeed fat and happy. However, if the average bank in the nation had the overhead control of the top 15th percentile performers, it could achieve ROAEs approaching 13.64%. Therefore, it makes total sense for the average bank to become more efficient in net overhead control. My prediction for high-performance banking is controlled net overhead and gains in tax efficiency.

Itu00e2u20acu2122s all about relationships

The banking industry often looks at its business drivers with a narrow perspective. Itu00e2u20acu2122s time to toss the peer analysis attitude and begin tapping the power of positive relationships.

I have learned invaluable lessons from the chairman of the bank where I am a founding director. The success of our bank is truly to the credit of a lifetime of business experience. He describes the banking sector as u00e2u20acu0153transaction-orientedu00e2u20ac and feels our bank is special because we are u00e2u20acu0153relationship driven.u00e2u20ac What does this mean? And what sort of edge does it give us over our competition? It means that we pursue business relationships on the loan and the deposit sides. We gain the business of the owners and, in doing so, attract its employees to bank with usu00e2u20ac”sometimes becoming shareholders as well. Over time, the sum of these relationships helps us produce more value than our competitors. I call this the u00e2u20acu0153profitability wheel of banking.u00e2u20ac Each relationship represents a spoke with the potential to push the profit wheel forward.

The chairman of a bank must understands the potential value of empowering his own people. He must believe in maximizing employees to the highest level of efficiency and compensating them accordingly. He also must make certain each employee is entirely embedded in the bank. He should constantly motivate management to be lean and mean. He also should challenge internal audit and external audit to search for opportunities for greater efficiency. The bank where I am a director embodies all these qualities.

The average assets per employee at the average bank in the country are at $3.482 million. And what about our bank? An impressive $6.791 million! Industry average loans per employeeu00e2u20ac”$2.37 million. At our banku00e2u20ac”$5.49 million. Why canu00e2u20acu2122t the industry at large achieve the same results? Some might say itu00e2u20acu2122s because our young, five-year-old bank has the advantage of the most newfangled technology. (If this were true, Iu00e2u20acu2122d say go invest in technology and earn a handsome payback!) But the truth is, this sort of productivity is only possible when the right people are put to the task.

Identify your A-team

You have to know your A-team at all times. These are your core employees with the know-how to cover the bases and keep you in the black. Every community bank is different, but I believe most community banks could easily reduce staff 10% to 25% and still operate at the same level of efficiency.

Your first strategy is to identify your A-team and develop an employee productivity plan. This is not as tough as it sounds. Keep tabs on the community banks that are the most efficient. Visit them, build relationships with them and find out how they do it. Successful community bankers are very proud of their work and are usually very happy to tell you how they get the job done.

The second strategy: Learn how to compensate management and your A-team for producing shareholder value. Get creative! When compared to other industries, community bankers are significantly undercompensated for their value creation.

The community banking industry has been chasing its own tail on this issue for too long. Use peer studies as the basis for your compensation plans and all you get is a round-robin effect. Is the peer level on par with the value the board wants you to create? Because u00e2u20acu0153peeru00e2u20ac generally means u00e2u20acu0153averageu00e2u20acu00e2u20ac”which could mean youu00e2u20acu2122re settling for less. I think the industry should move toward value-creation-based compensation. It could be built to include multiple levels of value creation. Rewarding management with a percentage of the value created is a wonderful best practice to introduce. Remember, management is the executor of your strategic plan. They are the lifeblood of your institutionu00e2u20acu2122s value creation, meaning it is vital to keep them happy if they meet your goals.

Taxes arenu00e2u20acu2122t avoidableu00e2u20ac”but can be managed

One of the most inefficient areas in community banking is taxes. The average community bank pays out 30% of its pretax income in taxes. The majority of community banks are not tax efficient! If a bank wants to be tax efficient, it should not pay a dollar over its alternative minimum tax (AMT) calculation. In banks that are not dependent on individual state tax rates, the tax rate should be between 18% and 20%. Do the math. What if you could increase your net income by 10% of your pretax earnings? Tax efficiency is significant. Iu00e2u20acu2122m constantly befuddled by the way the banking community ignores tax planning (see sidebar).

Model it

It is amazing to see an average community bank go from ho-hum to Wow! What if you could take your bank from an 11.15% ROAE to a 15.53% ROAE? This process of asking yourself, u00e2u20acu0153What if?u00e2u20ac is an important part of the strategic planning process and is the only way to clearly conceive the potential of your strategy.

However, you canu00e2u20acu2122t produce gains in net overhead control and tax efficiency overnight. To get started, I recommend modeling out three to five years. Then ask yourself, u00e2u20acu0153Is this attainable in our business model?u00e2u20ac It may appear to be attainable in less time than you imagined. Or, it may take longer. Either way, youu00e2u20acu2122ll have all the knowledge you need to put your plan in motion.

A rosier picture is possible

So what does the future of community banking look like? It doesnu00e2u20acu2122t have to be a blur of inefficiencies. You can paint a clearer picture simply by beginning to understand where value is lurking in your bank. Set the value creation process in motion by bringing in more relationships, operating at high net-operating efficiency, and investigating all means of attaining tax efficiency. When compared to all banks nationally, your reward will be balanced with a moderate level of risk. This attainable balance of risk and reward will produce much-desired value and directly translate into the stock price of your bank. Along the way, remember to compensate management and your A-team with a percentage of the value created. This type of value creation process will result in a dynamic and prosperous banking community. So what are you waiting for? Start cleaning up your act!