Searching For A New Growth Strategy

In the year 2000, when Mike O’Neill rode to the rescue of the Bank of Hawaii, the company was in a difficult spot. Profitability was constrained by expenses and loan losses in far-away locations. It had operations in California, Arizona and about eight different countries in the South Pacific and Asia, some of which were prone to an occasional coup d’état. It owned banks with names like Banque de Tahiti and the National Bank of the Solomon Islands, 3,500 miles away from its headquarters in Honolulu. The stock had lost half its value in the three years prior to O’Neill’s arrival, dropping to $11.25 per share.

“Essentially, Bank of Hawaii was a big mess, for lack of a better word,” says Brett Rabatin, a stock analyst with the Birmingham, Alabama-based brokerage firm Sterne Agee & Leach Inc. “They had operations that were pretty far flung.”

O’Neill, now chairman of Citigroup Inc., changed all that when he became chief executive officer of what was then the bank’s holding company, Pacific Century Financial Corp. He reduced the size of the company, changed the name of the holding company to reflect its focus on Hawaii, and closed or sold off most the company’s operations in Asia, the South Pacific and the mainland United States. He made Bank of Hawaii focus on what the bank did best: Hawaii. The results were stellar. The stock price about quadrupled under O’Neill’s tenure. To this day, eight years after O’Neill left Bank of Hawaii Corp., it is one of the top performers among its peers. During the financial crisis, it raised its dividend and had no quarterly losses. All of its quarterly earnings go back to shareholders in the form of dividends or stock buybacks. As of the third quarter, the $13.4-billion asset bank holding company had a return on average equity of 16 percent, more than double the median in 2011 for publicly traded banks and thrifts between $5 billion and $50 billion, according to SNL Financial data. The bank’s return on average assets was 1.2 percent (the median in 2011 for similar-sized banks and thrifts was .82 percent). “Bank of Hawaii is one of the best capital managers of all banks,” says Jacquelynne Chimera, a stock analyst for New York-based investment bank Keefe, Bruyette & Woods Inc. “They do an excellent job of returning capital to shareholders.”

In an age of dwindling profitability and slow loan growth, many banks are reassessing their performance, just as Bank of Hawaii did in the early 2000s. They are making tough decisions in strategic planning sessions about whether to buy or sell, get bigger or smaller, go into new lines of business or get out of others. All are players in an increasingly difficult game called banking. The winners in this story each took remarkably different paths when changing strategy. But they foresaw changes accurately in the marketplace and executed successfully. They focused on what they did best, rather than pursue growth for growth’s sake. Their strategies couldn’t be more dissimilar, and yet, the way they approached them was the same.

Bank of Hawaii succeeded by returning to its core business in Hawaii. Heartland Financial in Dubuque, Iowa, did the opposite; it expanded from Madison, Wisconsin, to San Diego, California. Heartland has consistently contradicted conventional wisdom, most phenomenally by expanding its mortgage business after the mortgage industry tanked. Capital One Financial Corp. in McLean, Virginia, has transformed itself from a monoline credit card company to an extremely profitable multidimensional bank using technology to gain advantages from competitors. All these banks fundamentally changed their strategies and it worked.

Geri Forehand, national director of strategic services at Sheshunoff Consulting + Solutions in Austin, Texas, says many banks are looking to change their strategy given the certainty of low interest rates in the years ahead. (The Federal Reserve has promised to keep rates low at least into 2015). That has put pressure on margins. Fee income in the form of checking account overdrafts has dried up. Growth isn’t exactly saving the day, either. Aggregate loans and leases were down 3.2 percent as of the third quarter of 2012 compared to four years ago, according to the Federal Deposit Insurance Corp.

Many banks are looking to buy particular assets or increase fee income in such an environment, says consultant Forehand.

He says that he has talked to more than 100 banks thinking about alternative lines of business, including equipment finance or Small Business Administration lending. Banks and thrifts often like to add an insurance agency business, stock brokerage or wealth management operation, but those businesses are entirely different than banking. It is much easier to make money buying an existing, profitable fee-income business than it is building one from scratch, Forehand says.

However, banks should be cautious about how they approach the integration.

“If you’re going to acquire an agency, you have to acquire one with the understanding it will be run like an insurance agency, and not try to put a bank’s culture on it.”

Since there are always risks in going into a new line of business, Forehand advises banks to focus on doing a better job with existing capabilities.

“I don’t advise my banks to go from wholesale to retail, or from commercial real estate to C&I (commercial and industrial),” he says. “If you have 10 years to make changes, that might work.”

Most of his banks are focused on refining their strategies rather than changing what they do.

“I think this is one of the most important times in my years in consulting,” Forehand says. “Everyone is aware of changes in the regulatory world. Everyone understands the interest rate pressures. But it’s critical now to look at pricing structure, product mix and make sure you have discipline and hold people accountable and execute your strategy for the next three to five years.”

