Where Will The Revenue Come From?

Like most banking companies, Umpqua Holdings Corp. in Portland, Oregon, lost money in 2009. It eked out a profit of $28 million the following year, and is on pace to hit $60 million in 2011?not quite the $84 million it earned in 2006-but things are clearly moving in the right direction.

As asset quality improves, the biggest looming challenge for Chairman and Chief Executive Officer Ray Davis and his board appears to be on the revenue front. Loan growth has slowed due to the sluggish economy, and while $11.5 billion-asset Umpqua’s margins have held up better than most, the hit from Washington’s crackdown on fees has been painful. Account service fees slid 11 percent in the second quarter from a year earlier, due mostly to Regulation E, which requires customers to opt-in to overdraft coverage on debit-card and ATM transactions. And Davis expects to lose another $4 million next year, thanks to the so-called Durbin amendment, which mandated limits on interchange fees.

In early 2010, Umpqua’s board and management began to see light at the end of the tunnel and started to get aggressive about what comes next. They bought three failed banks from the Federal Deposit Insurance Corp. (FDIC), stepped up investments in new retail outlets and hired away banking teams from weakened rivals.

“We needed to create some momentum for future growth,” Davis says. “We knew that if we wanted to grow the loan portfolio and revenues, we needed more scale than what we had.”

At the same time, Umpqua launched three new “revenue-generating divisions”-wealth management, international banking and capital markets-which research indicated show some promise. “We started these businesses because our markets needed the services, and also because with the new rules and regulations coming out of Congress, we needed to offset the revenue losses,” Davis says.

There are plenty of dividing lines in the banking industry today. Up to now, credit quality and capital levels have been the chief variables separating the haves from the have-nots. As those metrics stabilize, the next key point of differentiation will likely come in the ability to generate top-line revenue growth.

The industry’s second-quarter profit jumped 38 percent from a year earlier, to $28.8 billion, according to the FDIC. But the figures were driven mostly by releases of earlier loan-loss provisions and some cost cutting.

When it came to revenues, the news was bleak. Slack loan demand and margin pressures brought the industry’s total interest income in the first half of this year to $257.6 billion-down $100 billion, or 28 percent, from the first six months of 2007. Non-interest income declined $14 billion, or 11 percent, to $116.6 billion, over the same time.

Do the math-roughly $230 billion of annualized revenues evaporated over the past four years-and things don’t look poised to get better any time soon. “It’s kind of the perfect storm,” says Hank Israel, a partner with Novantas LLC, a New York consulting firm. “Every indicator is pointing to negative revenue growth for banks.”

No one is immune from the fallout. San Francisco-based Wells Fargo & Co., the industry’s long-time poster child for revenue growth, saw linked-quarter revenues decline in the first quarter, and then stay flat in the second.

A weak housing market-$1.2 trillion-asset Wells is the nation’s largest mortgage originator-played a big role in the slump, but pressure is being felt across the board. Officials project the company will lose another $250 million every quarter when Durbin takes effect in October.

“There are some revenue streams we have enjoyed in the past that will no longer be here in the same size or type going forward,” says John Stumpf, Wells Fargo’s chairman and CEO. “We’ll have to adjust to that. Some of it will be through increased costs to our customers, and some of it will be (absorbed) by us. We’re going to have to tighten our belts.”

To be sure, an economic recovery would help matters. The industry’s loan-to-deposit ratio presently stands just north of 72 percent, according to the FDIC. If it were to return to pre-crisis levels of more than 90 percent, a good dea of that lost revenue would return.

Even if the economy does come back strong, a combination of recent legislative and regulatory restrictions on bank fees promises to eat into the revenue side of the income statement. A provision of the Dodd-Frank Act, the Durbin Amendment, caps the interchange fee debit-card issuers with more than $10 billion in assets can charge merchants to around 24 cents per-transaction, plus a few cents more for fraud prevention.

That’s well below the 44 cents per-transaction banks have grown accustomed to collecting, and is expected to cost the industry up to $8 billion in revenues in its first year. Many observers expect Durbin’s lower fee structure to eventually migrate to credit card interchange charges, as well as banks below the $10 billion threshold.

While banks are still charging about the same price for overdraft fees as before the Fed’s opt-in requirements, the industry’s revenues dropped about $2 billion in 2010, compared to a year earlier, to $35.4 billion, due to lower customer adoption, according to Moebs Services, a Lake Bluff, Illinois, economic research firm.

