Fee Income: Carving Out A Strategy

With spread income waning, what bank wouldn`t like to ferret out a special niche that the competition has overlooked and generate fee income in the process? Here are the stories of four banks that have honed their strategies and are successfully cashing in on revenue opportunities. The message each of them leaves is clear: Creating the kind of culture that thrives on fees takes a lot of patience and hard work. But the result, they say, is worth it.Ah, the 1990s. What banker could forget them? Consolidation reigned supreme, making smaller institutions larger, turning big ones into giants, and eliminating entire classes of community banks that lacked either the gumption or earnings to compete. It was the decade of stock options, shareholder activism, and the Internet, which the pundits still promise will radically change the way the industry conducts its business. All the while, tough new competitors made inroads, intent on stealing away, if not the entire customer relationship, at least the most profitable pieces of it.Through it all, the industry came out of the `90s sporting record profitability. A look at the typical bank`s income statement shows the primary reason why. As pressures on banks` traditional spread-based businesses have grown, noninterest income has filled the gap, and then some. In 1989, spreads accounted for 83% of bank and thrift revenues, while noninterest income was responsible for just 17%, according to SNL Securities. By last year, fees generated a whopping 43% of industry revenuesu00e2u20ac”a 34% compounded growth rate. Spreads? Just 57% of revenues.Once a small line item on the typical bank`s income statement, the ascent of fees has been, in many regards, a matter of survival. Everywhere bankers look today, spreads are in peril. Securitization and other capital markets innovations have created opportunity for low-cost specialty lenders, pushing down the interest rates banks can charge for many loans. At the same time, mutual fund companies, online brokerages, and Internet-only banks have sapped away the deposit base that many banks have traditionally relied on for low-cost funding. According to the Federal Deposit Insurance Corp., banks` share of household wealth declined from 38% in 1990 to below 30% today.Investors with myriad places to put their money show little sympathy for such trends. So for many bank boards and managements, the message is clear: boost returns or die. And that`s where, for smart banks, at least, fees have emerged as a saving grace. While interest income is subject to a host of market forces, “You can make a good argument that any increase in fee income drops straight to the bottom line,” says Bill Cooper, chairman and CEO of Minneapolis-based TCF Financial Corp. He calls fees “maybe the most important part of our income picture today … and something that distinguishes us in the eyes of investors.” Indeed, shareholders and analysts alike have grown fond of the earnings diversity, growth potential, and market insulation that fees provide. “As investors, when we start worrying about threats to the spread business, we like to see a bank getting 55% of its revenue from noncredit sources,” explains Ben Crabtree, a banking analyst for George C. Baum & Co. in Minneapolis. Today, most financial institutions charge businesses for services, such as cash management, that once were used as carrots for the lending relationship. On the retail side, the shift has been more pronounced. Bounced-check charges and other account-related fees have never been higher, and customers, while outraged on one hand, are in fact, paying for convenience like never before, doling out money for using any of the estimated 150,000 ATM machines now in operation. Thus, the fee income future looks bright. Debit card use is exploding, providing merchant interchange fees to banks that facilitate them. The Internet, along with electronic bill payment and e-brokerage services, promises to add fuel to the fee fire. And increasingly, banks are seeking to leverage their brands and customer trust to push their ways into the fee-rich investment products and insurance games.Fees aren`t perfect, nor are they created equally. Investors are distinguishing between different types of fees, valuing those in arenas with considerable barriers to entry, like data- or card-processing operations, more highly than commodity-like account fees, such as check printing. Some fees, including insufficient funds charges, carry with them the very real risk of customer alienation. Others, such as loan origination and servicing charges, are themselves tied to credit cycles. Meanwhile, many of the businesses that look most attractive, such as back-office processing or even SBA lending, are either too pricey or too difficult for the average bank to enter. Still, says Jay Tejera, a banking analyst for Ragen McKenzie Inc. in Seattle, growing price competition will soon push lending margins to the point where everyone feels pain, making fee income all that more important. “In the end, the banks and thrifts