De Novo? De No-no!

Retail banking’s newest craze is going to cost a lot of banks a lot of money.

Banks of all sizes are falling all over one another lately to get in on the Newest Big Thing in retail bankingu00e2u20ac”de novo expansion. Bank of America says it will add 600 branches to its 4,200-branch network over the next several years, for instance. AmSouth will open 30 branches in 30 months in Florida. Chase has recently indicated an interest in expanding its branch networks, as well.

All very ambitious, except for one thing: Most banks’ new de novo plans will fail miserablyu00e2u20ac”and will cost shareholders oodles of money. Yes, de novo expansion can be a fabulous way for a bank to grow, but it’s devilishly hard to do right. And most of the entrants in the de novo game don’t have the skills to make their plans work. Worst of all, the macro environment is about to become a lot more difficult.

One problem with these new schemes has to do with plain, old supply and demand. De novo expansion made all kinds of sense back in the 1990s, during the last big banking crazeu00e2u20ac”consolidation. Back then, banks were actually shutting “redundant” branches as they acquired one another. That left a competitive opening for focused, service-intensive retail operators such as TCF Financial of Wayzata, Minnesota and Commerce Bancorp of Cherry Hill, New Jersey. They moved in, grabbed share, and made a huge amount of money. The strategy worked: Since 1996, Commerce’s earnings have grown by 19% annually, on average, while its stock price has quadrupled. TCF’s stock more than doubled over the past two years, while its earnings have grown by 12% annually.

With the competitive field crowding, however, it’s going be a lot tougher for the newer players to attract deposits as fast as they expect. The TCFs and Commerces already know the drill, and aren’t likely to be affected. But banks with no particular de novo expertise will butt heads early and often, and run into very tough going.

What’s more, executing a de novo strategy involves a lot more than selecting a site and buying some brick and mortar. Employees have to be recruited and trained. The new locations have to be properly marketed. Often, retail product menus need to be radically revamped.

Most important, the service component has to be several levels above what the typical bank offers. The best retail players keep their branches open seven days a week, and until 8:00 p.m. during the week. Front-line employees are highly motivated and know their product sets cold. Free add-on products and services, from dog biscuits to coin-counting machines, are often standard.

None of this is cheap or easy to implement. Few large banks are positioned to carry it off it well.

Put all this together, and de novo-related red ink can get deep pretty fast, while the long-term payoff might be more uncertain than most banks realize.

Even in the current environment, where the soggy stock market has provided a tailwind to bank deposit inflows, the typical new branch doesn’t turn profitable until its third year of operation. So even in the best case, a bank carrying out a multiyear plan might face five years of losses before the new strategy makes a dime.

To see just how bad things can get, let’s run some hypothetical, best-case numbers. Suppose you’re a 350-branch bank that’s been bitten by the de novo bug, and you decide to open 75 new branches over five years. If everything goes really well, each new branch will lose $350,000 in its first year (that’s roughly TCF’s experience), with losses declining steadily from there, to a marginal, $10,000 loss in year three. You’ll open ten branches in year one, and 12 in year two, and so on, until you get to your five-year goal of 75.

Got all that? If everything goes according to plan, your scheme will lose your bank $3.5 million in year one, $6 million in year two, and $7.25 million in year three. Total expected losses will approach $30 million over the first five years.
Some growth initiative! And all that’s on the assumption everything goes rightu00e2u20ac”unfortunately, it almost certainly won’t. The stock market will eventually turn around, for one thing, so that deposit inflow tailwind will turn into a headwind. And with so many banks opening so many new branches, competition for new customers will become fierce.
The bottom line: Your new branches won’t likely turn profitable in three years; they may take four, five, or six years, instead. And if that happens, the losses will be many times higher than what you are budgeting for.

It’s the sort of thing that can get CEOs fired.

So if your bank is considering a de novo strategy, here’s my advice: Be afraid, be very afraid!