Moebs projects that the industry’s overdraft revenues will rebound in 2011, to a record $38 billion. But the numbers would have been higher if not for the opt-in rules.

The expected revenue hit is big enough that Novantas calculates the industry would need to shutter as many as 50,000 branches to make up the difference on the cost side. Alternatively, account maintenance fees would have to increase by at least eightfold.

Neither of those is likely to happen, and even hinting at them risks alienating customers that have more alternatives today not only from the bank down the street, but also from online banks, Google, Apple and other nonbank competitors, and seem more willing than in the past to walk.

With compliance costs and capital requirements rising, something clearly has to give. If the industry is to survive with the same number of banks it has now, new sources of revenue will need to be found. If not, only those with the product scale, relationship skills and work ethic to grind out growth in an extremely competitive environment will survive.

In other words, the stage appears set for a competitive bloodbath, one where the ability to take a bigger slice of a smaller revenue pie or to conjure up some new revenues from someplace else will become the defining characteristic in the industry’s coming wave of consolidation.

“The revenue coming out of an individual customer’s wallet–from net interest margin, from fees-has been as high as it will get,” says Rusty Cloutier, chairman and CEO of $1 billion-asset MidSouth Bancorp in Lafayette, Louisiana. “Everyone is trying to figure out, what’s the best strategy to get more revenues in the future?”

After four years of fighting the good fight on credit quality, directors now must confront the bleak revenue forecast and all that comes with it. While some boards will inevitably choose to sell, most are stepping up-and doing so with purpose.

Anat Bird, president of SCB Forums Ltd, a Sacramento, California, firm that brings bank leaders together to share insights, says the boards she has contact with are thinking more strategically, prodding management to make up for anticipated revenue shortfalls with new products or business lines.

“They’re looking out three to five years, and focusing their efforts on two or three initiatives-building benchmarks and milestones to ensure progress is being made,” says Bird, a member of three bank boards, $15 billion-asset MidFirst Bank in Oklahoma City; Sterling Bancshares, a $5 billion-asset bank in Houston and $4 billion-asset WSFS Financial Corp. in Wilmington, Delaware.

Board members aren’t expected to plot the actual strategy, although in many cases their insights are helpful. Either way, they should be on top of the situation. What does this mean to the bank? How is it going to raise additional revenues?

When management comes up with its plan to grow revenues, the board should probe even deeper-and be prepared to share insights. Is the suggested strategy a good fit for the bank’s markets and expertise? Does the organization have the resources, infrastructure and personnel to execute it? What’s the time frame for execution? How will the board measure success?

Bird offers the example of a bank with a new small-business banking initiative. “Tell me what I should expect every quarter. Even if break-even is 18 months away, I want to see the progress in very short intervals, to ensure we’re on the right path.”

And of course, what’s the expected payoff? “You need a clear view of the expected bottom-line impact,” says Charles Wendel, president of Financial Institutions Consulting in New York. “It’s much easier to predict the costs of things than it is the revenue potential.”

This is uncharted territory, and there is no readily apparent “right” strategy for confronting the revenue crunch. “You really just need to look at your shortfall, and start chipping away at it,” Bird says.

For many banks, the first line of response has been cost cuts, although they’re swimming upstream. Spending on compliance, fraud mitigation and other back-office functions is on the rise, due to new regulations and new threats. Indeed, the industry’s non-interest expenses in the first half of 2011 jumped 6.6 percent from a year earlier, all but mandating some cuts.

Wells Fargo’s belt-tightening program, dubbed “Project Compass,” is expected to generate about $1.5 billion in quarterly savings. One goal is to become more nimble in dealings with customers. But it’s also a response to the revenue pressures.

The cuts will come from all parts of the company, with an emphasis on eliminating duplication and overlap. A serial acquirer, Wells has accumulated some 300 different management-training programs. “At this point in the business cycle, when revenues aren’t so strong, we really ought to simplify things and pick maybe 10,” explains Pat Callahan, the executive vice president in charge of Compass.

In an odd twist, the handful of healthy banks that find themselves just below the $10 billion-asset level at which Durbin officially applies are going so far as to forestall growth to preserve higher interchange fees. At $9.7 billion-asset Prosperity Bancshares in Houston, Chairman and CEO David Zalman says he’s turned down a couple of attractive smaller deals to keep from crossing the threshold.