that figure out how to morph their spread-based relationships into ones that provide more fee-based revenues will be the ones that survive,” he says. To get a better handle on what it takes to build and run a truly successful fee-based business, Bank Director talked with a handful of board-level executives about what their revenue-building strategies. Each of the following four banks is focused on a different fee niche, and each is at a slightly different stage in the evolution of that particular product or service. Regardless of the business, however, the same basic lessons are clear: Success in the fee world takes vision, planning, and execution. Generally speaking, the best fees are those that somehow set a company apart from its competitors and generate consistent revenue growth over time. More often than not, that means instilling a strong sales cultureu00e2u20ac”something many banks, run as they often are by former lenders, can find difficult to achieve. Above all, it takes patience. Creating the kind of culture that thrives on fees can take years, if not decades. Jack Tsui, chief operating officer and a director of BancWest Corp., speaks for the industry when describing his bank`s efforts: “We`ve worked very hard in the past few years to build our fee income, and we`ve made some good progress. But we`re nowhere near finished yet.”Ask Bill Cooper for his philosophy of fee income, and he spouts out a deceivingly simple-sounding formula that makes him, at first blush, sound like Einstein: “A little number times a big number,” he says, “equals a big number.”For years, Cooper, the chairman and CEO of TCF Financial Corp., has used this credo to produce some of the industry`s best account-related fee numbers. In the first quarter, the company garnered $56.3 millionu00e2u20ac”or 31% of total net revenuesu00e2u20ac”from fees for such basic account services as insufficient funds, Internet access, ATM and debit card-access, and check printing. Cooper has made a religion of wringing the most out of middle-income customersu00e2u20ac”he collectively dubs them “Joe Lunchbucket”u00e2u20ac”that many of his competitors don`t want. He scoffs at his rivals` complex database marketing initiatives, saying that segmenting customers in pursuit of sales is a waste of time. He also wonders aloud at his own luck and why a bank would shun any customer in the present dog-eat-dog environment.In contrast to some of those banks, $10.8 billion asset TCF courts and accepts all comers. It services 1.2 million checking accountsu00e2u20ac”75% of them in the “totally free checking” categoryu00e2u20ac”and boasts a 25% market share in the Twin Cities, along with a growing presence in fragmented Chicago.The average balance on those free checking accounts is a scant $500, hardly an attractive number in many bankers` eyes. Cooper, however, says that it`s impossible to predict how profitable a customer might be, or which ones might generate the most revenues, based on a balance snapshot. Better, he says, to compile a lot of customers and offer them a lot of products. “All that person has to do is make one changeu00e2u20ac”begin using one serviceu00e2u20ac”and they become very profitable,” Cooper explains. “With a large customer base, I have the opportunity to constantly invent new products or get those people to use existing products.” Customer attraction rooted in convenience is crucial to TCF`s fee strategy. The bank`s branches are open 12 hours a day, 363 days a year. It boasts 204 supermarket branchesu00e2u20ac”the fourth-largest number in the countryu00e2u20ac”and, with more than 1,400 ATMs, the sixth-largest offsite ATM network.It`s tough to argue with success. TCF`s average account generates more than $165 per year in fees, a figure Cooper expects to grow as he adds more products in the pipeline. The latest hot trend? Debit cards. Starting from scratch a couple of years ago, TCF is now the 13th-biggest debit card issuer in the country, with 968,000 cards outstanding at the close of the first quarter. Cooper promotes them heavily, offering free long-distance phone cards to users. Since the phone card promotion began six months ago, usage has risen by 50%u00e2u20ac”good news for TCF, which gets a 1.5% interchange fee from the merchant on whatever is purchased. In the first quarter, debit-card usage generated $6 million in fees. “The reason I have the opportunity to make that fee,” Cooper explains, “is because that customer is there in the first place.”This is not as easy as it might appear. TCF`s success has been built over 15 years, requiring a complex, sometimes painful, culture change. When Cooper arrived at the former thrift`s helm in 1985, it was flirting with insolvency even as its executives lived the high life. Eight executives took up the entire 25,000 square-foot top floor of the company`s headquarters tower, where the floors were marble and the bill for orchids alone ran $9,000 a month. “There were 15 ladies who just cleaned and watered the plants,” he recalls. Cooper`s firstu00e2u20ac”and easiestu00e2u20ac”task was to cut the fat. “We sat down with a pencil the first day and cut 400 people. We said, `The plant ladies are gone. [If] you want a plant, water it yourself.