One bank that seems to have succeeded at that is Bank of Hawaii.

When O’Neill came to the bank in 2000, he became the driving force behind the strategic planning sessions with the board, says David Heenan, who has been a director since 1983. The board knew of the company’s frailties, he says, but the board needed a leader who could focus the bank on a new strategy.

“The Bank of the Pacific,” as it was sometimes called, had a strategy that was as far-fetched as its territory was far-flung.

“It took more management time and effort and attention than anyone expected,” Heenan said. “[The faraway island outposts] not only didn’t contribute to the bottom line, they were a drain on the company. The investment community and shareholders never put a premium on that. There was no economic value created by that.”

O’Neill realized that and brought in an executive team on three- to four-year assignments to help clean up the balance sheet and sell assets.

“He is very attuned to attracting and motivating people with particular expertise to work out issues,” Heenan says. “He has a golden Rolodex.”

O’Neill’s office didn’t respond to a request for comment.

Working with the board, the executive team decided to shift funding to more core deposits, just as Capital One would do several years later, says Al Landon, who worked as chief risk officer and chief financial officer under O’Neill and later served as chief executive officer from 2004 to 2010. O’Neill and his team focused on improving underwriting, controlling costs and strengthening the bank’s risk management processes in a low-loan growth environment.

The bank saved $17 million to $18 million per year outsourcing technology software and equipment. It also closed a few branches and opened others in strategic locations, Landon says. It sold its credit card portfolio.

Bank of Hawaii also focused more attention on customer service. It started a customer service department whose job it was to follow up when a customer had a complaint and make sure it got fixed, Landon says. If someone complained about a fee, their overall relationship with the bank was assessed to determine if the fee should be waived.

To get staff onboard with the bank’s goals, employees were granted shares in the company and executives gave presentations outlining the bank’s periodic financial performance.

By the time O’Neill left in 2004, the bank had shrunk from $14 billion in assets to $9.7 billion and went from having 4,300 employees to 2,600. Non-performing assets to total loans and other real estate owned fell from nearly 2 percent to one quarter of one percent.

“You could hardly ask for a better outcome,” the stock analyst Rabatin says, noting, however, that Bank of Hawaii is surrounded by ocean and can’t easily expand. “The geography in some ways limits any bank there. It’s never going to be a strong growth story.”

For investors looking for stable dividend income, that has worked out just fine. And it wasn’t bad for O’Neill either. He bought $10 million in stock when he joined the bank. In 2002, he refused to take any cash salary and was paid in stock. By 2004, when he left, the value of his shares were $128 million.

Peter Ho took over the top leadership role in 2010. He has continued the strategy put in place by O’Neill to focus on controlling costs, attaining excellence in operations and returning value to shareholders.

Born and raised in Hawaii, the 47-year-old Ho was educated at the University of Southern California. He joined the bank in 1993 and has spent most of his career there, now serving as its chairman, president and CEO.

Stock analyst Aaron James Deer, with New York-based investment bank Sandler O’Neill + Partners, says Ho is definitely an operations person who knows numbers and performance and stays focused and disciplined.

“Sometimes you get a CEO in a role who feels an overwhelming need to put their stamp on an organization. He hasn’t let arrogance get in the way of high quality management,” Deer says.

To say that Ho is conservative is sort of an understatement.

When asked what the bank is going to do about the tough economy, he answers that the question is not what the bank is going to do but, “what are you not going to do?”

“For the most part, it’s people who are able to maintain the things they do best that get rewarded over the long term,” he says.

Ho attributes his management team’s success to knowledge of its territory and its business. It has been in Hawaii for 115 years. It has been in Guam, one of the areas where it kept a presence, for 50 years.

“It’s basically sticking to the knitting and strengthening our areas of advantage,” Heenan says.

Of course, sticking to your knitting is not a strategy that will appeal to many banks looking for growth. But even the banks that do acquisitions do them consistently with a plan that doesn’t veer off course.

Take Capital One, for example.

The company was the top big bank performer in Bank Director’s Bank Performance Scorecard last year, which was based on a combination of profitability, capital and asset quality. Much of that is attributable to the $302-billion asset Capital One’s high-yielding credit card business.

Co-founder, Chairman and Chief Executive Officer Rich Fairbank spun off Capital One from the former Signet Banking Corp. in 1994 and it thrived for years as a monoline credit card company. Annual return on equity was always above 21 percent from 1996 to 2004.

The company was from its earliest days a technology-driven company. At a time when other credit card companies were offering everyone the same rate, Capital One tailored rates and products based on a consumer’s creditworthiness and other data.

Capital One did not make executives or board members available for an interview for this story.