“It will cost us $5 million a year if we go over the $10 billion-asset mark,” Zalman says. “I realize we can’t stay under $10 billion forever. But if I can save that money this year, it’s worth it.”

Such moves could no doubt help short-term earnings. When it comes to long-term viability, however, revenue growth reins supreme. Most industry observers argue that the successful banks of the future will be the ones that are able to steal customers from other lenders, and get more business from the ones they already have.

To do so, they must offer a value proposition–be it superior service, greater convenience, well-targeted product offerings-or something else that enables them to stand out from the crowd.

They’ll also need to improve their sales processes and perhaps invest in new technologies to better build and manage relationships and get more revenue from each customer. According to a recent survey by the Bank Administration Institute in Chicago, 80 percent of bankers cited inflexible information technology systems as the biggest impediment to building stronger relationships.

Scale will be more important, too, and the quickest way to get bigger is to expand, via acquisition or organically. Iberiabank Corp., an $11.5 billion-asset company in Lafayette, Louisiana, has acquired two healthy banks and five failed institutions since the beginning of 2008. It has moved into new markets, such as Birmingham, Alabama, and Houston, and hired away relationship managers individually and in bunches who have grown tired of working for banks that have been shaving client credit lines and services to manage their own problems.

“They’re not moving for money,” Chairman and CEO Daryl Byrd says of his new hires. “They want to work in an environment where they can serve their customers’ needs.”

None of this is new. Bankers have been talking about relationship-based selling for more than two decades-paying consultants, investing in customer-relationship management software and tweaking incentive plans-but have made only modest headway.

Wells Fargo, a cross-selling leader, averages about six products per-customer, employing preferential pricing such as 25 basis points off the rate of a home-equity loan, for instance, or the waiving of certain fees with a qualifying balance, to get more of a customer’s business. But it’s not as easy as it might sound, and must be led from the top.

Culturally, “ownership” of the relationship needs to be the institution’s, not the individual banker’s. Incentive plans and measurement must account for, say, the product manager in charge of home equity loans giving up some margin for the greater good.

Banks also need to overhaul their product lineups to reflect both new regulatory requirements and their expected impact on revenues. At $19 billion-asset TCF Financial Corp. in Wayzata, Minnesota, Chairman and CEO Bill Cooper has earned plaudits from Wall Street for the company’s ability to land customers with free checking products, and then wringing overdraft and debit-interchange fees from them.

Regulation E and Durbin cut into the core of that business model. TCF has already lost about $21.5 million per-quarter in account-related service fees, and Cooper expects to lose another $15 million per-quarter once the new interchange fees take hold. That’s roughly a 12 percent bite from the company’s total revenues in the second quarter of 2010.

There’s no good way for Cooper to spin it, but he’s trying. TCF is launching a new overdraft product, which charges per-day fees instead of per-item ones. The product was piloted in Michigan, and “customers really like it a lot,” he says. “It helps them avoid the train wreck of 10 separate (overdraft) charges in one day, and makes it easier for them to manage their lives.”

The new product won’t generate the same per-account revenues, but happier customers hopefully will mean that TCF also won’t have the same attrition rate, which Cooper is betting will up customer counts. “We’re looking over the edge of the earth, recognizing that the world is changing,” he says. “We have to adjust to that.”

To make up for the coming decline in interchange revenues, meanwhile, many banks are experimenting with new fees. In August, for instance, Wells Fargo joined New York-based JPMorgan Chase & Co., Suntrust Banks of Atlanta and Birmingham, Alabama-based Regions Financial Corp. with plans to test a monthly fee for debit-card users.

Whether or not such charges will stick remains to be seen. Customers have grown accustomed to not paying for their accounts, and could pick up and run. “The biggest mistake a bank could make is to try to price-up its existing checking and payments services,” says Novantas’s Israel.

Better, he says, to focus fee-generation initiatives on value-added services, such as purchase protection for card purchases or free credit reports. “If you try to rely on punitive or maintenance fees, you’re going to chase away customers.”