`” The executive offices were moved to the third floor, and 150 bookkeepers took over the top floor. More difficult and time consuming was the transformation of TCF`s culture into a fee-generating machine. In 1985, TCF had only 30,000 checking accounts, and sales of account-related products were virtually nonexistent. Cooper brought in loyal lieutenants from his days at Michigan National Corp. and created a sales-based organization from scratch. Branch managers` pay was tied to sales, and the company got aggressive about convenience, extending hours and opening hundreds of supermarket branches that cater to small clients with even smaller needs.Uncomfortable with the changes, many traditional branch managers quit and were replaced by members of the frontline sales force who were accustomed to working on commission. Today, Cooper says, a TCF branch manager is more likely to come from The Limited or The Gap than from another bank. “Our bankers need to be able to sell and manage, and they need to be comfortable having their performance measured objectively,” Cooper says. When asked how a bank should go about creating such a culture, Cooper says it`s all in the execution. “What we`ve done is easy to talk about, but extremely hard to do.” The folks at Synovus Financial Corp. like to say they were into e-commerce and outsourcing before eitherone was cool. The Columbus, Georgia-based banking company has a strong middle-market commercial lending business that stretches across four states. But what really makes its bottom line roar is its 81% ownership of Total Systems Services Inc., one of the nation`s leading processors of bankcard transactions. In the first quarter of 2000, data processing fees accounted for $134 million, or more than the $13 billion asset banking company`s net interest income. It is a business that most banks would love to have but, admittedly, find nearly impossible to duplicate. Indeed, James Yancey, Synovus` chief operating officer and a director, says that the emergence of Total Systems as the powerhouse it is today is the result of both foresight and a bit of luck. In 1974, a Florida bank that processed bankcard data using paper punchcards considered buying the technology to speed its own processing but instead opted to outsource the operations to Synovus, which had devised its own bankcard processing software years earlier. That set off a wave of business that continues today. As credit card usage began to boom nationally, other banks signed on. Nine years later, the bank spun off 19% of Total Systems, creating a stand-alone company that still garners much of the Synovus board`s attention. Today, Total Systems processes data on 181 million card accountsu00e2u20ac”performing an average of 380 transactions per secondu00e2u20ac”and boasts a client roster that includes Bank of America, Providian Financial Corp., and Sears. A new initiative, DotsConnect, promises to increase that figure by leveraging Total Systems` relationships and technology to become a global solutions provider on the Internet. “Back in 1966, we didn`t call it e-commerce. We just called it high-tech,” recalls Yancey, who has been with Synovus for more than 30 years. “And I don`t think we felt that we were on the front edge of an outsourcing revolution, either. But not long after that, banks began to realize that they didn`t have to do everything themselves, and we were perfectly positioned to capitalize on that.” Owning a controlling stake in a technology firm places Synovus in an enviable position. As Yancey notes, “If you take Total Systems` fee income out of our banking operations, we look pretty average.” But this strategy also has raised some sticky issues for Synovus`s board. Early on, some directors were incredulous at the notion that large banks in faraway places would want to use the technology of a small Georgia bank to manage vital operations. As it grew, the board wrestled with balancing the presence of a fast-growing nonbank entity under a bank umbrella. By necessity, Total Systems has its own cultureu00e2u20ac”with the hiring and pay practices of a high-flying tech firm. Directors have had to resist the temptation to manage it like a bank. Says Yancey: “The challenge is not to let our old banking ways interfere with the high-tech culture.” But the pluses far outweigh any negatives. Total Systems` impact on the bottom line has generated significant shareholder value, which means that Synovus`s lending officers can be more conservative and avoid taking undue risks in search of growth. “There`s no reason for us to lower our underwriting standards and take more risk in order to grow,” Yancey explains. Does the marriage make long-term sense? Although it hasn`t happened yet, a bank might balk at doing business with Total Systems because of its bank affiliation. Or Total Systems could have difficulty pursuing some types of acquisitions because of Synovus`s ownership stake. Indeed, some analysts