De Novo Banking: Strategies for Growth and Expansion

Back in the wild and woolly 1990s, when consolidation of the U.S. banking industry resembled the Oklahoma land grab, the strategy du jour was to grow through acquisition-a phenomenon that created several large banking companies with extensive retail networks. These days banks are again expanding their franchises, but this time they’re using a very different strategy. The acquisition market is slower and hungry institutions are choosing to build their growth instead of buy it.

While such active players as Bank of America Corp., Washington Mutual, and Commerce Bancorp have announced that they will open a significant number of new branches over the next two and a half years, the trend is actually more prevalent among community banks. What all these banks recognize is an expansion strategy that actually may be less costly than acquisitions. “It’s a great tool to build market share and grow,” says Randy Dennis, president of DD&F Consulting Group in Little Rock, Arkansas.

However, it’s not necessarily a quick or easy strategy to execute. It takes time for new branches to become profitable, and they can be a big drain on the time and attention of senior management. Moreover, at least one leading consulting firm believes that, ultimately, a bank’s branches won’t perform any better than its existing ones, which suggests that if an organization’s retail banking skills are suspect, so-called de novo branching will only extend its mediocrity over a wider base. “The degree to which you’ve been successful in the rest of your company is a proxy for how successful you’re going to be with a de novo strategy,” says Paul Simoff, a principal at Toledo, Ohio-based Austin Associates.

There are a variety of reasons why branching has become more popular in recent years. Gordon Goetzmann, a managing vice president at New York-based First Manhattan Consulting Group, says that, as a group, the 30 largest banks in the country see the retail business as offering the best growth potential for this year and next. “All [their] other businesses are still in the doldrums and retail is in the limelight,” he says. Bruce Voelker, a partner at the New York-based Accenture, also points out that banks have gained a new appreciation for the importance of bank branches because consumers still want them. “The industry realizes that its customer base wants to have a multichannel environment in which to bank,” he says.

There may also be something of a sea change occurring in the industry, where a growing number of banks now view branching as a practical way to expand their retail presence. Many of the industry’s largest acquisitions in the late 1990s failed to perform as advertised, leaving the acquirers chastened and their investors burned. Building rather than buying growth does have its limitations: New branches can take several years to reach profitability, and a branching strategy probably isn’t practical for a bank that wants to double or triple its size in a relatively short period of time. But many acquisitions fail because the acquiring bank doesn’t achieve the desired synergies, or loses too many of the acquired bank’s customers. “In most cases, I’d say that building is cheaper than buying,” says Charles Miller, a managing director at Alex Sheshunoff & Co.

Much of the new branch momentum seems to be coming from community banks, according to First Manhattan’s analysis. Ironically, the 30 largest banks have closed twice as many branches as they have opened in recent years. By First Manhattan’s count, this group had approximately 34,000 branches across the United States in 1997 compared to 30,700 in 2002. Community banks, on the other hand, have grown their branches-from 39,900 in 1997 to 48,000 last year.

Why would the big banks be dumping so many branches? Goetzmann says these companies, many of which are the products of multiple mergers in the previous decade, felt pressure from Wall Street to cut costs by rationalizing their branch networks. Indeed, most in-market mergers are predicated on the expectation that the newly combined branch system, which has lots of overlapping offices, will be pruned. “Quite honestly, that’s what the Street was looking for,” he explains.

A de novo strategy needs to be conceived and executed carefully because developing profitable new branches is more difficult than it sounds. The method used by Young & Associates-a 25-year-old consulting firm in Kent, Ohio that started out performing de novo assignments for banks-provides one template approach to the branching decision.

The firm performs a comprehensive feasibility study, starting by developing a socioeconomic profile of the target market and looking at such characteristics as population growth, age distribution, income and housing trends, and the business environment. Each characteristic is important in determining whether the market will support one or more new branches, explains Martina Stofkova, an associate consultant at the firm. For example, markets with an older population tend to offer more deposits, while markets with younger people offer more lending opportunities. A growing housing market should be a good source of mortgage loans, while a strong base of small and mid-size businesses offers commercial loan potential. And a higher income level correlates with a higher propensity to use financial services.

“Typically, a successful branch would be in a larger market with an above-average population-per-branch ratio,” says Stofkova. “The market would have a larger deposit base and would be experiencing deposit growth. The larger the deposit base, the lower the risk [because] it is easier to generate a small market share in a bigger market than a large share in a small market.”

In analyzing a new market’s socioeconomic characteristics, it’s important to understand whether it has customers that are similar in nature to a bank’s existing service area-because if they’re different, the bank may have to refine its strategy. “Is there an affinity in the marketplace for your kind of company?” asks Simoff at Austin Associates. “Are there customers in that market who are similar to what you’ve been serving?”

It’s also important to look closely at the nature of the competition. Markets controlled by a large regional bank offer greater opportunities than those dominated by smaller community banks, which tend to be tougher opponents. “The community banks have been growing [deposits] at a higher rate than regional banks,” says Stofkova.

New branches, on average, take between three and four years to become profitable, which means that de novo branching will not give a quick boost to a bank’s profitability. Instead, it is a long-term growth strategy that may take several years to fully succeed. “It takes time to achieve profitability, and you need to keep that in mind,” says Voelker at Accenture. “This will take time and management attention.”

There can be a variety of reasons why a branching strategy fails to achieve its expected payoff, beginning with a failure to perform a thorough feasibility study. But a common mistake that many banks have made in the past is to overspend. Obviously, the higher its fixed costs, the longer it takes for a branch to become profitable. Stofkova advises her clients to spend modestly on their new branches and avoid the tendency to overstaff them. “As long as the branch projects the proper image for the bank, the smaller the expense the better,” she says.

Another frequent mistake is underestimating the importance of loan growth in the dynamic of branch profitability. Banks have a tendency to focus primarily on a market’s potential to provide core deposits-while missing the fact that loan growth can make or break a new branch. “A low loan-to-deposit ratio and loan-to-asset ratio means more funds are used for investments, generating lower yields than loans,” says Stofkova. “It’s not just deposits that drive [branch profitability],” agrees Dennis at DD&F Consulting. “I don’t know anyone who builds [branches] just for deposits.”

A third misstep that banks often make is to lose sight of profitability while pushing for growth, which can be a big problem in highly competitive markets where a new entrant is forced to underprice its deposit products in a bid to build market share. “Growth doesn’t necessarily contribute to profitability,” says Stofkova. To illustrate her point, she describes two theoretical branches, both with an annual profit of $200,000-but one with assets of $20 million and the other $40 million. Let’s also assume the banks need 10% equity capital to support their assets, which means $2 million and $4 million, respectively. Obviously, the smaller branch turns out to be much more profitable because it makes the same income on half the capital.

But the biggest reason why some branching strategies fail is that the banks aren’t strong enough retail organizations to begin with. Indeed, First Manhattan’s Goetzmann believes that the level of a bank’s retail skill is the single most important factor in determining the success of a branching strategy. “When you look at some of the better players, you can see that they’ve figured out what they want the bank to be to customers,” he says. “They’ve already figured out what their existing strengths are, and they just continue those with their de novo branches.”

The implicit message here is this: If your retail banking skills are lacking, fix those first before worrying about opening new branches.