One example: Cloutier’s MidSouth Bancorp recently changed its “value checking” product to “premier,” which costs $8 per-month, but includes a rebate program for debit-card usage at select retailers. MidSouth also is launching a new identity-theft protection service that is more competitively priced than some of the standalone offerings in the market. “We think the way to increase revenues is to bring value back to the customers in the offerings we have,” he says.

It’s early in the game, and there is no widespread agreement on what model will work. Many are still plotting their fee-replacement strategies. In August, TCF cut its debit-card rewards program, saying it could no longer afford to hand out freebies due to Durbin’s fee restrictions. But Cooper says he’s not inclined to charge a fee for debit-card usage.

“Most banks are going to have a minimum (qualifying) balance of $1,500, and they’re going to charge you 20 cents every time you use your card, along with $3 a month,” he says. “We don’t want to discourage use of the card. There are better ways to recoup that lost money than with a straight-up card fee.”

Beyond fee hikes, many banks are looking for new products to give a charge to revenues. Simply competing on price for commodity lending products is likely not the best strategy. Better to target particular niches that are unique to an individual bank’s local markets.

This is a place where the board, through its contacts and expertise, can provide some valuable input. Tony Plath, a finance professor at the University of North Carolina at Charlotte, tells of one bank in a college market with several technology executives on its board that has found success leasing to high-tech startups. The directors “know the market and its players, and can help the bank select the right clients,” he says.

Another lender-this one in an upscale community outside of Charlotte-has found a good source of revenues in jumbo mortgage loans. “The board is well-connected to the local real estate market,” Plath explains, and is able to effectively vet buyers of multi-million-dollar homes. “It’s a pipeline to well-heeled borrowers who don’t mind borrowing money at 9 percent rates.”

A third bank, in a bedroom community about an hour outside of a major city, has created a promising business in, of all things, subprime auto finance. “They’re in a lower-middle-income town, and people need to have cars to get to their jobs in the city,” Plath explains.

“The point is, the bank of the future will need to be a savvy niche marketer. That’s not in most banks’ DNA. They’re used to providing commodity products and services, but that’s not going to fly any more,” Plath says.

Equally promising are efforts to expand into adjacent lines of business, which are capable of generating significant fees. Stumpf, for instance, says Wells is intent on growing its wealth-management business, as well as insurance and an investment banking unit it acquired in its blockbuster deal with Wachovia.

In some extreme cases, directors can play a direct role in new business launches. Iberiabank recently tapped Jefferson Parker, an eight-year director with a 30-year track record as an investment banker, to start a boutique capital-markets business targeting the energy sector. After Parker had a falling out with his partners at his old employer, Chairman and CEO Daryl Byrd asked if he wanted to build a business at Iberiabank.

Byrd expects the business to dovetail nicely with an existing oil-and-gas lending business. “For now, it’s an investment we have to make,” he explains, noting that the unit has yet to turn a profit. “But we expect it to be a very good fee-income producer.” The only downside, Byrd adds, is that Parker had to resign his board seat. “There should only be one insider on the board, and that’s me.”

Generally speaking, Anat Bird says it makes more sense to buy such non-bank operations than to build them from the ground-up. Even then, these are longer-term bets. It takes time to integrate such operations into the organization, and banks have historically found commissioned sales people to be a difficult fit for their straight-laced cultures.

That said, the potential for long-term revenue growth is real. BB&T Corp., a $159 billion-asset company in Winston-Salem, North Carolina, has acquired some 70 insurance brokerages over the past 15 years. It struggled mightily at first to get them in the fold culturally. The company’s patience is paying off now, however: BB&T captured $550 million in revenues from insurance sales in the first half of this year.

Down the road, new technologies-most notably mobile banking-could open the door to entire new sources of revenue. One closely watched effort is PNC Financial Services Group’s “virtual wallet” product, which enables customers to manage multiple accounts, pay bills, track spending, savings and more via their mobile devices.

Plath envisions a not-too-distant future where a smart phone not only serves as a payments device, but also hosts driver’s license and school information, medical records and other sensitive data. “Banks excel in data storage and retrieval, and there are billions of dollars in revenue to be had from that,” he says.

Revenues for the banking industry might never return to their pre-crisis levels, but that doesn’t mean individual banks can’t find success. In the end, the winners in the upcoming battle will be those with the capital strength, creativity and cultures required to find new sources of revenue and take business away from rivals. Let the battle begin. |BD|

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