and investors say that Synovus could be more valuable if it is split in two. Yancey acknowledges such concerns. “It`s a question that we put on the board`s table rather frequently. We`re not afraid to examine it,” he says. “So far, however, it`s been to our advantage to be together, rather than separate.” Several years ago, the board and management of First Hawaiian Bank looked at the income statementand decided that fees were nowhere near where they needed to be. “It was a glaring omission,” recalls Jack Tsui, the bank`s president and a director and COO of Honolulu-based BancWest Corp., the new holding company formed by its 1999 merger with Bank of the West. To fill the hole, the $17.5 billion company has focused much of its energy on leveraging its branch-based sales force to boost mutual funds, annuities, and other investment products sales. As other banks have learned, it`s not an easy nut to crack. Banks have strong brands and customer trust, which can be powerful. But they also may be perceived as too conservative for higher-risk investment activity, and are often not the first place clients think of when it comes time to choose an investment adviser. Figuring out how to capitalize on those strengths while minimizing the perceived weaknesses is crucial to success. BancWest appears well on its way to achieving that elusive goal. In 1999, the company generated $48.9 million in revenues from the sales of trust, mutual funds, and insurance products, an increase of 35% from 1998. Today, the company manages more than $3 billion in its own proprietary fundsu00e2u20ac”up 70% from 1996 levels. While much of that total is from pension funds and other institutional investors, retail sales are surging. In the first quarter of 2000, the company sold $149.5 million of retail investment products, 89% more than the same period in 1999. Income from those operations is about double year-earlier totals.BancWest is far from the top of the heap among banking institutions when it comes to the money-management business. Large institutions like State Street Corp., Northern Trust Corp., and Buck Consultants have long made managing the wealth of institutional and high-net worth individuals a top priority, and they garner hefty fees from such operations. But in recent years, a growing number of more traditional-looking banks, such as BancWest, have scrambled to get into the business, and with good reason. Analyst Tejera notes that by 2020, some $50 trillion in assets is expected to be inherited by younger generations. Most of that money won`t flow into deposit accounts. Already, mutual funds control about $5 trillion in assets, compared to about $2 trillion in bank deposits. Money management “is a business that banks really have to get right if they`re going to retain their customers and generate good fees over the long run,” Tejera says. “And it`s an elephant field; a place where banks can compete with products that appeal to their solidly middle-class customers.” For BancWest, which owns its own trust company, misfortune begat such an opportunity. About five years ago, the managers of First Hawaiian were caught trading in exotic derivatives. The bank`s board went public with the discovery immediately, terminating those managers and pledging to reimburse client losses. It was embarrassing, Tsui recalls, “but we never lost a client.” That solidified customer trustu00e2u20ac”and helped forge a new, more conservative investment philosophy. The momentum has been sustained by performance. One of the unwritten rules of fund management is that a ranking in the top quartile of funds gives a bank significant marketing clout. The BancWest-managed funds have done that and more, consistently outperforming the S&P 500 index. For the year-ended March 31, its proprietary Bishop Street Funds reported a gain of 23.3%, versus 17.9% for the S&P 500.”Years ago, we lost a lot of business to mutual funds and money managers because of customer perceptions. We`ve changed that by offering competitive results that are attracting people`s attention,” Tsui says. “All we want down the road is to be positioned as a superior money manager and get slightly more than our fair share of the business. I don`t think that`s asking too much.” As with most fee businesses, performance must be supplemented with a strong sales environment. BankWest provides incentives for investment product sales across the organization. Tellers and bankers get referral fees for customers steered to commission-based investment reps; branch managers and employees get bonuses for reaching certain volume goals. Several BancWest boards are involved as wellu00e2u20ac”the holding company and each of the two banks` boards regularly review the investment product offerings, and the company`s trust department has its own advisory committee. Perhaps most telling, the directors put their money where the company`s interests lie: Several have placed substantial sums of their own money in BancWest investment accounts. While BancWest still has a ways to go before its money management initiatives reap the