Setting Priorities

Management of capital is the business of bank management, and maximizing the value of that capital, and shareholders’ equity, requires making long-term decisions and setting short-term priorities. Thus, having an understanding of the big picture is critical. The year 2007 has the clear potential of being a tipping point for many banks in terms of soundness, profitability, and growth.


Soundness, in terms of credit quality, is starting to be challenged by changing real estate valuesu00e2u20ac”both residential and commercial. Speculation has been fueled by low interest rates, rising valuations, and ready liquidity at both the high and low ends of the market. The most important factor has been the availability of low-cost financing. And as one banker observed, “the value of real estate is what you can borrow on it.”

Bankers across the country are starting to talk about a slowdown in real estate, largely due to properties staying on the market longer and asking prices that are being reducedu00e2u20ac”and then reduced further. On a regional basis, one of the most troubling developments is the difficulty many real estate owners and borrowers are having getting insurance in areas impacted by Hurricane Katrina, which is affecting rebuilding and valuations.

Yet the driving force behind lower real estate valuations is this: when the public perception regarding the future value of real estate changes from being extremely positive to flat, or worse, negative. At that point, valuations and liquidity drop. Low interest rates will only cushion the fall. The bottom line: Many bankers will be looking to become the first in their markets to become selective real estate lendersu00e2u20ac”not the last.


Profitability is being challenged by the flat yield curve. Even banks that were asset sensitive are sometimes finding funding costs catching up much faster than expected. And increasing noninterest income, especially in terms of overdraft fees, is getting more difficult.

The strategy of cutting expenses to increase profits works for the short term but only becomes meaningful long term when the bank is able to maintain low costs and good service quality. World Savings, built by Herb and Marion Sandler, is one of the classic American banking success stories. Driven by a unique combination of low costs, excellent service quality, and unparalleled discipline, the Sandlers set the standard for superb execution year after year. One of the most important factors behind their success is integrity of both personal and business values.

World Savings has an efficiency ratio that translates into net overhead expenses (overhead less fee income) of approximately 90 basis points on assets. The major implication of those 90 basis points is that the institution can pay money-market rates for funds and make excellent quality loans at competitive rates without sacrificing quality. In short, World Savings is a good example of a company that has been successful because it focuses on ethics, integrity, and building a real business that serves customers, employees, and shareholders over the long term.


In an ideal world, deposit and loan growth are perfectly matched in terms of amounts, cost, and duration. All deposits are stable, and all loans are good. (And, perhaps most important, all golf handicaps are low and going lower.)

However, the reality today is that profitable deposit growth is a real challenge. Price competition is increasing dramatically for deposits and loans, especially from the larger institutions that rely on price as their primary competitive weapon. And competitors are becoming much more effective in targeting profitable customers.

I have mentioned in previous issues the seven driving forces that represent a simple, straightforward approach for achieving high-performance capital management. These forces did not come down from a mountaintop carved on a stone tablet. They are simply a starting point. Each of these forces has its own set of priorities and may vary significantly based on the bank’s specific challenges and opportunities.

The following are some brief thoughts on priorities focusing on two of the seven forces: shareholder management and financial management.

Managing the bank and the shareholders

For the CEO, “management” often refers to both the bank and its shareholders. Obviously managing the bank in terms of soundness, profitability, and growth is the number-one priority. Managing the shareholders, however, is critically important to maximizing the value of the bank’s performance.

Long term, CEOs and boards desire shareholders who share their vision of the bank’s future profitability and growth. Building the right shareholder base takes time and discipline. One key to success is to, in effect, encourage some shareholders to sell their stock who don’t share the vision and discourage “incompatible investors” from ever becoming shareholders.

Today, there are more people studying more information with more money to invest than any time in history. Hundreds of sophisticated bank stock investors are taking advantage of the disparities between performance and valuation on both the long and short side of the market. The result is that performance tends to be recognized and valued more quickly than in the past.

Shareholders of banks that are able to consistently maintain a higher multiple on earning than a similarly performing bank often reap major rewards. First, the cost of raising capital is significantly less. Second, acquiring other banks can be accomplished with less dilution. Third, the higher the multiple, the greater the perception of success, which tends to feed on itself, especially in terms of attracting management talent as well as investors. The question is, which would you rather be: the bank that is always in analysts’ terms “fully priced relative to performance” or the one that is always “underpriced relative to performance?”

Sometimes the disparity in valuation is due simply to geographic location. Given exactly the same earnings and earnings-per-share growth rates, the growth potential of the bank’s market will drive valuation, e.g., Florida versus rural North Dakota (with apologies to my friends in North Dakota).

Yet, sometimes the reason for the higher P/E ratio is, in part, a direct reflection of the CEO. Bank CEOs across the country can readily identify those executives who always seem to get higher P/E multiples given similar performance. My own view is that maximizing shareholder value is a marathon, not a 100-yard dash, and that ultimately it comes down to 100% people. The CEO who builds long-term shareholder value attracts not only investors willing to pay a higher multiple, but the outstanding bank management talent that can provide the earnings performance.

Leadership in banking ultimately is a combination of having sound banking judgment and the ability to instill confidence in shareholders, employees, and customers. Long term, the foundation of instilling confidence is demonstrating sound banking judgment and making certain that everyone in the organization not only shares that underlying value, but believes in it.

Financial management

Financial management has the most immediate and predictable impact on increasing shareholder value of all the driving forces. This is especially true for shareholders who are committed to staying long term.

Banking, in my view, is one of the best long-term businesses in the country. No other business comes close in terms of being very manageable and providing a sustainable source of long-term shareholder returns, whether in the form of dividends, appreciation, or both.

Regarding regulation, a long-time Chicago banking friend, John Madden, says, “Too much regulation? If I can make 20% on my equity after taxes, I will put up with a lot of regulation.” Obviously, a lot of regulation is overkill, especially for the CEO who doesn’t have legions of people to deal with the issues. The bottom line from a valuation viewpoint is that strong regulation is one of the fundamental building blocks of investor confidence and, hence, confidence in bank earningsu00e2u20ac”all of which lead to higher valuations on those earnings.

Any list of priorities for financial management should include the following:

Raising capital-Current price/earnings multiples are high and investor interest in banks of a broad range in size is strong.

Acquiring or being acquired-If a sale is contemplated in the next two to three years, many bankers are seriously evaluating the opportunity to take advantage of the historically high acquisition prices being paid. These exceptionally high prices are primarily in high-growth markets located in Florida, Texas, and California.

Sales/leaseback of facilities-Virtually all the major banks have completed an extensive sale/leaseback of a significant portion of their facilities from main offices to branches. These sale/leasebacks generally increase earnings, capital, and enhance expansion flexibility. Today with interest rates relatively low, valuations high, and a number of major investors ready to be competitive in bidding for the bank’s facilities, many midsize banks are evaluating such opportunities. Furthermore, the bank is viewed as an exceptionally strong tenant, which translates into the investor being willing to accept a lower return, which benefits the bank.

The bottom line: All these issues must be top of mind for directors, as they make decisions that will allow the bank to stay sound, enhance profitability, and ensure successful growth. Because the dynamics of the banking business continually change, the board must have foresight and be armed with sound intelligence to make the best decisions for capital management and to promote shareholder value for the future.

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