The bank invented the 0 percent balance transfer, which it offered to good credit customers, says Thomas Brown, president and founder of New York-based Second Curve Capital. Brown invests in financial stocks and personally owns Capital One stock.

“In some 30 years I’ve been analyzing banking, it was one of the greatest innovations I’ve seen,” Brown says. “What Capital One is good at is recognizing a profit zone. A profit zone is a segment of the population that is profitable. Competition comes in and competes away the profit zone. They are early in exiting profit zones as they are shrinking and entering profit zones as they are growing.”

Why don’t other banks do the same thing?

Brown explains that banks do have access to loads of data about what is shrinking and growing on their balance sheets, but that doesn’t mean they act on it.

“Sometimes, the institutional imperative to grow overtakes the learning,” he says. “You have to have discipline to say: ‘I’m not going to grow in this.’ Wall Street loves growth.”

Wall Street was at the time funding Capital One’s operations, buying its loans and securitizing them. During the mid-2000s, Fairbank saw that he needed to diversify his funding base to include a more stable base of core deposits. Capital One bought New Orleans-based Hibernia Corp. in 2005 and North Fork Bancorp in Melville, New York, in 2006.

Brown thought at the time that those acquisitions were a bad idea. They weren’t. Considering what happened during the financial crisis, when funding dried up for many financial companies, it was a move that might have saved the bank, he says. There is perhaps not a banker on the planet with the foresight of Fairbank.

“If I had to own one company over the next decade, it would be Capital One,” Brown says.

Michael Kon, a senior analyst at Chicago-based research firm Morningstar Inc., said he was worried at first about Capital One’s latest acquisitions, its 2011 purchase of HSBC’s credit card portfolio, and of ING Direct, which was an online bank. Basically, the deposits of ING help fund the credit cards from HSBC. Kon worried Capital One would run into problems reconciling its different businesses, which run the gamut from online banking, to branch banking to credit cards.

He has since decided the bank is well capitalized, the credit cards are high yielding, and there is a large “margin of safety” in the acquisitions as a result.

The HSBC and ING deals didn’t steer Capital One off course; instead, they enhanced the course.

Fairbank is a “credit card guy but he’s also a visionary. His visions have proven to be right on the money so far. He navigated several crises and he always ended up on top,” Kon says.

David Darst, an analyst with New York-based investment bank Guggenheim Securities, says Capital One is well positioned for a future where banks will have to invest heavily in technology and know their customers well. The ING Direct purchase only helps that strategy.

“They don’t have a far-flung deposit network so they can focus more on technology and the user experience,” he says.

Banks don’t need to be the size of Capital One to successfully change their strategy.

Heartland Financial USA Inc., a Dubuque, Iowa-based institution with $4.6 billion in assets, kicked conventional wisdom aside and decided to expand into mortgage banking in 2010, just when everyone else was trying to get out of it. Heartland hired a mortgage executive named Jeff Walton, who brought with him a team of about 25 mortgage officers. The company has doubled its mortgage origination volume to about $1.6 billion annually.

The bank’s return on average equity was 17 percent as of the third quarter of last year, compared to just 2 percent in the year 2009, when it had to take a goodwill impairment charge of $12.7 million after real estate-related losses on its loans in Arizona and Montana. Heartland diversified its income such that non-interest income now makes up 42 percent of its revenue, with 43 percent of that mortgage-related. Mortgage gains-on-sales are $50 million annualized. The servicing portfolio is about $2 billion, up from $1.15 billion in 2009.

With it, the stock has followed suit, climbing more than 70 percent in the last 12 months to roughly $26 per share.

“We anticipated a margin squeeze in the future,” explains Lynn Fuller, Heartland’s chairman, president and CEO. “We always have been kind of contrarian. If everyone is getting back out, we get back in.”

He says the board and management talked about the new strategy for some time before coming to the conclusion that it was a good move. The board has a strategy session every year for one day, but it took much more research and several conversations at monthly board meetings before it approved the change. Risk management is much more of a focus than it was 10 years ago, and that was also part of the discussion, says Thomas Flynn, an independent director and vice chairman on the board of Heartland Financial.

“I had to develop a strong feeling that I understood the mortgage business,” he says. “That takes time.”

Seven of the mortgage offices are in cities with no bank branches nearby, so lone wolfs could be a problem were it not for the bank’s strong underwriting department and software systems designed to check and recheck everything.

Ramping up the mortgage department required going beyond what the small community bank could do in-house. Heartland purchased Commerce Velocity origination software, as well as hedging software for interest rate risk and software to service the loan portfolio and handle the mountains of paperwork required, says Heartland Chief Financial Officer John Schmidt.

Fuller recognizes that the mortgage refinancing boom won’t last forever, so the bank is developing relationships with real estate agents to improve mortgage purchase volume.