kind of results for which Tsui is hoping, the company already is harvesting some intangible fruits from those labors. “We`re trying to make our relationships with customers stronger, and leverage the confidence they have in us,” he explains. “Every new offering we have solidifies that relationship and makes it more profitable.”Old Kent Financial Corp. does a lot of things right. But its board is especially proud of one streak in particular:The Grand Rapids, Michigan-based banking company has produced 41 consecutive years of earnings per share and dividend growth. “We believe it`s our most distinguishing characteristic, the thing investors think of when they think of Old Kent,” says Robert Warrington, the company`s vice chairman. As with most of the industry, fees have become an increasingly significant part of that earnings equation, accounting for 38% of 1999`s net revenues, from around 15% a decade earlier. “Realistically, banks have no control over spreads. Fee businesses give you control and help optimize your market valuation,” Warrington says. With such pronouncements about spreads, it might be surprising that Old Kent`s biggest fee generator is mortgage banking, an area that many banks have abandoned as being too vulnerable to market fluctuations. With a 147 origination offices in 32 states, the $19.6 billion company ranks among the nation`s top 20 mortgage originators and servicers. Last year, the business produced revenues of $188.3 million, or about 8% of total revenues, even as rising interest rates slowed originations. Warrington is the first to admit that fees generated from a cyclical business like mortgage lending are less attractive to investors than those garnered from “widget businesses,” like data processing, or even account services. Mortgage banking is a competitive, thin-margin business, subject to the peaks and valleys of interest rates and the economy. But a company has to run with what it does best, he quickly adds, and for Old Kent, that was mortgage lending. “For whatever reason, companies tend to develop core competencies and skill sets in certain areas. Some managers or business units turn out to be stronger than others, and you develop your business plans to play to those strengths,” explains Warrington, who came up through the mortgage banking ranks, and today is chairman of subsidiary Old Kent Mortgage Co. “It`s a fundamental principle: If you have good people in a particular segment, good things happen. In our case, we had a lot of very good mortgage bankers.”Building on that recognition, Old Kent`s board authorized the formation of a centralized mortgage subsidiary in 1993, and by 1996, the company had acquired four mortgage broker operations, giving it a national reach. The timing couldn`t have been better. Not only were the ensuing three years among the best in mortgage banking history, the blossoming of a secondary market for mortgage-backed securities made it much easier to crank up origination and servicing volumes without a lot of additional risk.Old Kent doesn`t keep mortgage loans on its balance sheet. Rather, it sells pools of the loans it originates to investors as securities. Because it doesn`t have to worry so much about the spreads, it can market more productsu00e2u20ac”boosting its volume-based origination and servicing revenues. “We`ll originate any mortgage that`s legal, so long as we can sell it to someone else at a profit,” Warrington states.Last year illustrates the point. Even with a rise in interest rates in the latter half of the year, the company originated $12.2 billion in mortgages, generating net revenues of $13.6 million. Gains from sales of securities backed by those loans raked in $162 million, while net servicing revenues hit $12.7 million. The company services roughly 150,000 accounts, with total outstandings of about $18 billion.It`s a business that`s more challenging than first meets the eye. The quality of the sales force, and its incentives, are crucial to driving originations, while servicing is a high-touch business. “We smother our customers with service and devote constant attention to operational detail,” Warrington says. Similarly, having the ability to balance production and servicing volumes is important to success. During the up cycle, Old Kent makes use of temporary workers, who can then be cut during volume slumps. This year is such a time. Originations for many mortgage lenders are off by 30% to 50%, and Old Kent has suffered, too. But not as much as you might expect. One of the vagaries of the mortgage business is that while higher interest rates hurt originations, they also reduce prepayments, increasing the value of the servicing portfolio. Warrington calls it a “macro hedge”: as interest rates change, a company with strong originations and servicing can rock back and forth between the two. “Production is more valuable than servicing, and we do better when we originate a lot of loans, so [today`s higher interest rates] hurt,” he explains. “But even in down times you can mitigate a lot of that hurt with a solid servicing portfolio.”