Heartland’s business model looks risky in other ways besides mortgage. The company has at least nine different state chartered banks and operations in 14 states, the results of acquisitions and a few de novos. The decentralized operating model, like the growth in the mortgage business, also has been a strategic decision, but it has been decades in the making. It has been mostly successful for Heartland. The company has consolidated back office functions for human resources, audit, information technology, credit and compliance, while allowing each bank to have its own management team, strategy and business plan. That reduces the costs of the community banks while allowing them freedom to serve their customers as they see best. It would sound like a formula for chaos, except there is an annual strategy session and bank presidents meet three to four times per year in roundtable strategic sessions in Dubuque, Schmidt says.

The management team has had many years to iron out the kinks in such a model since it has been purchasing banks for more than 20 years. The holding company, which was formed in 1981, has never had a loss and has paid dividends for 31 years, says Jeff Davis, a former stock analyst who followed the company and is now a managing director at Mercer Capital, a business valuation and financial advisory firm in Memphis, Tennessee.

The best acquirers use a “thoughtful process that looks over a number of years and none of these transformations have been predicated on hell bent growth,” he says. “That tends to get you in trouble.”

The banking company has maintained its overall asset quality and efficiency while adding new banks to the organization, two keys to successful acquisitions.

Heartland board member Flynn thinks consistency is part of the story behind Heartland’s success.

“We try to stay consistent with our underlying foundation about what we are trying to accomplish and that hasn’t changed in 10 years,” he says. “We know who we are.”

Of course, acquisitions and buying fee-based businesses are the sort of thing that make regulators nervous. Schmidt says the company’s regulators, which consist primarily of the Federal Reserve and the Federal Deposit Insurance Corp., have “taken a hard look” at its mortgage operations and business model and are comfortable with it.

Julie Stackhouse, senior vice president with the Federal Reserve Bank of St. Louis, says her offices look in particular at a material change in the income stream for a bank.

“Credit risk is still the dominant risk, but if there is a material change in income stream, we would want examiners to know how it occurred and what is being done to manage that risk,” she says.

She sees problems when new businesses or assets are acquired, but were not well analyzed for their potential risks. To appease regulatory concerns, boards should keep a record in board minutes showing members discussed the risk of any type of acquisition or expansion of a business line, she says.

For example, one particular area of concern is when a bank tries to work with a third party, such as a broker or marketing agent, to acquire a fee-income stream or assets such as auto loans.

“Sometimes we’ve seen transactions with third parties where there is a big increase in fee income in the short-term but if you look at the relationship long-term, it is not a good thing for the bank,” she says.

The new Consumer Financial Protection Bureau got started in 2011, and is only now beginning to hit banks and other financial institutions with enforcement actions and fines. It also takes complaints from consumers about any financial institution.

If a bank is buying a package of auto loans, or offering to service a debt-collection agencies’ portfolio of delinquent loans, for example, it needs to consider what reputational or compliance risks it might be taking on, Stackhouse says.

“We all know consumer law is the wild card in the year ahead,” Stackhouse says.

There is much uncertainty in the regulatory environment, but that is no excuse for boards not engaging in the strategic planning process, says Michelle Rae Gula, who specializes in strategic planning for community banks as president of m.rae associates in Walnutport, Pennsylvania.

In many cases, bank boards aren’t asking tough questions about strategy and the possibility of changing the business plan or acquiring other businesses, she says.

“You come to a wall with organic growth,” she says. “Right now, I just don’t think certain growth plans can be accomplished organically.”

She is encouraging banks she works with to look at their opportunities, and not to write off acquisitions as if it were a bad word. Another option is to change the customer demographic the bank is focusing on, but that is also a strategic change and needs to be evaluated carefully, she says.

“If you haven’t had a conversation about strategy, you need to do it,” she says. “Get back in the board room and don’t leave until you have an answer.”

Capital One, Bank of Hawaii and Heartland Financial were all banks that weren’t afraid to make drastic changes. But they did so in a way that was focused on the core of what they did best. They had the foresight to see changes in the marketplace and act on them. And their execution was flawless.

For Forehand, the question of what to do about strategy is pressing on all banks and thrifts. The status quo seems to be a losing proposition. “It would be lovely to have 5 percent loan growth but that’s just not happening,” he says. “You have to get better at what you do.”


Naomi Snyder


Editor-in-Chief Naomi Snyder is in charge of the editorial coverage at Bank Director. She oversees the magazine and the editorial team’s efforts on the Bank Director website, newsletter and special projects. She has more than two decades of experience in business journalism and spent 15 years as a newspaper reporter. She has a master’s degree in journalism from the University of Illinois and a bachelor’s degree from the University of Michigan.

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